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Liquidity and succession using an ESOP

MHEDA company Alliance Material Handling Inc. (Jessup, MD) was formed by the merger of three partners in 2001. In 2004, Hobb Santel, Ted Wolff and Joe DeFrange were joined by a fourth shareholder: an ESOP trust created for the benefit of the company’s employees.

The trust was formed under an Employee Stock Ownership Plan, or ESOP. The ESOP purchased stock from the other three shareholders for fair value using borrowed money. Santel, Wolfe and DeFrange did not pay any immediate taxes on their sale of stock to the ESOP. Alliance Material Handling will fund the ESOP using tax-deductible dollars to repay the borrowed money, and Alliance employees will gain ownership free and clear under the ESOP as the loan is repaid.

Business owners, including MHEDA distributors like Alliance, Modern Group (Bristol, PA) and others, are increasingly turning to ESOPs as a corporate finance tool to provide for liquidity and succession. For the business owner, an ESOP is a way to create liquidity, preserve company independence, protect wealth, diversify assets, plan for an orderly and phased succession, and defer taxes. For employees, an ESOP is a company-funded retirement plan that offers an ownership stake in the company. For the company, an ESOP is a way to finance ownership transition in a tax-favored transaction. But what exactly is it?

What an ESOP Is
ESOPs are tax-qualified retirement plans created as part of the Employee Retirement Security Income Security Act (ERISA) in 1974. The ESOP concept dates back as early as the 1950s, when investment banker Louis Kelso first conceived that businesses nationwide would be stronger and more profitable if employees of a company were offered a stake in the company’s success. According to the nonprofit National Center for Employee Ownership (www.nceo.org), today there are more than 11,000 ESOP companies nationwide covering more than 8.5 million employees.

ESOPs are similar to other retirement plans, such as 401(k) and profit-sharing plans, but they have sev-eral distinguishing characteristics. Unlike other plans, which are required by law to diversify their assets, ESOPs are required to invest primarily in the stock of the employer company. Also, unlike other retirement plans that generally invest employer contributions when received, ESOPs can borrow money to fund the purchase of a block of employer stock and repay this debt with future contributions.

Therefore, ESOPs can be used by business owners to create an internal market to sell a block of company stock. The ESOP can purchase all or a portion of a company’s stock in one or more transactions, depending on the goals of the shareholders. For business owners who want liquidity and diversification in stages, an ESOP may be an ideal approach.

The government provides special tax incentives to spur creation of ESOPs. For example, companies can fund the purchase of stock from shareholders using tax-deductible dollars. Shareholders generally can defer capital gains taxes on the sale of shares to an ESOP if the ESOP owns more than 30 percent of outstanding company shares, the company is or becomes a “C” corporation, and the selling shareholder uses the proceeds of the transaction to purchase stocks or bonds of any domestic operating corporation.

If You Want Employees to Think and Act Like Owners, Make Them Owners.
For more information about Employee Stock Ownership Plans, check out these Web sites:

The ESOP Association www.esopassociation.org
The National Center for Employee Ownership www.nceo.org

More ESOP-related tips from MHEDA members Modern Group and Cisco-Eagle.

Unlike other “S” corporation shareholders, if an ESOP is a shareholder of a company that is or becomes an “S” corporation, the ESOP does not pay taxes on its share of the corporate income. A company such as Modern Group, which sponsors an ESOP that owns 100 percent of company stock, is effectively tax-free because, as an “S” corporation, the company pays no corporate income tax and the ESOP, as a tax-exempt shareholder, pays no individual income tax on the corporation’s income.

How an ESOP Works
The first step in establishing an ESOP is to analyze your company’s financial information, revisit your business plan, and determine what you want to accomplish with the ESOP. The goal of this feasibility analysis, accomplished with or without outside professional help, is an approximate valuation of the company and an ESOP transaction design that will meet your goals.

A typical leveraged ESOP transaction works like this:

  1. The company establishes an Employee Stock Ownership Trust.
  2. The Company borrows money from a bank, usually secured by a security interest in the company’s assets.
  3. The Trust borrows this money from the company, secured by a pledge of the stock that it purchases with the money.
  4. The Trust uses the borrowed money to purchase all or a portion of the company stock from the stockholder.
  5. The bank may require the shareholder to pledge some of the money it receives as security for the bank’s loan to the company.

ESOP transactions are not “name your own price.” An ESOP must have an independent appraiser determine the fair market value of the shares of company stock to be purchased by the ESOP and cannot pay more than fair value for the shares.

Structured properly, ESOPs provide business owners with both liquidity and succession at a controlled pace, while simultaneously creating an employee benefit based largely on the success of the business. ESOP companies generally outperform their non-ESOP counterparts, measured by productivity and profitability. Participation in an ESOP gives employees a “piece of the action.”

ESOPs can provide significant tax and organizational benefits for closely held companies. ESOPs work particularly well for established and profitable companies with good potential successor management. The key downsides of ESOPs are the need to borrow money for funding the transaction and the relative complexity of ESOP transactions. Be sure to consult with an experienced professional when contemplating an ESOP so you are aware of what will be involved with an initial transaction and beyond. There may also be ways to use an ESOP transaction to accomplish important company and shareholder goals that are not immediately obvious.

If you are looking for an exit strategy that offers fair value for your company ownership, doesn’t require an immediate sale to a third party, and rewards the people who have helped build your business, consider an ESOP. It may be the right “win-win” strategy for the company, the shareholders and the employees. Just ask the shareholders and employee-owners of Alliance!


Material Handling Equipment Distributors Association
Meet the Author
James G. Steiker is president of SES Advisors Inc., located in Philadelphia, Pennsylvania, and on the Web at www.sesadvisors.com.


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