Michael G Wolff

Interest in Employee Stock Ownership Plans (ESOPs) as an exit strategy is growing, but delayed compensation, loss of control, government involvement, restrictions to capital resources and cash flow issues are all reasons this exit strategy should be evaluated very carefully before being employed.

Tax savings and timing are the two primary benefits derived by owners considering an ESOP as an exit strategy.  While there is merit to these benefits, unless the driving force is a commitment to employee ownership, an ESOP is not likely the best exit strategy for a small business owner.  Even those with a strong desire to reward key employees can often find other more viable methods for accomplishing this objective. (more)

No doubt you have read newspaper headlines and heard media pundits proclaim an economic “crisis,” but the situation may represent a chance to prosper.  The word “crisis” in Chinese translates to dangerous opportunity and though the future is unpredictable, deep discounts on equipment, under-priced real estate, low interest rates, inflation on the horizon, and faltering companies provide opportunities abound for those in the right position. (more)

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Type: Business-to-business, manufacturing and distribution preferred.

Type: Business-to-business, manufacturing and distribution preferred.

The primary problem with ESOPs stems from the fact that little or no purchase capital comes from an outside source, which means the purchase is funded by the company (i.e. the owner).  Typically, an ESOP organization receives a loan from a bank that is collateralized by the assets of the business.  Since most businesses can not fully collateralize a loan equal to the value of the business, the owner typically must guarantee payment.  In addition to guaranteeing the loan, in order to ensure funds are available in the case of default, sale proceeds are usually placed in an escrow account from which an owner may draw down the balance as the loan is repaid.  Ultimately, this means the owner must wait a fairly long time to receive sale proceeds, sometimes as much as ten or twelve years or more. 

During the period of time the owner is letting their proceeds “ride” with the business, additional risk is introduced to the business and the longer the time, the greater the risk.  Given that it is typical to wait seven or eight years, sometimes much longer, for an owner to be fully compensated, the time risk shouldn’t be overlooked.  This situation is exacerbated by the fact that the seller increasingly loses control over future events from the time of the sale.

In most cases, before an owner has received full compensation for selling their business, they have relinquished ownership control to the employees.  For this reason, many business owners choose to stay on as president or CEO in an effort to influence the course of business.  This begs an important question.  If an owner has to collateralize the purchase loan and stay on for five years or longer to ensure they receive full compensation, why should they give up the benefit of ownership?
 
Another issue related to the self funding nature of an ESOP is that during the period of time the loan is outstanding, the business may suffer greatly from a lack of capital due to debt service and other financial obligations.  In addition to debt service, the business must cover ESOP administrative expenses, which ranges between thirty thousand and seventy –five thousand dollars, with a typical cost of fifty thousand dollars annually.  Finally, the business may have obligations to buy-out vested employees as they leave.  This pressure on capital resources can often severely limit the overall prosperity of the business.

Further risk is inherent in the fact the ESOPs are heavily regulated by the government, which may change the rules at any time.  Though the government appears to be pro ESOP as a method of distributing wealth, considering the present administration’s view of “wealthy” business owners, it is certainly feasible that changes may be made to ensure owners pay their “fair” share of taxes.  Further regulations are also not out of the question.

Despite the tax advantages, due to the self funding nature of an ESOP, many business owners would be far better off pursuing other exit strategies, particularly if their business lacks size and steady income.  Many experts argue that an ESOP should not even be considered unless a company consistently produces a million dollars plus in annual cash flow and has a market value greater than five million dollars.

Under the right circumstances an ESOP can provide a viable exit strategy, but it should be evaluated carefully against other alternatives.  Often, under thorough analysis, even small business owners dedicated to rewarding their employees find that they will incur less risk and receive greater overall compensation by keeping their business a few years longer, collecting their salary and profits, and selling their business to an outside party.

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While some business owners are pulling back, others are taking action to capitalize on current conditions.  For instance, we are working with one business owner to acquire deeply discounted equipment and an under priced production facility which will allow them to vertically integrate operations.  It is an attractive move considering the equipment is selling for about one quarter of its cost just a year ago and the real estate, which is only six years old, is priced at about fifty percent of what it would cost to build.

Initial figures indicate the venture should drop somewhere between three quarters and a million dollars to their bottom line.  In addition, over time there may also be a solid return on real estate investment. 

Given the inevitable inflation down line due to the economic stimulus spending, another one of our clients feels it is the right time to move from their leased facility and purchase new space.  The property appears to be a good value and offers some expense reduction, but it is also a hedge against inflation.

Leases will likely rise with inflation and interest rates are likely to go up as well, which may mean it is a great time to buy real estate.  Though high interest rates tend to have a negative affect on real estate values, over the long run the value of real estate should keep pace with inflation.  More importantly, the debt service will stay the same, but the dollars used to make payments will be worth less and less as inflation erodes their value over time.

Many of us will never again in our lifetime experience an economic environment similar to the conditions that exist today and it brings to mind the old parable about the two salesmen sent to Africa to see if they should expand there.  The first salesman reports back that the natives don’t wear shoes, so there is no opportunity.   The second salesman reports back that there is a great opportunity because the natives don’t wear shoes.  Between “crisis” and “dangerous opportunity,” I like the latter.

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