Two months ago, we discussed what a smaller contractor should do if they are interested in cashing out, and last month we kicked up the conversation to options for larger contractors. I came away feeling that we need to cover the Employee Stock Ownership Plan (ESOP) concept for larger contractors, since larger contractors are one of the more consistent sellers to an ESOP.
Why would a contractor decide to sell to an ESOP? Because it gives the seller the ability to value the company independently based on free cashflow and not based on bids from competitors. ESOPs require an independent valuation, prepared by a firm familiar with the contracting business, which is your starting point to move ahead. So, if your company generates about $4 milllion to $5 million in Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), it is worth your while to spend some time learning about what ESOPs can provide for shareholders as well as employees.
Knowing I wanted to follow up on ESOPs, I asked Nathan Perkins, managing director with FMI Capital and an expert on ESOPs, a list of questions about the state of the ESOP market, how to use them to capture and keep quality employees, how things have changed since the pandemic, the impact of interest rates and inflation and what the future holds for ESOPs. I encourage you to read it.
I also asked Nathan to provide a summary of the tax benefits associated with ESOPs. To sum it up, ESOPs provide additional cash flow because taxes are either reduced or eliminated, depending how you structure the transaction.
If you find you have further interest or questions about the processes and how they work, we could schedule a Zoom meeting for those that are interested. We would do that without listing who was in attendance.
Garry Bartecki talked with ESOP expert Nathan Perkins about ESOPs, the state of the market, and what is impacting the market and decision-making.
BARTECKI: What is the state of the ESOP market, and what are some of the key components impacting decisions today?
PERKINS: ESOPs have been growing in popularity as a succession planning and employee retention tool for business owners. ESOPs can help owners sell their businesses to their employees, ensuring continuity and preserving the company culture.
- Regulatory Environment: The regulatory environment for ESOPs can influence their prevalence and structure. Changes in tax laws and regulations may impact the attractiveness of ESOPs as a business transition strategy.
- Financing: The ability of employees to finance the purchase of company shares can affect the feasibility of ESOP transactions. Companies may use a combination of debt, seller financing, and contributions from the business to fund the ESOP.
- Valuation: Determining the fair market value of a company's shares for ESOP transactions is critical. Professional valuation firms are often involved to ensure fairness and compliance with regulations.
- Employee Benefits: ESOPs offer employees an opportunity to accumulate ownership in the company. Employees may become more engaged and motivated when they have a financial stake in the business's success.
- Exit Strategy: For business owners looking to retire or exit their companies, ESOPs can provide an alternative to selling to external parties or competitors.
- Industry Variability: The prevalence of ESOPs can vary by industry. Some industries, such as manufacturing and construction, have a long history of using ESOPs, while others may be less common.
- Challenges: ESOP transactions can be complex and require careful planning and execution. Challenges may include financing, governance, and managing the transition from owner to employee ownership.
BARTECKI: How do ESOPs help businesses attract and retain employees?
PERKINS: Employee Stock Ownership Plans (ESOPs) can be effective tools for attracting and retaining employees for several reasons:
- Ownership Stake: ESOPs provide employees with a direct ownership stake in the company. When employees have a financial interest in the success of the organization, they are more likely to be motivated and committed to achieving the company's goals. This sense of ownership can lead to increased loyalty and dedication to the company's long-term success.
- Financial Incentive: ESOPs offer employees the opportunity to share in the company's financial success. As the company performs well, the value of their ESOP shares increases. This can serve as a powerful financial incentive, aligning the interests of employees with those of the company and its shareholders.
- Long-Term Perspective: ESOPs encourage employees to think long-term rather than focusing solely on short-term gains. This can be especially valuable for companies that prioritize sustainable growth and stability over quick profits. Employees are more likely to stay with a company that emphasizes long-term success.
- Employee Engagement: When employees feel like owners, they are more likely to be engaged and committed to their work. They may be more willing to go above and beyond to contribute to the company's success because they directly benefit from that success.
- Retention Incentive: ESOPs often have vesting schedules, which means that employees must stay with the company for a certain period of time to fully vest in their ESOP accounts. This serves as a retention incentive, as employees who leave the company before vesting forfeit some or all of their ESOP benefits.
- Retirement Benefits: ESOPs can serve as a valuable retirement savings vehicle for employees. Knowing that they are building a significant retirement nest egg through their ESOP participation can be a strong incentive for employees to stay with the company for the long term. Competitive Advantage: Offering an ESOP can be a competitive advantage when recruiting new talent. It can set a company apart from competitors and attract candidates who value the opportunity to become company owners.
- Positive Company Culture: ESOPs can contribute to a positive company culture. They promote transparency, open communication, and a sense of teamwork among employees, which can enhance the overall work environment.
- Tax Benefits: ESOPs can provide tax benefits to both the company and employees. Contributions to ESOPs are often tax-deductible for the company, and employees may receive favorable tax treatment on the distribution of their ESOP benefits.
- Succession Planning: For companies looking to transition ownership from one generation to the next, ESOPs offer a structured way to do so while retaining the company's legacy and culture.
Overall, ESOPs can be a powerful tool for attracting and retaining employees who value ownership, financial incentives, and a long-term commitment to the company's success. However, it's important for companies to communicate effectively about the benefits of ESOP participation and provide ongoing education to employees to ensure they fully understand and appreciate the value of their ESOP ownership.
BARTECKI: How have ESOPs changed since the pandemic?
PERKINS: The pandemic brought about significant economic uncertainty, which could have influenced ESOP transactions. Some companies may have delayed or reconsidered ESOP plans due to concerns about the financial stability of their businesses.
- Valuation Challenges: Valuing a company for an ESOP transaction became more complex during the pandemic. The economic disruption caused by COVID-19 could have affected a company's financial performance and, consequently, its valuation. Companies may have needed to reevaluate their share prices and adjust their ESOP plans accordingly.
- Remote Work: Many companies shifted to remote work arrangements during the pandemic. This change in work dynamics could have raised questions about how ESOPs are managed and how employees participate when they are not physically present at the workplace. Companies may have needed to adapt their communication and administration processes to accommodate remote employees.
- Financial Stress: Some companies faced financial stress during the pandemic, which could have made it challenging to fund ESOP transactions or to maintain the required contributions to the ESOP trust. Economic relief measures may have provided some relief to businesses in need.
- Government Assistance: Governments in various countries implemented stimulus packages and support measures to help businesses and individuals during the pandemic. Some of these measures may have influenced ESOPs, particularly in terms of financial support or tax incentives related to employee ownership.
- Renewed Focus on Employee Well-Being: The pandemic underscored the importance of employee well-being and engagement. Companies that valued their employees' contributions and wanted to retain talent may have viewed ESOPs as a way to further engage and reward their workforce during challenging times. Succession Planning: For business owners nearing retirement, the pandemic may have prompted them to reevaluate their succession plans. ESOPs can be an attractive option for owners looking to exit their businesses while ensuring continuity and stability.
BARTECKI: How have rising interest rates and inflation impacted ESOPs?
PERKINS: Inflation can impact a company's financial performance and asset values. This can make it challenging to accurately value a business for an ESOP transaction. In times of high inflation, traditional valuation methods may need to be adjusted, and the valuation process may become more complex. Additionally, rising interest rates can affect the discount rates used in valuation models, potentially impacting the perceived value of the ESOP.
- Borrowing Costs: ESOP transactions often involve the use of debt to finance the purchase of company shares by the ESOP trust. When interest rates rise, borrowing costs can increase, which may affect the affordability of the transaction. Higher interest rates can also impact the sustainability of debt service and the ability of the company to make contributions to the ESOP to repay debt.
- Cash Flow Considerations: Higher interest rates can result in increased debt service payments, which can impact a company's cash flow. This may influence the company's ability to fund ongoing ESOP contributions and meet other financial obligations.
- Holding Company Stock: ESOP participants often hold shares of the company's stock in their retirement accounts. If rising interest rates lead to lower stock prices (due to higher discount rates used in valuation), participants may see a decrease in the value of their retirement accounts, potentially affecting their retirement planning.
- Financing Terms: As interest rates rise, the terms of ESOP financing, including interest rates and repayment schedules, may need to be renegotiated. Companies and ESOP trustees may need to work closely with lenders to ensure that financing remains viable and sustainable.
- Transaction Costs: Rising interest rates can lead to higher transaction costs, such as legal and financial advisory fees. Companies considering ESOP transactions should account for these potential increased costs in their planning.
It's important to note that the impact of inflation and rising interest rates on ESOP transactions can vary depending on the specific circumstances of each transaction, including the industry, the company's financial position, and the terms of the transaction. Companies and their advisors should carefully analyze these factors and consider how to mitigate potential risks associated with inflation and rising rates when structuring and executing ESOP transactions.
Additionally, economic conditions, interest rates, and inflation rates can change over time, so it's crucial for businesses and ESOP trustees to continually monitor the economic environment and adjust their strategies accordingly. Consulting with financial and legal professionals with expertise in ESOPs can provide valuable insights and guidance in navigating these challenges.
BARTECKI: What does the future look like for ESOP transactions?
PERKINS: The future of Employee Stock Ownership Plan (ESOP) transactions will likely be influenced by various factors, including economic conditions, regulatory changes, and evolving business practices. While I cannot predict the future, I can offer some potential trends and considerations that may shape the landscape of ESOP transactions in the coming years:
- Continued Popularity: ESOPs have been growing in popularity as a business succession and employee retention strategy. This trend is likely to continue as business owners seek exit strategies that preserve their company's legacy and culture while rewarding employees.
- Economic Conditions: The state of the economy will play a significant role in the future of ESOPs. Economic growth, stability, and access to financing will impact the feasibility and attractiveness of ESOP transactions.
- Succession Planning: As baby boomer business owners retire, ESOPs may become a preferred method of transitioning ownership to employees. Business owners may increasingly view ESOPs as a way to ensure the continuity of their companies.
- Regulatory Environment: Changes in tax laws, regulations, and government policies can influence the structure and attractiveness of ESOPs. Future regulatory developments may impact the incentives and benefits associated with ESOP transactions.
- Financing: The availability and cost of financing for ESOP transactions will continue to be a critical factor. Interest rates, lender willingness, and terms of financing can affect the feasibility of ESOPs.
- Industry Variability: ESOP prevalence may vary by industry. Some industries may continue to embrace ESOPs as a means of retaining talent and achieving ownership succession, while others may rely on different strategies.
- Employee Engagement: As companies place greater emphasis on employee engagement and well-being, ESOPs may remain attractive for their ability to align employees' interests with those of the company. ESOPs can contribute to a positive company culture and motivated workforce.
- Technology and Remote Work: Advances in technology and the rise of remote work may necessitate adjustments in how ESOPs are managed and communicated to employees. Companies will need to find effective ways to engage remote employees in the ESOP process.
- Sustainability and Long-Term Growth: Companies focused on sustainability and long-term growth may see ESOPs to encourage employees to think about the company's success in the long run rather than just short-term profits.
- Education and Awareness: Increasing education and awareness about ESOPs among business owners, employees, and professionals can promote their adoption. Organizations that specialize in ESOP education and advocacy may play a role in this regard.
It's important to recognize that ESOP transactions are not one-size-fits-all solutions, and their suitability will depend on individual business circumstances. Companies interested in ESOPs should consult with legal, financial, and ESOP experts to assess whether an ESOP is a viable and advantageous option for their specific situation.
In summary, while the future of ESOP transactions will depend on a range of factors, they are likely to remain a relevant and valuable strategy for business owners and employees seeking shared ownership and succession planning solutions.