The Benefits of an ESOP in a Family Business Transfer: Succession When There's No Clear Heir
For many family business owners, succession is more complicated than it looks. One child works in the business and another doesn't. The heir who wants to run the company can't afford to buy it. Or there's simply no family member willing or able to take the reins. Selling to an outside buyer may solve the money question but change the company's culture and identity forever.
That's an ExitReadiness® issue. An Employee Stock Ownership Plan, or ESOP, is a qualified retirement plan that lets employees gradually become indirect owners of the business they help build. For the right company, it can give the owner liquidity, reward and retain employees, offer significant tax advantages, and keep the company independent. In a family business, it can also help an owner treat children fairly while keeping the business in capable hands.
In this episode, Pat Ennis and Walter Deyhle, joined by Corby Megorden, talk with Kelly O. Finnell, J.D., CLU, AIF®, President of EFS ESOP Consultants and author of The ESOP Coach: Using ESOPs in Ownership Succession Planning. Drawing on more than 40 years of helping owners design and execute ESOPs, Kelly explains when an ESOP makes sense, how it works in family situations, the tax benefits, what it costs, and how governance changes after the transaction.
Key Takeaways
Know the financial thresholds. Kelly looks for at least $2 million in adjusted EBITDA and at least 35 employees. Below that, the fees can outweigh the benefits.
A strong successor management team is essential. An ESOP is an internal transition. The best candidate, Kelly says, is a company where the owner already comes in late, leaves early, and takes a long lunch.
Culture and legacy point toward an ESOP. If an owner believes the company's success rests on its culture, or wants its name and identity to survive, an ESOP can preserve what a third-party sale would change.
It can balance active and inactive heirs. An owner might sell 49% to an ESOP and use the proceeds as the inactive child's inheritance, while the active child inherits the remaining 51% and runs the business.
It can fund a full exit while a child leads. If the owner needs 100% liquidity and the active child can't finance a buyout, the owner can sell all the stock to the ESOP and name the child CEO.
The tax benefits are significant. Under Section 1042, an owner selling C corporation stock to an ESOP can defer capital gains by reinvesting in qualified replacement property, potentially eliminating the gain through a step-up in basis at death. A 100% ESOP-owned S corporation pays no federal income tax at either the company or shareholder level. Confirm the details with your tax advisors.
Budget for the cost. Kelly estimates all-in implementation costs of roughly $500,000 to $750,000, with ongoing costs around $75,000 a year for the trustee, annual valuation, and a specialized administrator.
Plan for governance and communication. After the sale, the ESOP trustee is the shareholder, typically adding independent directors to the board. Employees won't appreciate the ESOP until they understand it, which can take three to five years of consistent communication.
Where to Start: Kelly's Next Steps
Educate yourself. Many owners don't know an ESOP is an option. Start with Kelly's three-page strategy guide on his website, then read The ESOP Coach, which includes real case studies of family companies.
Have an exploratory conversation. With your exit planner or other advisor, meet with an ESOP consultant to see whether you might be a good candidate.
Commission a feasibility study. If it looks promising, a feasibility study provides the financial modeling, a fee estimate, and a cost-benefit analysis comparing fees to the value of the tax benefits.
About Kelly O. Finnell
Kelly O. Finnell, J.D., CLU, AIF®, is President of EFS ESOP Consultants and one of the nation's foremost ESOP authorities, with more than 40 years of experience helping business owners design and execute ESOPs. He is the author of The ESOP Coach: Using ESOPs in Ownership Succession Planning and has published dozens of articles on ESOPs. He is active in the National Center for Employee Ownership (NCEO) and The ESOP Association, holds a law degree from the University of Memphis, and is an Accredited Investment Fiduciary®.
Connect with Kelly: execfin.com
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Disclaimer: The information presented in this podcast is provided for educational purposes only. Neither the presenters nor ENNIS Legacy Partners are engaged to render legal, accounting, tax, or other professional services. Consult a qualified professional regarding your specific circumstances. ENNIS Legacy Partners assumes no legal liability for any loss related to information contained in this presentation.
Full Episode Transcript
This transcript was generated automatically and lightly edited for readability. It may contain minor errors.
Hey there, this is Pat Ennis of ENNIS Legacy Partners. Welcome to the ExitReadiness® PODCAST. I'm here with co-host Walter Deyhle and business partner Corby Megorden. Our mission here on the ExitReadiness® PODCAST is to provide you, the business owner, with subject matter expertise on topics pertaining to building sellable business value and then for planning your eventual exit from the business. We want to help you build a business that's sellable or transferable and then exit successfully on your own terms and conditions.
An employee stock ownership plan, or ESOP, is a qualified retirement plan that allows employees to gradually become indirect owners of the business they're helping to build. Shares are allocated to employee accounts over time based on factors such as compensation or years of service. For many privately held businesses, an ESOP can serve as a thoughtful ownership transition plan, providing liquidity to the owner, rewarding and retaining employees, offering some real, significant tax advantages, and allowing the company to remain independent while ownership gradually shifts to the people inside the business. And an ESOP strategy can be helpful in transitioning a family business. So today we're going to discuss the benefits of an ESOP in a family business transfer.
We're excited to have with us our guest, Kelly Finnell. Kelly is one of the nation's premier ESOP consultants, having spent more than 40 years helping business owners design and execute ESOPs. He's a sought-after speaker nationally, and really internationally, as well as an author. He's published dozens of articles on the use of ESOPs, and he's written one of the most comprehensive books available on the topic, The ESOP Coach: Using ESOPs in Ownership Succession Planning. Kelly serves as a consistent pillar in the ESOP community as an active member of the National Center for Employee Ownership, NCEO, The ESOP Association, and numerous other professional and community organizations.
He has a law degree from the University of Memphis and holds the Accredited Investment Fiduciary professional designation. Kelly, thanks for joining us. We're excited to have you with us. It's good to see you again, and we're looking forward to this conversation. Oh, thanks, Pat. It's great to be with you.
Hey Kelly, thanks for joining. We've talked about ESOPs on this podcast before, and I think it's always of interest to our listeners, but I think it's going to be really neat today to match up what we've talked about with ESOPs and how they can fit into family business exit planning, because I think a lot of people assume there really isn't a fit, that ESOPs are for huge companies. So before we dive into the fit for family businesses specifically, can you review for our listeners what you feel are the general parameters for when an ESOP could make sense for a business? Yeah, absolutely, Walter. There are, of course, financial considerations and what we sometimes call soft considerations.
In terms of the financial considerations, a business needs to have at least $2 million of adjusted EBITDA and at least 35 employees to be a good candidate. In terms of the soft considerations, it is critical that a company have a strong successor management team. An ESOP is a form of internal transition, and anytime you have an internal transition, you have to have a strong successor management team. The founder of the company is going to be using the plan as their exit strategy, so there needs to be someone there with experience who can run the company.
I often say the best candidate for an ESOP is a company where the boss comes in late, leaves early, and takes a long lunch. You might have a business owner who's already delegated the operation of their company to the successor, and that's a really strong candidate. That doesn't have to be the case; you could use the ESOP as a springboard to create an internal management transition, but making sure there's a plan and that the plan is executed is really, really important. Also in terms of soft considerations, an ESOP works really well where the success of the company is based on company culture. An owner knows that if they sell to a third party, the culture is destined to change; the culture of the company is going to become the culture of the acquirer.
So the majority of our clients are professional services companies, engineering firms, architectural firms, firms where the success of the company is based on its culture. Also where business owners see the company almost as one of their children, and they're focused on legacy planning. For example, we did an ESOP a few years ago for a firm in Dallas, and there had been a business in the city of Dallas with this company's name on it for 105 years. It was really important to this business owner that that remain. They were concerned that if they sold to a third party, the identity of the company would change, and they just weren't willing to accept that.
And the final soft consideration is what I call the compassionate capitalist: someone who wants to do well for himself and his family, but at the same time wants to take care of the people who helped them get to the point where they could execute this strategy. I've got this thing I call the greed scale. On one end of the greed scale is Mother Teresa; on the other end is Gordon Gekko. To be a good candidate for an ESOP, you don't have to be Mother Teresa looking to give your business away. But you can't be Gordon Gekko, thinking only about yourself and trying to squeeze out the last penny for your own benefit without any concern for the future financial security of your employees.
Yeah. Then, Kelly, there's a nuance with ESOPs in a family business, as opposed to a group of people saying, "Rather than a third party, we're going to do an ESOP." What are the things you see in an owner that would lead them to say, "I'll do this," instead of passing it on to the kids? Well, I see situations where they do both, where they do an ESOP and pass a portion on to the kids. A classic example would be a business owner with two children. One of them is active in the business, the other is inactive, and the business owner knows that passing the company to both of them is just a formula for disaster.
The interests of the active and the inactive child are going to be very divergent. The active child is going to want capital to reinvest in the business, and the inactive child is going to want to take every penny out of the company as distributions for their own financial security. So we often use ESOPs in that kind of situation. The business owner sells a portion, maybe 49%, to the ESOP, takes the cash from that, and that becomes the inheritance of the inactive child. And then the active child inherits the 51%, manages the business, and eventually benefits from the sale of that 51%.
So that's a classic case for us to use an ESOP in a family-owned company. We also have situations where a business owner needs to sell 100% of the company to have the liquidity they need for their future financial security. They might have an active child, but that child doesn't have the cash or the credit to borrow the money to buy out Dad. So perhaps the business owner sells 100% of the stock to the ESOP but at the same time names the son as CEO. The son might not have control of the stock, but he's going to be able to operate the company and receive salary and bonuses from it.
So those are the two situations, Corby, where we often see ESOPs in family-owned companies. Kelly, in family situations with ESOPs, do you run into challenges, relationally, emotionally, or in any other way, that we don't run into when it's not a family business? Absolutely, Pat. The family dynamic always complicates things, as I'm sure you experience in your business all the time. A family dynamic creates emotions and expectations and all sorts of negative things, like jealousy.
So in those kinds of situations, it's often very helpful if we have a business coach working alongside us, because we don't deal with that. We deal with executing an ESOP transaction, but oftentimes much more than that is needed in these situations, and if they have a business coach who can help them navigate that part of it, that's extremely helpful. Yeah. And along those lines, we know that at times parents can have a view of their children that may not be entirely objective. You mentioned the management team; can you speak to the idea of growth, and the fire-in-the-belly concept, for a successful ESOP?
Yeah, you're absolutely right. All the statistics indicate that second-generation family businesses often fail, and third-generation family businesses frequently fail. But again, that's a business coaching issue; we work alongside coaches, but we don't get involved in coaching business owners on how to deal with that. You're absolutely right, though: it's very difficult to be objective about your own family members and their capabilities, so it's critical to have a professional involved who can help you assess that objectively. Yeah, thanks for that plug, Kelly.
That's one of the things we do: we help with that shepherding, if you will, the coaching and training of the successors, so they can take the business to the next level, because it does need to go to the next level. There's going to be debt, and hopefully revenues and profitability are going to continue to go up. So yes, the child in the business who's going to be running the company absolutely needs to have the chops to take it to the next level. Hey Kelly, let me ask you a question. I come from a tax background, so when I think of ESOPs, I always think of the potential for avoiding capital gains tax.
And I always find it interesting that whenever we're talking to ESOP people, you have to drag that out of them. Is that just a side benefit they get, or have you had situations where it's been the primary driving force in setting up the ESOP? Well, there are two major tax benefits available to owners and their companies in an ESOP transaction. The one you're referencing is the tax benefit available to the owners. In 1984, Congress added a section to the Internal Revenue Code, Section 1042, which is a like-kind exchange provision.
It works in a very similar way to 1031 and 1035, the other two like-kind exchange provisions in the code. The concept is, I own a piece of property, the stock in my closely held company. If I sell that property to an ESOP and then take the money from that sale and reinvest it in like-kind property, which would be the stocks or bonds of a U.S. domestic operating company, and if I follow all the other rules, and as you can imagine there are about 10 pages of rules that apply to 1042, then there's no tax on the gain that results from the sale to the ESOP. But the caveat is that, like other like-kind exchanges, the owner has a transferred basis in the reinvestment, which is referred to under 1042 as qualified replacement property.
A simple example: I have zero cost basis in the stock of my closely held company. I sell it for $10 million, reinvest under 1042, and buy $10 million worth of Google stock. I paid $10 million for that Google stock, but for tax purposes my cost basis is zero, because my basis was transferred from the basis in the stock of my closely held company, which was zero. So if I ever sell that Google stock, I'm going to pay tax on the gain on that $10 million, assuming it hasn't appreciated, and if it has appreciated, on whatever the value is at that point.
So that's a great opportunity for business owners to defer the gain and perhaps even eliminate it. If they can hold the qualified replacement property until death and their estate gets a stepped-up basis, then the tax deferral becomes tax forgiveness. So we often see people investing in very conservative, income-producing assets with the hope of holding on to them until death. That's a big potential tax benefit. We see it used most often on the East Coast and the West Coast, in the high-tax jurisdictions, and far less often in Tennessee and Texas and other states that don't have such a confiscatory state tax structure.
The other tax benefit, and perhaps the reason that 1042, as you referenced, Walter, isn't discussed as often, is a much more significant tax benefit, and that's the tax benefit for the company. If you have a 100% ESOP-owned S corporation, then that corporation's income is never again going to be subject to tax. There's no tax at the company level, because it's an S corporation, a flow-through entity. And there's no tax at the shareholder level, because, as Pat referenced earlier, the stock is held by the ESOP trustee, and like the trustee of a 401(k) plan, the other form of qualified plan people are most familiar with, that trustee is exempt from tax.
So there's no tax at the company level, because we have a pass-through entity, and no tax at the shareholder level, because we've passed our income through to a tax-exempt entity, the ESOP trustee. That dwarfs the 1042 tax benefit. That's the tax benefit I hear people talk about most often: the ability to operate your for-profit company as if it were a church or a synagogue, on a tax-free basis. Yeah, that makes sense. Kelly, you mentioned culture, and culture is so critical.
Just as you have the greed scale, is there some kind of culture scale that says, okay, this culture is strong enough to actually perform well in an ESOP, versus, oh, we're going to shape the culture once we do the ESOP? Well, I would say that if a business owner tells me that the key to their success is culture, then I know I have a great candidate. If I don't get that input during an early meeting, then I want to make sure they're focused on establishing a strong ESOP communication program, so they can build that 100% employee-owned culture after the transaction. When I first got into the business back in the early '80s, I was naive. I assumed that if an owner announced to the employees that they were going to own the company, and it wasn't going to cost them anything, then after the meeting all the employees would come up to the owner, give them a big hug, and say, "Thanks, boss."
That's not realistic. That's not what happens. Employees don't initially understand what the ESOP is, how it works, and how it's going to benefit them, and you're only going to get bang for your buck and that appreciation to the extent that you commit to a strong, consistent employee communication program. That's something we help our clients with. We provide electronic newsletters they can send out quarterly, we'll do annual meetings for them, and we'll do a frequently-asked-questions document.
We'll provide all the materials they need to help people understand what the ESOP is, and as a result of understanding it, they're going to appreciate it. One big caveat: it might take three to five years. If you have an engineering firm with highly educated people, it's going to take three years. If you have a less educated workforce, it's going to take longer, which I think is perfectly logical. So it takes time and work.
Yeah. So, Kelly, regarding the transaction, describe the different professional roles that are needed: what your role would be and what other professionals are needed. And then, to whatever degree you can, give an idea of how much an owner could expect to invest financially to make this happen, because that's always a big question. Of course: how much is this going to cost me? There are tax benefits and all these other benefits, but what's the price tag?
In terms of professionals, we're always referred into a case by a professional. We don't market directly to business owners. It's usually an exit planner, a business coach, an attorney, a commercial banker, or an investment banker; those are the kinds of front-end professionals we deal with. We'll have a meeting with the professional who referred us in and with the business owner, and during that meeting, which we don't charge a fee for, we'll answer all their questions, help them understand, and get the information we need to determine whether they might be a good candidate. If they are, and if they're interested in going to the next step, they'll engage us to do a feasibility study.
In that study, we'll give them all the financial modeling they need to see whether this is the right strategy for them. Assuming it is, the next step is when the other professionals get involved: implementation. On the buyer team, we're going to have the ESOP trustee, who's going to be the purchaser in the transaction. That trustee is going to have a team. The first person on that team is their valuation advisor, who needs to have years of not just valuation experience, but ESOP valuation experience.
And then they're going to have an experienced ESOP attorney on their team. That's the buyer team. The seller team is going to be us, as the ESOP consultant, the advisor who brought us in, and their attorney. When people ask me what the major problem with ESOPs is, I always tell them: too many damn lawyers involved in the deal. You've got the company lawyer, you've got me and my partner, who are lawyers, you've got the trustee's lawyer, and then you end up with bank counsel, because most of these transactions are funded in part with a bank loan.
So lots of lawyers are involved, and there's a lot of complexity, which is the reason you have all of these lawyers. And when you have complexity and lawyers, you have fees. So I think, at a minimum, a business owner could expect their total all-in cost to be half a million dollars, and it could go up to maybe $750,000, depending on the team they engage. That's a lot of money. So as part of our feasibility study, we provide a more precise estimate of what their fees are going to be.
And then we answer the question: what do you get for all of this money? We do a cost-benefit analysis comparing the fees to the net present value of the tax benefits. As you referenced, Pat, that's the balance. That's why I always say that to be a good candidate, you need at least $2 million of EBITDA. If you have $2 million of EBITDA, your fees are going to be less than 5% of the tax benefit, so the cost-benefit analysis works.
If you have half a million dollars of EBITDA, then your fees in the first year are going to soak up all of your earnings plus some, and it's going to take forever to recoup your costs. That makes sense. Yeah. And along those lines, Kelly, you always hear, "Oh my goodness, even once you've done an ESOP, they're expensive to keep going." Can you speak to that? Yeah, there's expense involved, but those expenses shrink in comparison to the implementation fees.
On an ongoing basis, you still have the trustee, so you have a trustee fee, but the trustee's ongoing fee is going to be significantly less than their transaction fee. You're going to have the valuation firm, but again, their fee is going to be significantly less than their transaction fee. And you're going to have a new party, a TPA, a third-party administrator. Most businesses have a TPA for their 401(k) plan, and they might assume at the beginning that they'll just use that same firm, but that usually doesn't work out. Most 401(k) administrators aren't capable of administering an ESOP.
So you're probably going to hire a specialized TPA for that function, and that's going to have a cost associated with it, but it's not a crazy expensive fee. It's going to be more than the fee for the 401(k) TPA, but not a significant deal. So you might have $75,000 in ongoing fees, which, as I said, pales in comparison to the implementation cost, but it's not inconsequential. Yeah. Good. And can you speak to governance, too? I'm familiar with a non-family ESOP, but board members and so on: what are the requirements?
Yeah. Corporate governance in any situation, whether you have an ESOP company or not, starts with the shareholders at the base of the pyramid. The shareholders control who's going to be on the board; they elect the company's board of directors. And the board of directors is responsible for hiring, monitoring, and perhaps firing the officers of the company. Whether you have an ESOP company or a non-ESOP company, that all remains the same; the difference is the identity of the shareholder.
Before the transaction, I owned the company. I was the shareholder, I elected the board, and I had total control. After the transaction, I'm no longer the shareholder; the ESOP trustee is. Now, ESOP trustees don't want to be running businesses. They don't know how, they don't have the expertise, they don't have the time, and most importantly, they don't have the insurance to cover them if they make a mistake.
So ESOP trustees are going to rely on the existing company management team for advice on whom they should elect to the company's board of directors. Before the transaction, most of our clients don't have any independent directors; they're all insiders, employees. One of the things the trustee is going to require if you do a majority ESOP transaction is that the company bring on some independent directors. A typical structure would be three insiders and two independent directors. The trustee isn't going to go out and find those independent directors.
The trustee is going to rely on recommendations from the existing pre-transaction management team, evaluate the capability of those people, make sure they're independent, and then, based on that, elect them, so the three insiders and two independents become the director team for the company going forward. Very good. And one last question along these lines: we know that in a lot of family businesses, family members work in the business. Does that dynamic change if an ESOP is done? Yeah, it doesn't have to.
With respect to family members' employment, compensation, and perks, the ESOP trustee is not going to tell a business owner that after the transaction all of those things have to go away. But the trustee is going to say you have to tell us in advance what they're going to be, because those items affect the company's earnings, and as the purchaser, that's what we're buying: the company's future earnings. So all of those things are going to be incorporated into the stock purchase agreement: which family members are going to work, what they're going to be paid, and what their perks are going to be. And then each year, when the valuation firm comes back to update its valuation, it's going to check the company's financials and compare what actually happened during the year with what the company said would happen in the stock purchase agreement.
So they're going to monitor it. The company and the owner tell the purchaser in advance what they're going to do after the transaction, and then there's a system for monitoring that to make sure they stay true to their word. So Kelly, we've come to the end of our time. In a minute I'm going to ask whether you'd like to share your contact information and whether there's anything you want to promote. But before I do that, is there anything else you would suggest to a family-owned business?
We like to leave listeners with a few action steps they can take if this topic is of interest to them. So in closing, are there one, two, or three things you might suggest to the owner of a family business who's considering an ESOP? I think the most important thing is for them to educate themselves. There are so many business owners out there who don't even know an ESOP is an option. They know about selling to a strategic buyer or a financial buyer, dying with their boots on, or leaving the company to their children, but it's amazing how few business owners even know that an ESOP might be worth considering.
So educate yourself. You can go to our website, which is full of educational information. You can go to my book, The ESOP Coach, which has case studies in it. One of the things I've learned over the last 45 years is that business owners learn best by relating to real-life case stories, so there are case stories about business owners who have sold a family company, or an interest in a family company, to an ESOP. They can read the details, see whether it seems like something they're interested in, and then let's have a call to discuss their situation and their questions and help them determine whether it might make sense to go to the next step, which would be an ESOP feasibility study.
Okay, fantastic. Is there anything you'd like to promote today? And if someone does want to contact you, how can they do that? Yeah, I'd suggest that you start out slow in this education process. We have something on our website, a little three-page piece called a strategy guide, that you can download. Then, if you want to take the next step, get the book, and if you want to take the step after that, let's have a call.
Our website address is www.execfin.com, and our contact information is there as well. Fantastic. Thanks so much, Kelly. We really appreciate you being here with us today; it was extremely helpful, as we knew it would be. And listeners, if you want help thinking this through, maximizing the value of your business, or planning for that eventual exit, you can contact us here at ENNIS Legacy Partners through our website, ennislp.com, or exitreadiness.com. Either one of those gets you there.
You can also access a number of free exit-related assessments on our website. So thank you for listening, and if you've benefited from today's episode, please consider liking it and sharing it on social media. That's always helpful. And until next time on the ExitReadiness® PODCAST, this is Pat Ennis and Walter Deyhle with Corby Megorden signing off.
