Financing the Leveraged ESOP: Opportunities for Commercial Lenders Hidden in Plain Sight
Employee stock ownership plans can offer many benefits to company owners who are in the market to sell their businesses. Howard Brod Brownstein, Robert Willner and Brandon Ralph explain the ins and outs of leveraged ESOP finance and encourage lenders to identify ESOP opportunities in their existing portfolios.
When planning the sale of a business, or as part of their estate planning, business owners often utilize an employee stock ownership plan (ESOP) as a tax efficient alternative to a sale to a third-party buyer. While an ESOP transaction can be a complicated process, the benefits can be compelling. The sale to the ESOP will be for fair market value, as determined by an independent valuation company, while providing significant tax benefits to the seller, the company and its employees. A succession of ownership will maintain the stability of the company’s organization, since the employees will become the owners of their employer.
One key factor in executing an ESOP transaction is lining up financing for the ESOP to provide the cash needed to consummate the sale, which is the main focus of this article.
What is an ESOP?
An ESOP is a form of qualified retirement plan that has existed for more than 50 years. These plans are a sanctioned form of tax shelter based on long established Internal Revenue Code rules and Treasury Department regulations, which are granted broad exemptions from the anti-self-dealing rules that hinder other forms of qualified retirement plans.
A trust is established pursuant to the ESOP and a trustee is engaged to act on behalf of the trust. The trustee owes fiduciary duties to the ESOP participants, so the trustee is generally an experienced trust company or professional who acts in this capacity for numerous ESOPs. After negotiating the purchase price and terms with the sellers, the trustee purchases the equity securities (ESOP stock) of the plan sponsor, i.e., the company.
Over time, the ESOP stock vests in the plan participants — the company employees — as additional compensation is deferred until the participant receives distributions from the ESOP. To ensure liquidity, upon a participant’s death, retirement or separation from the company, the company is obligated to repurchase the ESOP stock from the participant at its current fair market value.
The sponsoring company can be large or small, and public or private. ESOPs, however, are most typically utilized by middle-market or smaller privately-owned companies. An ESOP is not an operating entity and has no source of revenue or capital other than what the sponsoring company has contributed, lent or paid to the ESOP as a dividend. Accordingly, to consummate a purchase of the ESOP stock, except in the case of a 100% seller-financed sale, the ESOP will need cash to complete the purchase, and the cash must come from somewhere.
The Ins and Outs of Leveraged ESOP Finance
The rules governing ESOPs make it an unattractive borrower, so typically the sponsoring company will borrow the funds from an outside lender to complete the transaction and then lend those funds to the ESOP, referred to as an “inside loan,” which the ESOP will utilize for the cash portion of the purchase price paid to the sellers. The inside loan is designed to be repaid through annual tax-deductible contributions by the company to the ESOP and dividends paid on the ESOP stock. The inside loan is largely cash-neutral to the company, meaning the contributions and dividends to the ESOP come back to the company dollar for dollar in the form of payments on the inside loan. The ESOP participants receive allocated shares annually as the inside loan is repaid. The outside loan to the company is generally underwritten to company cash flow and secured by the company’s assets, hence, the name “leveraged ESOP finance.”
The tax benefits to the sellers are one of the greatest advantages of an ESOP transaction compared to a conventional sale. Capital gains taxes owed by the selling shareholders can be deferred — and may be eliminated upon death — provided that:
- The ESOP acquires at least 30% of the company
- The company is a C corporation (an S corporation or LLC is permitted to convert to a C corporation prior to closing of the ESOP transaction
- The seller reinvests the sale proceeds in qualified replacement property (QRP), called an “Internal Revenue Code §1042 rollover”
QRP can be equity securities or debt instruments, excluding obligations of government entities and certificates of deposit. The securities must be issued by domestic corporations that are operating businesses, not investment entities, and cannot be the ESOP stock acquired by the ESOP. The QRP must be acquired within three months before or 12 months after the sale to the ESOP. Any gains remain deferred if the QRP is transferred by gift or to a charity, and gains may be eliminated completely at death via a step-up in basis.
In preparing for a leveraged ESOP transaction, the company will frequently hire an ESOP advisor who will, among other things, provide guidance on transaction value and structure as well as arrange lender financing. The company will also engage an ESOP trustee who is required under applicable rules governing ESOPs to obtain a valuation opinion of the ESOP stock by a qualified independent appraiser that meets the requirements of Internal Revenue Code §170(a)(1) and utilizes good faith procedures to determine the fair market value of the ESOP stock. That valuation must be as of the date of the closing of the ESOP transaction and be described in a written report that includes the methodologies used. The appraiser reports to the trustee, but the company is allowed to pay the appraiser’s fees. The company will also periodically hire an actuary or other qualified consultant to prepare a repurchase obligation study, which is a projection of the company’s obligation to repurchase vested ESOP stock from plan participants or their estates, and the projected cash flow the company will need to meet that obligation.
The rules governing ESOPS require the trustee to formally determine that the purchase of the company’s equity interests by the ESOP is in the best interests of the ESOP participants. The aforementioned valuation report is a key element of this determination. The trustee will submit an application to the IRS for a “determination letter” confirming that the ESOP is a qualified retirement plan and that the ESOP’s documents satisfy IRS requirements. Among other requirements, the ESOP documents must include provisions for mandatory distributions, put options, diversification of holdings and allocations that may be prohibited.
The Outside Loan
To determine how much can be borrowed to finance an ESOP, the outside lender must assess the excess debt capacity of the company. Excess debt capacity is generally determined by the company’s EBITDA, market debt multiples and collateral. The total debt capacity minus total existing debt equals the excess debt capacity available to fund the ESOP transaction. For example, if a company’s EBITDA is $10 million and a multiple of 2.5x is deemed to apply (based upon the quality of the EBITDA, which may depend upon the company’s industry, stability, growth prospects and other factors), then its debt capacity might be deemed to be $25 million. And so, if the company has existing debt of $5 million, its incremental debt capacity might be deemed to be $20 million. A cushion, however, should be provided between the debt capacity and the amount actually financed to allow for contingencies.
Loan underwriting should include analysis of the strength and depth of management, the long-term ability of the business to generate cash flow, and the existing and future claims on that cash flow, including the projected repurchase obligations previously discussed. Underwriting analysis should also consider the stability of the income stream, the existing debt and required debt service, the future needs to fund capital investment and working capital. Typical credit metrics include loan to transaction price ratio, fixed charge coverage and cash flow leverage. The lender will review this analysis to answer the question: Does the company generate sufficient EBITDA to meet its obligations and run the business?
Any shortfall between the purchase price and the excess debt capacity is typically bridged by subordinated seller carryback debt. Typical subordination terms permit the company to pay interest on the seller debt so long as the senior debt is not in default and the proposed interest payment will not cause the company to trip its financial covenants on a pro forma basis. It is also common for sellers to receive warrants as part of the sale compensation, but any cash pay feature of the warrant will also be subordinated to the bank financing.
Note that a loan used to fund an ESOP purchase of stock is a type of leveraged buyout, which can often render the company’s balance sheet insolvent. Such transactions may be open to challenge as a fraudulent transfer, and so such risk must be analyzed and quantified. Also remember, ESOP accounting treats the inside loan as a “contra-equity” account, often creating negative tangible net worth on the company’s balance sheet. Additionally, seller paper and other debt will reduce balance sheet equity. Lenders need to understand these accounting impacts and set financial covenants accordingly.
From the company’s perspective, as with any qualified retirement plan, contributions to an ESOP are tax deductible. Generally, this can be up to 25% of participant payroll, although compensation is subject to a limitation of $330,000 as of 2023. Dividends paid by a C corporation are deductible if they are paid to the ESOP and/or if dividends paid through to ESOP participants are used to repay the inside loan, or used to purchase employer securities if participants are permitted to retain cash.
Among the requirements that relate to the company’s liquidity are mandatory distribution requirements whereby the company must offer cash to the ESOP participants when making distributions or, if distributing stock, the company must give participants the right to put stock back into the company and not the ESOP. The ESOP can permit distributions to be deferred over five years to help with planning for needed liquidity. Vesting schedules, whereby participants’ ESOP shares are vested over five years, can also help smooth out the liquidity requirement. There are exceptions for unallocated ESOP stock, which can be released from a suspense account as the inside loan is repaid, using either a principal and interest method or a principal-only method with a 10-year cap on principal only.
A diversification requirement, whereby the ESOP must permit participants to diversify their accounts during a six-year period, applies to participants aged 55 or older with 10 years of ESOP participation and applies to 25% of a participant’s account, or 50% in the last year of the six-year period. The repurchase obligation study discussed previously can facilitate better understanding of the company’s liquidity needs.
After a waiting period (typically five years following the closing of the ESOP transaction), an ESOPowned company that revoked its S status and became a C corporation to facilitate the sale by its shareholders to qualify for section 1042 rollover treatment is allowed to re-elect S corporation status. Being an S corporation provides additional benefits. A 100% ESOP-owned S corporation pays no federal income tax and, depending on the applicable state, may have no or nominal state income tax liability. For example, California imposes a 1.5% tax.
Mining for ESOP Opportunities
Lenders often need look no further than their existing portfolios to find ESOP opportunities. Companies in a lender’s portfolio may be excellent candidates for an ESOP. And the odds are great that these companies and/or their owners may choose to sell to a third-party buyer, often for no reason other than a previous unawareness of the ESOP option. If the company owners choose to sell to a third party, the third party will have its own financing and the lender may lose a valuable relationship.
It behooves a lender to discuss the benefits of the ESOP option with companies and their owners and let them know that if they choose to go that route, the lender will provide financing. This will enable the lender to not only keep a valuable relationship but also to increase its commitments and outstanding loans to the company, which is a win for everyone involved. As an added bonus, once the lender has financed the initial ESOP transaction, the lender has a built-in annuity. The company will want to prepay the seller debt periodically, giving the lender the opportunity to reload the term loan to be used for that purpose.
Once a company expresses an interest in the ESOP option, lenders should refer them to experienced counsel and an ESOP advisory firm to structure the transaction. Likewise, the lender should engage experienced counsel to provide advice during the proposal and underwriting stages, as well as to assist with ESOP diligence and loan documentation. ESOP loan documentation should include, among other things, usual and customary guardrails to ensure the borrower complies and remains in compliance with applicable laws and regulations governing ESOPs. The failure of the company to comply with these laws and regulations could result in significant penalty taxes, liability for breach of fiduciary duties and tax liability, as well as potential unwinding of the ESOP transaction.
Experienced counsel will also advise the lender on non-GAAP addbacks to EBITDA which are usual and customary in ESOP transactions, as well as restricted payments the lender will need to permit, such as mandatory repurchases of vested ESOP stock.
Clearly, much is involved for all parties — especially lenders — in providing leveraged ESOP finance. In the end, ESOP finance is worthwhile if a careful process is followed. A leveraged ESOP can be a potentially advantageous alternative to a conventional sale, permitting a privately-held business to continue, and can also be a way for employees to become the owners. Important legal and regulatory requirements must be met, which require engaging experienced legal and advisory professionals for all parties. ESOP transactions can provide substantial potential tax savings for the sellers and the companies that sponsor them, as well as an opportunity for lenders to keep a long-time customer or gain a new one. Middle-market lenders would be wise to educate themselves thoroughly about ESOPs and to line up experienced professionals to assist them.
ABOUT THE AUTHORS:
Howard Brod Brownstein is president of The Brownstein Corporation, a turnaround management and M&A firm in Conshohocken, PA, and serves on ABF Journal’s editorial advisory board.
Robert A. Willner is a shareholder with Buchalter in the commercial finance group and is the chair of the firm’s leveraged ESOP finance practice group.
Brandon Ralph is a vice president at AmbroseAdvisors, an investment banking and advisory firm in Riverside, CA.
Philip J. Wolman of Buchalter provided the authors with tax and ERISA advice for this article.
Note: This article is not intended to create or constitute, nor does it create or constitute, an attorney-client or any other legal relationship. No statement in this article constitutes legal advice nor should any article herein be construed, relied upon or interpreted as legal advice. This article is for general information purposes only regarding recent legal developments of interest and is not a substitute for legal counsel on any subject matter. No reader should act or refrain from acting on the basis of any information included herein without seeking appropriate legal advice on the particular facts and circumstances affecting that reader. For more information, visit buchalter.com.