Business owners commonly hear of the use of an “ESOP” in planning for a management buyout. It is presented as a wondrous and magical vehicle by some, and as a dangerous nightmare by others. Like most business tools it is not magical or deadly – it simply needs to be used in appropriate circumstances.
An ESOP is an Employee Stock Ownership Plan. It is a special type of tax-qualified Profit Sharing Plan, which invests in company stock, instead of in marketable securities.
Basically, the prime advantages are as follows:
- If the owner sells stock to the ESOP, and realizes a gain on such sale, income tax on such gain may be deferred, as long as the owner invests the proceeds of the sale in domestic equity securities (i.e. a U.S. stock).
- If the ESOP borrows money to finance a portion of its stock purchase, the Company may then make tax-deductible contributions to the ESOP to enable it to service the debt – both interest and principal.
- If the ESOP borrows money, it may be able to do so at below market rates, because of certain tax advantages the bank can gain on interest income from the ESOP.
- The trustees of the ESOP vote on the shares which it owns. Such trustees may be officers of the Company and/or key management members. Thus an owner who is still active in the Company can retain management control, as long as he is willing to operate the Company fairly and rationally, in the best interests of all beneficial shareholders.
Given these tremendous advantages, the ESOP sounds like (and can be) a tremendous tool for tax-advantaged sale. However, it won’t always work. In order to determine if it’s a likely fit, owners need to consider the following:
- Is there an employee group with significant retirement money already tucked away?
In many cases, employees may have participated for years in other types of employer sponsored retirement plans. If they have, and savings accumulated are substantial in such plans, employees may be able to convert their accumulated retirement funds to equity in the ESOP investment. This may provide the capital that the employee group needs to make the transaction viable.
- Is there a strong upper-to-middle management group which will have the ability to run the Company effectively?
Chances are, the ESOP will have to finance a portion of its purchase. If the owner intends to exit, the ESOP will not be able to obtain such financing unless a bank or other investor can be convinced that the successor management group will run the Company well.
- Are there at least a handful of key members of management who will be the prime leaders (and/or major beneficial owners) of the buyout, and are such key management players willing to personally guarantee debt?
Generally, if the owner is selling all or a large majority of his stock to the ESOP, the ESOP is likely to need to borrow to pay the exiting owner. In such case the lender will likely want personal guarantees from key management members, both in connection with new amounts to be loaned, and possibly in connection with a request to remove the exiting shareholder from personal debt guarantees already in place. Management members will only be motivated to take on this responsibility if they are confident of their capabilities, and excited about the prospect of significant ownership. The bank may prefer to defer removal of the former owner from debt guarantees until they watch the success of the new management team for a time, but this is less likely if several other key people step up to replacement of those guarantees. (Even with far less substantial assets behind the guarantees of a management team, their raw willingness to “bet” on themselves significantly improves the odds for enthusiastic bank support.)
- Is payroll large enough to allow adequate contributions to the ESOP in future years to service the debt?
If the ESOP has to borrow, as an example, $1,000,000 to complete a stock purchase, it will have debt service obligations of principal and interest, over a period that may range, typically, from 5 to 10 years (10 year amortization is fairly common, with an earlier balloon date). For purposes of this example, let’s assume the ESOP payment required would be $150,000 per year. Generally, ESOP contributions are limited to 15% of payroll. Thus, in this example, annual payroll would have to be around $1,000,000 per year, in order to allow a base for a $150,000 annual tax-deductible contribution to the ESOP. If the Company’s aggregate annual payroll costs were only $300,000 per year, the maximum tax-deductible contribution would be around $45,000 – not enough to service the ESOP debt planned. Although it still might be possible to use the ESOP advantageously for a part of the stock purchase, the $1,000,000 originally contemplated to be borrowed would not be feasible.
- Are there outside investors who would like to purchase the Company, and who have substantial retirement moneys of their own from other corporate retirement plans?
Sometimes individual buyers come to us who may have $500,000 or more from 401(k) or other corporate retirement plans from their previous employment. Under certain conditions, these moneys can be transferred to our client’s Company plan, and eligible for use to purchase stock through the newly formed ESOP. Such funds, combined with other personal funds of the buyer, and with other ESOP funds from employees, may help to make an otherwise difficult ESOP transition viable.
- As exiting owner, do you anticipate a large taxable gain on sale of your Company?
Most of the core benefits of an ESOP, from the exiting owner’s viewpoint, relate to the tax deferrals available. If the gain would be substantial, and the tax significant, and if the owner can afford to leave the proceeds invested for some time post sale, (growing tax-deferred) the owner may be able to sell to the ESOP for well less than true cash value which an outsider would pay, and still retain the same or more “take-home” cash.
- How strong is the alternative of sale to outsiders?
If the Company is in an industry, which is strongly aggressive in the acquisition market-place, it may bring a disproportionately high price in sale. If strong commercial and industrial buyers will want your particular business for market share or for some special type of capability, they may compete ruthlessly in pricing their bids for purchase of the Company, to be sure they beat the competition. When this is the case, the competitive price point for purchase of the Company can well be driven above any level that the employee group will ever reasonably be able to compete with, and successfully pay.
The best fit for the ESOP transaction (instead of independent sale) is commonly in the weaker market, where capitalized earnings and/or asset base would tell you that the Company is worth more than what open market buyers are willing to pay. Examples? Construction or contracting companies in an economic slump. Old-line manufacturers with no growth potential, but fairly stable or very slowly dwindling sales levels. Companies with high asset book values, little debt, but disproportionately small recurring earnings levels (borrowing base good, earnings enough that liquidation doesn’t make sense, but not much competitive market for purchase).
If you think ESOP purchase may be fit for your Company, where do you go from here? In general, the first step in considering an ESOP is to walk through the individual circumstances to assess the financial viability of an ESOP buyout. An experienced consultant can tell you what percentage employee participation to expect, how much bank financing is realistic, and what sort of operating cash flow the Company would need to make it successful.
On the flip side, what are some of the pitfalls?
- ESOPs seem to work especially well when they can fund enough cash to do all or nearly all of the purchase in one swoop. When only a portion of the stock can be purchased, or when the owner must remain on the hook for significant debt, the risk increases dramatically. If operations fail, the owner may have to return to run the Company, and his option for sale to outsiders is significantly impaired. The Company has done poorly at this stage, which is why the owner has returned with a problem. Outside buyers do not hasten to take a minority interest. Nor are they eager to “marry” a failing management group which owns stock in the Company through an ESOP.
- In reviewing ESOP potential, owners need to be particularly careful to assess viability before talking to management employees. It is very difficult to invite employees to consider ownership, and then to withdraw such invitation, in favor of sale to outsiders. Employees become disgruntled, and outside buyers may be fearful of employee retention issues.
- When stock is owned by an ESOP, such stock is voted by its Trustees. Such Trustees must act in the best interests of the shareholders as a whole. This means that the Trustee has a fiduciary responsibility not to take wild and excessive benefits or salary withdrawals personally (the three week trips to attend half-day seminars in Europe are probably out).
- Companies which are partially owned by an ESOP may be less desirable to buyers. Don’t expect to sell part of your stock to an ESOP today, and then sell the rest to an outside buyer tomorrow. The ESOP shareholders can be made to sell at a later date, by the Trustees, but buyers generally are loathe to come in as the “bad guys” who forced the employees to give up stock ownership. Also, trustees may face fiduciary liability if there could be any doubt whatsoever as to the adequacy of the price attained.
- ESOPs are costly to implement and costly to administer. They require formal initial and periodic valuations of the Company by an independent source, and careful adherence to a complex set of federal rules and regulations. It is foolish and dangerous to enter into these transactions without specialized legal advice – in spite of the fact that such advice is costly. Count on spending $50,000 plus to get the plan started and the purchase in place. Additionally, you will be required to have an annual audit of the Plan, probably at least a CPA’s review of the Company, a valuation of the Company, and a far more modest, but still important level of ongoing legal advice as ESOP rules change and Plan participants come and go over the years.
In summary, when are ESOPs usually most effective? When:
- the owner will have substantial gain on sale, and thus a significant benefit from the tax deferral
- the employee salary base is sizeable, allowing hefty contributions to fund debt repayment by the ESOP
- there is a strong middle management group – preferably with 4 to 6 financially stable and professionally capable people – eager to become owners and willing to guarantee debt
- there is a predecessor retirement plan which has been in place for a time, which may allow capital transfer for ESOP stock purchase
- the external markets for possible purchase of the Company are not particularly strong or aggressive
The Company needn’t score a “10” on all of the above for the ESOP purchase to be a fit. If very few of the above 5 criterion are met, however, it’s unlikely to work. If, on the other hand, most do seem to be reasonably well-met, chances are quite good that an ESOP is a viable and productive option, which should be at least examined as one possible exit strategy.