Rewarding Employees: Selling Your Business Through an MBO or ESOP

After the experience of starting a business, the prospect of retirement can be as exciting as it is overwhelming. To ensure that the company you have built lasts, you need to have a business succession plan. Some business owners have spent years preparing their child or another relative to take over control, ensuring the business remains in the family. Others look to sell to a third party for a quick way out, which will also provide them with a nest egg for their next phase of life. However, a third option is transferring the business to your employees. If you prefer the idea of transferring your business to longtime, trusted employees who have contributed to the company’s success over the years, there are two options to consider: a management buyout (MBO) and an employee stock ownership plan (ESOP).

Management Buyout

An MBO can be a smart exit strategy for many business owners. This type of transfer is not a one-time event but a process by which your existing management team joins together to take the reins. They arrange a deal with you to buy your business’s assets and operations, either all at once or in stages. An MBO has the benefit of being more efficient and confidential than a third-party transaction, and the deal structure may also be more flexible. In addition, you may gain peace of mind knowing that the company’s legacy will stay in the hands of leaders who know your business best. Instead of selling to a stranger or competitor, you can sell your business to people who have earned your confidence through their loyalty and hard work.

With this strategy, you may be able to exit gradually and continue serving the company in another capacity, such as an officer, consultant, or director. You may also be able to keep some control over the company if that is a priority for you.

When considering an MBO, ask yourself the following questions:

Do you have a strong, trusted management team in place? Are they interested in owning the business?
How much cash do you need from the sale to meet your retirement goals? Are you comfortable selling at fair market value rather than the premium you may be able to get from a third-party buyer?
If management has little or no capital, where will they obtain the funds for the buyout, and how much time will they need to secure them?
When will the transfer of control occur?
Do you want to stay involved with the company during or after the transition?

Opting for an MBO may mean that you miss out on the highest market price for the sale; an MBO must be priced at fair market value to satisfy tax and legal requirements, whereas third-party buyers may pay more because they see strategic or synergistic value beyond the company’s current worth. Your management team may also require assistance in securing financing. However, an MBO offers a chance to partner with trusted buyers who hold valuable knowledge about your company, its history, and its culture and may be more likely to invest in preserving your business’s legacy. An MBO can provide you with a smooth and practical path to retirement while rewarding the individuals who were instrumental in helping you build your business over the years.

Employee Stock Ownership Plans

An ESOP is a tax-qualified retirement plan established under Internal Revenue Code section 401(a) and subject to regulation under the Employee Retirement Income Security Act of 1974 (ERISA).Instead of selling a business directly to management or an external buyer, an owner may sell some or all of the company stock to a trust created for the benefit of employees. In this structure, the company establishes an ESOP trust that holds shares of the company for the benefit of eligible employees.

Eligible employees—generally those meeting specified age and service requirements—become ESOP participants and receive allocations of stock held by the trust without having to purchase shares themselves.Although participants do not hold the shares directly, they have an economic interest in their shares. When participants retire or otherwise leave the company, the company is typically obligated to repurchase the vested shares at their current fair market value.

This type of succession plan is similar to an MBO because ownership remains within the company, rather than being sold to an outside buyer. However, an ESOP comes with special tax perks for both the owner selling the business and the company itself. For instance, if the company is a C corporation and certain conditions are met, the selling owner may be able to delay paying capital gains taxes on the sale. Since ESOPs primarily invest in company stock, they must adhere to strict federal rules regarding the valuation of the stock, the disclosure of information to employees, and the fair management of the plan.

When reviewing this potential succession strategy, several important considerations arise.

Cash flow impact. In a leveraged ESOP, most or all of the company’s excess cash flow may be needed to both repay the ESOP loan—used when the business buys the selling owner’s shares and transfers them into the ESOP trust—and to meet future repurchase obligations for retiring or departing employees who hold vested shares. Such ongoing demands on cash can reduce the funds available for reinvestment, expansion, or reserve planning.
Allocation requirements. Shares in an ESOP must be allocated on a nondiscriminatory basis, typically using an employee compensation formula that ensures equal treatment among employees. Because the plan cannot disproportionately favor executives or key managers, it does not serve as a substitute for traditional incentive or retention plans.
Professional and administrative costs. ESOPs require specialized legal, tax, valuation, and fiduciary guidance at formation and throughout the life of the plan. Annual administration, compliance filings, and third-party valuations create ongoing expenses.
Leadership continuity. A successful ESOP depends on a strong and sustainable management team. If the current owner intends to step back or exit the business, leadership succession must be firmly established.

ESOPs provide a way to reward the employees who helped build the company by allowing them to acquire an ownership interest with no personal financial investment. As the business grows, the value of their ESOP accounts increases, giving employees a direct stake in the company’s success, which can enhance motivation, productivity, and long-term retention. An ESOP also offers flexibility for an owner who wishes to transition gradually, allowing a staged sale while they still remain involved in the business during the succession process.

Choosing the Right Path: Balancing Legacy, Control, and Value in Your Exit Strategy

Both MBOs and ESOPs can be effective strategies for transferring ownership to employees, but each option requires careful planning and a clear understanding of the legal, financial, and operational implications. We welcome the opportunity to discuss these strategies in more detail and help you determine the approach that best protects your business, your legacy, and the people who helped make it successful.