Creating Buyers: The ESOP as Exit Strategy

Interest in creating employee stock-ownership plans seems to be ticking up among business owners worried that capital-gains tax rates soon may rise. They may want to sell now while the rates stay at 15%.

These are tough times for selling a privately owned business. Valuations are low as the economy struggles to emerge from its recession, and even where buyers and sellers can agree on price, it can be difficult to secure bank financing to complete a deal. That’s pushing some business owners to create their own buyers — in the form of employee stock-ownership plans that also serve the purpose of providing employees with retirement benefits.

ESOPs are employee benefit plans subject to regulation under ERISA, the Employee Retirement Income Security Act of 1974. But they’re also an efficient exit strategy for owners of privately held companies, whose ranks are expected to swell now that Baby Boomers are beginning to retire. In a typical ESOP deal, the company creating the ESOP borrows the money to fund the transaction and then pays it back over time. It contributes shares to the ESOP trust annually and allocates them to employees, usually in proportion to their compensation but sometimes incorporating a years-of-service criteria, too.

Denver Wholesale Florist Co. in Denver, Colorado, which recently created an ESOP, is a prototypical example. The company began as a marketing organization for carnation growers in Colorado 100 years ago and at one point had about 100 shareholders. As carnation growing migrated to South America in the 1960s and 1970s, the company transformed itself into a flower wholesaler. It now has 15 locations across the country.

“We don’t have carnation growers in Colorado anymore, and by 2007 a lot of our owners were in their 70s and weren’t actively involved in the company anymore,” says David Lisowski, president of DWF. “At that point, a decision had to be made about how to provide [cash] for them.”

The company entertained the idea of selling to a third party or liquidating, but soon settled on a sale to the employees as the preferred option. Among other things, securing financing wasn’t a problem. Over its century of operation, the company had amassed plenty of real estate that was fully depreciated, and it was able to use that as collateral for a bank loan to finance the $8.5 million transaction. The deal closed in August 2008.

Because DWF was structured as a C corporation, the deal also included some tax incentives for the selling shareholders. Under federal tax law, owners of C corporations who sell to an ESOP can defer capital-gains taxes on their profits if they roll the proceeds into marketable securities within 12 months of the transaction, provided the ESOP acquires at least 30% of the company’s shares. “There is no tax liability until those replacement securities are sold,” observes James Daniel, an attorney with law firm Womble Carlyle Sandridge & Rice in Charlotte, North Carolina. Hold those securities until death, he adds, and they will then pass to the former owner’s heirs with a step up in basis, so that no tax is ever paid on the original capital gains.

Owners of companies that can’t get financing to buy out the entire company have other options for completing a deal. They can sell a minority stake, for example, with plans to sell more at a later date, or they can hold a note from the company for a portion of the sale price.

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