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By David McManus and Darren Gleeman
Cannabis operators have plenty of challenges keeping pace with rampant industry growth. Rising competition, scaling labor, pricing pressure, and of course regulatory compliance create a web of issues that call for creative strategic thinking. Simply put, companies should be seeking every advantage to maintain momentum.
An Employee Stock Ownership Plan (ESOP) is a structural weapon that is uniquely applicable yet vastly
underutilized in the sector. ESOPs provide significant tax benefits, cash flow, and staffing advantages that can boost cannabis companies looking to capitalize on opportunities.
At its core, an ESOP creates an employee-owned company that is not subject to federal tax. Leadership
ultimately still maintains control of the organization, while generating additional cash and overcoming
the infamous hurdle of 280E.
ESOPs pay zero federal tax and zero state tax
ESOPs were originally created as a way for the U.S. to encourage broader ownership and wealth generation among employee bases. It is a proven structure in other sectors: there are currently 6,500 ESOPs and 14 million participants, with the heaviest concentration in manufacturing and construction.
The most important incentive is that any cannabis company owned 100% by an ESOP pays zero federal tax, zero state tax, and zero UBIT. With no exposure to federal taxes, 280E restrictions are neutralized.
A company that pays no tax does not have to worry about deductions. Deductions are “made-up” by the IRS. If you are a tax-free entity, it does not matter if you can take deductions or not.
This means the company will have between two and three times more free cash flow immediately. This allows companies to improve facilities, reduce prices, make acquisitions, offer higher wages, and increase their “war chest” for future needs. In an era of intense competition, such flexibility can be the difference between timely growth and falling behind.
ESOPs pay zero capital gains tax on the sale of the company
Another government subsidy deals with capital gains. Normally, when a company is sold, the shareholders must pay capital gains taxes. However, if an owner sells to their employees via an ESOP, capital gains taxes are deferred, and if structured properly, they can be deferred indefinitely.
In the event that cannabis becomes legalized at the federal level and 280E is rendered moot, ESOP owned companies will continue to pay zero taxes.
Employee-owned companies are more likely to retain staff
Cannabis operators face intense competition for labor. Reports forecast that the industry could support as many as 1.75 million jobs in the U.S. In 2023, the estimated workforce is 417,000 – there will be a lot more work to recruit and retain employees in the years ahead.
ESOPs provide a unique employee benefit that brings an entirely new dimension to the recruiting process and the brand overall: with an ESOP, the employees are owners. Once this realization takes hold, employees enjoy the pride of ownership, and they start to think and act like owners. If the company is sold down the road, the employees have tremendous upside.
Ownership through ESOPs also contributes to social equity measures, a central focus of employee growth and opportunity in the sector. Company ownership is noted as one of the primary drivers of wealth in the U.S., as highlighted by the Aspen Institute: “as retiring owners—including those of color—exit their businesses in the coming years, ESOPs may offer a historic opportunity to make meaningful progress on building wealth for those who have for too long been left behind.”
How is an ESOP structured?
Establishing an ESOP requires some maneuvering. There are a number of steps to take, with financial
incentives laid out along the way.
- The company owner begins by initiating an internal leveraged buyout, with employees serving as the third-party buyer. This costs the employees nothing. It is a gift to the employees from the owners and the government.
- The owner can defer capital gains tax on the sale to employees.
- Funding for the ESOP comes from outside debt and/or seller notes.
- Cash flow generated from ESOP tax savings will be used to pay down the initial loan.
- The owner can receive warrants to buy back a portion of the firm from the ESOP in the future. This allows for a “2nd bite of the apple” for the initial owners.
Explore the starting point
The first step for operators is to complete a thorough investment banking analysis of the company. This will include a formal valuation and will exploring structure, tax issues, tax savings, and other elements that are fundamental to an exit.
Once leaders have a grasp on the scope of change, they can engage with their internal team and their advisors on critical questions. How much cash flow will be generated, what are the near-term opportunities at hand, and what headwinds might the company face? Envisioning the future state of the business will lead to a strategic roadmap for how to maximize the ESOP structure.
In the words of Wayne Gretzky, “the key to winning is skating first to where the puck will be next.”
About the Co-Author
Darren Gleeman is a corporate finance expert and investment banker based in New York, NY. He is currently the Managing Partner of MBO Ventures, and previously was the founder of e-Coupons, and Managing Partner of GMD Trading and GB Trading. He is an alumnus of The Wharton School at the University of Pennsylvania.
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