A Guide to Completing Seamless Second-Stage ESOP Transactions

In the complex world of succession planning, employee stock ownership plans (ESOPs) emerge as vital instruments for passing the future of a business into the hands of its trusted employees. For some companies, however, separating this transfer of ownership into two or more stages offers many benefits—from easing the current owner’s transition to retirement to spreading the financial burden across multiple transactions.

The second stage in an ESOP transaction brings companies one step closer to full employee ownership, but it also comes with important decisions and attention to fine details. Discover the ins and outs of second-stage ESOP transactions, including which businesses stand to benefit most, how to select the right method, and why flexible financing is essential.

Starting an ESOP with partial ownership
In a 2024 analysis, the National Center for Employee Ownership estimated that there are 6,500 ESOPs and 14.7 million participants, representing more than $2.1 trillion in assets across 6,322 companies. Among these thousands of plans, the vast majority are fully owned ESOPs. However, beginning with a partially owned ESOP and then transitioning to complete stock ownership is the right choice for many businesses. 

For example, if the business’s owner would like to retain majority ownership and continue to influence the company’s direction, this plan allows them to ease into handing over control. Likewise, if the business has several owners—each with different retirement timelines—a two-stage, three-stage, or even four-stage ESOP transaction allows each to exit the company on their own schedule. ESOP ownership transactions typically do not exceed four stages as transaction costs and professional fees can accumulate.

A partial ownership structure also has advantages for companies that are unable to fund a 100% transfer of stock ownership using their current cash flow alone and want to minimize the total debt obligation for financing the purchase of all ownership shares. In some instances, the company may not qualify for the size loan to purchase all shares at once through a combination of bank and seller financing. A multi-stage ESOP transaction allows businesses to purchase shares in more digestible chunks as their cash flow allows.

Choosing the right second-stage transaction method
With careful planning and ready cash or financing, a second-stage ESOP transaction can be as seamless as the initial transaction. This second phase is often less expensive than the first but still takes time and focus—especially when it comes to selecting the right transaction method.

There are two main methods of conducting the second-stage in an ESOP transaction: a direct sale of non-ESOP shares or the redemption of non-ESOP shares.

To decide which is the better method, businesses must examine each option’s benefits and drawbacks, from their tax advantages to their impact on share values.

  • Direct sale: In a direct sale, the stockholder sells their non-ESOP shares directly to the ESOP. This option has potential tax advantages if the taxpayer held the securities for at least three years before the sale, the company is classified as a C corporation at the time of the sale, and the ESOP controls at least 30% of employer stock after the sale. For transactions that meet these conditions, the stockholder may be able to defer taxes on the sale by making a Section 1042 gain deferral election.

  • Company redemption: In a redemption strategy, the company first redeems the non-ESOP shares then sells them to the ESOP—with the company financing at least some portion of the purchase price. Because this method reduces the total number of shares while lowering the company’s value—due to the decrease in shares and the new debt—the overall share value usually does not decrease. In fact, oftentimes it increases over the long-run. Companies that want to limit their downside exposure may choose to explore price protection options to stabilize these share prices.

Work with the financing experts for second-stage ESOP transactions
When it comes to planning a company’s future, second-stage ESOP transactions offer the flexibility businesses need to smoothly move toward full employee ownership—on their timeline. But staged transactions require strategic planning and financing. First American Bank has gained a reputation for providing guidance and flexible ESOP financing designed to support your company’s stability and strategic goals.

With more than 20 years of ESOP financing experience, our dedicated ESOP lending team brings deep expertise and knowledge to understand the nuances of each client’s ESOP transaction. Using our hallmark customization and client focus, we work with businesses to create the optimal ESOP financing solution for all stakeholders.

Uncover second-stage ESOP financing solutions.
Contact a First American Bank ESOP expert

This information is for educational purposes only. It is not legal or tax advice. For legal or tax advice, you should consult your own legal counsel, tax, and investment advisers.

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