Is an ESOP in Your Future? Don’t Overlook This Valuable Succession-Planning Tool

2024 marks 50 years since Congress passed legislation codifying the tax benefits of employee stock ownership plans (ESOPs). Senator Russell Long, then chairman of the Senate Finance Committee, personally saw to it that ESOPs received favorable treatment in the Employee Retirement Income Security Act (ERISA) of 1974.

Despite being enshrined in our tax law for half a century, ESOPs have been slow to catch on. Few insurance agencies have availed themselves of the ESOP structure. Not many independent agency owners are aware of their tax advantages or that they’re an attractive alternative to selling to a third party.

But when properly structured, an ESOP may well be the best option for certain types of owners who want to stage their exit from the business, retain control of their firm and take care of their employees. ESOPs offer unique advantages that often outweigh other methods of perpetuation.

Who Is an ESOP Right For?

ESOPs aren’t for everyone, but they do warrant a closer look for well-run agencies that have at least 20 employees, little or no debt, an employee-focused culture and a strong management team.

Stable companies with consistent and reliable cash flows make the best ESOP candidates. Does this sound like the independent agency system?

Consider that when it comes time to retire, most agency owners would prefer to keep the business in the family or sell to their top managers. In other words, they want their agencies to stay independent. They may also want to leave lasting legacies in their communities.

Internal buyouts aren’t always possible, so an owner may end up selling to a private equity firm. All things being equal, independent owners would rather not be acquired by a larger firm that likely doesn’t share their goals, will replace their staff, isn’t community-focused and requires an earn-out to receive full payment.

This makes an ESOP a very appealing option, especially for the far-sighted owner who has the patience to wait a few years for a payoff.

Julius Anderson, president of Anderson Insurance Associates in Charleston, South Carolina, converted his agency to an ESOP in 2020. “As I approached my golden years, I wanted to make sure my agency remained a locally owned, viable independent business,” he says. “Selling to a larger agency didn’t appeal to me because I wanted our agency to remain a cornerstone of our community. An ESOP was an attractive way to perpetuate what we had built and take care of our employees.”

Advantages of an ESOP

The beauty of an ESOP is that it fulfills the owner’s need for a fair price but also ensures the business they built lives on. Here are the advantages of an ESOP in a nutshell:

• A retiring owner can pass their business on to their employees rather than an outside firm.
• The owner receives fair market value for their firm from the ESOP.
• A 100% ESOP can result in a tax-free corporation and faster repayment of debt since the loan’s interest and principal are fully deductible.
• With a partial ESOP, the owner retains a controlling interest in their ownership of the agency.
• Employees have a new retirement plan worth more than their 401(k) plan benefits.
• Employees have an incentive to work together to ensure the company succeeds.

How Does it Work?

Owners sell all or part of their stock to an ESOP trust that holds company shares on behalf of the employees. According to ESOP specialists Pilot Hill Advisors, ESOPs can be partially or 100% leveraged, depending on whether the owner wants to exit the business completely or stage their exit.

With 100% leveraged ESOPs, usually half or more of the transaction is financed by a bank loan and internal cash, and the remaining amount comes from a subordinated seller note. Often the bank refinances the seller’s note after the first note is paid off.

In a partially leveraged ESOP, the ESOP purchases a minority stake in the agency, which is financed through a bank loan or internal cash. The ESOP can buy out the owner when the owner is ready to retire.

Owners can finance the entire transaction with pre-tax dollars, meaning the debt used to finance the purchase is deductible from taxation. In addition, ESOPs can be used to create a 100% tax-free company since the ESOP is a pension plan and doesn’t pay taxes. The beneficiaries pay the taxes when they take their retirement money out of the ESOP.

What About Control?

Because the owner doesn’t have to sell all of their stock at once to an ESOP, they can retain control of their firm as long as they continue to own the majority of the stock. The owner can stage their retirement at their own pace.

In Anderson’s case, he wanted his agency to become a 100% ESOP company. After receiving a portion of the value of his agency in the initial transaction, he took a subordinating note for the remaining balance. “I wanted to send a message to my employees that this is your company,” he explains, “not a hybrid of part mine, part yours.”

While employees do have an economic interest in an ESOP company, they don’t own or vote shares of stock. The ESOP trust holds the shares for the benefit of the participants. These shares are paid out when a participant retires, usually over a five-year period. The ESOP accomplishes this by buying back the stock from the participant at fair market value.

ERISA requires that a trustee be appointed as a fiduciary to the ESOP trust. Among other duties, the trustee must determine the fair market value of shares each year and ensure that participants receive the distributions they are entitled to when they retire.

An Owner with Vision

It takes an owner with foresight and vision to create an ESOP company. The owner will need to do a feasibility study, conduct a valuation, file a plan with the IRS and obtain funding. The transition requires planning, the assistance of ESOP experts and lenders, and a willingness to defer a potentially large payoff over several years.

But for the owner who believes in rewarding talented employees and wants to build a culture where next-generation leaders can flourish and share in their agency’s growth, an ESOP may be perfect. ESOPs allow the owner to provide very generous retirement benefits to their employees. Plan participants receive more retirement income than they could accumulate on their own, about three times as much as non-ESOP participants, according to the National Center for Employee Ownership (NCEO).

An agency with an ESOP is also likely to see greater retention and better job satisfaction than one acquired by an outside firm. NCEO reports that ESOP companies grow faster than would have been expected without an ESOP, with lower turnover and higher productivity. In fact, six of the Insurance Journal’s top 100 agencies are ESOP companies.

“It’s not an overnight decision,” Anderson says of his firm’s transition to an ESOP. He stresses the need to work with advisors and banks that are familiar with both independent agency operations and ESOPs. “Not every bank understands ESOPs,” he says. “Find professionals you can be comfortable with sharing information about your financials and book of business. This is an investment you’re making.”

In sum, ESOPs aren’t for the owner who simply wants to cash in or sell to the highest bidder. They’re for owners who care about their people and their legacy. They’re also a great way to stage an exit. Any owner of a midsized agency who’s thinking about retirement should definitely consider an ESOP.