The Weirdest Way to Sell Your Company (that almost nobody knows about)

Unless you’re living under a rock, you know the most common options for exiting your business:

1. Sell to / Merge with Strategic Acquirer
2. Sell to Financial Acquirer (Private Equity, for example)
3. IPO

Unfortunately...

Exiting your business can be a nightmare.

Not every business is going to have a long line of strategics waiting to pounce.

And those PE funds that seemed super-enthusiastic six months ago might be distracted when you’re ready to sell.

IPO? That’s whole different jungle.

But you might have other options.

One in particular: the ESOP.

Most people have no idea what an ESOP is, let alone how it works or why it can be unbelievably awesome.

So let’s hit it step by step:

What’s an ESOP, and how do you exit with one?

ESOP = Employee Stock Ownership Plan

ESOPs got their legal framework with ERISA in 1974, and are a structured, regulated entity outside your company that exists to buy out shareholders and spread ownership among employees.

Generally speaking, in an ESOP transaction the owners of the business sell up to 100% of their shares to the ESOP. The bank loans money to the ESOP so that it may pay for some or all of those shares being acquired from the owners. It allows employees to own part or all of the company they work for, the selling shareholder(s) receives cash & get a clean in-house exit with the potential for enormous tax advantages.

But before we get into that, first you need to know:

An ESOP isn’t a perfect fit for every business.

ESOPs do have a few requirements:

• Must be a C-Corp or S-Corp (or convert prior to transaction)
• Needs baseline profitability & financial stability. Starting point where it makes sense: ~$1M Adjusted EBITDA. This is a bank-financed transaction, after all. There will be a valuation, and it must be based in reality
• At least 10 employees, but 15+ is better

If it’s a fit, know this:

ESOPs are awesome.

When an ESOP makes sense, it REALLY makes sense:

• Employee Benefit Windfall on Retirement. An ESOP is like a 401k, but instead of investing in a basket of securities, employees get shares of the employer. But it requires no contributions by the employees - contributions are non-cash, tax-free or tax-deferred by the employer
• Customizable. More flexible than selling to a 3rd party buyer who might force low upfront cash, earnouts, lockups etc. One shareholder can exit, even if all others want to keep running the company. Totally flexible
• Get an Attractive Valuation for your Shares. ESOP valuation typically exceeds average PE valuation by 15-20%, and comes within 5-10% of your “best-case strategic buyer” valuation (if you could find one), but without the strings attached
• Control. You can still maintain control via synthetic equity, even if you sell 100% of your voting stock
• Deferred Capital Gains Taxes. Potential to permanently defer capital gains taxes (federal & state) through Section 1042 (kind of like a 1031 in real estate). In a nutshell, you can tie up 15-20% of the sale price in S&P500 securities, hold them until death, pass them to your heirs, and the step-up basis at death means you never pay the taxes
• Business Gets an IRS-Approved Tax Shield. Example: Entire purchase price is paid with pre-tax dollars (it’s a leveraged transaction). The company stays as an S-Corp (pass-through entity) owned by the ESOP (tax-exempt status). Any money that remains can be used for any corporate purpose, including paying your seller note, acquisitions, R&D, company growth… tax free.
• Management Permanently Incentivized. You can design a Non-Qualified Incentive Plan structure where you reward key employees with millions, with 0 tax impact. So valuable, that key management will never want to leave the company - and you can choose who to reward
• Cash at Closing. These days, banks will lend 2-2.5x TTM Adjusted Cash Flow. So if the business is doing $2M EBITDA → $4-$5M at closing, with the remainder a Seller note payable by company to the shareholders (you). Principal & interest is all non-taxable.
• 2nd Bite at the Apple. Basically, you can retain another 30-35% that you can sell to the ESOP later on - at the FUTURE business value after it has grown for years while NOT HAVING TO PAY TAXES. At Year 10, could be worth as much or more than Day 1 ESOP sale because not having to pay tax adds +40-45% to equity value of business every year.

Too good to be true?

If your response isn’t:

1. Sounds too good to be true
2. If this were legal, why aren’t more people doing this? or
3. This can’t be legal. I don’t believe you

….then I didn’t explain something well enough.

Basically, you get:

• A legal tax shield
• A way out, even if your acquirer prospects really suck
• Ongoing growth
• Great valuation on sale
• A transaction where you’re in control
• A way to incentivize key employees going forward

…and more.

While there are hurdles your business must get over in order to qualify for an ESOP transaction, I stand by my guns…

As far as exits go, it’s a pretty awesome option.

If you’re considering doing an ESOP and want the best in the business, reach out!

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