By Jason Watson, CPA

Posted Sunday, May 26, 2019

Exit strategies or succession planning usually consider employee ownership as a strong possibility. It is a difficult decision for most business owners since their business is their baby, and the blood, sweat and tears remain a close memory. However, no one gets out of this world alive so like it or not, the exit plan should be discussed.

Some businesses don’t fare as well as others when determining the exit plan. For example, you are a solo attorney working a lot of one and done cases such as divorce or DUIs where there is very little recurring revenue. This is difficult to sell or transition to others since most acquisitions involving personal services are based on future revenue. Take this same solo attorney and consider him or her an estate planning attorney who might have “maintenance agreements” with the clients; this dynamic of future recurring revenue now creates an economic benefit that another attorney might want to acquire. Boom! You’ve created an attraction that can be leveraged into succession.

According the National Center for Employee Ownership website-

The General Social Survey (GSS) data are reported in detail in a separate page on this site. In sum, however, they showed that as of 2014, 19.5% of all employees working in the private sector reported owning stock or stock options in their companies, while 7.2% specifically held stock options. Looked at another way, 36% of employees working for companies with stock (this excludes government employers, nonprofits, partnerships, etc.) owned stock or options in their companies. This means that approximately 32 million Americans own employer stock through ESOPs, options, stock purchase plans, and 401(k) plans

Why? Many employers determine that productivity and employee satisfaction improve when employees have ownership. In addition, employee recruitment and retention are also improved. Employee ownership therefore becomes a part of the continuity or exit plan for many employers.

An ESOP might be a great succession plan. First, what the heck is an ESOP. According to a May 2017 article in the Journal of Accountancy–

ESOPs were created by the Employee Retirement Income Security Act of 1974 (ERISA), P.L. 93-406, and have long been used as a vehicle for ownership succession planning. According to The ESOP Association, there are approximately 10,000 ESOPs in the United States, covering 10.3 million employees. While ESOPs exist in a broad range of industries, they are most prevalent in manufacturing and construction companies, as well as engineering and architecture firms.

The basic gist is that the present owners sell their shares to the ESOP and typically take back a note from the ESOP (a loan). The ESOP can also obtain outside financing to purchase the outstanding shares. From there the business provides the funding to the ESOP to pay its debt obligation. According to the National Center for Employee Ownership and affirmed by a Journal of Accountancy article, the cost to set up an ESOP which includes the feasibility analysis, paperwork and initial valuation ranges from $40,000 to $80,000 (and higher). As such this is requires some careful consideration.

Here are some links-

www.wcgurl.com/6113 (NCEO’s article on ESOPs and S Corporations)

www.wcgurl.com/6111 (Journal of Accountancy on ESOPs in a CPA Firm)

WCG is currently exploring the poor man’s version of an ESOP where our primary entity is a C corporation which has a robust shareholder agreement for buying and selling of shares. While we are sacrificing the huge tax benefits of a true ESOP we are saving on costs and increasing our flexibility. One day we might convert to an ESOP just not today.

Why do you need a shareholder agreement? If you own 5% of a privately held small business you basically own 0%. Huh? Unless there is a market (public or private) where the minority shareholder can sell his or her shares, a 5% ownership in a privately held small business is not marketable and therefore not as valuable. In the business valuation world we call this degradation of value a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM). Here is the IRS Job Aid on Discount for Lack of Marketability.

Therefore, a business needs to create a market both on the buy and sell side. For example, CPA firms typically are valued at about 1.0 to 1.5 times gross revenue depending on the quality of book of business (age of clientele, average fee, amount of recurring revenue, etc.). Using our example you could set up a program where an employee could buy shares using a valuation formula. Let’s say you have a CPA firm and you believe the factor is 1.2, and you also wanted to give your employees a 10% discount. You are growing and so you also want to use an average revenue number based on the previous two years to smooth out the value.

Your per share value formula would be (90% x Avg Revenue x 1.2) / number of authorized shares. This could be used for the buy side, and on the sell side.

On the buy side you could allow employees to purchase stock annually. You could also issue shares as a form of compensation (yes, that would find its way onto a W-2). You could also use this arrangement for a future owner where he or she pays some cash and obtains bank financing for the remainder allowing acquisition of a large chunk of stock. Many business-oriented banks will put together a deal where the new owner puts in 20% and the bank finances the 80% using the original owners as a backstop for collateralization. In other words, the sellers or original owners would promise to buy the stock back from the bank upon default, should it occur.

On the sell side you could allow employees to sell annually as well, and only upon separation from the business. By creating a market, a 5% minority ownership now has value. Some other considerations include that no person or entity other than current employees can own stock, and should an employee get divorced he or she cannot give the marital property to the other spouse.

Another consideration is voting rights. Do the minority shareholders have a vote? Perhaps by proxy? Ownership without a voice might not feel like ownership to your employees. How about wholesale sale? In other words, are the majority owners allowed to sell the entire business including the employees’ interests? Do the employees get a first right of refusal to buy out the majority owners?

Our example above was straightforward since CPA firms have enough market data to determine a gross revenue or sales factor. Other businesses use factors as well such as insurance agencies, financial advisor firms, franchised restaurants among several others. If a market approach to valuation using a gross revenue or sales factor cannot be used, a more complicated valuation approach or agreed-upon formula must be used. There are other factors too such as EBITDA (earnings before interest, tax, depreciation, amortization).

How does the current owner(s) pull money out? Our schematic to the right illustrates an arrangement that could be followed. We can get a bit nutty with the customization of this too… this is very simple but super flexible.

In our arrangement, income flows into the C corporation which is owned by you and your employees. A contractual arrangement would exist where the C Corp would pay your S Corp a management fee leaving a small amount of C corporation income behind (near zero).

This is a generalization and proper consultation with a tax professional (us) and an attorney (others) is a must.

Leaving your business behind to junior still works under the ESOP or home-grown stock purchase plan. They own stock like any other person either acquired through purchase, gifting or upon death.

Jason Watson, CPA is the Managing Partner of WCG (formerly Watson CPA Group), a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.