Good news: A company’s employees may become the buyer of the company in a structure named ESOP (Employee Stock Ownership Plan).
Bad news: An ESOP is complicated and the purchase prices is often 5X-6X EBITDA.
Motivation: An owner desires to transfer the company to employees, increase after-tax earnings, diversify personal assets, and still control key decisions. (Private Capital Markets, Second Edition, p. 425).
The ideal: The ideal situation for a business owner in an ESOP sale is (1) you sell 100 percent of your stock, (2) the sale is all cash and (3) the ESOP sale price is the same price that an unaffiliated buyer would pay. (Valuing Your Business, p.125).
Definition: An ESOP is a qualified plan under ERISA (Department of Labor). An ESOP is a tax-qualified defined contribution plan that has two distinguishing features: (1) It is allowed to invest exclusively in the stock of its sponsoring company, and (2) it can borrow money. A sponsoring corporation can contribute cash or stock to an ESOP on a tax-deductible basis. ESOP, at fair market value, often completely avoiding capital gain tax on the transaction (Private Capital Markets, Second Edition, p. 425).
Benefits: Structured properly, with an ESOP, the owner of a privately-held company can:
- Sell stock of the company, pay no tax on the proceeds, and still keep control.
- Increase the company’s working capital and cash flow with no cash expenditure and no productive efforts.
- Buy out minority and majority stockholders with pretax dollars.
- Make acquisitions with pretax dollars that are tax free to the seller.
- Cut the cost of borrowing loan principal nearly in half by deducting principal payments as well as interest.
- Provide employees equity upside with no cash outlay on their part or on the owner’s part.
- Create the ESOP and achieve these objectives without the approval of employees.
- (Private Capital Markets, Second Edition, p. 424).
Risk: In an ESOP, your company sells its stock to employees. A company’s employees typically do not have the personal funds to purchase the company’s stock in an ESOP. Your company will most likely need to borrow money from a bank to fund the ESOP. Initially, your company, as a guarantor, is responsible for 100% of the money borrowed to fund the ESOP, including the payments on the debt.
Leveraged ESOP: In a leveraged ESOP, the ESOP or its corporate sponsor borrows money from a bank or other qualified lender. The company usually gives the lender a guarantee that it will make contributions to the trust which enable the trust to amortize the loan on schedule; or, if the lender prefers, the company may borrow directly and make a loan back to the ESOP. If the leveraging is meant to provide new capital for expansion or capital improvements, the company will use the cash to buy new shares of stock in the company. If the leveraging is being used to buy out the stock of a retiring owner, the ESOP will acquire those existing shares. If the leveraging is being used to divest a division, the ESOP will buy the shares of a newly created shell company, which will in turn purchase the division and its assets. (The ESOP Association).
Key relationships to consider
The Percentage of Stock Sold
Between 30% to 100% [a]
In an ESOP transaction, a corporation sets up a trust fund, called an Employee Stock Ownership Trust (ESOT) into which it contributes new shares of its own stock or cash to buy existing shares[b]
Type of Entity
Must be a corporation [c]
Federal Tax on Gain
No federal tax on the gain if you use the cash to purchase securities of most U.S. corporations and if you held the stock for three or more years [d]
Contribution to an ESOP
In general, the company’s contribution to an ESOP is deductive for federal income taxes, but the deduction is limited to 25% of the company’s annual payroll [e]
5X-6X EBITDA [f]
A trustee is required for the ESOT
The accounting for an ESOP is very difficult and there are many ways the plan can become disqualified by ERISA
[a] Valuing Your Business, p. 123.
[b] Private Capital Markets, Second Edition, p. 424.
[c] Valuing Your Business, p. 123, Private Capital Markets, Second Edition, p. 426.
[d] Valuing Your Business, p. 123.
[e] Valuing Your Business, p. 124, Private Capital Markets, Second Edition, p. 427.
[f] The Exit Strategy Handbook, Fourth Edition, p. 53.