Darren Gleeman is a financial expert. Darren is the Managing Partner of MBO Ventures. He was the founder of e-Coupons, Managing Partner of both GMD Trading, and GB Trading. He’s highly sought after for his ESOP knowledge and financial acumen, as well as being a prolific angel investor with early investments in companies such as Screaming Media (NASDAQ:SCRM), Blackboard (NASDAQ:BBBB), Social Radar and his latest investments in ClassEdu and Accelerant Manufacturing.

https://www.linkedin.com/in/darrengleeman/

An ESOP is a way to sell your company today for Fair Market Value. ESOPs were created by Congress to incentivize business owners to sell their company to their employees instead of to a competitor or to a private equity firm—these incentives are all based on significant tax subsidies.

With an ESOP, a cannabis business owner can take tax free chips off the table today, run the company completely income tax free forever, continue to operate the company into the future and also get the opportunity to profit from another larger exit in the future.

Below are 5 benefits of why selling to an ESOP might make sense for today’s cannabis owner.

1. Zero Income Taxes

When a cannabis company transitions to an ESOP, it no longer pays federal and state income taxes. It becomes a tax-exempt business. This was put in place in 1998 by Congress and signed into law by Former President Bill Clinton. 

This tax-exempt status is particularly impactful for cannabis businesses because they are burdened by Section 280E of the Internal Revenue Code, which severely limits tax deductions for plant touching cannabis companies. Since an ESOP pays no income tax, 280E becomes irrelevant. The company is not getting around or evading 280E. It just doesn’t have any relevance when you pay no tax.

This tax-exempt status fundamentally changes the company’s cash flow dynamics. The money that would have gone to tax payments now stays in the company. For a cannabis firm, this increase in cash flow can be dramatic, potentially doubling or even tripling the amount of cash on hand. This additional liquidity is used to pay down debt (allowing the ESOP to buy the company from the owners), reinvest into the company to fuel growth, enhance operations, and pursue new opportunities.

2. Sell to the Employees and Pay Zero Capital Gains Tax on the Sale (Deferred and Can Be Deferred Forever)

When you sell your business to an ESOP, a standout financial perk is the ability to defer capital gains tax on the proceeds from the sale. This isn’t just a temporary reprieve; with the right planning, this deferral can effectively become permanent.

Here’s how it works: Typically, when you sell a business, the profit from the sale is subject to capital gains tax. However, in an ESOP transaction, the IRS provides a provision that allows you to roll over the proceeds into other securities, effectively deferring the capital gains tax. This means that instead of paying taxes on the gains now, you can invest the proceeds into a portfolio of stocks, bonds, or other qualifying investments, postponing the tax liability. Instead of investing all the sale proceeds into replacement securities, you can leverage a portion of this amount, reducing the need to use your own cash upfront.

The beauty of this arrangement is that with strategic financial planning, you can manage these investments in a way that the capital gains tax deferral can be extended indefinitely. For instance, by holding onto these replacement securities and planning your estate wisely, you can potentially pass on these assets without ever triggering the capital gains tax. This not only benefits you financially but can also serve as a powerful tool in wealth management and estate planning, ensuring that more of your wealth is preserved for your heirs or chosen beneficiaries.

3. Warrants: A 2nd Bite of the Apple for the Former Owners

The concept of warrants within the context of an ESOP sale adds an intriguing layer of strategic flexibility for the selling business owner. Similar to stock options, warrants grant you the right, but not the obligation, to buy back shares of your company at a predetermined price, known as the strike price, within a specific timeframe.

This mechanism allows the former owner(s) to benefit from the company’s future growth and success.

Suppose the company flourishes under the ESOP structure, increasing in value. In that case, the warrant holders have the opportunity to repurchase a portion of the company at a price that could be significantly lower than the market value at the time of exercise.

Incorporating warrants into the ESOP transaction can align everyone’s long-term personal and financial goals. For the company and its employee-owners, the knowledge that you have the option to buy back a chunk of the business can serve as a powerful incentive to drive the company’s performance. It underscores your ongoing interest and confidence in the business, fostering a collaborative environment where everyone is working toward the common goal of increasing the company’s value.

4. Continuity of Management

An ESOP sale ensures the business’s leadership and strategic direction remain steady. The Board of Directors, often retaining its composition, continues to govern, ensuring minimal disruption. Former owners and the existing management team are still holding leadership roles, serving on the board, or providing advisory insights. This stability in management and governance allows the company to leverage the vast experience and leadership skills of its founders and long-standing executives, maintaining the business’s core vision and strategies.

5. Elevating Retention and Performance with ESOPs

Implementing an Employee Stock Ownership Plan (ESOP) significantly enhances employee retention and overall company performance. According to a 2023 study, ESOPs boost employee retention rates by an impressive 300% compared to the national average, underscoring the profound sense of ownership and commitment that employee ownership instills. This elevated retention reflects a workforce that is more engaged, motivated, and aligned with the company’s objectives, contributing positively to company stability and employee satisfaction.

Final Thoughts

Moreover, the impact of ESOPs extends beyond just retention. Another landmark study found that companies with ESOPs experience an increase in sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected without an ESOP.