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ESOP Process

Succession Planning is a process that takes time and the assistance of planning professionals. Here is how the ESOP planning and implementation process might evolve in a typical scenario.

Owners often have to be jolted into recognizing the need to engage in succession planning. This jolt might come in the form of:

  • A medical crisis. Many business owners resist recognizing their own mortality and avoid planning until they have a brush with mortality. This may come from a personal experience with cancer or heart disease or from a close friend’s medical crisis or untimely death.
  • Defection of a key employee. When a long-term, trusted employee announces he is leaving the company it can send shock waves through the owner, especially if the key employee was integral to the owner’s succession planning. Sometimes the owner can begin the planning process immediately and retain the key employee. However, in many cases it is too late to convince the key employee to stay and the owner has to learn a hard lesson from his mistakes.
  • A third-party demand. Many times third parties will require business owners to implement a succession plan. I have seen lenders, surety companies, suppliers, customers and franchisors tell business owners to either implement a succession plan or the third party will cut them of. These third parties recognize the risk of their business relationship being disrupted by inadequate succession planning.

Once a business owner recognizes the need to start the planning process, he often will begin discussing it with one of his key advisors. In my experience this, most often, is his CPA. Typically a company’s CPA knows the business owner and his company better than any of its other advisors. As the business owner discusses succession planning alternatives with his CPA, the CPA often brings specialists into the discussion – investment bankers, estate and/or transactional attorneys, ESOP consultants, etc. If the CPA does not involve other experts, it may behoove the business owner to request it.

If, based upon this initial exploration process, the business owner decides to investigate whether an ESOP would best accomplish his planning goals, he should hire an ESOP consultant to prepare an ESOP Feasibility Analysis. A Feasibility Analysis serves dual purposes:

  • It will provide the business owner and other key decision makers all of the information they need to make an informed decision whether to implement an ESOP, and
  • It will serve as a road map to help guide the parties through the ESOP implementation process.

Assuming that the decision makers like what they see in the Feasibility Study, I recommend that they allow us to arrange discussions with a valuation consultant and with potential bank lenders. While our Feasibility Study contains predictive data on these two subjects, I believe it is critical to get definitive commitments on valuation and financing prior to incurring or committing to any other ESOP implementation expenses.

Please note that neither the company nor its owner(s) should engage the valuation consultant. As noted at several points earlier in this book, the law requires that the valuation consultant be independent. This is best achieved by having the ESOP trustee hire a valuation consultant who has no prior relationship with the company or its owner(s).

Once the company has decided that an ESOP is the appropriate ownership succession planning strategy and the company has a valuation and financing structure it is comfortable with, it is time to assemble the ESOP team. The team typically will consist of:

  • The company’s owner(s) and successor management team;
  • The company’s attorney and CPA;
  • The ESOP consultant;
  • The ESOP attorney;
  • The bank that will finance the purchase;
  • The ESOP trustee, and
  • The owner(s)’ financial advisor.

The attorneys and ESOP consultant will be involved in the preparation of the following documents:

  • The ESOP Plan, Trust and Summary Plan Description;
  • The stock sales agreement;
  • The Inside Loan agreements and related documents;
  • Opinions of Counsel;
  • Post-sales employment agreements, and
  • An Equity-Based Incentive Plan for the Company’s successor management team.

The attorneys also will be responsible for reviewing and negotiating the bank loan agreements.

The ESOP consultant will be responsible for coordinating a Plan Administration firm that will administer the ESOP and 401k. Most companies that adopt an ESOP already have a 401k plan and it is important that the two plans be operated by a single plan administrator. The consultant also will be responsible for creating an Employee Communication program designed to help the employees understand what the ESOP is, how it will operate and how it will benefit them.

The time and cost involved in implementing an ESOP are dependent upon several factors. If the ESOP will be unleveraged, the entire plan could be structured and implemented within 30-45 days and could cost as little as $25,000. If the ESOP will be leveraged using Seller Notes only (no bank debt) the plan could be structured and implemented within 60-120 days and cost as little as $50,000. If the ESOP will be leveraged using bank debt and Seller Notes (the most common structure) the plan could be implemented within 90-180 days and cost $100,000+. Please note that these estimates are all-inclusive and consider legal, valuation and trustee fees.

I am frequently asked how the cost of implementing an ESOP compares to the cost of other succession planning options. In my experience an ESOP is less expensive than a sale to Outsiders or Insiders.

Sales to Outsiders generally involve investment bankers or business brokers who typically charge a fee that is a percentage of the sales price. If you are selling your company for $10 million, you may pay an investment banker $400,000 (4%) and pay attorney, accounting and other fees of $50,000-$100,000. A $10 million ESOP transaction may have total fees of $200,000. This is less than half the cost of selling to an Outsider.

The professional fees involved in selling to Insiders may be very low; perhaps as little as $25,000. However, there are very significant tax costs involved in selling to Insiders. Generally, a sale to Insiders will have a tax cost of at least 50%. Therefore, on a $10 million sale to Insiders the tax cost will be $5 million, approximately 25 times the total cost involved in implementing an ESOP.

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