The Power of the ESOP in Acquisitions

The M&A market is defined by many types of buyers, but consolidators have been the most publicized. Beyond the public markets and headlines, similar behavior is taking place among privately held companies.

The Power of the ESOP in AcquisitionsThe significant tax advantages provided to companies with Employee Stock Ownership Plans (ESOPs) mean that they often become strong partners and end up as consolidators. According to the National Center for Employee Ownership (NCEO), there are probably at least as many companies acquired by ESOP-owned companies as there are new ESOPs in any year. Furthermore, ESOP-related acquisitions have increased fivefold since 2011.[1]

Growth through acquisition offers companies an opportunity to gain complementary lines of business, operational improvements and efficiencies, and employees with new or broader skill sets, all while growing the business.

ESOP-Owned Companies Make Superior Acquirers

Efficiency of cash flow makes ESOP-owned companies (specifically 100% S corporation ESOPs, which do not pay income taxes) superior acquirers in any market, but especially in today’s environment, where it has become harder for cash to earn a targeted return.

ESOP-owned companies have several qualities that make them effective consolidators:

  • They have an employee-first culture.
  • They are strong borrowers for bank financing.
  • There are potential tax advantages to selling shareholders.
  • A target’s cash flow is more valuable to an ESOP buyer than a non-ESOP buyer.
  • Cash accumulates on an ESOP company’s balance sheet due to tax treatment.

Economic Impact of an Acquisition

Consider the following example: The target company has $9 million in EBITDA, $6.3 million in free cash flow, and a Letter of Intent (LOI) to be acquired for $60 million.

In one scenario, an ESOP or non-ESOP buyer borrows $40 million (4.4 x EBITDA) in a mixture of senior and, if needed, subordinated debt and contributes $20 million of company cash to complete the purchase. In this fairly common acquisition, the non-ESOP buyer will use the target company’s earnings to repay the borrowed money and realize a return by benefiting from synergies, growing the business, and repaying the debt. However, if the buyer is an ESOP-owned company, the company can pay down the debt much faster by eliminating or reducing the amount of income tax the target pays.

Alternatively, an ESOP buyer may not have to borrow to complete this acquisition. Because 100% S corporation ESOP-owned companies do not pay taxes, the ESOP company can accumulate on its balance sheet money to use for growth and acquisitions. In today’s market, the ESOP-owned company will most likely enjoy a stronger return through using its balance sheet cash in an acquisition versus an investment in money markets or similar instruments. The company’s board has a fiduciary responsibility to ESOP participants to generate a fair return on the company’s balance sheet cash; as such, risk versus return should be carefully considered and thoroughly analyzed.

Additionally, tax savings accrued from the target company (approximately $4.2 million annually in this example) can ultimately be used by the ESOP-owned company for additional acquisitions, organic expansion, or corporate obligations (such as payments to retiring ESOP participants), further adding to its return. Compelling economics are the biggest reason we have seen ESOP-owned companies become active buyers.

Considerations for Existing ESOP Participants

It is imperative that the management team and board members of ESOP-owned companies understand the effects of adding a new group of employees as beneficiaries of the ESOP. Following an acquisition, the equity value of the company will most likely increase. However, the equity will now be spread among a larger employee base, which will change existing employees’ ESOP account values.

To avoid negatively impacting existing ESOP beneficiaries, the company and board should carefully consider options such as:

  • Issuing new shares in conjunction with an acquisition
  • Buying back shares allocated to existing ESOP beneficiaries
  • Excluding or limiting the target company employees’ participation in the ESOP

Best Practices for a Successful Acquisition

While ESOP-owned companies tend to have higher success rates than do non-ESOP-owned companies when it comes to acquiring other companies, the following key considerations will lead to positive outcomes:

  • Don’t overpay. Many companies, in a frenzy of excitement during the negotiation, overpay for acquisitions. Do not underestimate the need to stay disciplined. Remain focused on the acquisition strategy and realistic about the impact of the target. Diligent financial analysis regarding the return on investment and cash payback is required. Take time during the negotiations to regularly review your assumptions. 

  • Keep your business on track. Acquisitions are very time-consuming, leaving little time to concentrate on the day-to-day operations of the core business. Most of the workforce should remain focused on existing customers while a select few work through acquisition and, ultimately, integration issues. Make sure you have a strong team of professionals to assist your staff. 

  • Don’t overleverage. Taking on too much bank debt can be disastrous. To avoid this situation, it’s paramount to understand how much capital to put into a deal and to have strong, trustworthy relationships with lenders. Detailed financial modeling, including several different scenarios, will help mitigate potential failures.

  • Plan for integration. The financial projections might make perfect sense, but they will not be meaningful without a solid integration plan. Realistic planning is critical to success; without it, the expected synergies could be lost. Put in place a plan with set milestones by which the acquisition integration can be measured and corrections made as needed. Furthermore, if the ESOP is to have a positive effect on motivation, productivity, and success, it’s vital to maintain proper and effective communication with both the acquiring and target company participants.

Conclusion

ESOP-owned companies have a variety of options as they begin to explore strategic alternatives to achieve growth goals. In order to gain enhanced value, it is crucial that companies ensure proper diligence and consideration of the terms of an acquisition. Engaging the services of an investment banker, financial advisors, and legal counsel can help protect everyone involved in the transaction process.

With the right team and appropriate structure, acquisitions by ESOP-owned companies tend to be very advantageous. In fact, 98% of ESOP acquisitions are reported as successful.[2]

[1] “ESOP Companies: More Successful Acquisitions,” Employee-Owned America.

[2] Cromlish, Suzanne M., “Empowering the 99%...One ESOP at a Time! A Mixed Methods National Study of Acquisitions by Employee Owned Companies (ESOPs),” Case Western Reserve University, August 2017.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.

Eric Zaleski

 

Eric Zaleski

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