Owners of closely held companies looking at their exit planning options should invest time in evaluating business transition options. No one exit strategy is right for every seller—or for every company going forward.
That’s why an important step toward a successful company sale — one that all parties involved agree is fair — is making sure you understand key differences between business transition planning options. Concerns that might arise for the business owner(s) include:
- Sale price, business valuation, and negotiations
- Structuring the sale, seller tax liabilities, and repayment risks
- Exit control and continuity of culture and operations
Choosing between a management buyout (MBO) and a sale to an employee stock ownership plan (ESOP) invites a side-by-side comparison of the pros and cons of each, and the priorities and values these two exit strategies align with. Both options involve selling a business to current employees, after all.
At the same time, there are plenty of differences between MBOs and ESOPs, and the reasons for choosing one transition path or the other. In this article, we’ll take a look at the similarities and differences, as well as key factors to consider when choosing the right exit strategy for you — and for your company’s future.
What is a Management Buyout?
In an MBO, a company’s current key management employee or team purchases the business from the owner or shareholders. The purchase usually involves borrowed money, making most MBOs leveraged transactions. Often, the management team and business owner agree to an MBO because this type of sale can meet the needs of both parties to the transaction:
- The seller believes that the management team is committed to the company’s ongoing success, understands the business, and is capable of running it with continuity.
- The management team wants the incentive and potential benefit of managing the company’s continued growth.
What is an ESOP?
An ESOP is a qualified retirement plan that creates a buyer in the form of an ESOP trust, which is established and funded to purchase company stock. The ESOP trust can be funded using borrowed money, seller notes, or some combination of both. Shares purchased are then allocated to individual employee accounts, and employees become fully vested over time.
The Employee Retirement Income Security Act of 1974 (ERISA) sets minimum standards for ESOPs, and regulatory compliance is key to qualifying for the tax benefits that can create a cash flow advantage for an ESOP company.
How are MBOs and ESOPs Similar?
As noted above, both exit strategies involve the sale of the business to current employees, possibly including family members. Other similarities include some level of flexibility in how the sales can be funded, whether using borrowed funds for a leveraged buyout or ESOP, seller financing, or a combination of both—though, in many cases, management team members sometimes also put up some of their own cash for MBO purchases, along with funds from other sources.
MBOs and ESOPs both rely on cash flow after the sale to repay the purchase, between repayment of seller notes and bank loans. In the case of MBOs, this can limit what’s affordable, in terms of company size. Both MBOs and ESOPs need to remain successful, profitable businesses with healthy free cash flow to repay any seller notes.
Both MBOs and ESOP sales can involve a limited purchase price for the business compared with a strategic third-party buyer. Management employees usually don’t have the means to pay that kind of premium, and business valuation puts limits on what can be financed. Similarly, an ESOP sale guarantees fair market value for the business and relies on valuation expertise to arrive at the sale price, rather than a strictly negotiated number.
An ESOP sale allows the business owner to stay on after the sale as an employee of the ESOP-owned company. Similar agreements may be part of MBO negotiations, which would allow the seller to continue working and slowly transition out of the organization. But it’s not guaranteed, and the seller may need an alternative plan if terms for remaining don’t pan out.
Both ESOPs and MBOs should incorporate succession planning into the long-term process, with a focus on goals of operational continuity and ongoing business growth.
Major Differences Between MBOs and ESOPs
Many of the biggest differences between these two business transition options have to do with regulatory aspects of ESOPs, since they’re qualified retirement plans and subject to regulation under the IRS and the Department of Labor. Because of the regulatory aspects, an ESOP transition actually often involves a fairly predictable path, starting with an initial feasibility study that determines whether an ESOP is a viable option.
An ESOP also requires specific roles and structures to be established. Many businesses work closely with an ESOP consultant, an independent valuation professional, an ESOP trustee, and a third-party administrator through the transition and beyond, to stay compliant with ERISA regulations, and to follow best practices to help ensure healthy cash flow for a well-funded ESOP, a healthy business, and reliable repayment of seller notes and bank loans.
While an MBO transaction is typically for the entirety of a business, ESOPs allow for partial sales. So for the owner who wants to access some of the cash without giving up all ownership stakes, or in the case of multiple shareholders who disagree, an ESOP can offer a solution. Sales of smaller percentages might not even require bank financing in some cases.
An ESOP’s tax advantages represent a major point of differentiation. A seller of a C corporation to an ESOP may be able to defer capital gains tax on the sale. Going forward, contributions to the ESOP are tax deductible for the business, and ESOP-owned S corporation stock isn’t subject to income tax. Those tax benefits help put the company in a strong cash position, which facilitates growth and continued success … and that can reduce repayment risk on seller notes.
In fact, on average, ESOP companies tend to outperform non-employee owned businesses and keep more of their workers employed, especially during challenging times like the 2008 financial crisis and the COVID-19 pandemic. For the seller with a strong interest in leaving a legacy, an ESOP can be an attractive exit strategy.
Key Considerations for the Selling Business Owner
It’s important to begin thinking about the ownership transition well in advance. These questions can be a helpful starting point to compare the MBO and ESOP options:
- Why do you want employees to take ownership of the business?
- Do you think all employees are capable of thinking and acting like owners?
- Financially, what do you need from the sale?
- How long do you intend to remain working, and do you want to stay in your role after the sale?
- How confident are you in the company’s continued success after the transition?
As your planned business exit nears, you’re likely to have questions about which exit strategy makes the most sense for you, for the business you spent your life building, and for the loyal employees who helped you succeed. Learn more about your options when you download Your Ultimate Guide to Business Exit Strategies. Click the link below to claim your free copy today.
