ESOPs: A Tool To Build a Thriving Franchise with Committed, Invested Employees

Remember when you first jumped into your franchise? Remember how optimistic you were about the future? There is something tangible about that hope. The visceral nature of hope drives us through tough days. It fuels us through long nights. Some of us look forward to the next deal, reaching that next sales hurdle and accomplishing a goal that has been just out of reach. For a scant few, money is the great driver. This article is probably not for you. A smaller group, still, are machines. It is the work, the grind, that drives you. This may not be for you either. For many of the franchisees I meet, it’s their people that drives them. The customers, the employees, their suppliers, and investors are their passion. They are driven by the joy of seeing their tide lift all the boats in their wake. This article is for you.

“HELP WANTED.” The most important and most cursed phrase of every franchisee. The Great Resignation, the tech boom, demographic shifts, and similar challenges have led to a difficult situation for those operating franchises.

Most franchisees we interact with aren’t losing sleep about keeping the sales clerk they hired last week or the person stocking shelves. We all are worried about our top talent. Good managers are hard to find. Managers who work hard, care for those they manage, and strive to improve their skills are rare. Losing these people can represent losing years of effort and expense on the part of the franchisee. These people are irreplaceable in the short term and, perhaps, in the long term. For some of us, these managers also represent relationships and, in some cases, friendships. If employees are just a means to an end, this article may not be useful to you. If you place value in the people who work for you, this article is for you.

The only thing many franchisees hate more than “HELP WANTED” is “1040.” Taxes. Argh! We work hard. We take smaller salaries than many would believe in the hope of showing a profit, only to see that profit bitten.

There are our three challenges: maintaining hope, retaining people, and earning a profit. How can we accomplish those three things?

The simplest answer is, “You need a value manual.” You have the manual to operate your franchise. However, if we’re all being honest, we didn’t get into business to operate a franchise. The franchise represented an opportunity to create more financial value. Shouldn’t you have a manual to direct the best way to maximize that value?

This article discusses a tool that appears to be underutilized by franchisees and/or allowed by franchisors. We’ll do our best to illustrate the value of using this tool. However, remember that any tool is only as good as the job it was built to accomplish. In other words, if you need to drive a nail, you don’t want a saw. That doesn’t make the saw a bad tool, it just isn’t the right tool for that particular job. Before you run off and buy any tool, chat with an expert about the job at hand.

Franchisees and franchisors (and most business owners) have complex financial situations that require nuance. One tool likely isn’t sufficient to solve all challenges. Additionally, if the financial professional you currently work with (CPA, attorney, insurance agent, investment advisor) gives you a blanket statement of, “No,” get a second opinion. No professional can be familiar with all tools. “No” is a safer answer (and less time-consuming) than “Let me research that.” Reaching out to a second professional rarely results in replacing the original professional. It often means expanding your base of professionals and the pool of intelligence from which you can draw!

The ESOP

The employee stock ownership plan (ESOP) was created decades ago by Congress to encourage small-business owners to allocate a portion of ownership to their employees. The tax code gives owners substantial tax breaks to bring employees into the ownership fold. Additionally, that tax break isn’t a one-time deal, it’s an ongoing provision that allows an owner to continually defer taxation of profits in certain circumstances.

Our focus here is on multi-unit operations. ESOPs, at their essence, buy stock from owners. By law, they must do so at fair market value. This means you won’t get top dollar. However, the tax savings may mean you keep more money than you would have if you sold your operation at top dollar. Ownership can choose to sell bits of stock at a time into the ESOP or sell it in large swaths with the use of a bank loan made to the company. The seller may be able to defer capital gains on the sale of that stock. Additionally, an ESOP-owned S Corp may be able to avoid federal income tax altogether.

The sale of stock also allows ownership to diversify their net worth. Cash is generated from the sale of the stock to employees. That can be a Catch-22. Be prepared to invest that money elsewhere, preferably in investments that don’t correlate to your franchise.

Finally, an ESOP allows you to retain your best people with golden handcuffs. However, this takes time. There are waiting periods, vesting schedules, etc. This tool allows an owner to effect a nuanced transition. An owner may want to phase out of ownership in lieu of an all-or-nothing sale. An ESOP gives you the ability to slowly transition your operation in a manner you see fit. Finally, remember that an ESOP won’t create good company culture. This tool is best used to cultivate existing culture.

What’s the catch? There are a number. First, if you’re a franchisee, you’ll need to obtain your franchisor’s approval. This likely represents the low utilization among franchisees. Franchisors want personal buy-in from their ownership. They may let you transfer title to a corporate entity, but often an owner is still liable for operations. Second, while you want to keep your best managers, your managers will need to be capable of running the operation if you step away. Golden handcuffs are a two-way street. You don’t want to throw ownership at poor managers to keep them around. You want to incentivize people you just can’t live without and promote a good company culture. Finally, ESOPs have considerable up-front costs and ongoing maintenance requirements. Make sure you know those costs before making commitments. Make sure the firm you are using can provide both the set-up and maintenance, or that you have a firm for each service.

In the final analysis, an ESOP can help ownership retain talent, lower taxes, transition the business, and create hope among a large swath of people. Your customers and employees can profit from long-term consistency of business. Investors can gain value by deferring taxes. Suppliers can maintain long-term relationships that can smooth out and minimize time required for transactions. And you can better control and experience the monetary value of what you’ve spent years creating.

Additional resources

Selling a Franchise Company to an ESOP (Adamy Valuation)

Is Employee Owned an Option for a Franchisee? (America's Best Franchises)

One Key ESOP Taxation Advantage: No Federal or State Income Tax (ESOP Partners)

Scott Eichler is a Registered Investment Advisor and founder of Standing Oak Financial Advisors, as well as author of the best-selling book “Don’t Play Chicken with Your Nest Egg.” Contact him at seichler@standingoakadvisors.com or 714-451-8216.