March 01, 2012

An updated version of this article is available. Please see "Revisiting the ESOP Advantage for Government Contractors," published in the Spring 2017 Journal.  

It is no secret that the size of the U.S. federal government increased significantly over the past decade. According to the Office of Management and Budget, federal outlays more than doubled between 1999 and 2010. A direct result of this increase in spending is the expansion of the government contracting industry over the same period. What was once primarily residential and vacant land outside the Beltway is now occupied by the headquarters and satellite offices of hundreds of government contractors. However, after a decade of deficit spending, debate regarding the federal budget intensified to the point of a possible government shutdown in 2011. The certainty of continually higher government spending has apparently ended and has been replaced with a new period of uncertainty and increasing efforts by Washington to cut government expenditures, including defense spending.

Although merger and acquisition activity in the government contracting industry remained somewhat robust in 2011, it is hardly the ideal environment for a business owner looking for liquidity. Due to increased budget uncertainty and its impact on government contractors, valuations of publicly traded companies in the industry have taken a hit. In addition, companies continue to face the same challenges that existed prior to the change in market conditions, such as attracting and retaining top talent, competing for contracts, and remaining profitable. Business owners who desire some liquidity, while also maintaining the independence and competitiveness of their business, should strongly consider implementing an employee stock ownership plan.

An employee stock ownership plan, or ESOP, is a type of retirement plan that facilitates the transition of a firm’s ownership to its employees by creating a trust on behalf of employees that purchases company stock from a selling shareholder. What differentiates an ESOP from other defined contribution plans is its ability to borrow money to purchase such stock. ESOPs provide the sellers with an intelligent solution to succession planning and flexible transaction structures, all while minimizing, and possibly eliminating, taxes. Employees, without direct cost to them, are able to participate in the future success of the firm through equity ownership. Finally, studies show the company benefits from higher worker productivity and certain tax advantages that ultimately result in improved cash flow. In fact, more than 11,500 companies in the United States already enjoy the many benefits of employee ownership, and the rewards are even more abundant for companies that offer services to the federal government.

For Owners: An Exit Strategy Worth Considering

The typical owner of a government contractor has sacrificed significant time, energy, and money in the pursuit of success for their business. They have celebrated the company’s victories and learned from its failures. But much like any other success story, in order for the triumphs to continue, the torch is eventually passed to a new owner. The transition from active executive to passive investor, retirement, or other venture can be challenging. The decision on just how to exit the business can be as equally strenuous, especially when presented with various options. By selling to an ESOP, owners can maintain control when it comes to their exit from the business and are offered a variety of paths.

In many instances, owners prefer to gradually transition responsibilities to a new generation of management. Unlike a typical sale to a strategic or private equity buyer, an owner can sell minority ownership interests to an ESOP over time, thereby allowing the owner to maintain control, achieve some desired liquidity, and participate in the future appreciation of the business. This scenario is especially true for 8(a) certified companies, such as service-disabled veteran-owned and minority-owned small businesses. Federal government regulations typically allow owners of 8(a) companies to sell a minority ownership interest (up to 49%) to an ESOP, allowing the owner an opportunity to focus on succession planning and diversifying wealth while not surrendering the significant benefit of 8(a) status. When the company graduates from 8(a) status, the owner will then be able to sell the remaining stock to the ESOP or sell the company to a third party.

The future outlook of the government contracting industry may be more uncertain, but there is no doubt that the government will continue to collect taxes. However, by selling at least 30% of the common stock of a C corporation to an ESOP, an owner can defer and possibly eliminate capital gains. Because of this unique tax benefit, the after tax proceeds earned in a sale to an ESOP are often equal to, and can frequently exceed, the after tax proceeds from the sale to a third party buyer.

A Right Fit for Government Contracting

Although there are many rewards to gain from employee ownership, not every company is an ideal candidate for implementing an ESOP. An ESOP’s purpose is not to invest in troubled companies, but rather to acquire ownership in a stable entity that is capable of achieving long-term growth and providing a reasonable return to employees.

Merely operating in the government space is not enough to make a successful ESOP company. First, a firm should have sufficient cash flow to meet its obligations, including making contributions to the ESOP that could be used to service related debt or purchase shares. Second, a successful ESOP company typically has an experienced management team that ensures the company will be left in competent hands once the selling shareholder decides to step away. This factor is especially important for government contractors given the unique contracting requirements and relationships needed to secure future work. Finally, the company should operate within a market that has long-term stability. Government contractors have historically been somewhat insulated from changes in the macroenvironment. While concerns about budgets may temporarily hurt a company that relies on government spending, analysts expect the industry to continue to grow at a moderate pace in the future. For firms that provide goods and services to expanding sectors of the government, such as intelligence, cybersecurity, and unmanned aircrafts, the growth prospects are even more encouraging.

For Companies: Lower Taxes and Increased Cash Flow

After a contractor receives payment from the government for services rendered, it does not take very long for a large share of those funds to make it back to the government in the form of taxes collected. A company can reduce or eliminate its tax burden by implementing an ESOP since contributions of cash and stock up to 25% of qualified payroll are tax deductible. Since labor costs make up a significant portion of a government contractor’s costs, the annual contribution limit is typically at the higher end of the range when compared to other employee-owned companies of similar size. Even when an ESOP borrows funds to finance a stock purchase, contributions to the ESOP that are used to repay principal are tax deductible, along with the portion that is used to repay interest.

The tax benefits of ESOPs are most significant for S corporations that are 100% owned by an ESOP. S corporations pass through income to their shareholders who are then responsible for paying appropriate taxes. When the sole shareholder is a tax-exempt entity, like an ESOP, the tax burden is completely eliminated. By paying fewer or no taxes, a government contractor is able to use the additional cash flow to invest in the growth of the company or to reward its shareholders in the form of increased dividends.

Winning the Battle for Talent

A common challenge government contractors face is finding and retaining skilled employees. Although it may not seem like it inside the Beltway, qualified workers with higher educations and top-secret clearances are a rare find. In other parts of the United States where the federal government is not as ubiquitous, these employees are even scarcer. Further complicating the matter, government contractors not only battle for talent with their competitors, they must also compete with their own client, the U.S. government, from enlisting their employees, a process the government calls “insourcing.”

One of the many incentives a government contractor can offer its current and prospective employees is equity ownership from the ESOP. Much like other defined benefit contribution plans, an ESOP provides retirement benefits that achieve tax-deferred growth until the employee receives a distribution, which typically occurs upon retirement or when an employee leaves the company. However, when it comes to ESOPs, this benefit is realized at no direct cost to the employee. Further, studies suggest that employee productivity improves once a company establishes an ESOP, ultimately resulting in higher revenue and earnings relative to what may have been generated without it.

ESOP Costs Are Allowable

When providing products or services to the federal government, companies must be conscious of which costs can be charged to the contract. These costs generally fall into two categories: allowable and unallowable. In the case of ESOPs, Federal Acquisition Regulation rules state that contributions of both cash and stock are allowable so long as they are not excessive and are distributed to employee accounts in the same year. As such, ESOP costs are often reimbursed by the government.

Conclusion

The exit strategies owners ultimately decide to undertake not only have significant consequences for themselves but also the companies they leave behind and their employees. For many companies, implementing an ESOP is an ideal way to reward owners with liquidity and certain tax advantages pursuant to the sale of stock, while also providing current and future employees with incentives to continue to contribute to the success of the firm. The unique nature of the government contracting industry makes many companies that provide services to the federal government great candidates for ESOPs. Accordingly, as competition in the industry continues to escalate, an ESOP could potentially help a government contractor gain the edge it needs to outperform the competition by leveraging its greatest strength, its employees.