Now that you have decided to establish an employee stock option plan (ESOP), upfront planning should be your primary focus. And the financing process will be the most fundamental stage in structuring a successful ESOP. The wonderful thing about financing an ESOP transaction is that there are multiple options to consider, and all should be evaluated to determine which is the best solution for the shareholders.
ESOP Financing Objectives
There are three main goals when financing your sale to an ESOP.
- Create liquidity. The financing provided allows the shareholders to sell their stock or equity investment and, in turn, receive cash, enabling them to diversify their personal holdings.
- Match the goals of the sellers, the company, and the capital provider. Several questions should be considered:
- How much cash do the shareholders want to receive?
- Can the company comfortably repay the debt while still considering what is required to continue to run and grow the business?
- Who are the right capital providers who understand the business, its needs, and the transaction?
- Borrow at competitive rates, terms, and conditions. Ensure the company’s financial advisor has deep ties to the banking sector to ensure the best rates are received.
Keys to Successfully Financing Your ESOP
- Prepare a detailed financial forecast. You are no doubt doing this already, as forecasting is an essential component of running a successful company. However, a forecast becomes even more important when seeking financing for your ESOP transaction, as it provides the hard data on which you will base your decisions. Financials with a three-to-five-year forecast are appropriate. Consider any operational and growth needs within these projections as well. Capital providers will analyze your historical and projected financial statements to determine the ability to service the debt and will likely stress-test the projections if the future earnings vary materially from the historical.
- Know the deal parameters. Your investment banker will explain the deal parameters and the various scenarios, along with the terms and conditions, to help market your company to lenders. This is where you take a very active position in presenting to prospective lenders. You will need to show competence and organization as you assist prospective lenders with their analysis and ensure an efficient process. Remember, they want your business as much as you want theirs. Combining all these strategies will ensure success in achieving your goals.
- Maintain a Strong Management Team. Having a solid management team in place shows the bank that you have the necessary depth, professionalism, and delineation of responsibilities. This provides assurance to the lender that the company is not dependent on just one person.
ESOP Financing Sources
There are two primary financing sources: bank financing and seller financing.
Bank financing, commonly called senior financing, has its pros and cons. The financing provided by banks satisfies the selling shareholder’s desire for diversification and cash in hand at closing and is generally secured at advantageous terms. A five-to-seven-year repayment term coupled with advantageous interest rates make senior financing very attractive in nearly all ESOP transactions.
However, with a bank now your partner, other considerations of oversight come into play. The bank will analyze various items such as collateral, earnings history, and your financial projections to determine what covenants will be required to ensure the company’s ability to repay debt. Financial covenants are standard with ESOP transactions and usually focus on the amount of leverage (debt versus cash flow) and debt service (cash flow over debt repayment obligations). Furthermore, because banks have regulators, they are subject to market risk just as companies are. The regulations can dictate terms and conditions the bank is willing to extend.
Leverage Levels. Leverage is a key term in banking as it reflects the amount of debt capacity a company has versus its cash flow to repay that debt. Following the Great Recession, banks have been made subject to strict guidelines on how much leverage they can provide a company. This is not only true in operations financing, but also in an ESOP transaction. An ESOP transaction is likely going to be unsecured – creating potentially more perceived risk for the bank. Therefore, banks focus on the amount of leverage based on the size of the company’s recurring cash flow.
Cash flow. If you have strong and recurring EBITDA, you are likely to receive more leverage, which equates to more liquidity at closing. Consequently, lower or large fluctuations in your EBITDA may lower your cash in hand. As you continue to repay your bank loan over time, the bank gains comfort and is likely to increase your liquidity if there is any secondary or seller debt to refinance.
Collateral. Collateral is important to lenders as a backstop to pay off their debt if cash flow is unavailable. In most ESOP transactions, debt provided by the lenders is not collateralized. For this reason, it is important to partner with the right bank to ensure they understand the overall structure, just as much as you do. If collateral is available, the terms of the loan can be more favorable.
Seller financing also has pros and cons. At inception, seller financing trades your current stock and equity investment risk into a note with debt risk, whereby the seller acts as the bank. This is a major consideration when evaluating financing and risk diversification. Seller financing comes with several benefits. It allows you to control the debt repayment and avoid regulatory oversight and covenants, and you will not have to contend with close monitoring of your company’s performance. At the same time, seller financing allows you to earn a market yield on your seller note and creates potential upside or extra cash payout down the road through a warrant.
Your financing objectives in your ESOP transaction will guide you to financing sources. A combination of bank and seller financing is common in many ESOPs as it achieves the best of both options.
Selecting Your Capital Provider
Selecting your capital provider should be done very carefully. Begin with your company’s current bank. Since there is an established relationship, likely formed over many years, they know how your business operates, who is involved, how you manage cash, and your loan repayment history. This relationship will prove to be an effective approach to satisfying your capital needs.
However, not all banks understand ESOPs or your bank might not be comfortable lending the amount of debt required for an ESOP transaction. When that is the case, it is prudent to expand the search to banks with ESOP experience. Mid-market banks are a great place to start, but keep in mind that the megabanks fully understand and excel with ESOP transactions. Most ESOP-focused banks can lend nationally so geography is not necessarily an impediment. Their specific underwriting knowledge regarding ESOPs is important when it comes to meeting your closing timeline.
It is worthwhile to consider alternative sources of capital that are more flexible and that can work with your bank in a secondary or subordinate position. While they may provide you with more cash at closing, they are more expensive and may come with additional oversight.
Creating the optimal transaction structure and securing the ideal partner will provide a clear understanding for everyone involved, both before and after the ESOP is established. As discussed in one of our earlier articles, PCE’s Transaction Process, it is important to review and weigh all your options. ESOP financing is not a one-size-fits-all approach, and you may find out that bank financing, seller financing or a combination of both will satisfy your goals.