Management buyout or ESOP? How two inside sales compare

Many owners who want the company to stay in familiar hands narrow the choice to two inside buyers: the management team, or an employee stock ownership plan (ESOP) that holds shares for employees. Both can keep the company independent and reward the people who built it. They differ in who ends up owning the shares, how the price is set, how the purchase is paid for and what the company carries afterward.

The Two Structures in Brief

In a management buyout, members of the leadership team buy the owner’s shares directly, usually with a lender and sometimes with an outside investor. In an ESOP sale, a trust buys the shares for eligible employees, who do not use their own money; the company funds the plan over time.

Side by Side

Price

In a management buyout, the price is whatever the owner and the managers agree, and the managers can pay only what they can finance. Some owners accept less from their own team to make a deal workable; others hold to a full price and are paid over a longer period.

In an ESOP sale, federal law allows the plan to pay no more than fair market value, determined in good faith by the trustee, and the valuation must be done by an independent appraiser. That ceiling protects the employees, and it means an ESOP cannot stretch beyond appraised value. Neither structure is assured of producing the higher number.

Financing, and Who Carries the Risk

Managers often have limited capital, so the owner frequently finances part of the price with a seller note, and lenders may ask managers for personal guarantees. An outside equity partner may expect a say in governance and, in time, a way to sell its stake.

In an ESOP sale, the company’s contributions to the plan repay the acquisition debt. NCEO estimates the cost of setting up an ESOP for a business transition at about 2 to 4 percent of the total transaction. In either structure, any part of the price paid over time depends on how the company performs after closing.

Control and Governance Afterward

After a management buyout, the managers are the owners. They elect the board and make the decisions, subject to whatever the seller negotiates while a note is outstanding.

After an ESOP sale, ownership, governance and management are separate. The trustee holds the shares and generally votes them, including for directors, while the board and management run the company. Many owners stay on as a director or advisor. In a privately held company, employees direct the vote on their allocated shares only for certain major decisions, such as a merger or a sale of substantially all of the company’s assets.

Taxes

An ESOP brings tax features a management buyout does not. Contributions used to repay an ESOP loan, principal included, are generally deductible within limits, and an S corporation’s income attributable to ESOP ownership is generally not subject to federal income tax. A seller of C corporation stock may be able to defer capital gains tax under Section 1042 if the ESOP owns at least 30 percent after the sale; a sale to managers does not qualify. Those features come with the costs and ongoing obligations of a retirement plan holding company stock.

Tax treatment depends on each owner’s and company’s circumstances; owners should review any transaction with their CPA and legal counsel.

When a Management Buyout May Be the Better Path

• A strong management team wants to own the business and can raise much of the financing.
• The owner wants to reward a few key leaders rather than the wider workforce.
• The company is small enough that the costs of an ESOP would weigh heavily. NCEO suggests that companies with fewer than 20 to 30 employees and $1 million in EBITDA are generally not good candidates.
• The owner and the managers want to agree on price and terms between themselves, without trustee review or an annual appraisal.
• The owner does not want the company to take on the obligations of a retirement plan holding company stock, including the repurchase obligation.
• A simpler process matters more to the owner than the tax features an ESOP may offer.

When an ESOP May Be the Better Path

• The managers are capable but cannot finance a purchase on their own.
• The owner wants ownership spread across the workforce rather than concentrated in a few people.
• The company’s cash flow can support acquisition debt, and the tax features are relevant to the owner and the company.
• The owner wants to sell in stages and stay involved for a period.

Each of those still carries the trade-offs above: the fair market value ceiling, the ongoing obligations and, often, part of the price paid over time.

Combining the Two

The choice is not always one or the other. Some companies pair an ESOP with incentives for key managers, such as stock appreciation rights, phantom stock or a direct stake alongside the ESOP. These need careful design. In S corporations, anti-abuse rules under Section 409(p) of the tax code impose heavy penalties if a small group holds too large a share of the company’s equity, counting certain incentive rights.

For a broader comparison that includes outside buyers, see Would a strategic buyer pay more?

Where to Go From Here

Is an ESOP the right fit? sets out the signals on both sides, and ESOP basics explains how a sale to an ESOP works. Approach and Process describes how Old Harbor Advisors helps owners weigh every path, including the ones that do not involve an ESOP. If you would like to talk it through, talk to us.

Sources

• NCEO, “How an Employee Stock Ownership Plan (ESOP) Works”
• NCEO, “How long does it take to set up a leveraged ESOP?”
• NCEO, ESOP tax incentives and contribution limits
• 26 U.S.C. § 404(a)(9), deduction of contributions to repay an ESOP loan
• 26 U.S.C. § 409(e) and (p), voting rights and S corporation rules
• 29 U.S.C. § 1002(18), “adequate consideration”

This post is for general information only. It is not legal, tax, or investment advice.