Business is Personal (Finance)

As a small company with continual day-to-day involvement from the founders, exit strategies are hard to come by. Finding a buyer willing to pay a large amount of money upfront for an operation that might stop being profitable after management change is a major barrier to overcome. For a company that is profitable, one possibility is to incrementally sell shares to employees under a Employee Stock Ownership Plan (ESOP).

There are many types of stock incentive plans -- for example, stock options and stock purchase plans. However, the acronym ESOP refers to a very specific type of plan. It is an ERISA-qualified plan (ie, retirement plan) where the employer contributes either stock or cash to the accounts of all eligible employees using a "fair" formula (percentage of salary is most commonly used). Stock to be contributed can be purchased from existing shareholders or created from new shares. In return, the employer can then take a deduction equal to the value of the contributed shares. In effect, the IRS buys the shares (via tax deductions) and gives those shares to the employees.

Let's go through some simple examples to understand how this might work:

Option 1: Distribute profits as salary

• 100K in taxable profits (C Corporation)
• 100K in debt at 10% interest (personally guaranteed)
• 40% personal income fed+state tax rate
• 10K interest, ending balance 110K
  
• 60K after-tax profits
• Net Balance Sheet: 60K - 110K = -50K

Option 2: Repay debt using profits

• 100K in taxable profits (C Corporation)
• 100K in debt at 10% interest (personally guaranteed)
• 40% corporation income fed+state tax rate
• 40K taxes, 60K after-tax corporate profits
• 60K debt paid, 4K interest on 40K remainder, ending balance 44K
• Net Balance Sheet: 0 - 44K = -44K
  

Option 3: ESOP share purchase

• 100K in taxable profits (C Corporation)
• 100K in debt at 10% interest (personally guaranteed)
• 10% owners percentage of payroll
• 40% personal income fed+state tax rate
  
• 25% personal capital gains fed+state tax rate
• 10K interest, ending balance 110K
• 75K after-tax capital gains
• 10K ESOP contribution / 6K after income tax
• Net Balance Sheet: 81K - 110K = -29K
  

Option 4: Repay debts using ESOP share creation

• 100K in taxable profits (C Corporation)
• 100K in debt at 10% interest (personally guaranteed)
• 10% owners percentage of payroll
• 40% personal income fed+state tax rate
  
• 100K debt paid off, ending balance 0K
  
• 10K ESOP contribution / 6K after income tax
• Net Balance Sheet: 6K - 0K = 6K

So we see in this scenario where a corporation is carrying debt, using an ESOP as the vehicle to distribute profits makes a big difference. Now the possibilities can get far more complex. For example:

• 100% ESOP-owned S-Corporations pay no taxes
• Dividends paid to ESOPs are not taxed
  
• ESOPs can borrow money to do a leveraged buyout of original share holders
• If an ESOP owns at least 30% of a company, capital gains on shares purchased can be deferred if the money is used to purchase other equities
• Cash can be contributed and invested in traditional investments to fund future ESOP share redemptions
  

The tax numbers sound really nice but there are complications:

• ESOPs are complex beasts and are expensive. There is nothing like Employee Fiduciary for ESOPs. Set-up costs might be $25K+ with annual fees starting at $7K+.
• All transactions require official share price valuation by a 3rd party. This is an expensive endeavor and hence usually limits any transactions to once a year.
• A lot of effort is needed on the part of management to produce the data and projections needed for valuations.
• The culture of the company might be changed where too many Indians think they are Chiefs because they own 0.1% of the company via their ESOP account.

At this point, my company is exploring the ESOP possibility. We're in the process of a preliminary valuation of our company as a first step but whether we go this route in the end, I do not know yet. For more reading, National Center for Employee Ownership's website has a wealth of information.

(Filed in exit strategies, retirement plans, taxes)