Is an ESOP the Right Exit Strategy for Your Business?

Understanding the Pros and Cons of Employee Ownership

At some point, every business owner confronts the question: What’s the right path for my exit? For many owners of family and founder-led companies, the answer has historically centered around family first, key employees second, and third-parties, Third parties an include a strategic buyer, private equity group, or competitor. Another option that is gaining attention is the Employee Stock Ownership Plan, or ESOP.

An ESOP isn’t for everyone. But in the right circumstances, it can offer significant financial and cultural benefits for both the seller and the employees.

Why Are More Owners Considering ESOPs?

There’s been a noticeable uptick in ESOP transactions recently, driven by a few key factors:

• Tax advantages that can materially impact after-tax proceeds to the seller.
• Continuity that appeals to founders concerned about their legacy and employees.
• A unique employee benefit that drives stronger employee retention, especially in periods of low unemployment.

Still, the mechanics are complex, and the path to seller liquidity is more gradual than other options.

Advantages of an ESOP

1. Structured Succession With Employee Ownership

For owners without a next-generation family member, a key executive leader who wants to buy the business, or an external buyer lined up, an ESOP creates an internal market for the business. This allows the owner to begin stepping away while rewarding employees and maintaining operational continuity.

2. Attractive Tax Treatment

Few exit options offer the tax flexibility of an ESOP. For example:

• C-corporation owners may defer capital gains taxes if proceeds are reinvested in qualified assets.
• S-corporations owned 100% by an ESOP pay no federal income taxes, creating material cash flow advantages.

These tax benefits can, in many cases, offset the absence of a competitive sale process.

3. Cultural Preservation

Unlike a sale to an outsider, employee ownership helps preserve the business's principles, operating rhythm, and brand identity. This is often a critical consideration for founders who have spent decades building not just a company, but a culture.

4. Employee Engagement and Retention

ESOP-owned companies consistently report higher employee retention and morale. During the COVID-19 pandemic, ESOP firms were up to four times more likely to retain staff, a powerful testament to the shared ownership model.

Challenges and Limitations

1. Slower Exit Timeline

If you’re looking to exit quickly and fully, an ESOP likely isn’t the best path. Most transitions unfold over years, with partial sales followed by continued leadership involvement.

2. Structural and Regulatory Complexity

Establishing an ESOP requires significant legal, financial, and compliance effort and expertise, which can be quite expensive upfront and as an ongoing cost. Requirements include:

• Appointing an independent trustee to manage the ESOP.
• Conducting annual third-party valuations to determine entrance and exit values.
• Ongoing adherence to ERISA and Department of Labor rules.

These elements create ongoing obligations that differ from a traditional sale, where none of these requirements exist post-close.

3. No Strategic Premium

ESOPs are required to transact at fair market value (“FMV”), a term defined by the IRS in Revenue Ruling 59-86, no bidding wars, no premium for synergies. Under the FMV standard, a buyer must be hypothetical, thus not considering the specifics of a buyer. In most cases, this will translate to a passive financial investor as the hypothetical buyer, resulting in a higher cost of capital and lower valuation as compared to a market or “investment” value that considers the lower cost of capital for certain buyers. Owners seeking to maximize valuation through competition will likely find more value in a third-party sale that doesn’t use FMV.

4. Governance Adjustments

With an ESOP, the company takes on fiduciary duties to its employee-owners. This may impact decisions around compensation, major transactions, or corporate direction. Founders who are used to full control should be prepared for more formal oversight. Studies have shown that ESOP companies make more conservative decisions regarding growth and investment due to these fiduciary obligations. A company that used to grow aggressively and quickly may find this a difficult culture change.

When Does an ESOP Make Sense?

We’ve found that ESOPs are best suited for companies that:

• Are mature and have steady, predictable cash flow to support leveraged transactions.
• Are focused on retaining employees and preserving culture.
• Are open to a phased ownership transition.
• Want to explore tax-advantaged liquidity solutions.

By contrast, a traditional sale process may better serve businesses in cyclical or declining industries or owners prioritizing a premium price and rapid exit.

Navigating the Right Exit Strategy

Choosing how to exit your business is complex. The process should center around people, purpose, and long-term outcomes. At Breneman Advisors, we help family and founder-led companies explore the full range of options, from ESOPs to third-party sales.

If you're evaluating your next move, let’s have a confidential conversation. Together, we’ll define the right strategy for your business, employees, and future.