Is Your Company Sale or ESOP Ready?

By Ashley Pellegrino, Senior Associate and John N. Vitucci, Partner

In many cases, a private business may be an owner’s most valuable asset. At the same time, often a business’ most valuable asset is its owner. This article focuses on preparing for a successful exit strategy through the sale of the business to a third party or an ESOP. Whether the business is ready for a third-party sale or sale to an Employee Stock Ownership Plan (ESOP), proper planning and preparation is necessary in both scenarios.

Proper Planning for a Sale

Devoted business owners deserve to receive a fair price for their most prized asset (some call it their “baby”) they’ve worked so hard to create. Preparing a business for sale is a crucial step in maximizing its value and ensuring a smooth transition for both the seller and the buyer. Unfortunately, proper planning is often disregarded and sales become forced especially in a death, disability or family dispute situation. In a forced sale, the seller has little to no bargaining power and will likely receive far less once the sale is final.

Business owners who rely entirely on selling a business as both their exit plan and succession strategy, seriously risk preserving a company’s value. Given the owner’s vast network of industry contacts and experience, the company often represents their largest asset. Succession planning is a prerequisite before deciding to sell a company to maintain a business’ profitability and retain its value. Effective succession planning is equivalent to a realtor staging a house before it goes to market; it protects value, piques interest and accelerates sales.

Competent CEO Successor

An important factor in selling a business or continuing a family business is whether there is a competent successor CEO or management team to run the business. This can have a dramatic impact on value regardless of whether the sale is to a third party or an ESOP. Buyers within the industry may care less about the management team but will often want the owner or the management team to stay on for a certain time period.

The decision to sell often incorporates several personal, business and economic factors. An owner may be in bad health, experiencing burnout, interested in pursuing other ambitions or aiming to diversify his or her wealth when contemplating selling or retirement. In some cases, business owners are approached with attractive, unrefusable offers from outside buyers. Contract renewals, product or services launches, expected industry changes and technological developments may also influence the sale of, or retirement from, a business. Current demand and heightened valuation multiples may also entice business owners to sell. Regardless, being ready and nicely prepared for a sale can make it easier for potential buyers to assess your company and maximize value.

Requirements for a Potential Sale

A potential buyer of any company will at minimum require two years of historical financial statements, including the interim financials for the current year of sale. Buyers would also like to see realistic financial statement projections going forward for five to 10 years. The more organized and accurate the accounting records, the easier it is for potential buyers to assess your company’s value. Accurate accounting data can help identify trends in your business and be used to maximize profitability. To ensure accounting data is accurate, accounting processes must be consistent.

A compilation, a review or an audit may be conducted to provide reasonable assurance to a buyer that the financials are presented fairly and are in accordance with Generally Accepted Accounting Principles (GAAP). Utilizing reliable accounting systems and generating accurate accounting data eases the burden on auditors of gathering evidence to support their audit opinion and can alleviate the cost in obtaining one. Financial statements with robust accounting processes are often perceived as more reliable and can accelerate the sale process. Your accounting firm or CFO are important players in helping with the historic and projected financial statements. Some business owners utilize outsourced CFO services to help in this regard. The outsourced CFO services can help clean up financials, help install better controls, risk management and help develop budgeting.

The accounting of business transactions must generally follow industry standards and GAAP. GAAP requires most businesses to post accounting activity using the cash or the accrual basis of accounting. Potential buyers generally expect financial statements to be produced using the accrual method since it presents a more accurate picture of a company’s profitability and makes it easier to compare similar companies. The accrual basis requires a company to match revenue earned with the expenses incurred to generate the revenue. For instance, a bill is recognized as an expense in the month it is received, even if payment of said bill is delayed; whereas the cash basis, used by many small companies, recognizes income and expenses only when money changes hands.

Cash accounting may sometimes distort profitability. A company using cash basis accounting may appear profitable until company expenses are paid. Business owners should consider using a CPA to confirm a company’s financial records comply with accounting standards and tax laws. Having prepared, accurate financial statements increase the reliability of a company’s profitability and can raise the price received for it.

A compilation is a financial report put together by a CPA firm that follows guidelines established by the American Institute of Certified Public Accountants (AICPA) to assure the financial statements are presented in accordance with GAAP or other recognized standards acknowledged by the AICPA. This is a relatively inexpensive report, compared to the other two reporting options, but it also provides no assurance.

A review is the next step up and provides limited assurance. This report must also be done by a qualified CPA firm, but unlike a compilation, the firm must be independent; in other words, the firm has no financial interests in the business, or with the area of the business it reviews. A review is typically two or three times more expensive than a compilation, with a corresponding increase in the level of work that goes into the review process, as well as the increased risk that the accounting firm assesses in preparing the reports. Reviews, however, are like compilations, in that they are the representation of management and not the CPA firm.

An audit is typically a much more involved process and provides reasonable assurance that the financials are presented fairly, in all material respects, and are in accordance with the stated financial framework, such as U.S. GAAP or International Financial Reporting Standards (IFRS). Audit procedures include an examination, substantive analytics, confirmations and, for some companies, the testing of internal controls. Audits can be two or three times the cost of a review and can even get into six figures, depending on the company, its size and the complexity of the transaction involved.

Sometimes a buyer may want a quality of earnings report as part of their due diligence process. Although a quality of earnings report is not an audit, it can help provide additional support for a target company’s revenue and expenses, including sustainability and accuracy of past operations. Some businesses may not be generating monthly internal financial statements or wait until year-end to book certain closing entries that should be made monthly or quarterly. In turn, any interim financial statements may be starkly different than what would be included in audited annual financial statements.

Although it is commonly recognized as a preferred metric, earnings before interest, taxes, depreciation and amortization (EBITDA) are an important metric in getting a business sold. However, there can be limitations in how EBITDA fails to address the need for growth reinvestment as a capital-intensive business doesn’t cash-flow as well as others.

For closely-held businesses, there will always be adjustments regarding the seller’s activity. Sellers and other key members of management may be taking above market compensation (called “excess” compensation) out of the business, which requires certain adjustments or replacements after the transaction closes. There could also be other discretionary bonuses and “unrelated expenses” the owner may be flowing through the business. With that knowledge to consider, it is important for the buyer to thoroughly examine and substantiate these amounts.

Strengthening a Company’s Value

A business owner’s main goal in getting a business sale ready is to increase a company’s marketability and value. In the event of a sale, company value directly correlates with the price received for the business. Increased brand awareness creates a larger customer base that can drive greater revenue and profits. Gross profit and operating margins can also be maximized by reducing the cost of a good or service. Costs may be reduced by forcing key suppliers to compete for your business. Metrics should be used to monitor a company’s performance and identify areas of improvement. These metrics can strengthen a company’s value by offering insight into potentially necessary changes. Proactively increasing the value of your company by generating more revenue and profits often justifies a higher sale price when the time comes.

Gather All Company Documents

In preparation for exit, business owners must gather all company-related documents. These documents may include corporate bylaws, licenses, permits, tax returns, benefit plans, employment agreements, leases and contracts. Having these documents organized and readily available offers transparency that builds trust and confidence in the transaction.

Name and Train Successors

All this preparation, while time-consuming and often overwhelming, helps an owner maximize company value. Proper planning prevents owners from accepting low-ball offers and ensures he or she gets what is deserved for the company. However, this value is often threatened by owners having no succession plan. Owners may not have had the time to name and train the next generation and these leadership gaps are often detrimental to a company’s value. Private equity or strategic buyers expect the next generation of leadership to be established and trained before the sale. If not, they may demand significant earnouts, claw backs or other draconian purchase covenants resulting in less money for the seller.

ESOP Considerations

Owners with no prior succession plan, owners who would like to reward employees with an ownership stake in the business or owners who are not yet ready to relinquish complete control may consider selling his or her company to an Employee Stock Ownership Plan (ESOP). The implementation of an ESOP can be utilized as either a complete exit or an interim step for a third-party sale down the road especially if a successor management team or the next generation of family members are not up to the task, while creating wealth and aligning all stakeholders (employees, management, selling shareholders and society). A sale to an ESOP will require many of the steps necessary in selling to a third party.

Given the current economic environment, some banks, especially regional banks, may be cutting back their lending in sale transactions except to their existing clients. In the instance where banks are lending, current loan funding amounts may be lower compared to a few years ago when interest rates were lower. Additionally, the banks are typically asking for more financial covenants which are designed to lower their risk. This could potentially make ESOPs more attractive in the current environment.

An ESOP enables business owners to gradually transition ownership to the next generation of ownership, be it family and/or the existing management team and reduces the risk of valuing abrupt changes often associated with third-party sales. Selling to an ESOP allows owners to maintain control while ensuring a seamless transition of leadership and talent to the successor management team. Owners can get monetized by proceeds from the sale, maintain an income by continuing employment and tax-efficient plan for retirement while employees receive retirement benefits proven to outpace traditional 401(k)s and outperform the S&P 500 in year-over-year investment returns. An ESOP is a creative solution that aligns the interests of business owners with that of other shareholders, management and employees.

Under current law, a 100% ESOP owned S Corporation will not incur any federal taxes. Most states follow the federal statute and do not tax ESOP S Corporation earnings. These tax benefits allow for a quicker monetization of the business compared to a third-party sale.

A 1042 ESOP exchange transaction enables selling owners to indefinitely defer capital gains tax on the sale of closely held C Corporations. At least 30% of the company’s equity must be sold to the ESOP, the stock sold to the ESOP must be common stock, and the seller must have held the stock for at least three years before selling to the ESOP. Proceeds of the sale must be reinvested in securities or bonds of domestic operating companies within a 15-month period that starts three months before closing and ends 12 months post-close. Under this transaction, the business owner and family members cannot participate in the ESOP. This strategy may make sense for an older business owner, with no family members in the business, who lives in a high tax state.

Business owners and family members interested in participation in the ESOP may do so by implementing a new 401(k) plan with an ESOP component or by adding an ESOP component to an existing 401(k) plan. While this approach has been commonly used by public companies, it is becoming increasingly prevalent in the private sector. The 401(k) component of these plans can be structured utilizing a pre-tax or ROTH approach. Under the ROTH approach, the invested ESOP equity is taxable today, but the retirement benefit (and its income) that is paid out after the later of five years and age 59.5 is withdrawn tax-free. This combined approach may result in superior economic benefits, increased investment flexibility and better alignment among stakeholders compared to the 1042 traditional ESOP transaction.

Ongoing Succession Planning

Preparing a business for sale is a comprehensive process that requires careful planning, financial analysis, operational optimization and legal compliance. Succession planning is an ongoing, vital part of this process that contributes to the success and sustainability of an organization. Business owners should be urgently preparing for succession regardless of intending to sell. An ESOP serves as both a succession plan and an exit strategy for current owners. Owners who would like to get their business sales ready or who are not yet ready to abandon their business and are interested in increasing liquidity, diversifying assets, or providing employees with a valuable retirement benefit should contact us.

Contact Us

If you have any questions about ESOPs, please contact your PKF O’Connor Davies client engagement partner or:

John N. Vitucci
Principal
ESOP Practice Leader
jvitucci@pkfod.com | 917.841.8718

Ashley Pellegrino
Senior Associate
apellegrino@pkfod.com | 646.699.2923