While ESOP companies are often better able to withstand economic recessions, they have the same exposure to financial crises that any other company has, and may have added complexities when dealing with specific circumstances. Whether you are a newly formed ESOP or a mature ESOP will determine what additional topics to address.
In times of economic peril, preparing your ESOP-owned company for potential disruption must be your first priority. Having a blueprint in hand will prove vital to your ability to pivot quickly and effectively in managing your distressed situation. Items you need to address include monthly financial statements; revenue sources and lines of business; expenses, debts, and covenant analyses; a 13-week cash flow; accounts receivable, inventory, and accounts payable; and other items pertinent to your company. Proactively addressing these items will help you survive the coming challenges and enable your creditors to respond quickly to your needs.
New ESOP Companies
For the vast majority of newly formed ESOPs, the most important consideration is a leveraged balance sheet. Leverage from outside sources – senior bank debt, mezzanine funding, unitranche, seller debt, or a combination of these – usually has strict compliance obligations. When creditors are not the selling shareholders, there will be a higher level of reporting, scrutiny, and oversight. Careful attention must be given to monitoring all loan requirements and carefully managing cash flow. Cash is still king, and so having the necessary financing available to weather the storm is crucial. Payroll, bank principal and interest, and vendor payments are just some of the priorities that will consume the most cash and cannot be avoided. As an alternative to bank debt, seller financing is much more flexible and can be arranged to allow you to allocate your cash to other items instead of debt payments.
Having a financing partner to assist with your financial blueprint will be essential in this stressed environment. Do not hesitate to be on offense and contact them first. Make it a habit to do it consistently, and establish a schedule that shows interest in them and builds a solid connection. Should additional or alternative financing be required, avenues are available. Working with an experienced investment banker will enable you to obtain the capital you need.
Mature ESOP Companies
Mature ESOP companies may have leveraged debt from second-stage transactions, acquisition financing or operations funding. However, mature, 100% S-Corp ESOPs will very likely not have debt. These companies need to address the largest call on cash – the repurchase obligation (“RO”).
In times of both distress and prosperity, RO studies should be performed annually to determine how much cash will be required to pay former ESOP participants. Though these amounts can vary widely based on the annual valuation, they are typically substantial. For example, let’s say a 2019 year-end stock price is valued at $110, and that’s the amount at which any upcoming ROs are pegged. However, early in 2020, the economy declines, thereby significantly affecting your stock price, which drops to $85. The large swing in value could lead to more participants than usual electing to cash out now at the higher stock price. It all depends on how your ESOP was designed.
Reserving cash and having available capital on the balance sheet for economic downturns and significant RO obligations ensures your mature ESOP will be able to meet its requirements. As part of its fiduciary responsibility to plan participants, your trustee will be with you all along the way regarding RO obligations and your company’s ability to satisfy these obligations.
Light at the End of the Tunnel
Even in a distressed economy, your company can still navigate its way through the dangers by identifying the tricky ESOP-related matters and taking the correct and careful approach. Take advantage of your professionals and their good advice. Maintain your board’s fiduciary responsibilities. Communicate with your trustee. And do all this at the onset of the recession. You will come through these rough times a stronger and leaner ESOP company, and that will be good for all participants.