By Stephen P. Magowan
Is an ESOP transaction too expensive for you? A common concern expressed by business owners is that the ESOP transaction is too costly -- there are legal and accounting fees; there are the costs of setting up the plan, of executing a transaction analysis study, if desired (also called a feasibility study), and of engaging an independent bank trustee (if an internal trustee is not used); and there is the cost of the appraiser engaged by the trustee to perform the valuation study.
All this adds up, certainly. But is it more costly to do a transaction with an ESOP than it is to do a transaction with a third-party buyer? A close look reveals that frequently the answer to that question is a resounding no.
Sale to a Third Party
Let's assume your business is worth $5 million and you are ready to transition out of your business. Let's also assume that your business is a corporation, and that it has been profitable for some time, but there is no obvious buyer for your business. Because of this, you engage a business broker to help you find the right buyer. After a few months, there is good news -- a buyer has emerged. The buyer does not have a lot of experience in your field, but can see the value of your business. So you decide to sell. What's all this going to cost you?
As a transactional lawyer I have worked on many deals similar to this, and I can say that your legal fees will start from the moment of negotiating the contract with the business broker, to negotiating a letter of intent with the buyer, to negotiating the contract, to following up with post-closing matters. The legal fees will come in somewhere between $30,000 and $70,000 depending on how heavily negotiated the transaction is.
You will also have accountant fees in connection with the due diligence. In addition, if you were to speak with any business person who has sold their business, you would learn that once the letter of intent process began, you would not be able to focus on your business.
Plus there are other expenses. The typical business broker fee is 5% -- that adds another $250,000 cost to the transaction. This brings your costs to over $300,000.
The buyer's side also has costs, probably in the $50,000 to $70,000 range. While you do not pay those costs, they certainly affect the pricing of the deal. Also, the buyer will want to acquire assets, not stock. If you have always been an S Corporation, this is probably not a problem, though there may be depreciation recapture. If your business is a C Corporation, or has been a C Corporation for any extended period, you will pay a double tax. Expect to take home less than forty cents on the dollar.
Finally, what happens to you, the business owner, after the transaction? In our example the buyer does not know your business. He or she will want you to stay on. After years of being your own boss, can you work for someone else?
Comparison to an ESOP
If you do a pre-transaction financial study and engage a bank trustee, an ESOP transaction is likely to cost you from $120,000 to $150,000, though it is possible to have a deal done cheaper.
In addition, the ESOP transaction involves only the purchase of stock and your gain will all be capital gains. If your corporation was a C Corporation, your gain from the sale of stock can also be deferred, perhaps permanently, under Code §1042.
Finally, you can stay on in the business as CEO, President or Chief Bottle Washer. The ESOP can be an integral part of your program to transfer the reins of business to the next level of management.
Should you do an ESOP?
The question of whether to do an ESOP should not be based on cost alone by any means. The point of this article is that the idea that the ESOP transaction is too expensive is largely a myth. You should not write off the ESOP possibility because of your concerns over costs. It may be that the ESOP transaction will not only be less expensive for you, but also provide other tax advantages to you as well. Finally, let's not forget that ESOP companies root jobs in their communities.