Why you might want to sell out — to your employees

More than half of our country’s small businesses are owned by people over 55. Many are thinking of succession planning. If you’re in that group, you may have a built-in buyer: your employees. If so, your enterprise may be a good fit for an employee stock ownership plan.

These are more common than you may realize. According to the latest figures from the National Center for Employee Ownership, such plans, known as ESOPs, were at more than 6,300 companies in the United States, holding total assets of more than $1.4 trillion and covering 14 million employee-owners.

One is New Age Industries, a manufacturer of plastic and rubber tubing in Southampton, Bucks County. The company began setting up its ESOP plan back in 2006, with subsequent contributions of stock made over the next few years.

By 2019, Ken Baker, the company’s CEO, had decided to sell the entire firm to his workers.

“I asked myself if I should sell it to private equity, to my competitor, or to a multinational,” Baker said. “And after all of that consideration, I knew that I should stay with the ESOP model.” So he did, selling the remainder of his shares to his approximately 265 employees. Baker’s employees now own 100% of the company.

“ESOPs have become a terrific option for selling a business,” said Mario O. Vicari, a director at accounting firm Kreischer Miller, where he specializes in family businesses. “They don’t fit into every circumstance, but they can be a really great transfer vehicle for a private owner.” Vicari said he has seen a significant increase in clients’ interest in ESOP plans over the last few years.

So how does it all work?

First, you would need a few financial professionals, like Vicari, to help set up a separate tax-exempt entity outside your business (usually a trust) representing the ESOP. Your employees each own a share of this entity. You, the owner, sell your shares to the entity. Once this is done, the entity owns the shares of your company and you walk away with the cash. However, your employees don’t pay you for your shares. So, where is the money found? The entity usually gets its money through a bank loan based on a valuation of your business. Your business pays off the loan over time. This way, your employees become owners of the company at no cost to them.

There are many rules and methods to do this. For example, you can contribute shares over time. If you have partners, they can choose whether or not to sell their shares. The shares in the trust are allocated to employees based on a formula you determine (seniority, job title, etc.).

But once the ESOP is up and running, everyone gets big benefits. Each time you elect to give company shares to the separate, tax-exempt entity, the firm gets a tax deduction for the value of those shares. Whatever income your company makes is non-taxable for the portion of your company owned by the entity, so if the entity ultimately owns 100% of your company’s shares, your company pays no federal income tax. Yes, you read right: no federal income tax.

“It’s the best business model out there,” Baker says.

That’s an amazing benefit for the owner. But the biggest benefit is for workers. Employee stock ownership plans are just like any other benefit plan for your company — a form of compensation that will attract and keep employees.

“Our ESOP plan has significantly helped with turnover, commitment, and how long people stay with the company,” Baker said. “My productivity numbers are just off the charts.” Baker also thinks that having an ESOP plan, because it’s a form of ownership, helps him land new employees, particularly when workers are in such short supply.

ESOPs do have their drawbacks.

For starters, setting up a plan is expensive. Lawyers and tax and investments experts will be needed. The plans require annual valuations and tax filings. They can face restrictive regulations based on a company’s size. They need administration for when employees leave or join the plan. The plan must be open to all employees and employees must fully vest in the shares within six years. When employees leave, the company is required to buy back their shares, which requires capital. Workers may vote on major issues, but most of the voting control can remain with the company’s board.

“You really need to have about 20 employees, and you have to have a minimum level of annual revenues” — anywhere between $500,000 and $1,000,000, said Kevin McPhillips, executive director of Pennsylvania Center for Employee Ownership, a nonprofit that help businesses understand the ESOP process. Baker is on the board of this organization.

McPhillips warns of the ongoing costs, the need to have a trustee, and the requirement to get your business valued annually so that employees know the value of their shares. He said that if very small businesses aren’t a good fit for an ESOP, his organization can suggest other transfer-of-ownership options.

One other drawback of an ESOP is that an independent valuation sets the purchase price — after all, there is no other way to know what the asset is worth, especially if the firm is privately held. Moreover, such valuation may not place a price tag on certain “strategic” intangibles, such as customer lists and locations. Regardless, advocates believe the positives trump the negatives.

“We have had great success in expanding employee ownership in Pennsylvania,” said McPhillips. “It’s because employee ownership genuinely changes lives for the better.”

Gene Marks is a certified public accountant and the owner of the Marks Group, a technology and financial management consulting firm in Bala Cynwyd.