As investment bankers, we are most successful when transaction volume is high and the market is healthy. The volume of ESOP activity generally follows the trends of the M&A market as a whole, but there are certain datapoints that make ESOPs a more or less popular alternative among M&A strategies. Primarily, we need a healthy economy, which helps drive all deal volume, not just sales to ESOPs. Following that, three considerations largely influence a business owners’ decision to sell to an ESOP as opposed to another liquidity or succession strategy:
access to debt capital
Knowing this, does the president of the United States influence these factors, which in turn impact ESOP activity? The answer, of course, is yes. But why? It turns out the key consideration is tax rates, which the president influences directly. And tax rates impact valuations, access to capital, and cash flow for the company installing the ESOP. Tax rates also impact the proceeds of owners selling to the ESOP.
How Tax Rates Affect ESOP Valuations
In the sale to an ESOP, the buyer (ESOP trustee) relies on a third-party valuation to determine the fair market value (FMV) of the securities they are purchasing on behalf of the employees. One of the most common methodologies in determining FMV is known as the income approach, which involves analyzing discounted cash flow or, less frequently, capitalized income. Both of these techniques rely on the prevailing corporate tax rate as a significant input. All else being equal, the lower the corporate tax rate, the higher the valuation. The Tax Cuts and Jobs Act of 2017, in lowering the corporate tax rate from 28% to 21%, had a positive impact on existing ESOP valuations and new ESOP formations. Since the corporate tax cut in the TCJA was permanent, new legislation will be required to change rates. If different parties control the two houses of Congress, it would be unlikely that significant tax legislation comes into play in the next two years. Therefore, we expect that tax rate changes will be minimal to none and will not impede ESOP valuations going forward.
How Tax Rates Affect ESOP Loans
Access to capital in ESOP transactions is driven by the lender’s willingness to lend money to the company, which in turn provides cash to the selling shareholder(s). Lenders perform a detailed analysis of the company’s historical and projected financial performance in determining the company’s ability to repay the debt financed. One of the main drivers of this analysis is after-tax cash flow, since most loans are repaid on an after-tax basis. However, ESOP loans should be payable on a pre-tax basis, meaning that a C-corporation ESOP would repay the same debt with approximately 25% lower earnings and an S-corporation ESOP would be able to repay the debt with as much as 60% lower earnings when compared to non-ESOP companies. This makes loans to ESOP companies less risky compared to loans used for liquidity events that do not have the ESOP tax advantages. This is why ESOPs are more attractive loan candidates in all tax environments and become even more attractive in a rising tax environment.
How Capital Gains Rates May Affect Sales to an ESOP
From a seller’s personal perspective, there is a more direct correlation between rising capital gains rates and the attraction to ESOPs, for the very simple reason that ESOPs allow the selling shareholder the opportunity to defer or eliminate all of their capital gains in the sale to an ESOP. We don’t expect the political environment over the coming two years to enable a significant change to the capital gains rates, but if we’re wrong, we expect that would drive more people to consider ESOPs as an exit option and an attractive means to liquidity for their privately held business.
How State Tax May Affect ESOP Owned Companies
While a split Congress, which seems likely as of this writing, will narrow the range of potential tax policy outcomes at the federal level, it is possible that changes in state tax law across the country could negatively impact all companies, including those that are ESOP owned. With the TCJA’s elimination of state and local tax deductions, states with higher income taxes have been suffering as wealthy taxpayers flee to states with lower or no state income tax. And now all states are suffering from lower tax receipts and higher expenditures due to the necessary spending related to the pandemic. These states will need to find funding elsewhere, and it could very well come in the form of a tax that impacts ESOP-owned companies as well as non-ESOP-owned companies. However, given that it will likely impact all companies, we believe that the relative advantage ESOP companies will have from a tax savings standpoint will keep them a popular exit strategy among owners of privately held businesses.
Tax headwinds are on the horizon, whether they are federal or state. Nevertheless, ESOP-owned companies will continue to hold their relative tax advantages over non-ESOP companies. That’s one of the many reasons we expect ESOPs to continue to be a popular exit strategy for the owners of privately held businesses. Even if both houses of Congress and the White House are controlled by one party, an increase in taxes will only serve to make ESOPs more attractive compared to other exit strategies.