The two most common uses of employee ownership plans (ESOPs) in SMEs are to buy the shares of a retiring owner in a private company or as an additional employee benefit/incentive plan. These two uses probably account for over two-thirds of all the ESOPs now in existence throughout the world.
The proportion of ESOPs created to buy out a retiring owner can be expected to increase with time, because of the number of ageing owners hitting the “market”.
Companies have also used ESOPs as a technique for corporate finance for a variety of purposes – to finance expansion, make an acquisition, spin-off a division, take over a private company, etc. In a small number of cases — about 1% in the US and the UK – ESOPs have been used to buy out a failing firm that would otherwise close.
Buying the Share of a Retiring Owner
Many closely-held, private companies have no plans, or incomplete plans, for business continuity after the retirement of the founder, or the departure of a major shareholder.
If the company repurchases a retiring or departing owner’s shares or the departing owner sells his or her shares to another company, the proceeds to the owner may be taxed in full as capital gains if certain requirements cannot be met.
Finding a buyer for these shares is not always easy even for a profitable company. A retiring owner may face an unpleasant choice between selling to a competitor or conglomerate, or liquidating. Employees often understand the value of a business better than anyone… from the inside.
An ESOP can provide a market for the equity of a retiring owner – or any interested major shareholder – of a private company, and provide a tax advantage and job security for employees at the same time as part of the process.
Employee Benefit or Incentive
Most ESOP companies have the need to set up an employee benefit or incentive program as a reason for starting their employee share plan. For many companies this is often the only reason.
Some companies hope that by making employees owners they will increase their dedication to the firm, improve work effort, reduce turnover, and generally bring a more harmonious atmosphere to the company.
Research has shown that giving workers a significant stake in their companies can improve employees’ attitudes towards their companies and that these improved attitudes towards their companies can translate into bottom-line improvements. Companies wanting to set up some kind of benefit plan find that an ESOP is usually the best choice.
Many studies on employee ownership show a positive correlation between ESOPs and company performance – and much anecdotal evidence lends itself favourably to ESOPs.
Feasibility of an ESOP Exit
The key to a successful exit via an ESOP is proper planning in the initial stages covering three critical factors.
> 1. Establishing exactly what the owner wants to achieve: Utilizing an ESOP for buyout demands precise definition of the requirements of the seller (what proportion of interest they want to divest, over what period, will they accept the fair market price of the business, do they want to maintain a continuing role for other family members in the business and so on).
> 2. Having an effective employee team and capable management: If the current employee team isn’t strong on the fundamentals of how the business operates, lacks the managerial capability or doesn’t get along as a team then they will fail to convince financing institutions of their capability to manage the business and maintain loan repayments.
Some restructuring, retraining and development of leadership skills in employees, particularly those who will take a management role, might be an essential prerequisite to ESOP buyout in these circumstances.
> 3. Putting the business in a financially viable position: A successful employee buyout could be defined as the purchase of predictable cash flows at an economically reasonable price. An ailing business won’t bring a good sale price for the retiring owner or be attractive to lending institutions.
The best time to consider an ESOP exit is when the business is in good condition since it must have the ability to generate cash flows sufficient to enable the repayment of debt and provide a satisfactory return on equity. The longer the period of grooming that can be put into preparing the business before discussing an ESOP the better.
In conclusion…
Selling a business to the next generation may mean putting it into the hands of people who lack the technical expertise or personal desire to carry it on successfully; selling to external buyers can be time-consuming, costly and will open up the business to intense scrutiny; liquidation of the assets will almost certainly not take into account goodwill and is likely to yield the lowest return.
Consequently, an increasing number of owners facing a succession decision is choosing to sell the business to their employees. Selling to employees can provide an attractive exit route that is tax-efficient, guarantees fair market value for the business and has the added social benefit of safeguarding jobs and preserving services within the community.
There are a number of forms of employee ownership suitable to business succession, some of which the ATO has concerns about if structured in particular ways. To ensure that your ESOP based business succession progresses satisfactorily, you need to be seeking the advice of experienced business advisers in this field.
Employee Ownership Australia is also developing a new model, based on a successful development in the UK. For more on Employee Ownership Trust business succession model, please see our blog post “A refreshingly different ownership model for private companies”.
See also: A Practical Guide to Employee Ownership In Australia, November 2022.
Employee ownership trusts: a flexible solution to business succession (Webinar, Prof. Andrew Pendleton, University of NSW, June, 2022)
For more on the EOT in Australia, see: Solving succession woes with Employee Ownership Trusts (University of New South Wales, November 2021).
If you or your staff are interested in considering employee ownership as a route towards a business succession of a company – especially a ‘high value’ one – please contact us at info@employeeownership.com.au.
For an excellent webinar discussion/presentation by four EOT businesses in the UK and the US, lead by Graeme Nuttall (June 2020), go to “Employee Ownership Trust Company Panel”
For stories on successful ‘business succession’ transitions of companies to employee ownership, see:
- Women lead employee-owned businesses lead the way in Scotland
- When staff run the show: the true benefits of employee ownership
See also our “Employee Buyouts” page and our “Employee Ownership Trusts” page.
See also our Learning from Private Companies about Employee Ownership Webinar
