While you might know that selling your company to an employee stock ownership plan (ESOP) is a potential exit strategy, how do you know if your company is prepared to sell to an ESOP? One of the significant benefits an ESOP affords is substantial flexibility, allowing you to control many aspects of the transaction, such as how much of the company to sell and how to finance the sale. But unless you have taken all factors of the transaction into account, you may experience unnecessary challenges and delays during the transaction process. In this article we talk about five key issues to consider before selling your business to an ESOP.
Five key considerations for preparing to sell your business to an ESOP:
- Exit strategy goals and objectives
- Setting realistic value expectations
- Contracts/licenses review
- Operational changes that come with being an ESOP-owned company
- Closing the sale
Exit strategy goals and objectives
Understanding exactly what you want to accomplish in selling your company is essential for choosing an exit strategy. You’ll need to clarify when you want to exit; how much equity, if any, you’ll want to retain; and what, if any, level of involvement you’ll want in the company after the sale.
Your goals and objectives will be crucial to structuring a transaction that delivers the greatest return to your company’s shareholders while providing a fair and equitable transaction for your employees.
To ensure your goals and objectives are realistic, you’ll want to engage an independent third party to appraise your company, estimate how much liquidity a sale can generate and develop a solid transaction budget — all of which will be based on the type of transaction you want to pursue and ultimately will help you formulate your optimal exit strategy.
Setting realistic value expectations
Having realistic expectations about the value of your company is crucial to determining whether selling to an ESOP is the best decision. To that end, you’ll want to consult an independent third-party valuation firm and/or investment bank.
To prepare for a valuation, you’ll need to provide quality historical financials and in-depth projections for the next three to five years. Following are key aspects of corporate diligence you’ll need in order to provide an accurate view of your company’s value and potential liquidity:
- Audited historical financials for the past five years. Audited financials are ideal as they provide the highest quality of financials. If you do not have CPA-prepared financials, be prepared to obtain them before engaging outside parties like an ESOP trustee.
- 24 months’ worth of internally prepared income statements, balance sheets and cash flow statements.
- Any identified owner addbacks, excessive benefits, personal expenses, generous salaries, related party leases and other one-time, nonrecurring expenses — all essential to an accurate valuation.
- Annual budget and long-term forecast. A long-term forecast (ideally five years) is crucial in valuing your company. If you don’t have one, you can work with an investment banking firm to develop a five-year forecast.
- Identified key growth drivers and areas of risk.
- To support the valuation, an investment banking firm will also request any report that tracks your company’s current progress, including, for example, backlog reports and pipeline and work-in-progress reports if you operate in the construction industry.
The documentation needed to value your company will likewise be crucial to ensuring the sale of your company goes smoothly, as any buyer will require the same information.
Alternatively, you could engage an investment banking firm to provide a preliminary valuation range by conducting an ESOP feasibility study. The firm would request similar diligence as noted above. The main difference is that an ESOP feasibility study will not only provide a preliminary appraisal of your business, but also will help you understand the scope of the transaction, including the type of returns you can expect. A feasibility study will show you how much liquidity you can realize and what the true cost of that liquidity will mean for your company and its cash flows over the forecasted period. Those amounts will, of course, be based on your goals and objectives.
You’ll want to review all existing contracts, agreements, licenses and related documentation for provisions that might require additional attention or action in order for the closing to proceed without delay. Below are some questions to consider:
- Do any customer contracts or vendor contracts have a change-in-control clause that requires notification and/or approval?
- Are there any state regulatory licensing requirements you need to consider before selling to an ESOP?
- Does your company derive significant revenue from any accreditation or certification that could be at risk following a sale?
- Are all real estate agreements held at marketable rates? If any real estate is owned by related parties and are not held at marketable rates, the company and its shareholders will want to ensure that marketable rates are agreed upon prior to a transaction team being engaged to ensure that no additional implications remain from a valuation perspective.
- Have you developed a management succession plan to ensure your company can continue to run as it does today?
- Are debt agreements in place that require lender consent in order for a sale to occur?
Operational changes that come with being an ESOP-owned company
Given the complexity of most ESOP transactions, you might be tempted to focus on preparing to become an ESOP-owned company rather than on what will be different after the transaction closes. But understanding what the sale to an ESOP will mean for your company and its operations is essential before signing on the dotted line. Below are some things you’ll want to think about.
Governance and operational decisions
Given that an ESOP operates as a trust, the ESOP trustee has sole control over the ownership of the shares held by the trust. In other words, the ESOP trustee, your board of directors and your company’s officers will control your company — not the employees, as they are beneficiaries of the trust. Depending on how your company is structured, the ESOP trustee may require that a board be established and that an independent member of the board of directors be appointed. The ESOP trustee is a passive shareholder and does not seek a seat on the board and is not involved in executive management decisions. Ultimately, the trustee serves at the pleasure of the board of directors, which allows the executive management team to continue to run the company.
As a fiduciary, the ESOP trustee is charged with acting in the best interest of the participant beneficiaries. To do so, the ESOP will interact with the board of directors and will oversee the administration of the ESOP. If your company doesn’t have a board or has a board of one, give some thought to expanding your corporate governance before you consider selling to an ESOP. The more stock you sell to an ESOP, the more important corporate governance becomes.
As an ESOP-owned company, you’ll work with your CPA to prepare financial statements annually. You’ll also work with the trustee’s valuation firm to establish the annual share price for ESOP participant statements. Finally, you’ll work with your company’s third-party administrator (TPA) to develop annual ESOP participant statements, including annual account balance and share price. This is the only financial disclosure you’ll be required to make to your company’s ESOP participants.
If you use third-party financing to fund the sale to the ESOP, you’ll have additional requirements to those detailed above. Lenders will typically require quarterly financial reporting, including a quarterly covenant test, typically focused on fixed-charge and senior operating leverage covenants. You must be prepared to calculate these covenants quarterly and promptly submit them to your lender.
To ensure an ESOP is effective, you’ll want to engage with your employees to help them understand what ownership means for them. Once the transaction has closed, you’ll want to communicate the news to employees immediately so that the company can begin to benefit from the ESOP ownership. You can work with your TPA to produce a presentation and brochure about the ESOP to give to your employees. Expand the reach of your communications by promoting your company’s ESOP ownership in corporate brochures and on your website. Strongly consider establishing an internal ESOP committee that works on engaging employees and developing your new ESOP corporate culture.
Staying up to date
Given the complexity of ESOPs, you’ll want to remain abreast of industry news and developments by, for example, attending annual conferences hosted by ESOP organizations and associations. Consider attending such conferences before establishing an ESOP to get to know the owners of other ESOP-owned companies and to gain an understanding of the ESOP community.
Closing the sale
Generally, ESOP sales take four to five months to close from the time you hire an investment banking firm to perform the valuation; the time frame is driven entirely by how prepared you are to close the transaction. Taking the steps outlined above will facilitate a prompt and efficient closing.
Once you decide to sell to an ESOP, you’ll have a few key final decisions, the most significant of which is selecting your ESOP trustee. Do not take this decision lightly, as your trustee will have significant input into the terms of the sale. Because ESOP sales are designed to mimic an arm’s-length transaction, the ESOP trustee will negotiate with you to ensure the price paid for your shares are at a fair market value. Consider interviewing three trustee firms of differing size to understand what is available to you and ensure that the trustee will be a good fit for your company. Once you select a trustee, the sale likely will close within 60 to 120 days.
By properly preparing for a sale to an ESOP, you’ll have ample time to consider all options and can deliver on the requested due diligence in a seamless manner. ESOP sales are complex, and no two transactions are alike, but the process is similar for all. Adequate preparation will ensure you are ready to pursue the best transaction for you. We welcome the opportunity to further discuss what an ESOP transaction entails and what other exit strategies are available to you.