How to Identify Prospective ESOP Situations for Ownership Transition

Introduction

In today's corporate and tax environment, successful ownership transition can sometimes be perplexing.  While many alternatives are available to accomplish this ownership transition objective, only a few alternatives are appropriate for any given set of circumstances.  The options typically include an initial public offering, a management buyout, a recapitalization, a sale to a third party, a sale to an employee stock ownership plan (ESOP), a joint venture, and others.

This article will discuss in detail one option, the leveraged ESOP, which is a powerful tool for accomplishing a successful transfer of ownership.  The benefits of an ESOP ownership transition include deferring capital gains taxes to the selling stockholder, the tax deductibility of principal payments on ESOP debt, low interest financing on certain transactions, possible improved employee productivity, and the opportunity to maintain operational control through employee ownership.

The following discussion summarizes the attributes a prospective ESOP company should have in order to best utilize the advantages of an ESOP for succession planning.

Diversification Desired by Owner

Diversification is important for all investors, but is particularly crucial for stockholders nearing retirement age.  For business owners whose major personal asset is their stock in a closely held company, an ESOP provides a valuable diversification vehicle.  The proceeds from the sale of stock to an ESOP can be reinvested in a diversified portfolio of securities with favorable tax benefits (discussed later), providing lower risk for an equivalent expected return on the owner's investment in the current business.

Continuity of Business Ownership

ESOPs can provide continuity of ownership and control since the ESOP trustee is typically a passive, financial stockholder whose objective is closely aligned with the success of the business.  Therefore, if the stockholder sells less than a 50% ownership interest, then effective operational control remains with those best qualified to manage the business.  Also, owners can reward past and future employee efforts through employee ownership.

Alignment of Employee/Stockholder Interests

Because an ESOP provides for the allocation of stock to the employee-participants in the qualified plan, employees become stockholders of the business.  Employees who are owners are more likely to be concerned with the business's profitability and productivity, which are typically stockholder concerns, than are employees who are not owners.  Research has shown that ESOP companies are more efficient, productive, and profitable than their non-ESOP competitors.

Consistent Management

A strong management team should be in place to handle succession if the owner/manager is leaving.  Some financial institutions may require employment contracts or non-compete agreements with key executives in leveraged ESOP transactions.

Size of the Business

Businesses with larger revenues and/or substantial assets are often better candidates for leveraged ESOPs because larger businesses can attract more favorable financing and typically have a lower cost of debt.  In addition, transaction costs as a percentage of proceeds are relatively lower for larger businesses.

Manufacturing companies have a larger investment in fixed assets that can be used to collateralize loans.  Service businesses should have earnings and cash flows that are strong enough to support an ESOP loan.  To enhance the ESOP debt collateral, selling stockholders may have to pledge a portion of the transaction proceeds to the bank, although the pledge can be limited in both amount and duration.

The most efficient minimum size of an ESOP loan is typically $2 to $5 million, with a $1 million transaction generally considered the smallest transaction size for an ESOP.  For smaller transactions to be successfully completed, the transaction structure should remain simple in order to reduce transaction costs.

Debt-Carrying Capacity

The business must be capable of generating adequate cash flow to satisfy the debt service requirements of the ESOP and any other interest-bearing debt.  Businesses with lower debt-to-equity ratios can take on more leverage in the form of ESOP financing.  Therefore, it is generally more difficult to finance an ESOP in capital-intensive businesses that typically have larger debt loads.  The business with low debt-to-equity ratios should have established a significant banking relationship with a financial institution in order to facilitate the ESOP financing.  While the existing debt level may be a constraint in the leverage of the ESOP, this drawback may be minimized because the ESOP-related income tax benefits and possible improved employee productivity can enhance the business's debt-carrying capacity.

Seller's Low Tax Basis in Company Stock

Individual owners that sell to an ESOP and reinvest the proceeds in qualified replacement securities (i.e., any domestic corporate stocks or bonds) can defer recognition of a capital gain if the ESOP owns at least 30% of the employer company immediately after the sale.  The deferred capital gains tax benefits are especially valuable to owners who would otherwise recognize a significant capital gain because of to a low tax basis in their stock.

Large Payroll Base

In cases where a significant percentage of a business is sold to an ESOP, a large payroll base allows the business to repay the principal on the ESOP debt with tax-deductible contributions.  However, there is a limit on the amount of employer contributions that are tax deductible.  If this limit is expected to be exceeded, the preferred securities can be sold to the ESOP.  Because of the tax deductibility of dividends on ESOP-owned preferred stock, the ESOP debt principal payments remain fully deductible.

Summary

This article is designed to assist those considering a leveraged ESOP acquisition with the appropriate strategy to pursue, based on all of the facts and circumstances surrounding each specific ownership transaction situation.  While there are many circumstances when an ESOP fits the financial and cultural aspects of a business's operations, it is important for business owners to keep in mind all the implications of becoming an ESOP-owned company.

Please contact Acclaro if you have any questions regarding the valuation of employer securities for ESOP purposes.

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