When a business owner starts thinking about retirement or an exit, the question of what happens to the business is rarely simple. More of those conversations are starting to include a term you may be hearing more often: the employee stock ownership plan, or ESOP. This article breaks down what it is, when it fits, and when it doesn’t.
An ESOP is a transition structure that’s been gaining attention across the small business ecosystem as the Silver Tsunami, or the wave of Baby Boomer business owners entering retirement age, picks up. It’s a powerful tool for succession, but not the right fit for every business, and no two are the same. Understanding how they work will allow you to guide your clients through their options when those conversations come up.
What is an ESOP?
In plain terms, an ESOP is a way for a business owner to sell a company to its employees. In an ESOP transaction, the business owner sells shares of the company to a trust, which holds them on behalf of employees. This allows the owner to exit gradually or all at once, depending on their goals. This arrangement allows employees to build equity in the company without an upfront investment of personal cash, as would typically be required in a traditional acquisition, while providing owners with a structured path to transition the business.
In addition to supporting succession planning, ESOPs also come with notable tax advantages:
- S corporation ESOPs can eliminate federal income tax on the ESOP-owned portion of company earnings.
- An owner who sells a C corporation to an ESOP has the potential to indefinitely defer taxes.
- Company contributions to an ESOP are also tax-deductible.
Ultimately, ESOPs provide a route to preserve the owner’s legacy. Owners can exit the company at a pace that works for them and their employees with the confidence that the business will continue on.
Why economic development leaders are paying close attention to ESOPs
Worker wealth and inequality concerns are top of mind for policy makers and economic development leaders. ESOPs offer a way to keep ownership within the company, maintain community ties, protect jobs, and support long-term economic stability. This makes them especially attractive to economic development leaders focused on preserving local businesses and jobs.
They also offer a mechanism for building employee wealth and reducing income inequality. According to The ESOP Association, “employees at ESOP companies tend to earn higher wages and have greater savings than their peers in non-ESOP companies.”
The emphasis on worker wealth has helped fuel a growing ecosystem of specialized advisors and organizations dedicated to supporting ESOP formation.
ESOPs aren’t a one-size-fits-all solution
ESOPs can be highly effective, but they’re not right for every business. Knowing which situations call for a different approach is just as important as recognizing when an ESOP makes sense.
An ESOP may not be appropriate for:
- Early-stage or unprofitable businesses
- Businesses with a small number of employees (generally fewer than 15–20)
- Owners who need or want to sell quickly or maximize profits
- Business models that are too owner-dependent to transfer meaningfully
The costs and complexity involved in structuring an ESOP are significant, and the business needs sufficient cash flow post-transaction to service the acquisition debt. These are thresholds that rule some businesses out early. They also require specialized legal, financial, and advisory support.
Additionally, while the ESOP support ecosystem is expanding, it is not yet scaled to meet the full volume of transitions expected from the Silver Tsunami. ESOPs are best evaluated as one option alongside traditional buyer acquisitions and other transition structures.
What makes a business a good ESOP candidate?
For the right business, an ESOP can be a highly effective transition strategy. Strong candidates typically share several key characteristics:
- Stable and profitable, typically with $1 million or more in EBITDA (earnings before interest, taxes, depreciation, and amortization)
- Motivated, tenured workforce invested in the business’s future
- An owner who wants to exit over time rather than in a single transaction
- A company with predictable cash flow to service the debt
For businesses with the right operational foundation and financials, ESOPs offer a route for owners to exit at their pace while employees continue doing the jobs they love while gaining ownership of the company.
How ESOPs are financed and where SBA 7(a) fits in
Most ESOP transactions are leveraged, typically structured with a combination of seller financing, bank debt, and, where appropriate, SBA-backed financing. A common structure is a leveraged ESOP, where the ESOP trust borrows funds to purchase shares. Financing is typically a combination of a loan from an outside lender (a bank or SBA loan) and a seller note, where the owner finances a portion of the transaction.
A common misconception is that the SBA financing isn’t compatible with ESOPs, but the reality is that it depends on the SBA lender’s approach. For some, the SBA 7(a) loan is becoming an increasingly relevant tool for ESOP deals.
SBA 7(a) loans can provide up to $5 million in financing, making them well-suited for smaller ESOP transactions. They also offer longer repayment terms, which can ease the post-transaction cash flow burden. With more flexible underwriting compared to a conventional loan, ESOPs work particularly well in situations with a solid business but complex deal structure.
Grow America works with you to finance ESOP transactions
Grow America works with lending partners to structure SBA 7(a) financing to support ESOP transitions. Bringing ESOP conversations to us early, before the deal is fully structured, allows us to offer support as you navigate the process. We understand the nuances of ESOPs and work closely with our referral partners and their clients to support these deals.
Lenders who can speak confidently about ESOPs—what they are, when they fit, and when they don’t—will be better positioned to serve clients navigating the Silver Tsunami. When an ESOP deal comes across your desk, we’re ready to work through it with you.