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Business Transition Challenges - The Employee-Owned Route

Tom Burroughes, Group Editor , March 14, 2019

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The debate about the best way to transition business ownership generates many ideas, ranging from trade sales through to IPOs. The employee-ownership route deserves consideration, a practitioner argues.

With most US businesses falling outside the Fortune 500 rankings, their smaller size means that they can also fall off advisors’ radar, leaving owners sometimes struggling to figure out the best way forward.

“There are cases where there’s a business that can continue but needs to have a transfer of ownership,” Goldstein told FWR. In many cases, businesses fall in the small- and mid-cap categories, and are unlisted and not traded on the public markets, he said. 

And the ESOP model can help deal with some transitions, although Goldstein was at pains to stress that it is not ideal for all cases. 

An ESOP is a type of stock bonus plan; a defined contribution retirement plan that is designed to be funded with employer stock. Employer contributions into an ESOP are deductible in the year that they are actually made to the plan. The contribution can consist of cash or the employer corporation's stock. If a contribution is made in stock, the employer won't recognize any gain or loss on its taxes (source: www.lawyers.com). There is no 10 per cent early distribution tax on distributions that are dividends from an ESOP, even if a person receives them before 59½ years of age.

An employer's tax-deductible contribution to an ESOP is capped at 25 per cent of the compensation paid or owed during the tax year to all of the plan's beneficiaries. In calculating this limit, the maximum compensation of an employee taken into account is $270,000 (this applied in 2017; this limit increases most years). If the contribution is more than the limit for a given year, the excess amount can be carried forward to future tax years. (Source: www.lawyers.com). 

ESOP companies have an advantage over other forms of companies, Goldstein said. “There is a stronger commitment to a stable and sustainable future, and avoids the resale cycle caused by private equity transactions that seek to return immediate returns to investors. These are the benefits. The challenges are finding good companies that meet the profile and are in need of transition. The risks are the same as for any business: tariffs, workforce, economic factors, disruption, etc.”

However, Goldstein cautioned that the legal and transaction costs required to set up an ESOP are not insignificant and there has been increased action taken by regulatory agencies investigating new ESOPs.

So, what of the future for Folience and the employee-owned approach?

“The future business strategy is to continue acquiring successful businesses with strong management teams to further diversify the revenue base. The scalability of the model is in the diminishing cost of shared services that support the transition of ownership and integration of the companies to the Folience platform,” Goldstein said. 

Some sectors of the economy are better suited to the ESOP approach than others, he said. 

“With ESOPs, employees do not pay for ownership - they invest their labor to earn equity in the business,” Goldstein added.

(Editor's note: We are keen to hear from other wealth management practitioners about what they think of the employee-owned approach to transition, either positively or negatively. Email the editor at tom.burroughes@wealthbriefing.com

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