Sweet Child O’Mine – Business Transition with Benefits

By Kevin Selzer

Owners of closely held businesses, particularly first-generation owners, often have a difficult time finding a suitable succession plan. These owners are faced not only with phasing out of their labor of love, but choosing a new direction for the thing they created. That new direction often starts by looking at third party investors and buyers, which may consist of competitors or private equity. If the owners find the third-party market undesirable, they may seek out alternatives. Our blog post today looks at three “internal” succession alternatives that owners may want to consider, particularly those that are driven by a desire to preserve legacy and/or protect the workforce, including existing management.

• Equity Incentive or Phantom Equity – Equity and phantom equity incentive arrangements tend to be small cogs in the business succession strategy since traditional equity incentive plans typically grant only between 5% and 15% of outstanding ownership. These arrangements generally transition ownership in exchange for services (and sometimes cash payments or notes) from employees, often in the form of stock options, restricted stock, or phantom equity. Phantom equity allows owners to replicate the economics of ownership without transferring actual ownership. For succession planning purposes, these plans are typically the incentive/retention tool used to increase business value for a later exit event.
• ESOPs – Employee Stock Ownership Plans (ESOPs) are a vehicle in which ownership is sold to a qualified retirement (employee benefit) plan. ESOPs are not new, but they are riding the apparent swell of support for employee ownership in the U.S. (e.g., see the law change in 2022 under SECURE 2.0 requiring the Department of Labor to promote worker-owned businesses). Some states have adopted tax credits and other incentives to assist with forming and maintaining employee-owned businesses. For example, Colorado-headquartered businesses can currently qualify for a tax credit of up to $150,000 to offset the cost of forming an ESOP. ESOP strategies are pursued primarily for their significant tax advantages and owners seeking preservation of legacy. Potential tax advantages include deferral of gain/tax, increased cash flow due to reduced tax at the business level, and significant estate planning opportunities. Sales to ESOPs can be partial or full sales of ownership and are often leveraged transactions, allowing owners to receive payment for their shares immediately.
• EOTs – Employee Ownership Trusts (EOTs) are a developing model in which ownership is sold to a perpetual trust that often has a social purpose (including employee-centric purposes). Unlike ESOPs, EOTs are in their infancy in the U.S. Ownership can be transferred to EOTs in a gift or, as with ESOPs, in a sale transaction. EOTs do not provide the tax advantages that ESOPs provide under current law, but they can be structured to provide greater legacy protection and may be a better fit for certain workforces due to the flexibility in how and when the ownership income is distributed to employees.