In our whitepaper, How Ownership Transition Planning Protects Both Franchisors and Franchisees, we discuss the fact that franchisees face the same succession and transition challenges that all business owners face, and don’t typically engage in exit planning. Most do not have a Business Ownership Transition Plan, a contingency plan, or a leadership succession plan in place. In this article, we’ll discuss one option for franchisees – one that is commonly misunderstood – the Employee Stock Ownership Plan (ESOP).

Reward Your Key Employees

Successful franchise business owners often depend on their key employees to ensure the smooth operation of the franchisee’s business. This is especially true of franchisees who own multiple franchise locations and can’t be in all locations at the same time. Sometimes owners would like to reward all of their employees but aren’t sure how to do this.

Franchise owners may want to consider selling their shares to an ESOP trust, which enables ALL the employees to become owners. Contrary to the name, the Employee Stock Ownership Plan does not mean selling stock directly to each employee. However, it does involve selling all or part of the owner’s shares to a trust for the benefit of all employees, and the owner can maintain operational control. It provides the owner liquidity, a built-in buyer, and some great tax advantages. If the employees stay with the franchise, their hard work will pay off in the form of stock that is distributed annually to a retirement account for them, based on their level of compensation.

In an article in Entrepreneur, Kelly Saxton, whose Saxton Group owns 50 McAlister's Delis and four Pinkberry locations throughout the U.S., says: "Our No. 1 asset is our employees.” Last year, he transferred 100% of his company stock to an ESOP on behalf of his employees. He says that the ESOP is a way to reward and motivate the people who make his business successful. "Our employees have helped me accomplish my goals. In the past this has been my company," he says. "Now I like to announce that this is our company."

Unique ESOP Factors for Franchisees

Developing an ESOP takes time and it is an involved process. Franchisees face some unique challenges when selling company stock. They need to consider the franchise agreement itself, which is often tied to the business owner as an individual rather than a corporation. In some cases, franchisors will allow the agreement to be transferred to a business entity if the owner (or a group of managers) remains liable for the operation of the business.

While some franchise agreements have restrictions on the transfer of ownership of the company, if the ESOP proposal is structured correctly, franchisors may allow the transfer as part of a solid business exit plan. It can benefit the franchisor in the long run to have franchises that are operated by a team of manager/owners who have a vested stake in the business.

An ESOP will often require third-party (i.e., bank) debt, and may also require the owner to participate as a lender. These types of transfers are done at Fair Market Value, as defined by the tax code, which is usually less than the Market Value used for an external sale. However, an ESOP transaction may generate a greater net dollar amount for the owner due to the minimization of taxes and fees. There are also tax advantages to the ESOP. For example, S Corporations owned by ESOPs pay no income taxes, and owners may be able to defer paying capital gains tax if the net proceeds are placed in certain types of tax-advantaged investments. These types of transfers are too often considered as being only for the largest companies, but this can be a costly, false assumption. A minimum of 15 to 20 employees is required, and it may actually be one of your best strategies to accomplish your long-term goals.

With the proper planning, an ESOP can be an attractive exit planning option for franchisees. It can provide the continuity of ownership for the franchisee’s company, security for the management team, a lump sum to fund the current owner’s retirement, and most of all, tax savings.

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