ESOPs as a Business Exit Strategy: Key Insights from Tom Walker [PODCAST]

In this episode of The Transaction Abstract Podcast, Joe Hellman sat down with Tom Walker, an attorney from Winthrop and Weinstein with over 35 years of ESOP experience, to explore Employee Stock Ownership Plans (ESOPs) as a business exit strategy.

What is an ESOP?

An ESOP is a qualified retirement plan similar to a 401(k), but with two key differences.

First, the primary investment is company stock, and second, it is funded primarily through company contributions rather than employee contributions. As employees work at the company, they accumulate stock in their accounts, allowing them to benefit from the company's success over time.

Walker explains that while an ESOP might not be suitable for every business, it provides a unique transition option for owners approaching retirement who value their company legacy and employee relationships.

Ideal Candidates for an ESOP

Walker suggests the following characteristics for businesses considering this succession planning path:

• Owners approaching retirement (within 5-6 years) who do not want an immediate exit
• Companies with 25+ employees (though exceptions exist)
• Business value exceeding $5 million to offset transaction costs
• Owners who prioritize legacy and employee welfare over maximizing sale price
• Companies with steady growth and positive cash flow
• A strong company culture where employees have contributed significantly to success

While owners typically receive about 90% of what they might get from a third-party sale, the ESOP offers other advantages, including a significantly higher transaction completion rate compared to traditional sales processes.

Valuation and Governance Considerations

One common misconception about ESOPs involves valuation. Walker emphasized that "The ESOP cannot pay more than fair market value," which is determined by a qualified independent appraiser engaged by the ESOP trust. This addresses Department of Labor concerns about potential overvaluation.

For owners transitioning to an ESOP structure, a commitment period is typically required:

• Owners who are actively managing the business usually need to commit to 3-5 years post-sale
• Owners with established management teams might only need to stay 1-2 years to ensure a smooth transition

Despite concerns about governance challenges, Walker noted that when ESOP companies later decide to sell, participant approval votes typically achieve 70-90% support when management makes a compelling case for the transaction.

Tax Benefits and Current Trends

A significant advantage of ESOP structures emerges when the ESOP owns 100% of an S corporation. In this scenario, the company pays no federal income taxes, freeing approximately 35% of earnings that would have gone to the government. This "found money" can help repay acquisition debt and increase company value for ESOP participants.

Walker observes growing interest in ESOPs, particularly as interest rates decrease and baby boomer business owners continue moving toward retirement. While higher interest rates temporarily dampened enthusiasm due to financing challenges, the market appears to be rebounding.

"I think it is a really good tool," Walker concludes. "People have heard all sorts of myths about ESOPs, but if you have a good advisor who can take you through this, that good advisor can help identify and screen out 90% of the not-so-good situations."

Listen to more episodes of The Transaction Abstract Podcast for additional insights on buying and selling businesses.