Sell Your Business to Employees: ESOP, Co-op or Trust

An owner can sell a business to its employees in four main ways in the United States: through an employee stock ownership plan (ESOP), by converting it into a worker cooperative, through an employee ownership trust (EOT), or by selling or granting shares to employees directly. Each route has a different buyer, a different set of legal rules and a different level of control for the workers afterward. The National Center for Employee Ownership (NCEO) says the most common reason companies become employee-owned is that the owner wants to exit and does not want to leave the business to private equity, a public company or another outsider.

This guide is for the owner. It compares the four routes, explains where the free conversion roadmap on this site fits, and sets out what federal law and the Small Business Administration (SBA) say about paying for a sale to employees. It gives no legal, tax or valuation advice and names no adviser as a recommendation: the lawyers, accountants and valuers who handle these sales are where the deal-specific answers come from.

The four routes at a glance

The right route depends on what the owner wants most: the price and tax treatment, keeping the company's character, or handing real control to the people who do the work. Employee-owned company compares the first three in more depth, and worker cooperative vs employee-owned looks at the control question.

Route 1: Sell to an ESOP

NCEO describes an ESOP as a type of retirement plan, similar to a 401(k), that invests primarily in company stock and holds its assets in a trust for employees. An ESOP may own 100% of a company's stock or only a small percentage. The IRS describes it as an IRC section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus and money purchase plan, designed to invest primarily in qualifying employer securities.

NCEO says ESOPs are often created in the process of selling a business, because the plan can buy a departing owner's shares in pretax dollars. Selling owners can sell any portion of their stock to the plan, and Congress created incentives for ESOPs to borrow money, called leveraged ESOPs, so they can buy more shares than they otherwise could. NCEO adds that non-leveraged ESOP deals tend to be smaller and have lower transaction costs.

Employees in an ESOP do not hold shares directly. They accrue shares in the plan over time and are paid out by having their shares bought back, typically after they leave the company. NCEO says that in ESOP companies employees directly vote their shares in some cases, but that these cases are rare. If one-member-one-vote control matters, the ESOP is not the route that delivers it.

Route 2: Convert to a worker cooperative

NCEO defines worker cooperatives as enterprises solely owned and democratically governed by their workers. Generally, employees join by paying a fee, and each worker gets one vote. NCEO says worker co-ops are most common in startups, small companies and companies with social missions, though they are possible at companies with thousands of workers.

The Democracy at Work Institute (DAWI) describes conversions as businesses that move from a traditional structure to employee ownership. It says it convened a national collaborative called Workers to Owners to bring worker ownership to scale through conversions of existing businesses. Its conversions page for worker co-ops is addressed both to a business owner considering the move and to employees who want to buy an existing business and convert it. For the formation steps, including conversion of an existing business, see how to start a worker cooperative, and for the structure itself, worker cooperatives.

The tax code recognizes this route too. Section 1042 of the Internal Revenue Code, covered below, applies to a sale to an "eligible worker-owned cooperative" as well as to an ESOP.

Route 3: Sell to an employee ownership trust

An EOT is, in NCEO's words, generally a purpose trust that owns some or all of the shares of a company. NCEO says there is no legal definition of what separates an EOT from similar trusts, but that to be an EOT the purpose of the trust should include the well-being of the company's employees.

NCEO describes the mechanics. The current owner creates a trust that will own some or all of the business. The company contributes cash to the trust, which uses it to buy shares from the owner, and in most cases the owner offers seller financing. Employees do not pay to be beneficiaries, and most trusts set aside part of annual profits for an employee profit-sharing pool. NCEO says the main reason owners choose an EOT is confidence that the character of the business is preserved, and that a secondary reason is that EOTs are more flexible and less expensive than other forms of employee ownership, especially ESOPs. It also says that business owners trying to maximize the value of their stake generally either sell to a third party or, sometimes, to an ESOP.

Route 4: Sell or grant shares to employees directly

NCEO notes that some private companies create their own plans to allow or encourage employees to buy shares, and others make stock grants. It says these "nonqualified" plans do not offer the tax advantages of qualified plans and must be carefully designed to avoid unintended consequences, but that they offer flexibility and low administration costs.

Where the conversion roadmap fits

The conversion roadmap is a free, interactive checklist for one of the four routes: converting an existing business into a worker cooperative. It does not cover ESOPs or trusts.

You start by choosing which of three positions is closest to yours: you own the business, you are one of the employees, or you are advising a business. The roadmap keeps the same five phases for each, and changes only the opening line and the suggested first move. The phases are:

1. Explore and assess fit. Whether the owner wants to sell to employees, whether the business has stable cash flow, and whether enough employees want to be owners.
2. Value the business. Getting an independent valuation to anchor the price.
3. Structure the deal and financing. Member buy-in, seller financing, SBA 7(a) loans and mission lenders.
4. Design legal structure and governance. The entity, the bylaws, how members join and how surplus is shared.
5. Transition and train. Closing the sale, training the new member-owners and planning the owner's exit.

Each phase has a checklist and a short list of questions. Ticked steps are saved in your own browser on the device you use, so you can come back to them later. Use it as a map of the questions to settle, in order, before you sit down with an adviser. It does not replace one.

How a sale to employees gets paid for

Employees rarely have the cash to buy a business outright, so the financing is usually the hardest part to design. Several sources come up across the routes.

Seller financing

NCEO says that in an EOT sale the trust buys the owner's shares with cash the company contributes and that, in most cases, the owner offers seller financing. In plain terms, the owner accepts part of the price over time instead of all of it at closing. The roadmap's financing phase raises the same option for a worker co-op conversion.

SBA 7(a) loans

The SBA's 7(a) loan terms page says most 7(a) loans have a maximum loan amount of $5 million. Federal law speaks directly to loans for employee buy-outs. Section 862 of Public Law 115-232, enacted in 2018, amended the 7(a) program in several ways that the statute text spells out:

• It added a paragraph saying the SBA "shall guarantee loans made to a cooperative" for the purpose described in paragraph (15) of section 7(a). That paragraph covers loans to qualified employee trusts to buy stock of a business, including transaction costs. The law says a cooperative is an entity the SBA Administrator determines to be a cooperative under applicable federal and state law.
• For a loan to a qualified employee trust or to a cooperative, it allows a seller to remain involved as an officer, director or key employee once the trust or cooperative has acquired 100 percent of ownership.
• It says a seller who remains an owner of the business, whatever the percentage, is required to provide a personal guarantee.
• It lets the Administrator elect not to require any mandatory equity from the trust or cooperative.
• It directed the SBA to run a program, through small business development centers, offering technical assistance and training on the transition to employee ownership through cooperatives and qualified employee trusts.

The SBA has also issued a procedural notice, effective June 24, 2024, saying SBA lenders may use their delegated authority to make loans to cooperatives and to eligible small businesses owned or controlled by a cooperative. The same notice removed the requirement for an independent business valuation for certain 7(a) loans involving ESOPs. Whether a particular lender will make a particular loan is the lender's decision, and lenders set their own terms. Cooperative lenders lists lenders that say they finance co-ops and the ranges they publish.

Mission lenders and conversion specialists

Several nonprofit and community lenders say they finance sales to employees. The Working World's site says it provides "the capital that employees need to buy the business from the founder" and the expertise for the transition. Project Equity's site says it provides transition services for partial or full employee ownership, including exploring options, evaluating feasibility, securing capital and preparing employees for ownership. These are descriptions of what each organization says it does, not an endorsement or a ranking, and none publishes a price range for a conversion.

What the tax code says about selling to an ESOP or co-op

Section 1042 of the Internal Revenue Code is titled "Sales of stock to employee stock ownership plans or certain cooperatives". It is the rule NCEO is referring to when it says selling owners can defer tax on the gain from an ESOP sale "if certain requirements are met." The statute's text sets those requirements:

Where those conditions are met, the statute says the gain that would be recognized as long-term capital gain is recognized only to the extent that the amount realized exceeds the cost of the replacement property. The statute also defines an "eligible worker-owned cooperative": an organization to which part I of subchapter T applies, a majority of whose members are its employees, a majority of whose voting stock is owned by members, a majority of whose board is elected by members on a one-person, one-vote basis, and a majority of whose allocated earnings and losses are allocated on the basis of patronage, capital contributions or both.

Two points follow from the text. First, the section covers stock of a C corporation, so whether it fits depends on how the business is organized. Second, it describes a rule, not an outcome: replacement property rules, the 30 percent test and the election all have to be met. An owner should have a tax adviser confirm whether the section applies before planning around it. ESOPs in S corporations follow different tax rules, so ask a tax adviser.

Questions to settle before you approach employees

Whatever route you lean toward, these questions come up in every version of the sale:

1. What do you want from the sale? A price, a timeline, a role afterward, and what happens to the company's name and character.
2. Does the business throw off enough cash? The buyer, whether a plan, trust or co-op, usually repays a loan out of the company's earnings, so the business has to carry both its payroll and the debt.
3. Do enough employees want to be owners? Ownership brings responsibility as well as a stake.
4. How is the price set? The roadmap points to an independent valuation. The SBA's 2024 notice removes the independent-valuation requirement only for certain ESOP loans, so check what your lender and your adviser require.
5. Who stays and who leaves? Under the SBA's rules a seller who remains an owner must give a personal guarantee, and a seller who has sold 100 percent may stay as an officer, director or key employee.
6. What control will the workers have? The four routes differ most here. See cooperative governance.

Frequently Asked Questions

Can I sell my business to my employees?

Yes. In the United States the main routes are an ESOP, a worker cooperative conversion, an employee ownership trust and a direct sale or share grants. Each has its own legal rules, so the structure you pick shapes the paperwork, the tax treatment and the workers' role.

What is the difference between an ESOP and a worker cooperative?

An ESOP is a retirement plan that holds company stock in trust for employees and is created by federal law. A worker cooperative is a company owned and democratically governed by its workers, who are members with one vote each. NCEO says that in ESOP companies employees directly vote their shares only in rare cases.

What does the conversion roadmap on this site cover?

It covers converting a business into a worker cooperative, in five phases from exploring fit to training the new owners. It is a free checklist that saves your ticks in your own browser. It does not cover ESOPs or employee ownership trusts, and it is not advice.

Can employees use an SBA loan to buy the business?

Federal law has the SBA guarantee 7(a) loans to cooperatives, and lets it guarantee loans to qualified employee trusts, to buy stock of a business, and the SBA has told its lenders they can use delegated authority for loans to cooperatives. The SBA's terms page says most 7(a) loans have a maximum of $5 million. Each lender decides whether to make a given loan.

What is Section 1042?

It is a section of the Internal Revenue Code about sales of stock to an ESOP or an eligible worker-owned cooperative. Where its conditions are met, gain that would be recognized as long-term capital gain is recognized only to the extent the amount realized exceeds the cost of qualified replacement property. It covers stock of a domestic C corporation that is not publicly traded and has holding-period, ownership and election requirements.

Does an employee ownership trust have a legal definition in the US?

NCEO says there is no legal definition of what separates an EOT from similar trusts. The trust's own documents set who the trustees are and what the trust must do, so ask a lawyer to explain what a specific trust would require.

Do employees have to pay to become owners?

It depends on the route. NCEO says employees do not pay to be beneficiaries of an EOT, and that in a worker cooperative employees generally join by paying a fee. In an ESOP the company funds the plan, and employees accrue shares over time.

Will the sale price match what an outside buyer would pay?

There is no standard answer. NCEO says owners seeking to maximize the value of their stake generally sell to a third party or, sometimes, to an ESOP. How the price is set for any route is a matter for a valuation and the negotiation between the parties.

Where to go next

• Conversion roadmap: the free checklist
• Employee-owned company: ESOP, EOT or worker co-op
• Worker cooperatives
• How to start a worker cooperative
• Worker cooperative vs employee-owned
• Cooperative lenders
• Patronage refunds