Selling a Franchise Company to an ESOP

By Nick Adamy

Business owners exploring exit planning options may have been introduced to the idea of selling some or all of their stock to an Employee Stock Ownership Plan (“ESOP”). ESOP proponents tout the tax advantages to sellers and the company, as well as the benfits to employees, that can be achieved with an ESOP. Certain industries tend to attract more ESOPs than others, and owners of franchise businesses, both franchisors and franchisees, may wonder whether an ESOP is a realistic fit for their company. This article focuses on franchisee ESOPs, particularly multi-unit operators. First, a general introduction to ESOPs is in order. An ESOP is an employee retirement plan, similar to a 401(k) plan. Generally speaking, the ESOP purchases stock from the company owner(s) at fair market value with funds contributed to employee retirement accounts, similar to 401(k) matching or profit-sharing contributions. The business owner(s) can sell stock over time, or in large chunks funded by bank debt loaned by the company to the ESOP.

Sellers can accrue several advantages by selling to an ESOP. If properly structured, the seller can defer capital gains tax on the sale indefinitely. Furthermore, the operations of the company might be largely unaffected by the sale, unlike a sale to a competitor where jobs may be at risk, the name may change, and culture may be affected. An ESOP can also provide tax benefits to the company going forward. In the case of 100% ESOP- owned S-corporations, the company will typically pay no federal income tax at all.

Before getting too excited about the benefits of an ESOP, however, franchisee owners should consider whether or not their company has the basic ingredients for ESOP success. These ingredients fall into three main categories: economics, management and culture. In addition, as will be discussed below, franchise agreements usually require the franchisor’s approval of franchisee ownership transfers, and the franchisor most likely will have to be agreeable to a sale.

Economics

First and foremost, the ESOP can pay no more than fair market value for company stock. This means that the price will almost always be lower than the amount a seller may be able

to get in a sale to a competitor or strategic buyer. Sellers looking to get top dollar for their stock will be disappointed by the price the ESOP can pay. If price is the primary concern for the seller, an ESOP is probably a non-starter.

In addition, the company should consider the costs associated with professional services that are necessary for implementing and administering the ESOP. Professionals include attorneys, stock appraisers, plan administrators, and in many cases, institution- al trustees. Given the relatively fixed costs of advisers and administration, the economics of an ESOP are likely to be more attractive to a multi-unit operator with an established administrative infrastructure than to a single- store franchisee.

A firm’s profitability and tax obligations also figure prominently into the decision. Since the ESOP can shield some (or, in some cases, all) of the company’s earnings from taxes, companies with higher profitability can be especially good candidates for an ESOP. Solid franchises in a rapidly growing restaurant chain might be a good example. The tax savings from the ESOP could help nance the franchisee’s costs of building or acquiring new locations, thereby accelerating growth beyond what could be achieved without the ESOP. While the company’s tax savings from the ESOP will not affect the price paid to the seller, owners who retain a portion of their shares will indirectly benefit from the growth the company can achieve by reinvesting its tax savings.

 

Management

It is important to understand that while an ESOP can be an ownership succession tool, it is not a management succession tool. If an owner intends to retire or otherwise exit the business, capable management needs to be in place to step up to the challenge of leading the company. In fact, the franchisor will likely insist on it before approving the ownership transfer. However, if an owner is not yet ready to ride off into the sunset, an ESOP can be a tool to allow him or her to take some chips off the table, while maintaining a role in the business. As a result, an owner would not have to wait to complete a management transition in order to achieve liquidity.

For many franchises, particularly multi-unit operators, the ESOP provides a unique opportunity. Often, these franchisee owners face an all- or-nothing decision about the exit options; they can sell to another system franchisee or other third party and retire, or worse yet, just go out of business. The ESOP provides an alternative that allows the leadership to remain intact, while providing liquidity for the owner.

Culture

When done right, an ESOP can give a company a competitive advantage by promoting a culture of employee engagement and accountability. This can result in higher productivity, lower turnover, and better customer service. However, the mere addition of an ESOP cannot by itself create these positive cultural elements. It helps immensely to have an educated workforce, low turnover, and a basic level of trust in management when implementing an ESOP. For companies that already have a relatively stable workforce, such as a high-end hotel or restaurant, the ESOP can provide a tool to reward long-term employees and promote employee retention and engagement.

On the other hand, franchise companies such as retailers and restaurant chains that tend to have high turnover and relatively young work forces can find cultural challenges with an ESOP. For these kinds of companies, employee engagement can be a significant challenge. Leaders hoping for an overnight change in employee morale from a purchase through an ESOP will likely be disappointed. However, even for companies in high-turnover industries, the ESOP can become a tool that creates a competitive advantage by reducing turnover and increasing employee engagement. Strong employee communications about the benefits of the ESOP to those workers must be developed in order to capitalize on the cultural benefits of employee ownership.

Unique Franchise Factors

Franchisee owners face unique is- sues in any sale of company stock, including a sale to an ESOP. One of the most important issues to consider is the franchise agreement itself. According to John Baer, of Greensfelder, Hemker & Gale, P.C., franchise agreements are often tied to the business owner as an individual. In order to keep franchisees more accountable, many franchisors tend to prefer naming an individual, rather than a corporation, as the franchisee. Those franchisors usually allow the franchise agreement to be transferred to a business entity if the individual owner re- mains liable for the operations of the business. Other franchisors allow a corporation to own the franchise from the start, but they might require the individual owners guarantee the business operations. Virtually all franchise agreements require that the business be operated by the individual owner or by persons or managers satisfactory to the franchisor. In addition, almost all franchise agreements have restrictions on transfer of ownership of the company or the agreement.

While such restrictions can seem daunting and add steps to the process, franchisors should remain open-minded toward proposals for ESOPs from their franchisees. When a franchisee brings an ESOP idea to the table, the franchisor should consider whether the ESOP is part of a solid management transition plan and which benefits new management might bring to the operation. For a franchisee who is having difficulty finding an outside buyer — or a buyer who can line up financing — an ESOP can be a welcome solution.

For the franchisee engaged in an ESOP sale, the ESOP can create some unusual dynamics as well. Typically, ESOPs have a waiting period of several months before new employees are eligible to participate, and most have vesting schedules that can take a number of years for employees to fully vest. As a result, ESOP companies with high turnover in entry-level positions tend to have ESOPs that are overrepresented by more stable management, administrative and corporate staff. For some companies, this could be problematic, but for others it may be a desired outcome.

Conclusion

An ESOP may provide an attractive exit alternative for franchisee owners. With the right mix of economic, management, and cultural ingredients in place, an ESOP can be not only an effective ownership transition tool, but also can provide tax benefits to the owners and the company. And, when done well, an ESOP can become a source of competitive advantage by engaging and motivating the workforce.

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Reprinted with permission from the April 2013 edition of the LAW JOURNAL NEWSLETTERS. © 2013 ALM Media Proper- ties, LLC. All rights reserved. Further duplication without per- mission is prohibited. For information, contact 877.257.3382 or reprints@alm.com. #081-05-13-04