As a business owner, you have a variety of options to achieve your liquidity and ownership transition / business exit objectives, including an Initial Public Offering (IPO), a sale to a third party outside buyer, or a sale to a related party such as a family member or management.

An IPO, third party sale, management buyout, or a sale to a family member are all common options, but one that’s sometimes overlooked and misunderstood is the Employee Stock Ownership Plan (ESOP).

ESOPs can provide owners with the ability to attain liquidity and address transition objectives in a tax-advantaged manner. ESOPs generally provide flexibility and intangible benefits that are difficult or impossible to achieve with alternative exit strategies. Whether your goal is to diversify while staying actively involved in the business or to execute on a complete sale of the business, an ESOP can accomplish either, among other objectives.

What Is an ESOP?

In its simplest form, an ESOP is a qualified retirement plan. ESOPs differ from other qualified plans in two key ways: (1) they are permitted to borrow money; and (2) they are designed to invest primarily in the stock of the sponsor company. These features make it possible for ESOPs to acquire shares of stock from selling shareholders and facilitate the transfer of ownership to employees over time, providing liquidity to one side, and ownership to another. Beyond being a traditional retirement plan, ESOPs serve as a corporate finance vehicle that can provide liquidity to selling shareholders while transforming employees into owners.

How Does It Work?

In a traditionally leveraged ESOP, the company borrows money from lenders (which may be third party sources or selling shareholders themselves) and then loans the proceeds to the ESOP trust for the purpose of acquiring shares. The shares purchased by the ESOP are allocated to employee accounts over time as the ESOP repays its loan to the company. The end result is that employees gain ownership in the company.

Intangible Benefits to Owners

It is common for owners to articulate objectives that go beyond the price they hope to achieve from the sale of their business. They want to take care of their loyal customers, employees and vendors — and they want their mission and legacy to continue to thrive. In some cases, owners want to begin the transition process and obtain liquidity, and at the same time remain involved and possibly even retain operational control.

ESOPs facilitate a succession strategy that allows the owner to steadily transition from CEO to board member to full retirement as desired. Many owners value the opportunity to be a part of a successful handoff to the employees, setting the company and the employees on a course that is congruent with their goals for both parties.

Owners who place a high value on preserving their company's culture, maintaining its legacy, and sustaining its impact within the community are often strong candidates for an ESOP and should consider it as an ownership transition alternative.

Structural Benefits for Company and selling shareholder

ESOPs are uniquely positioned to address many of the key considerations surrounding an ownership transition, providing shareholders with liquidity and succession solutions while preserving culture, maintaining business continuity, and rewarding employees through an additional retirement benefit that allows them to participate in the value they help create.

  • Flexibility: The terms of the transfer of ESOP shares can be very flexible. An owner may sell the entire stake in the business, sell a minority stake as a way to diversify assets, or set in motion a plan to gradually sell shares to the ESOP over time.
  • Reduced execution risk: You may hear that ESOPs are a “friendly buyer.” ESOPs can allow for transition of ownership with little disruption to the business. Compared to a third-party sale, there is generally a higher certainty of closing once the decision is made to consummate a sale to an ESOP.
  • Ability to maintain legacy and reward employees: Owners often care deeply about the culture of their company and believe that the employees and the culture are key elements of the company’s past and continued success.
  • ESOPs have a positive impact on employees: Employee-owned companies exhibit high job satisfaction, organizational commitment, motivation and workplace participation, resulting in higher retention and typically outperforming their peers. According to a recent study conducted by the National Center of Employee Ownership (NCEO)[1], “S corporation ESOP leaders report quit rates at roughly one-third of the national average.” Additionally, 50% of respondents rated ESOP ownership culture as “good,” with 38% saying it is “excellent.”
  • Retention: According to the NCEO survey, 51% of responding companies said they retain employees “better than most” of their competitors.
  • Additional retirement benefits: ESOP employees tend to retire with substantially higher retirement assets, with median ESOP retirement account balance sitting at $80,500, more than twice the amount in the median national 401(k) as of 2023. This is largely driven by increased contribution levels, higher rates of return, and lower volatility than traditional 401(k) plans.[2]

“One of the greatest strengths of an ESOP is its flexibility. ESOP transactions can be customized to align with the specific goals of each shareholder or shareholder group, whether those objectives are shared or distinct. At the same time, an ESOP can be designed to advance the company's strategic priorities while keeping employee ownership and long-term employee benefit at the forefront of the transaction.” says Amy Schuster, Head of ESOP Advisory at PNC.

Tax Benefits

The tax advantages associated with ESOPs can be significant for companies that sponsor ESOPs as well as for the selling shareholders who opt to transact with them. To encourage the application of ESOPs, Congress enacted certain tax incentives under the premise that employee ownership enhances company productivity, marketplace competitiveness and employee job security, satisfaction and motivation.

When the intangible benefits of employee ownership combine with meaningful cash flow enhancements from tax savings, the impact on companies can be tremendous.

  • Seller tax benefits: Under certain circumstances, sellers can defer or potentially eliminate capital gains tax on the sale of stock to an ESOP (utilizing Section 1042 of the Internal Revenue Code [“IRC Section 1042”]) and therefore may achieve higher after-tax proceeds compared to a sale to a third party.
  • Company tax benefits: There are several avenues through which a company can realize tax benefits associated with ESOP ownership. Most significant is the case where the ESOP owns 100% of the company’s stock and the company is an S Corporation.

The ESOP trust is a tax-exempt entity; once the trust owns 100% of the company’s outstanding equity, the company is no longer required to make tax distributions on earnings attributable to ESOP shares.

Effectively, the 100% S Corporation ESOP-owned company no longer pays federal income tax and, in most cases, no longer pays state and local income tax.

This meaningful cash savings is retained in the company and can be used to repay transaction debt and to reinvest in the business.

In the case where the ESOP owns less than 100% of the stock, the company will still benefit meaningfully by having the ability to deduct the full transaction price over time.

Competitive and Stability Advantages

  • Improved competitiveness: Research overwhelmingly shows that companies providing broad-based ownership coupled with a culture that fosters high employee involvement in work-level decisions outperform other companies (based on relative stock price performance versus the S&P 500).[3]
  • Stability and resilience: ESOPs have been known to perform better through difficult business, economic and industry cycles. Studies have shown that ESOP-owned companies are half as likely to close or go bankrupt, and three-fifths less likely to disappear at all.[4]
  • Strong contributors to the economy: ESOPs are proven job-creators, with 270 ESOPs created yearly, on average.[5] Although manufacturing, construction, and professional services represent some of the largest ESOP sectors, ESOPs are not limited to any particular industry. Their flexibility allows them to be successfully implemented across diverse businesses and markets.

Additional Considerations

ESOPs are generally a powerful tool for addressing myriad possibilities. It is a widely held view of many ESOP companies that the benefits of employee ownership are worth overcoming the inherent complexities of selling to and operating with an ESOP.

However, it is important to note that ESOPs are not appropriate or attractive for every situation. There are additional considerations that should be weighed, including but not limited to:

  • Inconsistent earnings (cyclicality): ESOPs tend to be best suited for businesses with consistent and predictable earnings so that they are well-positioned to service the transaction debt and future repurchase obligation requirements.
  • Compelling strategic offers: ESOPs can pay no more than fair market value for the stock. Fair market value is defined as the price negotiated between a hypothetical willing buyer and willing seller. If the selling shareholder is seeking to maximize his or her sale price, then an ESOP may not be the best means to achieve this goal — particularly if there is a buyer that would be willing to pay a premium for the business (a price greater than fair market value) for strategic reasons.
  • Upfront liquidity: When selling to an ESOP, the cash proceeds available to the selling shareholder at closing will be limited by the company’s debt capacity. This means that a meaningful portion of the total sale proceeds may be deferred and paid to the seller over a period of time. If a seller desires to maximize cash proceeds at closing, an ESOP may be less attractive versus alternative sale options. Further, if the company’s operations require significant growth capital or have other demands on capital, a leveraging event for an ESOP may not be in the best interest of the company.

Still, it is a worthwhile exercise to understand whether an ESOP could be used as a tool to realize the financial, tax, organizational, personal and legacy benefits of ESOPs.

"When structured appropriately, an ESOP allows owners to achieve liquidity and succession objectives while preserving what matters most, the company's culture, legacy, and future. It gives owners confidence that they have taken care of both the value they created and what comes next for the business," says Schuster.

For More Information

PNC's ESOP Solutions group provides independent, transparent, and thoughtful guidance on ownership transitions and liquidity needs for business owners considering an ESOP and ESOP advisory capabilities for ESOP-owned companies. To find out more about how the group helps companies address shareholder ownership transitions and liquidity needs, while building a lasting legacy through employee ownership, visit PNC Advisory Services.