Flexibility is the star attribute of a well-designed ESOP (employee stock ownership plan). Your ability to establish what percentage of the company you sell to the ESOP is just one reason ESOPs are so appealing. Whether you are currently exploring an ESOP as a succession strategy or your company is partially owned by an ESOP, understanding how to determine the optimal ownership level is key to achieving your individual and company goals. This article will examine how to choose between a partial and a 100% ESOP, how to decided when and if to increase the ESOPs ownership stake in the company, as well as several issues the company and its shareholders must consider for immediate and long-term ESOP success.
Once you have sold a partial interest of your business to an ESOP, you must conduct further analysis to determine when and if to increase the ESOP’s ownership. You and company management should review the company’s strategic goals and determine how the ESOP can be utilized to increase the chances of success for these goals.
Why Companies Increase ESOP Ownership
To provide liquidity after the retirement, death, or disability of shareholders
To make the ESOP a larger part of the strategic plan
To maximize tax benefits
To secure new shares for new participants in a mature ESOP
Increased ESOP Ownership Considerations
As your company and shareholders begin to explore the possibility of increasing ESOP ownership, several considerations should influence your decision to pursue any transaction, in order to ensure it will provide optimal benefit to all parties. Highlighted below are important considerations that often confront key stakeholders as we help companies and shareholders explore what increased ESOP ownership would mean for them.
Once a strategy has been analyzed and all stakeholders have agreed to increase the ESOP’s ownership, the company and the selling shareholders typically hire an investment banker to lay out the optimal path to increase ownership. Different strategies can provide very different benefits to the company; a feasibility study will refine structure and terms.
Long-Term Success Factors for the ESOP
1. Timeframe Considerations
As the shareholders and company pursue an ESOP transaction, the non-ESOP shareholders’ personal goals will be crucial to understanding the plan. As non-ESOP shareholders exit due to retirement, death, or disability, the company will need to be prepared to facilitate the transition. Whether the transition to 100% is part of a strategic process or not, the company, its shareholders, and the management team will need to develop a succession plan that ensures the transaction can be structured to maximize benefits for all stakeholders. The company also needs a plan for how to pay for the shares it purchases. An analysis of the company’s ability to support the purchase of the non-ESOP shareholders shares is valuable even if the actual transaction is years away.
2. Financing Considerations
Financing an ESOP transaction is accomplished with a variety of sources. At closing time, external financing sources provide liquidity to the selling shareholders. External financing can be raised from traditional senior lenders (banks), as well as alternative lenders such as mezzanine funds.
The selling shareholders’ notes offer another type of financing. The selling shareholders have the option of providing seller financing in the transaction. The sellers would receive competitive market rates for any portion of the transaction that they elect to finance. Seller financing can bridge the gap between the third-party financing and the value of the transaction. This can also provide an on-going income stream to the selling shareholders which can help lessen concerns over the loss of income they may have received from dividends or distributions.
The financing drivers typically change between the initial acquisition and the final 100% transaction. During a partial ESOP, the shareholders are typically focused on diversifying their wealth away from the business (whether for personal wealth diversification or future financial obligations). Therefore, during partial transactions, the company and its shareholders might choose to sell only up to the amount of third-party financing that is available. However, as the shareholders move to sell more significant tranches of the company’s equity to the ESOP, financing considerations evolve, as these transactions typically involve a higher purchase price, given the higher equity percentages sold. Therefore, during these transactions, may play a larger role in the capital structure.
As the company goes deeper into the capital structure, the financing costs increase. Typically, warrants are included as part of facilities that extend beyond senior debt. Warrants provide the company with some flexibility in its cash flow by reducing interest. Warrants are incorporated into the transaction to adequately compensate the subordinated lenders and/or selling shareholders, giving the company flexibility in how it manages its cash obligations during the initial years post-transaction. Warrants enhance the seller return while lowering the annual cash outflow for the company and align the interests of warrant holders and the ESOP.
3. Tax Considerations
One of the driving forces behind increased ESOP ownership is the significant tax benefit that a 100% ESOP can provide. For the company and its stakeholders to realize such benefits, they must conduct a thorough structuring analysis, because, from a tax perspective, there are opposing interests at stake.
A C-corporation structure provides the selling shareholders with the ability to defer, potentially permanently, all capital gains taxes associated with the sale. However, while the selling shareholders thus benefit, the company incurs an annual tax liability and is not as tax-efficient as a 100% S-corporation ESOP.
A 100% S-corp ESOP is exempt from federal income taxes. A driver of the 100% S-corp ESOP rationale is the desire to prevent corporate cash leakage. Companies that form partial ESOPs, in contrast, have to make annual shareholder distributions to cover the expected tax liability on the non-ESOP shareholder. The ESOP is then legally entitled to a proportionate distribution per S-corp rules. The desire to limit these distributions can become a driver of the 100% S-corp ESOP ownership, as companies ensure cash is used in the most efficient way possible.
A creative structure that enables both parties to benefit from the ESOP tax savings is a C-corp structure pursued at the time of the transaction, allowing the non-ESOP shareholders to defer taxes, followed by a reorganization to an S-corp (once the required holding period has passed), so that the company becomes a federally tax-exempt entity thereby providing the seller the capital gain deferral and enhancing the company’s cash flow.
4. Governance and Other Considerations
When assessing how governance may change when transitioning from a partial to a 100% ESOP, it is essential to look at governance from the perspectives of the following key stakeholders: Management Team, Board of Directors, and the ESOP Trustee.
During the initial transaction, selling shareholders usually represent a large portion of the management team. Therefore, the remaining shareholders and non-owner management members become a significant area of focus for the buyer (ESOP Trustee). The Trustee typically devotes considerable effort to understanding the management succession plan and identifying which non-shareholder management members will become the next leaders of the company. Further, if selling shareholders plan to be less involved in the company post-transaction, they should ensure that the post-transaction management team appears able to lead effectively and drive performance. As the company goes to 100% ESOP ownership, non-owner management teams become more important. Therefore, during the initial and second-stage transactions, it is crucial to engage management teams early on to ensure they understand and agree with the strategic goals contemplated.
Board of Directors
During the initial transaction, Board governance may remain the same pre- and post-transaction. As the ESOP increases ownership, the dynamics of the Board change, but its fundamental duty remains unchanged. As the ESOP progresses to 100%, it will be critical for the Board to make decisions, understanding that a shareholder of the company is a trust governed under ERISA law. While the ESOP Trustee does not typically request a seat on the Board, it remains focused on a fair price during each tranche of the transaction. As the company becomes majority-ESOP, and ultimately 100% ESOP, owned, the Board will likely transition from mostly internal members to include more independent Board members. As ESOP ownership increases, the company must remain mindful of these changing Board dynamics to ensure that it has enough time to adequately identify experienced and knowledgeable Board members.
As the company and its stakeholders explore increased ESOP ownership, it is possible also to change trustees. Typically, there are two forms of trustees: internal and external. An internal Trustee is the seller or a company-designated employee who serves as Trustee. For most companies, we typically recommend that an external (independent) Trustee, whether an individual or an institution, assume the role. The decision between an independent or institutional Trustee is based generally on company size and complexity. As the company evolves from partially ESOP owned to 100% ESOP owned, the role of the Trustee still remains mostly the same. The Trustee remains focused on the share price impact of the transaction, as well as the participant’s retirement benefits but transitioning that to an external party can be very helpful in the transition to a 100% ESOP-owned company.
In addition to governance, all stakeholders must consider the following issues to ensure that the ESOP is sustainable as the company transitions to 100% ESOP ownership.
An internal ESOP loan, which is a facility between the company and the ESOP Trust, primarily drives employee benefit levels. Given that the internal ESOP loan drives benefit level, the terms and negotiation of the loan between the company and the ESOP Trustee are very similar for a partial and a 100% ESOP. The most significant focus of the Trustee will be ensuring that the terms of the transaction are within fair market value and that the benefit level that participants receive is appropriate. The terms of the internal ESOP note can vary between transaction tranches and are a negotiated deal point with the ESOP Trustee.
Employee Engagement and Communication
One critical issue is employee engagement. As companies increase ownership, forming employee committees (e.g.., ESOP committee, improvement teams, sustainability committees) is essential to ensure employees feel like owners. If an ESOP is viewed solely as a way to exit a business, the company will never truly reap all the benefits of its new structure. When the company ensures that employees understand their role and how it impacts financial performance, employees are more likely to appreciate the impact they have on the company’s valuation. Consistent communication, therefore, becomes a crucial driver to enhanced corporate culture, ensuring the company can achieve its organizational goals.
How to Increase ESOP Ownership
Once considerations are analyzed, and a decision is reached, companies have multiple ways to increase the ESOP’s ownership:
Cash (or stock) contribution The ESOP can use company contributions to purchase shares directly over a period of time. This allows the company to maintain enhanced flexibility in managing target benefit levels by making discretionary contributions of either cash or stock.
Leveraged second-stage transaction The ESOP uses contributions and an internal loan to purchase shares directly. A second-stage leveraged ESOP transaction would likely be similar to the initial ESOP transaction and would provide the company with additional shares for stock allocations. Under this structure, the ESOP and/or the company would borrow funds to finance the acquisition.
Redemption The company redeems non-ESOP shareholders without involving the ESOP directly. Under this structure, the company would redeem all outstanding, non-ESOP owned shares and would hold redeemed shares in a treasury account for potential future contributions or sales.. Selling shareholders would not be able to elect a Section 1042 capital gains deferral under this structure.
Explore Your Options
Multiple avenues are available to companies considering selling a partial interest in the company to an ESOP or for ESOP-owned companies as they explore the next stage of their corporate strategy. Depending on the size of the initial ESOP transaction, stakeholders might not engage in significant negotiations around governance and control until the second-stage transaction. Shareholders and the company need to understand how increasing the ESOP’s ownership affects corporate governance.
However, ESOP transactions remain flexible and tailored to the needs of the company and its shareholders. The company and its shareholders should consider all options and customize the transaction to their needs. As companies and shareholders explore their possibilities, hiring qualified advisors remains paramount to ensuring the long-term success of the plan and the company.
If your company is interested in exploring what the next available steps are, we invite you to contact PCE and speak to one of our professionals to understand what increased ESOP ownership can mean for you and your company. As a middle-market, full-service Investment Banking Firm, PCE stands prepared to advise you and your company through its next stage of growth.