The Anatomy of a Deal Newsletter February 28, 2020
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
This piece is a collaboration with Todd Kegler, Director + Co-Chair of Kegler Brown's Mergers + Acquisitions Practice.
This month, we take a deeper look at a unique transaction structure: the sale to an Employee Stock Ownership Plan (usually called an ESOP—no, not the guy who wrote all of those fables).
As with any other succession strategy, ESOP sales are not right for every business. But for the right type of business, the ESOP sale offers a unique way to strengthen the company’s culture while providing significant tax benefits.
A number of great companies have been very successful operating as an ESOP, with the Publix grocery store chain often being cited as the “gold standard” of successful ESOPs. However, there are a number of stories of ESOPs that went bad, due in many cases to a lack of planning and proper analysis on the front-end to ensure that the ESOP would be successful.
I’m no expert on ESOPs. So this month, I’ve asked Todd Kegler, who co-chairs our mergers + acquisitions practice and who has significant experience with ESOP transactions, to share his thoughts.
With that, let’s dive right in…
1. What is an ESOP?
An ESOP is simply a defined contribution retirement plan that invests primarily in employer stock. In some ways, it is similar to a 401(k) Plan. When an employer company launches an ESOP, it forms a trust that purchases some or all of the employer company’s shares, and then holds these shares in retirement accounts for its employees. Employees share in the employer company’s success or failure through their participation in the ESOP plan. The company buys out employees’ accounts when they retire or leave the company.
The ESOP is a qualified non-discriminatory retirement plan governed by The Employer Retirement Income Security Act (ERISA) of 1974, and is subject IRS and Department of Labor oversight. There are tax benefits for having such a plan in place, but there are also rules and regulations that must be followed. So, it is critically important to seek professional advice if you’re considering an ESOP.
Unfortunately, ESOPs aren’t an option for every company. Generally, only C or S corporations may adopt an ESOP, and certain types of corporations (such as those used for certain professional services businesses) are prohibited as well. Another form of entity, such as a limited liability company, would need to convert to a C corporation or to an S corporation prior to adopting an ESOP.
2. How does a company transition to being ESOP-owned?
For most companies, an ESOP provides a succession strategy. The owner(s) of the business sell the stock of the company to an ESOP Trustee in much the same way that an owner would sell stock to an independent third party buyer. However, because the buyer is a qualified plan, there are some special differences and considerations, some of which are described further below.
3. How is the purchase price determined?
In a typical third party sale, the purchase price is whatever the buyer and seller agree upon. With an ESOP sale, the same market forces don’t really exist because the ESOP is not an independent third party that seeks to profit from the transaction, nor does the ESOP typically have its own source of capital to fund the transaction. Moreover, ERISA prohibits an ESOP from paying more than “fair market value” for the stock. Consequently, an independent qualified valuation expert performs a valuation of the business and issues a fairness opinion to the ESOP Trustee to rely upon in negotiating “fair market value” for the price and terms related to its purchase of the shares of the company.
4. How is the transaction financed?
In most cases, the ESOP transaction is financed through a combination of existing company cash, a traditional bank loan to the company, and seller-financing for the balance of the purchase price in the form of a promissory note that is payable to the selling shareholder(s). The ESOP Trustee, on behalf of the ESOP, is the actual purchaser of the stock, but the company is ultimately obligated to repay both the bank loan and the seller notes (and provides the security for these loans). The transactions required to create this scenario result in an “internal loan” between the ESOP and the company, and an “external loan” between the company and the lender(s).
5. What are the tax benefits of an ESOP?
ESOPs are popular for a number of reasons, but for many companies, the unique tax benefits associated with ESOPs are a major motivator. An ESOP offers a tax-efficient, leveraged buy-out vehicle. ESOPs can yield tax benefits to the company, to the selling shareholder(s) and to the company’s employees.
While there are several tax benefits, two of the more compelling tax benefits are as follows:
- ESOP-owned S corporations pay no federal income tax: Yes, you read that right. S corporations themselves pay no federal income tax because they are pass-through entities. Because the ESOP is a qualified, tax-exempt plan for income tax purposes, it doesn’t pay income tax either. So the result is a massive potential tax benefit for 100% ESOP-owned S corporations. And, even if the ESOP owns only part of the stock of the corporation, the percentage owned by the ESOP will be income tax free. For example, if the ESOP owns 50% of the S corporation stock, the 50% owned by the ESOP is income tax free, and the remaining 50% is taxed to its owners in the normal manner. Imagine what you could do if you could legally avoid paying income taxes!
- Owners of C corporations can rollover sale proceeds in a tax-free manner: If the target company is taxed as a C corporation at the time of sale, the selling shareholders could—provided they meet certain requirements and make an election under Section 1042—rollover their proceeds from the sale into qualified replacement investment property and defer payment of the capital gains taxes resulting from the sale to the ESOP. If the seller retains the qualified replacement property until death, the entire taxable gain could end up being forgiven.
Note that these two benefits are available for different types of corporations. However, if the target corporation is a C corporation prior to the ESOP transaction and is eligible to elect S corporation status after the transaction, both of these powerful tax benefits could be achieved. Even for corporations that can’t avail themselves of the benefits of switching from C corporation to S corporation status, the tax benefits may still be significant.
Of course, as with any tax issue, there are all kinds of caveats, rules, and restrictions that apply. A good advisor can help determine which tax benefits may be available for your situation.
6. Who controls the company if an ESOP owns the shares?
The ESOP is controlled by an ESOP trustee, which is usually an independent corporate trustee that is experienced in these matters. That said, ESOP trustees don’t have the interest or bandwidth to get involved in running the company’s operations day-to-day. So, in most cases, the existing board and management team remain in place after an ESOP transaction.
However, note that on certain major transactions, the employees themselves will be able to vote the stock allocated to them through the ESOP.
7. Do I have to sell all of the shares of my company to the ESOP?
No, but as noted above, S corp ESOPs don’t get the full tax benefit unless the ESOP owns all of the shares. In addition, some of the other tax benefits require the ESOP to own at least 30% of the shares. However, for some types of companies, a 100% ESOP sale may not be possible, so it may still be worth exploring whether an ESOP can make sense even in those cases.
8. Can I control which employees receive the shares in an ESOP?
Generally no, other than restricting participation to full-time employees. The company can prescribe vesting criteria for the stock allocated to a participant, subject to certain restrictions.
9. How and when do the employees receive payment for the shares held in their ESOP?
When an employee leaves the ESOP company, he or she will get paid for the vested stock held in his/her account. The payment for the stock is determined by a third party appraisal which ESOP companies must obtain annually from an independent professional valuation company.
10. What are the characteristics of companies that are successful in selling to an ESOP?
ESOP-owned companies work best when there is a culture of ownership among the employee base. ESOPs can be powerful tools when all of the employees believe that their efforts to contribute to the company’s growth will directly benefit them at retirement. Certain employee groups can grasp the concept and turn it into better results for the company. In contrast, certain employee groups don’t really understand or value the benefit that ESOPs can provide.
In addition, ESOPs only work when the company generates sufficient and steady cash flows to service the debt and to pay out employee share repurchases. For those ESOPs that are 100% owned by an S corporation, the cash flow issues are lessened to some degree by the federal income tax savings. But even for those companies, there may be difficulties in generating the consistent cash flows needed to satisfy these obligations.
11. What are the downsides from selling to an ESOP?
While the tax benefits noted above get all of the headlines, the truth is that selling to an ESOP solely to reap the tax rewards is generally a bad idea.
First, understand that ESOPs have substantial start-up costs and significant continuing compliance obligations. Transitioning out of an ESOP can be costly and painful as well. So the decision to enter into an ESOP should not be taken lightly.
In addition, there are both legal and practical restrictions on how much the ESOP can pay the selling shareholder(s) for the business. If you’re seeking top dollar for the company or require receipt of 100% of the sales proceeds at closing, it’s possible that you’ll have more success selling to a buyer in the open market.
Finally, employee ownership can sometimes change the relationship between management and employees. In some ways, this can be a positive dynamic. Employees in an ESOP will have more information about the company’s financial health and will certainly have much more concern for the company’s overall performance. However, employees who don’t have the full picture may become disgruntled if they perceive the stock’s value as too low due to mismanagement of the company, whether rightly or wrongly.
12. How do I determine if an ESOP is right for my company?
The first step is to have a discussion with an experienced ESOP advisor—someone like Todd—who can help you understand the pros and cons of ESOP ownership for your business, particularly in light of your company’s unique culture and the business owner’s goals.
The next step is to perform a deep-dive into the financials (known as a feasibility analysis) to determine whether an ESOP is even economically feasible given the cash requirements noted above.
There’s obviously a lot more to ESOPs than what we can cover here. The key takeaway: ESOPs don’t work for every business, but depending on the company’s circumstances and the owner’s goals, they could be a great solution to providing shareholders with an exit, continuity and a platform for future growth.
Next month: Crisis Demands Creativity in M+A
Read last month’s piece: Alternative Transaction Structures