MSP Acquisitions: ESOPs (Employee Stock Ownership Plan) Explained
Plenty of managed services providers (MSPs) explore mergers and acquisitions. But if you look closely enough, you'll also see MSP owners exploring another exit strategy. It's called the ESOP (Employee Stock Ownership Plan). The idea: Sell some or all of the company to its employees — the folks who built the business in the first place. I first heard about the ESOP strategy from IT Solutions CEO Ted Swanson in 2011. But in recent weeks, I've heard from three MSPs that are considering the ESOP strategy. Here's why.
Generally speaking, an ESOP can offer several key advantages, according to this Forbes article:
- Low risk of layoffs;
- Low risk of default on the acquisition debt; and
- Tax advantages to combate rising rates on ordinary income and capital gains.
According to the National Center for Employee Ownership (NCEO), about 11,000 companies now have ESOP plans — covering 13 million employees. The NCEO says there are three uses for ESOPs:
- To buy the shares of a departing owner: Owners of privately held companies can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to buy out an owner's shares, or it can have the ESOP borrow money to buy the shares.
- To borrow money at a lower after-tax cost: ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.
- To create an additional employee benefit: A company can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25% of covered pay) from taxable income. Or a company can contribute cash, buying shares from existing public or private owners. In public companies, which account for about 5% of the plans and about 40% of the plan participants, ESOPs are often used in conjunction with employee savings plans. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level.
The NCEO says the cost of setting up an ESOP can be $40,000 or more.
Where can you go for help? While I hesitate to endorse anyone specifically, Monroe Capital might have some insights. The company, which focuses on mid-market and lower mid-market companies, has launched a national ESOP lending practice. It's led by Managing Director Ty Dealy out of Atlanta, Ga.
Also, CSG Partners of New York and San Francisco has an ESOP practice — though I suspect most small MSPs operate below CSG's radar. The company says it has completed more than 100 transactions for companies valued at over $7 billion — numbers that might be too lofty for SMB-focused MSPs.
For more background, the Menke Group — an ESOP advisor — has in-depth information about designing, activating and administering an ESOP plan.
One favor: If you explore an ESOP approach let me know. I'd like to hear what path your company ultimately selects (ESOP, M&A or something else…) and why.
Joe,
Our firm, CSG Partners, is working with two MSPs that are considering using an ESOP in 2013. There are two primary drivers: (1) creating a buyer for the owner's stock and (2) tax savings.
With regard to the tax savings, with the increased income tax rates in 2013 most business owners will be losing 45%+ of the cash flow to income taxes (more in high tax states). By selling their stock to an ESOP, the owners can generate substantial tax savings. If a company is owned 100% by an ESOP and is structured as or converted into an S corporation, the business becomes non-taxable. By eliminating income taxes, this substantially increases the company's cash flow which can be used to pay down the transaction. Alternatively, the owner could sell a partial interest (e.g. 49%) and retain a controlling interest; in this situation, the company effectively gets a “bucket” of tax deductions equal to the sale value. For example, if a company sold $10MM of stock, this could create $10MM in income tax deductions. Often times this is enough to substantially reduce or eliminate their taxes for several years, thereby freeing up cash flow to service the transaction.
Also, there are potential tax savings to the selling owner. In a traditional Mamp;A, the selling owner will have capital gains taxes- with the Federal rate increasing to 23.8% plus state taxes (often 5%+), this can be substantial. Depending on how the Mamp;A deal is structured, there can also be some items of ordinary income triggered. With an ESOP, depending on how it is structured, the selling owner can sell to the ESOP and elect not to pay capital gains taxes. Congress created this tax incentive to encourage owners to sell to an ESOP. There are several requirements that have to be meet.
Long story short, an ESOP can be a very attractive liquidity and tax savings strategy for owners. However, it depends on the situation on whether an ESOP, traditional Mamp;A, or doing nothing is best. The key is getting into the numbers.
George Thacker
gthacker@csgpartners.com
George,
Sorry about belated reply. I've been traveling. Thanks for offering all the tips in your comment. And also: Thanks for confirming CSG Partners has MSP knowledge. Good to hear. Please keep us posted and let the MSPmentor community know if those MSPs implement ESOPs in 2013.
Joe Panettieri
Editorial Director
joe [at] NineLivesMediaInc [dot] com