Selling a Business to a Third-Party vs an ESOP: Benefits, Disadvantages, and the Breakeven Point
Selling a business is a significant step that requires several weighty considerations. One crucial decision is whether to sell the business to a company ESOP or a third-party buyer. Each scenario has distinct advantages and disadvantages regarding exit planning, profits, and tax benefits. In this article, Abrams Valuation Group, Inc. examines the pros and cons of each scenario. In addition, AVGI identifies the breakeven point, when either option would have an equal outcome for the business owner.
Selling as a C-Corporation to an ESOP Benefits
Two significant ESOP benefits exist that an owner can take advantage of when selling to an ESOP rather than a third-party owner.
The first and most obvious ESOP benefit of selling the company as a C-corporation to an ESOP is eliminating the seller’s personal capital gains taxes. However, depending on the sale scenario, the lure of this significant tax benefit may be outweighed by other benefits or the loss of other benefits. We will discuss this in more detail.
Several studies have shown that companies with an employee stock ownership plan outperform non-ESOP companies in employee and sales growth. Most notably, the Rutgers study by Douglas Kruse and Joseph Blasi (2000) found that actively engaged employee ownership companies outperformed non-ESOP companies by 2.4% higher sales growth, 2.3% annual employee growth, and 2.3% higher sales per employee. Viewing the sale through an exit planning perspective, a sale to an ESOP seems to ensure the continued growth and prosperity of the company better than a sale to a third party. This will, of course, depend on the owner’s exit planning goals.
Nevertheless, this objectively higher growth rate is a noted ESOP advantage that awards a sale to an ESOP a 15% valuation advantage over a sale to a third party. We will again discuss this in further detail.
Selling to an ESOP- Disadvantages
It’s also important to consider the disadvantages of selling to an ESOP to make a fully informed decision. Some of these disadvantages might not be obvious, as they can arise from a series of later decisions. We explore the major potential ESOP disadvantages below:
Suppose the company is an S Corporation (or other non-tax entity). In that case, it must first switch to a C corporation before completing the sale to the ESOP to take advantage of the Section 1042 rollover ESOP tax advantages. If the company were to be acquired by another C corporation in the future, it would no longer qualify for a step-up in the tax basis of its assets through a Section 338(h)(10) election. This means that the acquirer would be left with a lower basis of assets with which to calculate future depreciation, which leads to a direct dilution of company value. For this reason, S corporations enjoy a valuation premium over C corporations; switching from an S to a C corporation status means that the company relinquishes this premium.
The common practice among appraisers is to apply a lower Discount for Lack of Marketability (DLOM) for a sale to an ESOP vs a sale to a third-party. This practice is based on two main reasons:
a. The ESOP itself provides a market in which the shares of the company stock can be sold in contrast to a private business which is often a struggle to sell as there is a limited market of interested buyers.
b. The ESOP is more protected against exploitation and abuse by the control shareholder than a regular shareholder would be.
For these two reasons, a post-transaction valuation of a sale to an ESOP would have a lower DLOM discount rate than a sale to an external buyer. This lower discount rate can translate into a much higher post-sale company valuation with accompanying higher tax obligations for the seller.
If the owner sells a portion of the company’s stock to the ESOP, this immediately dilutes the firm’s fair market value. The company guarantees and subsequently pays the ESOP’s loan to complete the transaction, so the sale creates a liability for the company that did not exist prior to the sale. However, if the owner sells 100% of shares of company stock to the ESOP, the firm’s value is not diluted.
Suppose the owner sells a control interest to the ESOP (more than 50% of the company shares). In that case, the remaining ownership will automatically become a minority, suffering from a lack of control. This undermines the value of their ownership, as an appraiser would apply a discount for lack of control (DLOC) in valuing their shares. However, if the original sale contract stipulates that future sales must be at a control price, then the value of the minority shares remains unchanged.
These are all important considerations to factor in when contemplating a sale to an ESOP.
Selling as an S Corporation to a Third-Party- Benefits
The other side of the coin- remaining an S corporation and selling to an external buyer- has potential advantages and disadvantages as well. Here, we examine in detail the pros and cons of this sale scenario.
As we mentioned earlier, remaining an S corporation means that the company maintains the ability to step up its assets basis for taxation if they are acquired in the future by a C corporation. In “The Effect of Organizational Form on Acquisition Price,” Erickson and Wang reveal that acquiring C corporations pay between 11%-17% more to acquire S corporations than C corporations for the ability to step up the basis of assets and utilize the tax advantage of Section 338 (h)(10) of the Internal Revenue Code. For this analysis, AVGI assumes a midpoint of a 15% higher valuation premium for S corporation over C corporation status. Furthermore, if the company is small enough that relevant buyers might include individuals or other non-tax entities, maintaining S corporation status eliminates corporate tax, and it is reasonable to assume an even higher premium (in some cases as high as 43%).
Selling to a Third-Party-Disadvantages
The main disadvantage of selling to a third party as an S corporation is that this leaves the owner with personal capital gains tax. Depending on the profits of the transaction and the owner’s personal income tax situation, this may be a significant enough disadvantage to deter the owner from going through with the sale. Now we will examine the formulaic way to calculate which scenario is in the owner’s best interest and determine the breakeven point.
Sale to Third Party vs ESOP Benefit Calculator
Below are three of Jay B. Abrams’ original formulas, which can be used to determine
The owner’s total profit from selling the business as a C Corporation to an ESOP.
The owner’s total post-tax profit from selling the business as an S Corporation to a third-party buyer.
The breakeven formula determines the point at which the third-party sale vs. the ESOP advantages would be equal. At the breakeven point, the business owner would be indifferent as to whether they sold the business to an ESOP as a C Corp or an external buyer as an S Corp.
Profits after Sale to ESOP Calculation
This formula calculates the total profits for the business owner after the ESOP transaction.
Using the Formula: Sale to ESOP Benefit Example
Sir Maximo Bonestein is the 100% owner of his company. We will use this formula to calculate Sir Maximo’s post-sale wealth if he sells 51% of his company shares as a C Corp to an ESOP.
The marketable minority FMV is $8,888,889 . We subtract a 10% discount for lack of marketability (DLOM) and add a 25% control premium to arrive at a $10 million Private Control fair market value before the transaction. Sir Maximo’s 51% has a FMV of $5.1 million.
Assuming a 40% corporate tax rate, we subtract the after-tax cost of the ESOP loan from the $10 million pre-transaction FMV (1–40% = 60% of the amount of the loan, or 60% × $5.1 million = $3.06 million). $10 million – $3.06 million gives us a post-transaction FMV of $6,940,000.
Next we subtract the lifetime after-tax ESOP cost of 2% × $6,940,000 = $138,800. The remaining FMV of $6,801,200.
Next we apply a 20% DLOC and 15% Control Premium to arrive at a post-transaction FMV with the ESOP premium on a private-minority basis of $6,257,104.
Multiplied by Sir Maximo’s remaining 49% interest in the company + $5.1 million = Sir Maximo’s total wealth post-ESOP sale is $8,165,981. As he is able to utilize the Section 1042 rollover tax benefits, he does not pay any personal capital gains taxes on the 51% of shares he sold now or future capital gains taxes on the 49% of shares retained.
Profits after Sale to Third-Party Calculation
This formula calculates the business owners’ total wealth post-personal taxes following a sale to a third party.
Using the Formula: Sale to Third Party Example
Now we examine Sir Maximo’s alternative option: to sell 100% of his company as an S corporation to an external buyer. The pre-transaction FMV of the Company at the Public Minority level, i.e., before the control premium and the discount for lack of marketability (DLOM), is $10,222,222.
We subtract a 15% DLOM and add a 25% Control Premium to get a FMV at the private control level of $10,861,111. It’s important to note that the S corporation values are higher by 8.6111%, so the combined effect of the 15% S corporation premium and the 94.444% ratio of the valuation effect of the higher S corporation DLOM compared to the ESOP DLOM.
Next we calculate Sir Maximo’s personal capital gains taxes at a combined Federal + California State rate of 22.14%, which will leave Sir Maximo with post-tax wealth of $8,456,461. That is $290,480 higher than his total wealth in the ESOP sale.
Breakeven Point Calculation
Using the above equation, we calculate the breakeven percentage, p*. This is the percentage of company stock sold to the ESOP as a C corporation at which the valuation is identical to the sale to the third party as an S corporation. In Sir Maximo’s case, the breakeven percentage is 66.18112%, given all the assumptions we have made.
(Again, for a full breakdown of the calculations and analysis, please see Jay B. Abrams’ original article “The Tradeoff in Selling to an ESOP vs. an Outside Buyer” © 2003, Jay B. Abrams, ASA, CPA, MBA which is available for download below. )
The Bottom Line: When should you sell to an ESOP vs a Third-Party?
That depends. Based on the results from Sir Maximo’s case, it appears that he stands to gain more from a 100% sale to a third-party as an S Corp rather than a 51% sale to an ESOP as a C Corp. However, this purely financial calculation does not consider other personal exit planning, family and friends, or estate planning considerations. These non-financial factors may play a significant role in determining the best plan of action for the sale.
When considering an important business decision like a sale or partial sale of a company, Abrams Valuation Group, Inc. encourages business owners to discuss all aspects of the potential transaction with a qualified and trusted business transaction advisor. AVGI has over 30 years of experience in advising and supporting business owners through the business transaction process, from determining the best course of action to seeing the transaction through to completion. Give us a call or fill out a contact form to start your journey with the right foot forward.