Why Should Architectural Firms Consider Selling to an ESOP?

This Article was authored by Steven B. Greenapple and first appeared on the AIATrust website.

When contemplating a sale of their business, the owners of a Company have several alternatives to consider. They can (1) sell to a financial investor (private equity or family office); (2) sell to a strategic investor (another business who wants to expand into the Company’s markets); (3) sell to the Company’s management/key employees; (4) sell to an Employee Stock Ownership Plan (ESOP); or (5) sell to “the public” (an IPO).

Each of these alternatives provides different degrees of:

• Liquidity to current owners;
• Continuity of management/control;
• Incentive to managers and key employees; and
• Preservation of company culture and legacy.

For architectural (and other professional service) firms, the issue is complicated by the fact that the Company’s greatest assets – their employees – walk out the door every day.  Furthermore, the culture of many architectural (and engineering) firms is that ownership is perceived as being tied closely to success.  In other words, “ownership” is part of the culture of these firms.  For these reasons, most architectural many architectural (and engineering) firms focus on the management buyout and ESOP alternatives.

One problem with the management buyout is that it is enormously inefficient from a tax perspective.  Few, if any, employees have the financial means to buy a meaningful amount of equity.  Management buyouts are typically financed by the seller (either directly, or through the Company).  Repayment of the leveraged financing is funded by paying bonuses to the purchaser (which are taxable to the purchaser as ordinary income), who in turn uses the after-tax funds to pay the seller (which payments are taxable to the seller, typically, as capital gains).  The combined tax rate – depending on what state/city and tax bracket the purchaser and seller are in – can be substantially greater than 50%!  This approach may also create tension between those employees/ shareholders who are and are not included in the buyout.  The ESOP alternative solves both of these problems.

What an ESOP Is

• An ESOP is an “Employee Stock Ownership Plan” – not to be confused with a “stock option” plan.
• ESOPs are tax-qualified retirement plan for employees, with three special attributes:
  • They are designed to invest primarily in “employer securities” (the stock of the Company sponsoring the plan);
  • They can borrow money;
  • They can engage in a transaction with a “party in interest” (the current shareholder(s) who wants to sell stock).

Together, these special attributes create a qualified retirement plan that can borrow funds, and buy the Company which sponsors the Plan, from its shareholders.

Congress structured the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (the Code), specifically to encourage ESOPs.  An ESOP is a defined contribution plan which is a “qualified plan” under the Code.  All employees who work 1,000 hours are eligible to participate in the ESOP.  Each participant has an account (like a 401(k) plan).

ESOPs have been around since ERISA was created in 1974.  Originally, only C-corporations could sponsor an ESOP.  In 1998, Congress expanded ESOPs to include S-corps.  As qualified retirement plans, ESOPs are regulated by the IRS and the DOL.

What an ESOP Is NOT

Myth – Owners are “giving” the Company to the employees.

Facts:

• Owners are only “giving” away the future appreciation (less the return on the cash proceeds, and the seller financing) of the shares sold to the ESOP.
• ESOP Trustee cannot pay more than “adequate consideration,” which is fair market value of shares as determined by the Trustee in good faith with the assistance of an independent appraiser.
• The legal standard of fair market value is: “the price at which an asset would change hands between a willing buyer and a willing seller when neither is under a compulsion to buy or sell and both parties are well informed.”
• To the extent that there is a competitive sale process, ESOP will likely not be able to match the price. However, it is often close to – and may even exceed – the after-tax proceeds received from a competitive process.
• In addition, Sellers may retain a significant part of the “upside” in value, through seller financing.
• Because of the tax advantages of the ESOP, the seller financing can be paid much more quickly than using a management buyout.

Myth – Employees can examine the Company’s books.

Facts:

• Participants must receive an annual statement the showing value of their shares, but detailed financial information is not required to be disclosed.
• Some companies, as a matter of culture, choose to share some level of detailed financial information, but that decision is up to the Board of Directors.

Myth – Employees will control of the Company.

Facts:

• If current owners maintain majority ownership, this is simply not true.
• Even if the ESOP owns 100% of the Company, the Company will continue to be managed by its Board of Directors and executive officers.
• The ESOP Trustee – not the employees – elects the Board of Directors. The Board appoints management and manages the Company.  The ESOP can even be designed so that the Trustee is “directed” by the Board.

Myth – Significant transaction costs.

Fact:  The transaction costs are usually lower than selling to an outside party and are more than offset by tax savings.

How a Leveraged ESOP Transaction Works

In (relatively) simple terms, this is how an ESOP transaction works:

1. The Company borrows funds from a senior (bank) lender. If the transaction size exceeds the Company’s bank borrowing capacity, the Company borrows the balance of the funds from the selling shareholder using subordinated debt – effectively, the seller taking back a promissory note.  Together, the senior bank loan and the seller subordinated loan are referred to as the “Outside Loan.”The Company can pay the “Outside Loan” as quickly as possible – first to the bank, and then to the selling shareholder.  The portion of the Outside Loan funded by the sellers, provides an attractive rate of return, which typically includes a portion of the future value of the Company.  In a typical 100% ESOP transaction, the “Outside Loan” takes a total of 8 – 10 years to repay.
2. The ESOP borrows the proceeds of the Outside Loan, from the Company. This loan (from the Company to the ESOP) is referred to as the “Inside Loan.”
3. The ESOP uses proceeds of the Inside Loan to purchase shares from existing shareholders. The portion of the purchase price funded with the senior (bank) loan, is paid to the Sellers in cash.  The purchased shares are held in an “ESOP Suspense Account” as collateral for Inside Loan.
4. The Company makes tax-deductible contributions to the ESOP, which the ESOP uses to repay the Inside Loan.  These two payments (from the Company to the ESOP, and from the ESOP to the Company) are cash neutral to the Company, but nonetheless give the Company a tax deduction. In a typical 100% ESOP transaction, the “Inside Loan” is repaid over 20+ years.  This is because (as explained below), the time over which the Inside Loan is repaid, controls the allocation of shares from the ESOP Suspense Account to ESOP participant accounts.
5. With each Inside Loan payment by the ESOP to the Company, a pro-rata tranche of shares is released from the ESOP Suspense Account and allocated to ESOP participant accounts.  The allocation formula (similar to a profit-sharing plan) is typically based on each participant’s relative share, of the Company’s aggregate “eligible compensation” expense for that year.  The Inside Loan is paid over a longer period, so that shares are allocated gradually, providing a reasonable level of employee benefits.

Retirement Plan Attributes of ESOPs

• The ESOP is managed by a Trustee, who is a fiduciary. There are professional ESOP Trustees who are expert in (a) analyzing and negotiating ESOP transactions; and (b) managing ongoing ESOPs.  Some companies use professional trustees for (a), and internal trustees (an employee, or committee made up of employees) for (b).  Internal trustees are permitted to fulfill both functions but, as fiduciaries, they will be held to the “prudent expert” standard in doing so.
• ESOP recordkeeping is done by a third-party administrator (TPA) who is expert in ESOP account administration.
• The value of the stock purchased or owned by the ESOP is determined, at the time of the ESOP transaction and annually thereafter, by the Trustee with the assistance of a qualified independent financial advisor.
• Participants become vested in their accounts in the same manner as other defined contribution plans: 3-year “cliff-vesting” (no vesting for the first three years of participation in the plan, after which they become 100% vested in their ESOP account); or six-year graded vesting (no vesting for the first two years, after which they become vested in their account 20% per year after years 2 – 6).
• Generally, participants may elect to receive distributions from their ESOP account only after termination of their employment. These distributions are spread over five years, and commence either (a) in the year following termination of their employment, if termination is due to death, disability, or “normal” retirement; or (b) in the sixth year following termination of their employment, if termination is for any other reason (voluntary or involuntary, with or without cause).

Advantages of an ESOP

• Ownership Transition Structure – In a well thought out management buyout, plans must be made for how and when the sellers will be paid, who will receive shares, how the shares will be valued, to whom will other current shareholders sell their stock when they want to leave, what will happen the new shareholders leave, how ongoing employees will be incentivized, and how the risks and rewards of future financial performance will be allocated among buyers and sellers. An ESOP addresses all these issues, with answers that have proved successful over many decades and thousands of transactions.
• Continuity and Legacy – Current shareholders can choose to remain active in the Company – or not. An ESOP also provides for subsequent ownership transitions – long after the current shareholders have retired.
• Bank Financing for ESOP Transactions – Banks compete for opportunities to lend money for ESOP transactions. This senior financing provides a substantial portion of the value of the purchased shares, which is paid to the Sellers at the closing of the ESOP transaction.
• Tax Benefits –
  • Non-Recognition of Gain on Sale. If the requirements of Code Section 1042 are satisfied, the selling shareholders can elect to defer recognizing gain on the sale transaction.  Properly structured, this deferral can be made permanent.
    • Saves 15 – 20% capital gains federal tax (plus most states’ capital gains tax), plus 3.8% Medicare Surtax.
    • Company must be C corporation at the time of sale. LLCs and S corporations often convert to C corporation for this purpose.
    • ESOP must own at least 30% of the value of outstanding shares, immediately after the sale.
    • Seller must invest proceeds in “qualified replacement property” (QRP) – debt or equity of U.S. operating company(ies). Seller’s estate receives a step up in the QRP basis upon death, resulting in the tax deferral becoming permanent.
  • Deductions for Payment of Purchase Price. The ESOP pays for the financing for the purchased shares using contributions from the Company.  These contributions are deductible to the Company.
  • Company Can Operate Tax-Exempt! If the Company is (or becomes) an S-corporation, neither the Company (because it is an S-corporation) nor the ESOP (as a shareholder) pays any ordinary income tax on the Company’s income.  If the ESOP owns 100% of the Company, the Company effectively operates as a for-profit, tax-exempt entity.  This allows the leveraged financing created in connection with the ESOP purchasing stock, to be paid off much more quickly than in a non-ESOP management buyout.  After the financing has been paid, it allows the Company to accumulate cash for growth and acquisitions.
• Attract, Motivate, and Retain Employees –With proper education, the ESOP can make employees (and prospective employees) feel and act like entrepreneurs.  The effect on employees’ morale of seeing their ESOP account grow in value is a powerful tool to attract, motivate and retain employees.
• Design Flexibility – The ESOP transaction is designed by the Company and its shareholders.  The price and terms must be fair, but the percentage of the Company to be purchased by the ESOP, the structure of the financing, the size and timing of subsequent purchases (if any), are all determined by the Company and its shareholders.
• Certainty and Confidentiality – The ESOP Trustee, as a buyer, wants the ESOP transaction to close.  ESOP Trustees have no hidden agenda or conflicting interests.  The Trustee’s only concern is that the price and terms of the transaction are fair.  ESOP Trustees are confidential.  Your confidential information is not exposed to competitors.  Most companies creating an ESOP do not inform their non-executive employees of the transaction until it is closed.
• Other benefits –
  • If the ESOP purchases less than 100% initially, it can provide a market for future sales of shares.
  • Sellers who provide financing for a leveraged sale of stock to an ESOP can receive an attractive return on the financing, including sharing in the future value of the Company through warrants (similar to stock options).
  • Subject to their fiduciary duties as a Board of Directors, the Company’s Board remains free to adopt management incentive plans, cause the Company to acquire other companies, or sell the Company.

Disadvantages of an ESOP

• The shares must be valued annually.
• The Company must plan for and fund future repurchases of shares from ESOP participants’ accounts. Depending on employee demographics and the growth in share value, this can be significant.
• Accounting is complex and can be counterintuitive.
• The ESOP creates fiduciary duties.
  • Cannot pay more than “adequate consideration.”
  • Trustee is responsible for most fiduciary decisions.
• ESOPs operate in a regulated environment – DOL and IRS oversight.
• The size of the ESOP debt (the “Inside Loan”) must be designed, taking into consideration deduction limits and compensation limits set forth in the Code.
• Participants may direct the ESOP Trustee how to vote shares allocated to their accounts, with respect to certain major (and very infrequent) corporate actions (merger, sale of substantially all assets, etc.) which, under state law, require shareholder approval.

ESOP Issues Specific to Architectural Firms.

A couple of ESOP issues relate specifically to architects and other professional service firms.

1. Valuation. The value of the stock of a corporation depends largely on the earnings of the corporation to which the owner of the stock will be entitled.  Many professional service corporations pay all their free cash-flow to the owners, as bonuses, at the end of each year.  The owners expect this and depend upon it.  However, the owners often do not distinguish between the portion of their overall compensation that is based on their employment, as distinct from the portion of their compensation that is based on their ownership.  When selling the stock (whether to an ESOP or to any other buyer), this distinction must be made clear and adhered to going forward.  Post-closing, the Sellers (former owners) will continue to receive this cash for several years, but as payment for their stock – not as compensation for their services.  The tax treatment of the payments for stock are generally more favorable than the tax treatment of ordinary income.  However, the process of distinguishing between the two can be difficult.  An ESOP Transaction Analysis (discussed below) should illustrate the cash flow impact of this on all affected parties.
2. Restrictions on Ownership. Many states restrict ownership of architectural (and other professional service) firms to licensed professionals.  Some states provide exceptions for firms that were established before these restrictions came into effect.  Some states permit ESOPs, or other shareholders who are non-licensed professionals, to own a certain percentage of the firm.  ESOPs have been successfully established using a “management company” to provide all services for which a professional license is not required, and contracting with a licensed professional service firm for those services for which a license is required.

Recently, some states have expanded ESOP ownership of licensed professional service firms.  For example, in 2012 New York – which has historically been one of the strictest States in regulating ownership of licensed professional service firms – amended its laws to allow ESOPs to own up to 25% of a “Design Professional Service Corporation” (engineering, architecture, landscape architecture, land surveying, and geology or any combination thereof).  In July 2022 (effective July 21, 2024), New York State allowed ESOPs to own 100% of a DPC.

What’s the Next Step?

After discussing your questions with a qualified ESOP professional, the next step to making an informed decision as to whether an ESOP is right for your Company is to obtain a “Transaction Analysis.”  This is, essentially, a blueprint for an ESOP transaction.  It is based on detailed historical and projected financial information about your Company, and reflects the unique priorities and goals of the Company and its shareholders.  The Transaction Analysis will illustrate, in detail:

• The estimated value of the Company for ESOP purposes;
• The estimated amount of senior debt that the Company can raise for an ESOP transaction; and
• The projected cash flow impact on the Company and the Sellers, over the life of the financing for the ESOP transaction.
• The Transaction Analysis can include multiple variations of transaction structures (e.g., 30% transaction, 100% transaction, 1042 vs. non-1042, etc.).