Employee stock ownership plans or ESOPs for short, are a popular way to transfer business ownership while enjoying significant tax advantages. Current owners cash out in a planned, orderly way, while the company’s employees become the new business owners.
Comparing options: ESOP or business sale
On the other hand, business owners can sell the company to a third party. Which option is the best? Before making a decision, consider these points:
If the company is a pass-through entity, such as the US S-corporation, you may need to switch to a C corporation in order to take advantage of the Internal Revenue Code 1042 rollover. But if you later decide to sell the company to another C corporation, you waive the benefit of treating the assets in accordance with IRC 338(h)(10) election. This prevents your buyer from stepping up the business asset base for future depreciation, a potentially significant cost.
Unsurprisingly, S corporation business values often carry a hefty premium over their C corporation counterparts.
Role of discount for lack of marketability (DLOM) in ESOP valuations
Many business appraisers assign a lower discount for lack of marketability (DLOM) when valuing a business for ESOP than a third party sale. This is because the ESOP by its very nature provides a limited market and is shielded from abuse by the controlling owners.
ESOPs are more costly to run than other employee retirement plans. This extra cost reduces the business value.
There is strong market evidence that the companies implementing an ESOP tend to perform better than their peers. The reason may be that the owner employees are more motivated having the business ownership at stake. Firms using ESOPs have statistically higher sales growth prospects, better trained workforce and better key employee retention. All this increases the business value.
Selling to an ESOP also helps you avoid the capital gains tax on personal returns.
However, there are some benefits of selling the entire company to outside investors. In particular, pass through companies, including S corporations, sell at a premium in value compared to C corporations. This additional premium can run in the 10% – 15% range, a significant addition to the firm’s fair market value.
So converting the company to a C corporation in order to implement an ESOP plan may backfire should you choose to sell the company to a third party instead.