M&A, ESOP and Valuation Resources

More Cash, Less Tax: Refinancing Your ESOP Seller Note for Liquidity

Written by Eric Zaleski | August 16 2021

Employee stock ownership plan (ESOP) transactions come in all different structures, with various options regarding the source of capital available to fund the initial transaction. Year by year, as your ESOP matures, different considerations come into play regarding that capital structure. Making the right decisions for your business requires taking some time to examine the pros and cons of refinancing your seller note so you can take advantage of the capital markets.

Why Consider Refinancing Your ESOP Seller Note?

Most ESOPs have a bifurcated capital structure, with senior bank financing in first priority and seller financing in the secondary or subordinate position. For these ESOPs, bank financing provides cash in hand at the closing, while the seller note affords you annual interest income — an attractive return. And if you sold more than 50% of your equity to an ESOP within the past five to seven years, you likely still have a seller note. Like many business owners, however, you may find that now is the time to strongly consider refinancing a portion (or all) of your existing seller note into bank financing. There are several important reasons for this, including:

  1. Additional liquidity from your sale
  2. Potential tax advantages
  3. Favorable capital markets

Who Doesn’t Like More Cash?

One positive about maintaining a seller note today is the annual interest paid on that note — which likely is a far more attractive rate to the seller than you could earn in a bank CD or money market account. But keeping that seller note outstanding also presents a downside. For one, you must pay ordinary income tax on the amount that is paid to you. Furthermore, by remaining a creditor, you carry the risk of the debt that is owed to you. Refinancing your seller note allows you to diversify out of that risk, which is subject to the company’s performance.

Let’s put it into numbers with the following example:

  • Current seller note: $15 million, payable at 7% interest on an annual basis
    • Annual income: $1.05 million
    • Maintain $15 million in debt risk that is subject to company performance
  • Refinancing 50% of the seller note: $7.5 million
    • Annual income on remaining seller note: $525,000
    • Created liquidity for personal autonomy and diversified $7.5 million of debt risk

While refinancing half of your seller note reduces the annual proceeds, diversifying your assets and reducing risk is a wise choice.

Who Likes to Pay More Taxes?

As indicated above, interest paid on your seller note is taxed as ordinary income, probably in the highest tax bracket. Taxes are based on the amount of principal paid at that calendar year’s capital gains tax rate, unless you elected 1042 tax deferral in your sale to the ESOP (and thus are free from capital gains for the overall transaction amount). For instance, if you receive principal in 2021, you will pay the current tax rate of 20% — but receiving proceeds in ensuing years means you will pay the tax rate in that given year. And the Biden administration’s proposed tax changes promise a significant tax increase.

Let’s see the numbers again, assuming the same scenario as above:

  • Current seller note: $15 million, payable at 7% interest on an annual basis
    • Annual income: $1.05 million
    • Tax obligation (37%): $388,500
    • Net proceeds: $661,000
  • Refinancing 50% of the seller note: $7.5 million
    • Annual income on remaining seller note: $525,000
    • Tax obligation (37%): $194,250
    • Net proceeds: $330,750
    • $7.5 million cash
      • Tax obligation (20%): $1.5 million
      • Net proceeds: $6 million

If both the personal income tax rate and the capital gains tax rate increase as the Biden administration has promised, you will receive fewer net proceeds on those seller notes.

Is Now a Good Time to Refinance?

Coming off an entire year focused on assisting clients and prospects with PPP funding, banks are now eager to extend new loans. Refinancing ESOP seller notes offers a perfect way to satisfy this desire. There are two major reasons banks like this type of credit:

  1. Having paid down the initial tranche provided to fund the transaction; the company already has a history of repaying ESOP debt.
  2. Refinancing seller notes creates an annuity of income stream for the bank. Banks and relationship managers are trying to meet new production goals each year, and refinancing is a wonderful tool for that purpose.

Current interest rates are near all-time lows, and credit is abundant. Again, let’s revisit the example:

  • Current seller note: $15 million, payable at 7% interest on an annual basis
    • Annual cost to the company: $1.05 million
  • Refinancing 50% of the seller note: $7.5 million, at a bank rate of 4%
    • Annual bank interest cost to the company: $300,000
    • Cost savings on seller note interest to the company: $525,000
    • Net increased cash flow annually to the company by refinancing seller note: $225,000

Weighing the Pros and Cons

Cashing in your seller note for bank financing does create additional debt service on an annual basis. The board of directors has a fiduciary responsibility to do what is in the best interest of the company, however — which includes lowering its cost of capital.

Having cash in hand is valuable to the note holder, as is taking advantage of favorable tax rates in the present environment. Banks have strong balance sheets and are willing to lend to ESOP companies with a history of repayment. Furthermore, the cost of financing is likely to be lower with a bank loan versus the seller note, thereby increasing cash flow to the company and ultimately boosting value to the ESOP and its participants.

With extensive ESOP expertise, PCE Investment Bankers has access to numerous capital providers within the banking industry. Let us assist you in putting together a competitive market offer that will improve everyone’s position.

 

Eric Zaleski

Investment Banking | ESOP

ezaleski@pcecompanies.com

Chicago Office

407-621-2100 (main)

847-239-2466 (direct)

407-621-2199 (fax)