If you run a Material Handling business – or a related equipment leasing/dealership company – and have considered succession planning options, you may be left with a lot of questions. Most owners look at selling to their current management teams or selling to a competitor. Both approaches present significant challenges and most owners end up doing nothing.
Selling to a competitor sounds great in theory, but this approach most likely represents an asset sale, and accountants will tell you that you’ll face a large depreciation recapture expense and pay capital gains taxes on your proceeds of the sale – two large bills that will eat away at a significant amount of cash you would receive from the sale. In addition to the tax bill, there’s a good chance that your employees’ jobs could be consolidated with the competitor’s operations, risking the livelihood of your team. By the time all is said and done, most owners who take this approach walk away with a fraction of the sale price, and you can see why most people would just do nothing and
The other approach is to sell to your management team, which in some cases looks like a better option. The challenge here is that unless your management team has the cash to buy your stock from you, they’ll need to borrow it from a bank. The company will still make distributions to the shareholders and they’ll owe tax on their income, but they’ll have to repay that bank loan with their after-tax earnings, which is a drain on their personal finances and would also limit their ability to reinvest in the business and continue to grow it.
There are other options as well (like private equity buyers or a strategic third-party buyer) but those too include many of the same risks as above and also require a lengthy and uncertain process which involves sharing sensitive information about your business in a transaction with no certainty of closing.
A unique alternative is to sell the business to an Employee Stock Ownership Plan (“ESOP”). ESOPs are gaining popularity amongst owners of material handling businesses, but still many don’t understand how it works or why.
Selling to an ESOP is a tax-advantaged sale to a built-in buyer, an employee retirement trust. As opposed to other options, an ESOP sale is a stock sale rather than an asset sale, and along with that comes several notable tax benefits. At the personal level, depending on how the sale is structured, the selling owner can sell to an ESOP and exercise section 1042 of the tax code, allowing them to defer and potentially eliminate all capital gains taxes they would otherwise pay in exchange for meeting reinvestment requirements. Secondly, the owner in this case would not face a depreciation recapture expense, which can be significant for material handlers who have taken accelerated depreciation against the assets to limit their tax liability over the years.
The next big advantage benefits the corporation, which can continue to operate independently after the sale, except it can operate entirely free from federal and state taxes. In most cases, even when a company is operating tax-free, the selling owner can continue to enjoy upside in future business growth. ESOPs have very little impact on business operations, and in many cases owners maintain their leadership positions and continue to operate the company after the sale is done.
Employees also benefit substantially when an owner sells to an ESOP. Over time, as the ESOP repays the owner for the stock it purchased, stock gets allocated to employees within their individual ESOP accounts. Stock is allocated to each employee based on his/her percentage of overall company payroll, and like a 401k plan, the employees can “cash out” the shares that were allocated to them upon retirement, death, disability, or other qualifying life event.
ESOPs are typically designed as long-term benefit plans with vesting schedules, to incentivize employees to continue working and generating value for the company. Although, a key distinguishing feature is that unlike other retirement plans, employees never have to put their own money into an ESOP – the government views it much like a pension from the company, and the employees are taxed when they take the money out.
Another factor to consider when looking at selling your business is timing. The US has officially entered the longest running bull market in its history, valuations for companies are strong, and interest rates are still low by historical standards. If the market makes a correction or we enter a recession and the business goes down, your valuation will be lower and there is no telling how long it will take to regain the value you built over the good years. There is an argument for selling at the top of a market when things are still strong, but we also know that it’s impossible to time the sale of your business perfectly and there are numerous other factors including your age, your historical growth, and your growth projections.
Not everyone is suited for an ESOP, and ESOP sales have some downsides like any other approach. One hurdle for many owners is the complexity of an ESOP transaction – which is why it is important to hire advisors who understand ESOPs well to guide you through the process, analyze every scenario and answer every question. Another potential pitfall for owners is the fact that it typically takes around 3-5 years before they are fully paid out. Regardless whether the transaction was financed with bank debt or completely seller financed, the business still repays you with pre-tax dollars. Whereas, if you sold to someone else you would probably get all or most of your money up front, but it would likely come with earnout provisions or claw backs, etc and it would be taxed at capital gains, leaving you with substantially less sale proceeds.
The last consideration is the ongoing maintenance expenses related to an ESOP after the transaction is done. The company is obligated to pay for an annual valuation to determine the value of its stock every year, an institutional trustee will charge a trustee fee, and a third-party administrator will charge a nominal fee for your annual recordkeeping. While these all add up to somewhere between $30,000 and $50,000 per year, it is still an expense the company will need to account for going forward.
Who Should Consider an ESOP?
- Owners looking to sell all or part of their business in a tax-efficient manner
- Owners interested in keeping the business independent/not interested in selling to a competitor
- A business owner interested in easing out over time
- Profitable business with steady or flat growth
- Business paying substantial income taxes
- Interested in taking care of management team and employees
Common ESOP Benefits
- Selling owner can defer/eliminate capital gains taxes on proceeds from the sale
- Increase the company’s free cash flow by eliminating state and federal taxes
- Company remains independent after the sale
- Business owner continues to be involved in day-to-day operations
- Employees’ jobs remain secure and no risk of losing due to acquisition
- Employees gain a retirement benefit
- High likelihood of transaction closing and no need to share info with competitors
Who should not consider an ESOP?
- Companies that are growing but not yet profitable
- Business with fewer than 15 full-time W2 employees
- A business projecting a decline in performance
The first step for anyone interested in selling their business is to understand what your options are, and most people don’t even know that an ESOP is an option. If you are interested in understanding more about ESOPs and how they work for material handlers, learn more by joining our free webinar: www.MHWmag.com/ESOP
Nathan Perkins is a Managing Director with CSG Partners, the nation’s leading investment bank specializing in ESOP transactions. He advises business owners across the US on ESOPs and succession planning strategies. Email email@example.com or visit www.csgpartners.com to contact Nathan.