How an ESOP Feasibility Study Works & Why Your Company Needs One

Decisions about whether, when, and how to sell a company can be some of the most challenging in a business owner’s life.

The satisfaction of having built a successful company can be overshadowed by questions, including:

• Which exit strategy is right for the owner?
• Will selling your company have a positive or negative impact on employees?
• How much control can the seller maintain over the ownership transition?

For business owners deciding whether an ESOP is the best exit option, the first step toward making an informed decision is a no-cost, no-obligation ESOP feasibility analysis.

The primary purposes of any evaluation of feasibility — whether an initial, no-cost analysis or an in-depth, paid feasibility analysis — are to gather, organize, and analyze all relevant information so that both the seller and the corporate decision-makers can achieve the following goals:

1. Decide whether to move forward and create an ESOP
2. Structure the ESOP transaction to be fair and beneficial to both the seller and the ESOP company shareholders (i.e. employees)

For the purposes of this article, we’ll use the term feasibility study to refer to a fee-based service. A no-cost feasibility analysis, on the other hand, offers an introductory evaluation of a company’s suitability for success as an ESOP.

What Can a No-Cost Feasibility Analysis Tell Me?

Maybe you’ve already done some research, and you realize that your company meets many, if not all, benchmarks to support a successful and sustainable ESOP company. In general, a business is a very good candidate for an ESOP if it meets the following criteria, among others:

• Closely held company that meets minimum revenue requirements
• Multi-year operating history with consistent profitability and earnings growth
• Owner who wants liquidity to diversify assets, with an open mind to explore sale price versus after-tax proceeds and structures to optimize outcomes
• Leadership interested in supporting transition with planned succession

Even so, sometimes an owner’s expectation of enterprise value isn’t in line with a realistic fair market value. And unlike some third-party sales, an ESOP cannot offer synergistic or strategic premiums on the sale price.

An initial, no-cost, no-obligation feasibility analysis can clarify expectations for all involved parties well in advance, saving time, trouble, and money in the long run. Some of the details that are often brought to light by a preliminary ESOP feasibility questionnaire include:

• Fair market value of the business, how after-tax proceeds of the sale compare with after-tax proceeds of other exit strategies, including third-party sale
• How much liquidity the seller needs, whether 100% or a smaller fraction of ownership is to be sold, and how much the seller is willing to finance in notes
• Information about the seller’s intended horizon for departure from the company and what role they intend to fill in the time before they exit
• Whether the company’s financials can sustain an ESOP over the long term
• Bookkeeping, regulatory, and documentation needs to proceed with the discovery process and formation of an ESOP
• Employee demographics, such as the relative age of the workforce and expectations for upcoming retirements and departures

A clear understanding of all these elements not only informs the question of whether to proceed toward an ESOP sale, but also how to proceed. If a different exit strategy is in fact a better option for the seller and/or the company, the no-cost feasibility analysis should help distill the facts. If all parties aren’t on the same page, the subsequent, in-depth feasibility study can provide insight into what it takes to get them there.

If management needs succession planning help or assistance in developing communication plans for employees, you’ll most likely recognize the need by the end of a no-cost ESOP feasibility analysis.

What To Expect from an In-Depth ESOP Feasibility Study

The feasibility study, sometimes called a suitability study, represents a foundational step in the ESOP transition. Every ESOP feasibility study addresses these fundamental elements:

1. Business valuation to determine fair market value
2. Leadership and management team assessment to support a transition
3. Shareholders’ equity analysis to determine ESOP formation’s impact on the company’s financial performance
4. Plan design study to make recommendations for the sale structure and ESOP plan features and policies
5. Liquidity study to determine whether the company can withstand demands of future stock share repurchase obligations

1. Business Valuation

The ESOP transaction requires an in-depth business valuation by a third-party valuation professional. This company valuation can help the seller understand and envision the enterprise value as it measures up to the seller’s expectations. It also helps set the stage for exploring financing and transaction structures, like seller notes, that can help maximize after-tax proceeds on the sale. In some cases, these structural strategies can make an ESOP’s fair market value transaction competitive with third-party sale options.

2. Leadership & Management Assessment

Change, even for the better, can be a challenge for both organizations and individuals. Many closely held companies start small and grow organically, sometimes over generations, often within families.

It’s vital to know that all members of leadership and management teams have the skills and the desire to support the company’s ESOP transition. Addressing any deficiencies can be a matter of training, hiring, and communication — and the in-depth feasibility study will help you determine what is needed and in which areas of the company.

3. Stockholders’ Equity Analysis

The ESOP business structure can affect cash flow and profitability. So can financing amounts and terms, seller subordinated debt, and expected capital expenditures that may become necessary to support the business moving forward.

If a company has more than one owner, and not all owners want to sell their ownership stake — or if a single owner only prefers to sell a partial ownership stake — it’s essential to understand the impact of the ESOP sale on share value.

4. Plan Design Study

Every business is unique, and that maxim holds true for ESOPs as well. In addition to being an exit strategy for business owners, an ESOP is — first and foremost — a qualified retirement benefit plan.

That means there are decisions to be made about employee eligibility, vesting schedules, distribution timing, terms, and conditions, crediting current employees for past service, contribution levels, voting rights, and more. It may also point to a need to make changes to other retirement plans and employee benefits such as pension, 401(k), and profit-sharing plans.

An ESOP expert will also make sure you’re aware of key considerations when designating fiduciaries, ESOP trustees, or advisory committee members if you move forward with the ESOP transition.

5.  Liquidity Study & Initial Repurchase Obligation Review

An estimate of the ESOP’s first five to 10 years of repurchase obligations gives leadership a solid idea of what to expect to come up with in terms of funds, for planning purposes. It can help predict what’s needed to buy back employee shares at retirement, termination, disability, or death.

A Feasibility Study Should Instill Stakeholder Confidence

It’s important to recognize that different types of experts may have varying perspectives on feasibility. A wide range of professionals offer feasibility study services — including management consultants, investment bankers, CPAs, attorneys, and third-party administrators (TPAs). Some of these professionals have less experience and specialization in ESOPs; others may have more to gain by steering you toward a certain financing structure or plan design.

Just as wide-ranging are fees these professionals may charge, and the deliverable promised for the study. Before you dive in, ask:

What do I get for the money? Are you charged an hourly rate, or a flat fee, and what’s included?

Your deliverable may be an in-depth, maybe even book-length document. But what if you have follow-up questions or want to investigate more sale structure alternatives, lending options, or time horizon scenarios?

An expert who takes a consultative approach will explore every what-if, evaluate prospective trade-offs, and take a balanced look at all stakeholders — not only the seller. And if you’re working with a professional who charges an hourly rate, more questions can mean a lot more money for your answers.

Your feasibility study should examine multiple scenarios and lead you to be able to choose your ESOP transition path, sale structure, and plan design with full confidence. If you don’t get to the end of your feasibility study and know definitively whether and how to move forward, then your study’s not complete.

It’s also hard to overstate the importance of considering all stakeholders in the feasibility study. Some professionals may focus on seller outcomes, to the detriment of other important considerations, including:

• The long-term health of the company
• The ability of the ESOP to support employee wealth creation
• The need to retain and reward key management employees for a smooth transition

The truth is, building a better ESOP takes an experienced, holistic approach that recognizes all these essential stakeholders and eliminates uncertainty wherever possible.

Next Steps

The findings of your initial, no-cost feasibility analysis help you determine what happens next and the steps you need to take if you move toward an ESOP sale. This can involve preparing records and documents for your in-depth feasibility study, communication with lenders, strategic meetings, choosing the right corporate entity structure, and more.

You can expect an experienced ESOP consultant to prepare you in advance for the steps ahead, point out potential obstacles, and help you avoid them on your way to a smooth sale and ESOP transition. Look for a team of experts committed to simplifying the process, maximizing stakeholder outcomes, and educating all parties. Everyone should get optimal value both at the time of sale and over the long term.

You can start down your path toward a better understanding of how an ESOP sale can meet your liquidity needs while also creating a sustainable business legacy that can go on long after your departure. Request your free, no-obligation ESOP consultation today.