A defining trait of a family business owner-manager is not only their vested interest in the financial gains of their company’s products or services, but also their emotional investment in employees, customers, the community and even vendors. When contemplating an exit strategy, these owner-managers are often willing to forgo some financial returns in a deal if it can fulfill these emotional objectives.
In cases of emotional exits, owner-managers must look beyond mere tax efficiency to preserve the company’s purpose holistically. To achieve this, owner-managers should explore three potential options: the Perpetual Purpose Trust (PPT), the Employee Ownership Trust (EOT) and the Employee Stock Ownership Plan (ESOP). Each option offers unique benefits and considerations that can align with diverse business objectives and personal values.
Perpetual Purpose Trusts for Business Succession
A Perpetual Purpose Trust, in contrast to conventional trusts, serves a specific, non-charitable purpose without specified beneficiaries. This tool proves valuable in succession planning, especially for owners dedicated to upholding their company’s mission and values beyond their tenure.
Benefits of Utilizing a Perpetual Purpose Trust for Exit Planning
- Continuation of company’s mission and values: A purpose trust can guarantee the continuation of the company in line with the founder’s ethos after their departure. This is particularly significant for owners deeply committed to their company’s ethos and long-term vision.
- Flexibility: PPTs can be customized with management instructions covering areas from business operations to charitable endeavors, guaranteeing adherence to the founder’s principles or practices.
- Control over future management: The trust’s terms can enforce future management adherence to the trust’s purpose, maintaining the company’s privacy and emphasizing values over profits.
Disadvantages of Using a Perpetual Purpose Trust for Exit Planning
- Complexity and cost: Establishing and managing a PPT can be intricate and expensive, requiring specific legal expertise to draft and ongoing administrative expenses.
- Lack of accountability: With no beneficiaries and limited oversight from the government, it can be challenging to hold the trustees accountable for their management of the assets and operations. This could be a disadvantage if future generations desire an active role in the company.
- Perpetuity issues: Some jurisdictions may have rules against perpetuities, which could limit the duration of a PPT. This could potentially conflict with the goal of maintaining the company’s mission indefinitely.
- Limited tax advantages: Unlike other estate planning tools, PPTs are not primarily designed for tax minimization. While they can offer some tax benefits, they may not be as advantageous as other options in this regard.
- Potential for conflict: The directed nature of a PPT, with a stewardship committee comprised of various stakeholders, could lead to conflicts of interest or disagreements on the company’s direction.
A notable example of a Perpetual Purpose Trust in the U.S. is the Patagonia Purpose Trust. In September 2022, Yvon Chouinard, the founder of outdoor clothing and gear retailer Patagonia, transferred the voting stock of the company to a purpose trust to ensure the continuation of its mission to fight environmental crises. This move was aimed at preserving the company’s values and ensuring that profits were used for environmental protection efforts. Alongside the purpose trust, a 501(c)(4) nonprofit organization was set up to hold the nonvoting stock, funded by Patagonia’s dividends for environmental protection efforts.
Employee Stock Ownership Trust
An Employee Ownership Trust (EOT) serves as an employee ownership model that is emerging as a viable alternative to conventional ownership and succession planning methods. It provides a distinctive framework for ensuring business continuity, boosting employee engagement and upholding a company’s legacy.
Mechanics of an EOT
- Establishment and objectives: A business owner forms a trust that will possess a portion or the entirety of the company. The trust’s objectives encompass the welfare of the company’s workforce and can extend to preserving the company’s heritage, benefiting the community, or achieving social and environmental objectives.
- Funding and ownership transition: The company allocates funds to the trust, which then utilizes these funds to buy shares from the current owner. This process can lead to a complete or partial transfer of ownership to the trust, with the owner having the option to offer financing.
- Management and oversight: The trust functions for the benefit of the employees, overseen by trustees and trust protectors who are legally bound to fulfill the trust’s designated objectives. Employees may assume governance responsibilities within the trust or participate in the selection of governance personnel.
- Financial incentives for employees: Employees are not required to make payments to become trust beneficiaries. Instead, a segment of the company’s yearly profits is allocated to a profit-sharing pool for employees. Employees are not obliged to purchase their shares upon departure; instead, they receive ongoing profit shares throughout their tenure.
Advantages of EOTs
- Perpetual employee ownership: EOTs allow a company to remain employee-owned indefinitely, ensuring long-term stability and adherence to the founder’s vision.
- Enhanced employee morale and productivity: The sense of ownership and financial stake in the company’s success can motivate employees, improve staff retention and attract talent.
Disadvantages of EOTs
- Potential for lower sale price: The price received for shares sold to an EOT may be lower than what a third-party buyer might offer.
- Complexity and legal considerations: Setting up an EOT requires navigating specific legal and regulatory frameworks, which can be complex and necessitate professional advice.
- Tax implications and limitations: While EOTs offer tax benefits, there are other tax rules and potential implications to consider, such as the impact of future company performance on payments received.
In the United States, the concept of Employee Ownership Trusts (EOTs) is a relatively recent development gaining momentum as an innovative approach to business succession and employee involvement.
One example is Metis Construction. Established in Seattle by Mattias Scheiblehner, Metis Construction shifted to an EOT structure in February 2016. Specializing in commercial and residential construction, the company transferred all its shares to a trust, effectively transitioning to an employee-owned entity. The trust is structured as the permanent owner of the company, with the primary objective of ensuring perpetual employee ownership. Metis distributes 70% of its annual profits as profit sharing among employees based on hours worked.
Employee Stock Ownership Plan
An Employee Stock Ownership Plan (ESOP) serves as an employee benefit scheme granting workers an ownership stake in the company. ESOPs are ERISA qualified plans that provide various tax advantages for the sponsoring company, selling shareholders and participants. They are commonly utilized as a corporate financial tactic to align the interests of employees with those of company shareholders.
Advantages of ESOPs in Exit Planning:
- Tax benefits: ESOPs offer substantial tax advantages. Sellers can defer or eliminate capital gains taxes through a 1042 rollover. Companies can enjoy income tax deductions equal to their ESOP sale price and employee-owned S corporations face minimal income taxes in most areas.
- Continuity and legacy preservation: ESOPs ensure leadership continuity and uphold a business’s legacy. Existing management can carry on operating the business post-ESOP sale.
- Employee incentives: ESOPs motivate employees to increase productivity and work harder since they directly profit from the company’s success through their ownership stake.
- Attracting and retaining talent: ESOPs aid in attracting and retaining top talent, particularly in startups or early-stage companies, by including equity in the compensation package.
- Ownership transition flexibility: ESOPs enable a gradual ownership transition, allowing owners to sell their shares partially or completely over time.
- Fair market value: Sellers receive fair market value for their shares, ensuring a just transaction.
Disadvantages of ESOPs in Exit Planning:
- Complexity and regulations: ESOPs are governed by federal ERISA regulations, necessitating expert guidance from advisors well-versed in ESOP intricacies. The process is highly structured, involving complexities uncommon in other M&A transactions.
- Seller financing: In ESOP transactions, selling shareholders often contribute partial financing, which may pose a challenge if they intend to fully divest.
- Repurchase obligations: Companies must have the financial capacity to repurchase shares from employees upon retirement or departure, leading to a substantial financial commitment.
- Ongoing management: ESOPs demand annual independent valuations, adherence to strict regulations on stock allocations, vesting, repurchases and the filing of Form 5500, which can be administratively cumbersome.
- Risk of noncompliance: Noncompliance discovered by the Department of Labor during an ESOP audit can have severe repercussions, potentially resulting in a reversal of the transaction.
Employee Stock Ownership Plans (ESOPs) have proven to be effective exit strategies for numerous companies throughout the United States. These plans not only facilitate a seamless transfer of ownership but also provide advantages to both the selling owners and the employees.
Publix Super Markets, a prominent employee-owned corporation in the U.S., integrates its ESOP with other employee benefit schemes. This setup has significantly boosted employee satisfaction and loyalty, propelling the company’s success in the competitive grocery industry.
Conclusion
ESOPs serve as a beneficial tool for exit planning, providing tax advantages, business continuity and staff incentives. However, they bring a certain level of intricacy and regulatory supervision that necessitates meticulous planning and oversight.
The efficacy of a Perpetual Purpose Trust in exit planning relies on the owner’s objectives, such as their dedication to upholding the company’s mission, tax implications and desired level of compliance with regulations.
While Employee Ownership Trusts (EOTs) are less prevalent in the U.S. compared to the U.K., the growing interest and traction indicate their potential as a common method for employee ownership and business succession planning.
Each approach has its pros and cons, having been successfully employed for exit planning previously. The choice between them for a family business should be made based on individual circumstances.
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