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The ESOP Fable

I have worked hard to build this business, but it’s time I sell it while I’m healthy enough to enjoy life a little.” Raymond (not his real name) was as down-home a guy as you can imagine. But behind his slow draw was one really smart business owner. Raymond’s sensitivity to customers seemed to be the lynchpin of his success. “Heck, I didn’t know any better, so I decided I’d just follow what my customers wanted. I guess it’s worked out so far.”

Worked out it has. Raymond’s business had a market value of at least $25 million. I say “at least” because market value is never a definitive number. The final sale price of any business, large or small, depends on who the buyer is and the terms of payment. But as I started the engagement to sell his business, I was confident I could get Raymond $25 million or more.

That is until Raymond said he wanted to consider an ESOP, shorthand for an employee stock ownership plan. Raymond explained his thinking, “I’ve worked hard, but I have several employees who’ve been with me a long, long time, and it’s now their turn to enjoy the fruits of this business.

I told Raymond I hear this a lot. It’s not uncommon for a business owner to want to see their employees take over the business. I said to Raymond, “There is a reason you don’t often hear of a company actually being sold to an ESOP.”

I could sense he was annoyed by what he perceived as my negativism. I knew I had to quickly explain my rationale or risk losing his confidence in my judgment. I explained four reasons why an ESOP is generally not the right exit solution. First, just having a loyal and experienced team is not the first consideration when evaluating whether selling a business to an ESOP. Instead, the business owner has to know there is one leader who is not only ready to step up and take over the hard decisions, but that person has to be immediately recognized as the one “in charge.” The employees can’t run an employee-owned company; principles of leadership still apply. Second, the employees have to be willing to accept substantial financial risk to make an ESOP work. When push comes to shove, many employees don’t want to do that, or just can’t do that. Third, the expenses required to operate an ESOP are a surprise to most business owners. Here’s the painful reality about ESOP expenses: they have nothing to do with making the company better or stronger; they are just legally-mandated expenses to manage the ESOP. Finally, more times than not, once an ESOP buyout is designed, the owner realizes he/she will be getting less for the company than they could if they sold the business to a third party. To be sure, some owners are willing to accept a reduced price, but when they also learn they will be required (in most cases) to carry a seller note, they suddenly realize the economics of selling to an ESOP don’t look all that favorable.

Having said all that, I am a fan of ESOPs in specific situations, but I have found those specific situations are few and far between. While I admire an owner, like Raymond, who desires to see his employees succeed after he has sold the company, doing so through an ESOP is generally not the right way to achieve that goal.

JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. .  He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The story above is true, but the names and fact patterns above have been changed to preserve the parties’ identities.

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Tennessee Valley Group

Jim is an attorney (non-resident status with the Missouri Bar) and though he no longer practices law, he has read and negotiated enough legal documents to fill a cargo tanker. He has an MBA from Harvard Business School and knows how Wall Street and private equity operates. Jim is a Tennessee Supreme Court Rule 31 listed general civil mediator with tons of experience helping business owners (large and small) work through sensitive problems to achieve winning results. He is the author of "Home Run, A Pro's Guide to Selling Your Business, Seven Principles to Make Your Company Irresistible."

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