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Tax advantages of ESOPs as an exit opportunity for architecture and engineering firms

By: Patrice Radogna
Source: Accounting Today

Stakeholders in mature architecture and engineering firms nearing retirement are bombarded with ideas from many advisors for the “best” exit option.

Despite the owners’ desire to continue to run their firms as they always have and simply focus on their clients, they need to contemplate several key considerations of a solid and successful exit plan, which include:

  1. Creating a strong retirement package for exiting owners;
  2. Finding the right buyer—one that has financial strength and expertise to run their specialized firm;
  3. Building a solid succession plan for key employees; and
  4. Maintaining a “legacy” for the future of their firm. A legacy can be very important to owners of professional service firms as their lifework is embodied in their companies.

While stakeholders in other industry sectors face the same dilemma as they near retirement, there may be other options that are more viable to them due to their business models, and due to the abundant supply of willing buyers in the marketplace eager to invest in firms entrenched in the manufacturing, distribution, technology, medical or other industries. In examining the profile of a typical architecture and engineering firm, providing solutions to the four considerations listed above and demystifying Employee Stock Ownership Plan, ESOPs can offer an ideal exit alternative for A/E firm owners.

Mechanics of an ESOP

An ESOP is initiated when a legal entity, a trust, is formed to hold the stock for the benefit of the employee base. An ESOP utilizes the resources of the company’s own balance sheet to fund either a partial or full buy-out from the exiting shareholder. With an ESOP, an owner is able to gain the desired liquidity from a “ready market” (the ESOP) to a buyer who, through certain financing alternatives, can back the purchase of stock for the exiting shareholder. Further, with this buyer, the legacy of the firm stays with the people who have helped build that legacy—the employee base. Finally, should an owner wish to retain control of the business—or not—or simply continue with the operations, the ESOP provides a structure that allows an owner to step back based on a timeframe under his/her control.

An ESOP is an attractive alternative for many exiting shareholders of A/E firms, addressing many of the pitfalls of other exit options that may be more viable to other types of businesses.

Strengths and Weaknesses of an ESOP

The advantages of an ESOP for the right candidate have been well-documented, but those benefits are worth repeating when an A/E firm is contemplating whether an ESOP may be a “right fit” exit solution for them:

  • Liquidity and timing. When there are issues with other liquidity alternatives, the ESOP provides a ready financing vehicle for the owner. The owner can control (i) the timing of the sale (they can do a “partial” sale, and still stay engaged in the business), and (ii) the seller will continue to operate with current trusted, key personnel of the firm (an outside owner will not be introduced with an ESOP) should the selling shareholder choose to retain an ownership position.
  • Tax benefits. The immense tax benefits can result in increased cash flows:
    • As a sanctioned retirement plan, an ESOP is technically a tax-free trust. For S Corporations, the pre-tax income of the company, attributed to the pro rata level of shares (of total outstanding shares) that the Trust owns, is non-taxable income. At its maximum benefit, an ESOP trust that owns 100 percent of the company stock pays zero federal income taxes.
    • For those companies in which the ESOP does not hold 100 percent of the stock of the S Corporation, there is a tax benefit related to ESOP leverage. With an ESOP, both principal and interest debt payments (related to an ESOP loan) are tax deductible items. Thus as a financing vehicle, the ESOP provides significant tax breaks to the company.
  • Both of the tax benefits put the company at a tremendous competitive advantage as management now has excess cash flow due to the avoided tax that can be used for other purposes such as expansion, key employee retention, re-investment in the company or reduction of debt:
  • Tax incentives for selling shareholders. Shareholders can sell their stock to an ESOP trust and defer—or possibly eliminate—federal income taxes on the gain from the sale if the sale qualifies as a tax-free rollover under Section 1042 of the Internal Revenue Code. The principal factors to determine whether the sale qualifies are (i) the ESOP trust must own at least 30 percent of the company’s stock immediately after the sale, and (ii) the proceeds must be reinvested in Qualified Replacement Property within a 15-month period, beginning three months prior to the date of the sale.
  • Benefits for employees. Every year that stock is allocated to the account of an ESOP participant, employees receive additional compensation in the form of a retirement benefit. This may become the only retirement vehicle offered, or it may be offered in conjunction with other retirement benefit options. Research done by the National Center for Employee Ownership shows that ESOP companies on average contribute approximately 6 to 8 percent per year for all eligible participants, and often offer a secondary retirement plan. Finally, according to the study, ESOP participants have approximately 2.2 times as much account value (based on defined contribution plan assets originally contributed by the company) over a similar time period as participants in comparable non-ESOP defined contribution plans.

Overcoming Misconceptions when Setting Up the ESOP Plan

The perceived complexities and solutions to the challenges of setting up an ESOP are also worth attention and discussion. Below are a few misconceptions about ESOPs:

  • You will not be able to achieve “maximum price” when the buyer is an ESOP. It is true that there are other exit options that can often offer higher prices to owners of certain businesses. Due to the challenges of finding a strategic or financial buyer, this simply may not be a viable option for exiting shareholders of A/E firms. ERISA mandates that an ESOP, as a retirement plan, cannot pay more than fair market value in a transaction. For example, fair market value typically excludes any synergies that a seller may expect to receive when selling their shares to a strategic buyer. However, if there are no such viable strategic buyers then the fair market value is a very attractive option.
  • Management will be forced to share financial statements with employees. In fact, the law does not require financial statements be shared with plan participants. The only required financial disclosure is that each participant be furnished at least annually with a benefit statement documenting the number of shares allocated to his or her account and the fair market value of those shares.
  • ESOPs are risky retirement vehicles. Data from the Department of Labor shows ESOPs with more than 100 participants outperformed 401(k) plans in 15 of the 20 years between 1991 and 2010. The mean rate of return was over 2 percentage points greater during this period for ESOP companies versus companies that carried only a 401(k) retirement plan.
  • The firm is not large enough or performing well enough to be an ESOP company. While there is a cost/benefit analysis that should be performed, employers and employees and trusted professionals often lose sight of the tangible and intangible benefits of becoming an ESOP. ESOPs have proven quite effective for companies with as few as 20 to 50 employees. In 2014, there were nearly 3,000 ESOPs with 50 participants or less.
  • Acquiring the debt to finance the sale from an exiting shareholder will be difficult and risky to the company. This can be true if approaching conventional lenders that are not seasoned ESOP lenders. Experienced lenders in the ESOP field understand the significant, tax-related, cash flow benefits an ESOP company receives that can lower its risk. In fact, according to a 2009 study conducted by the NCEO, the historical default rate for ESOPs is significantly lower than default rates on other commercial loans. According to this study, the default rate on ESOP loans was less than 0.5 percent. Moreover, a Moody’s study found that private equity-owned companies in comparison logged a 19.4 percent default rate between January 2008 and September 2009, while 186 private equity-owned companies and non-sponsor-owned companies defaulted at a rate of roughly 18.6 percent over the same period.
  • If obtaining a loan is difficult and/or costly, there are options for the selling shareholder who is confident with the future performance of the company. A selling shareholder can choose to take back a seller note, also known as a promissory note, from the company to the selling shareholder. While ERISA dictates that the terms of the loan must be at fair market value, typically referring to the payback period and interest rate of such loan, the company can potentially issue warrants to the selling shareholder; doing so will provide some upside value to the exiting shareholder should the stock price increase beyond the strike price of the company as of the date of the initial transaction.
  • There is a post-transaction decline in stock value, thereby hurting the ESOP participants. This is a true statement in most transactions when the stock of a key employee or founding shareholder is bought by the company and financed with debt. If leverage is needed to finance this shareholder exit option, then there will be debt on the balance sheet that did not exist before (consistent with other buy-out options). However, the ESOP has just bought stock of (hopefully) significant value and, as the debt is repaid, the trust and its participants are left with a valuable asset from which the employee base will benefit into retirement.
  • High-level and/or key employees will not be incentivized sufficiently as the ESOP will dilute firm value. Adopting an ESOP can be dilutive to the value of the company stock, due to the increased level of debt on the balance sheet. There are common alternative management incentives that provide enhanced returns to key employees or the exiting shareholder that are considered at the time of the initial ESOP sale transaction. This is a discussion, however, that is beyond the scope of this article.
  • Having an ESOP is costly. Achieving liquidity for an owner, as well as providing retirement benefits for employees, requires expertise of certain key professionals. When compared to the fees of an investment banker or private equity in alternative exit scenarios, the fees end up being quite reasonable. The fees that need to be contemplated are those of a trustee (should the company desire to hire an external trustee, versus keeping that role internally), an ESOP attorney, an accountant and an independent business valuation professional. The value an ESOP brings to an exiting shareholder coupled with the ongoing retirement benefits to the entire employee workforce needs to be contemplated prior to a potentially myopic decision that going the ESOP route is too expensive.

How Is Fair Market Value Determined? What Are the Major Drivers of Value?

The value of A/E firms, as a subset of professional services firms, is highly impacted by the quality of intangible versus tangible assets of the firm. Factors that are significant and that impact value include (i) the quality, depth and tenure of the employee base, (ii) the goodwill of the company in the marketplace (reputation, name recognition, etc.), (iii) the depth of management and relationships beyond exiting shareholders, (iv) the quality and dispersion of the client base, (v) the level of repeat customers, (vi) expertise in niche versus commoditized services, and (vii) the backlog and sustained profitability. While not exhaustive by any means, these seven factors greatly impact the value of any A/E firm.

While a quick internet search can reveal many “rule of thumb” ideas about what these firms typically sell for, the process of determining a range of fair market value for any given A/E firm is not that simple. Valuations of A/E firms, performed by qualified valuation professionals are typically expressed as a multiple of revenues or earnings. As an example, multiples of revenue that range from 0.6 to 1.2 of revenues, or multiples of EBITDA that range from 3x to 6x are reasonable for illustration purposes. However, where exactly the value of any A/E firm falls in either of these ranges is highly correlated to the risk factors (via a comprehensive qualitative assessment measuring strengths and the weaknesses of the A/E firm) a valuation professional sees in the aforementioned factors.

There are a variety of other options besides ESOPs for business owners to execute a successful exit plan.

Sale of Company to a Strategic Buyer

When exploring exit strategy alternatives in many industries, owners can consider selling the business outright to a strategic acquirer. Sales to this pool of buyers may often result in the highest price available to a seller. Industry statistics reveal that historically, A/E firms have not been great takeover candidates for a strategic sale. This is due largely to several factors, including: (i) a cultural mismatch between the buying and selling firm; (ii) difficulty in realizing economic synergies in take-over situations; (iii) the lack of contracts that will assure both key employees and key clients will stay with the firm post-acquisition; and (iv) the fear residing with the exiting owner that an acquiring firm will tarnish the legacy of the firm that he has built.

Sale of Company to a Financial Buyer

For many firms, private equity (financial) buyers are often a great liquidity option for a partial or full sale. Private equity buyers possess the capital required to acquire the firms and have strong management teams to operate a wide variety of firms. However, A/E companies are not typically a target investment for private equity firms due to a cultural mismatch and the fact that a typical PE firm lacks skilled expertise to run A/E firms. If outside funding (to the PE firm) is necessary, they may also find it difficult to obtain outside financing, limiting the credit facilities available to structure a transaction.