ESOP Transaction Advisory

What is an ESOP and why might it be a good option?

• An ESOP is an Employee Stock Ownership Plan
• It is a Defined Pension Plan and is a distinct legal entity
• The Company is sold to a newly created ESOP that purchases the business for the sole benefit of its Employees

How can the Employees afford to purchase the Company?

• The Employees pay nothing
• Congress has directed income tax dollars to facilitate Employee ownership of Companies
• A bank loan is used to purchase the Company by the ESOP
• If the Company is an “S” Corp, the income flows through to the ESOP which, as a Defined Pension Plan, pays no
  income tax
• If the Company is a “C” Corp, acquisition principal, as well as interest, is deductible.

Does the Seller finance part of the transaction?

• The Seller takes back a loan, subordinated to the bank, at a much higher interest rate than the 1st lien holder
  (bank), and is granted synthetic equity (warrants)
• The targeted timeframe to pay back the bank is 36-48 months, at which time the ESOP usually refinances with
  the bank to pay out the Seller’s note
• Once the Seller’s note is paid, the ESOP usually refinances with the bank to pay out the Seller’s warrants
• If the Seller doesn’t wish to carry all of his note, there are some PE firms who participate in this type of mezzanine financing

What if the Company is a “C” Corp?

• The Seller can make an IRC S. 1042 election to defer, and sometimes permanently avoid, capital gains tax
• Under S. 1042 the Seller buys Qualified Replacement Property (QRP) (US stocks or bonds) with the whole or part of the sale proceeds
• Capital gains tax is deferred until the Seller decides to sell the QRP
• If the Seller chooses to never sell the QRP and owns it at her death, her heirs enjoy a step-up in cost basis to then current FMV, hence no tax is owed
• Congress is contemplating extending this benefit to “S” Corp ESOPs

Any other ESOP advantages?

• The Seller can decide to sell 30-100% of the Company to an ESOP
• A 100% ESOP never again pays income tax and hence is at a competitive advantage eg. being able to make strategic acquisitions with pre-tax dollars
• Studies indicate employee-owned companies enjoy increased productivity, therefore increased profit
• Management structure can stay in place, providing for succession of the business eg. to the Seller’s children
• Because an ESOP is a pension plan, when an Employee retires, he can opt to roll-over his ESOP funds into an IRA and control when to liquidate and pay income tax

Resources:

• National Center for Employee Ownership (NCEO)
• The ESOP Association
• The Principal - ESOP Administration