Outsized Interest in ESOPs
It is common for business owners who are thinking about retiring or selling their businesses to consider establishing an ESOP. The allure of the tax savings that can result from a sale to an ESOP seems particularly strong to business owners who have owned their companies for a long time and are facing significant capital gains tax exposure. Add in the evidence that employee-owned companies perform better than their counterparts, and an ESOP becomes an intriguing option.
What’s the Catch?
There are reasons, however, why approximately 70 entrepreneurs and family business owners sell their companies outright for every single net new ESOP formation. Selling to an ESOP might actually cost more in professional services fees than an owner would incur in a simple sale, because the costs of both seller and buyer (the ESOP) are born by the company. And then there are the ongoing administrative costs for such things as the annual valuation and the ESOP trustee.
There are other costs, too, if the owners choose to implement an ESOP in what we believe is the “right” way. We have seen ESOPs that have worked unbelievably well and others that have failed miserably. While there are many factors that influence an ESOP’s effectiveness, one of the most powerful is the company’s culture and the relationship between the owners and the rank and file employees.
In the situations where the ESOP worked well, almost without exception, the owners showed a genuine sense of gratitude for the employees and believed that the ESOP was as much a way to reward them as it was to achieve liquidity.
Our observation is that, in these situations, the owners naturally take the time to educate the employees about the business and its basic financial results, as well as how their day-to-day efforts affect the company’s share price. Doing so can require a daunting investment of time and resources, but our opinion is that it is a crucial step in getting the employees to really act like owners and to to realize the associated jump in performance.
To the contrary, when the owners view the ESOP as something akin to a necessary evil that stands between them and their tax savings, things tend to break down. When the owners do not embrace open communication and instead limit themselves to the statutory minimum amount of disclosure, the employee-owners can actually become more suspicious of management than they otherwise would have been. And should the company hit a rough patch, particularly one that causes the annual valuation to decline, the employees’ willingness to go the extra mile might disappear just when the company needs it the most, triggering a damaging and self-perpetuating downward cycle.
In certain situations, we strongly believe that an ESOP is a logical and effective way for entrepreneurs and family business owners to monetize the value they have created. In other cases, due to a need for more immediate liquidity or a cultural mismatch, for instance, an outright sale usually makes the most sense. In these situations, please consider introducing your clients to Bootstrap Capital. We are seeking opportunities to provide liquidity to small business owners and to honor their legacies by investing in and growing the companies they have founded, nurtured and developed.