United States: Advantages Of Using ESOPs To Structure Acquisitions and Divestitures In An Uncertain Economy

M&A advisors are becoming increasingly familiar with leveraged ESOP transactions and are routinely considering the ESOP platform in structuring acquisitions and divestitures. The first part of this article references the ways in which leveraged ESOPs have historically been used to provide a tax-advantaged exit strategy for privately held business owners. The article then discusses the advantages the leveraged ESOP structure can bring to M&A advisors and private equity groups charged with structuring acquisitions and divestitures during a down economy.

I. Introduction

For years, employee stock ownership plans (ESOPs) have provided both a ready exit strategy for privately held business owners and a platform for management buy-outs. More recently, M&A advisors have used leveraged ESOPs to accomplish both conventional stock and asset acquisitions and divestitures (including spin-offs of divisions or companies (e.g., failed "roll-up" companies). They have also been used by venture capital and private equity firms (collectively, "private equity groups") as investment platforms and in planning investment exit strategies.

In the current economic environment leveraged ESOPs can continue to be used for all of these purposes. They can also provide real advantages not available in traditional M&A transactions. With company owners postponing sales in the face of lower values and inferior offers, ESOPs allow for partial sales, maximize after-tax sales proceeds and provide sources of financing which are both tax-advantaged and flexible. The leveraged ESOP structure also provides an increase to company cash flow, and, on a go-forward basis, a more stable company structure with improved performance. Seller financing may also be measurably more attractive in an ESOP purchase scenario than under traditional M&A models.

II. Advantages Available in ESOP Structure

a) ESOP as A Qualified Retirement Plan that Can Borrow Funds to Create A Market and Make an "Internal" Purchase of Shares

An ESOP is no more than a defined contribution plan (like a profit sharing or 401(k) plan). It is designed to invest most of its assets in the stock of the sponsoring corporation (the "Company").

Unlike other qualified plans, an ESOP can use both borrowed money and funds rolled over tax-free from other qualified retirement plans and/or certain IRAs to purchase the stock of the sponsoring corporation. Armed with this ability, in uncertain economic times ESOPs can create a market for closely held shares that might not otherwise exist. Shares can be purchased from one or more individual(s) or entity(ies) looking for shareholder liquidity ("Sellers") or from the Company itself.

Because an ESOP purchase can be structured internally (i.e., without "taking the Company to market"), the transaction can be more easily closed within a specific time frame that meets buyer and/or seller objectives. If desired, an ESOP purchase offer can alternatively be timed to occur concurrently with additional M&A offers (with the ESOP serving as a "stalking horse" to potentially increase third party M&A offers).

b) Possibility of Partial and/or Tax-Deferred Sale Makes ESOP Purchase Transaction Attractive to Seller

(1) Partial Purchase Capability
An ESOP can purchase part or all of a company's shares and it need not purchase the shares in a single transaction. For a business owner seeking partial liquidity, an ESOP may be extremely attractive as compared to traditional M&A transactions in which buyers are rarely willing to purchase a minority interest.

(2) Possible Tax-Deferred or Tax-Free Sale
Moreover, as long as (1) the ESOP purchases at least 30 percent of the Company's shares and (2) the Company was (a) privately held (or an OTCBB company) for at least one year prior to the ESOP's stock purchase, (b) not a member of a corporate controlled group that included a public company (other than an OTCBB company) during such period, and (c) a C corporation at the time of the ESOP's stock purchase, then a selling shareholder (a "Seller") that (i) is an individual, trust, partnership or S corporation and (ii) has held its shares for at least three years prior to the sale closing date is able to make a tax-deferral election with respect to the sale under Section 1042 of the Internal Revenue Code.

Such an election will allow the Seller to sell his/her/its shares on a tax-deferred (or, in the case of individual Sellers) tax-free basis. Tax-deferred sale treatment is generally available if the Seller reinvests the Seller's sale proceeds in domestic stocks and bonds ("replacement securities") within 12 months of the transaction closing date. Tax-free sale treatment is generally available to the extent that an individual Seller acquires replacement securities in an amount equal to the ESOP purchase price and then holds them until his/her death. (The IRS makes it quite easy to hold replacement securities until death, since neither (i) gifting or making charitable contributions of the securities, nor (ii) borrowing against them (e.g., through margin loans) constitutes a disposition of the securities for purposes of the applicable IRS rules.)

(3) Even if Sale is Not Tax-Deferred or Tax-Free, It Will Result in Capital Gains
In the event that an ESOP purchases a Seller's shares and the Seller chooses not to make (or fails to qualify for the making of ) a tax-deferred election under Section 1042, the sale will result in capital gains (currently subject to a 15 percentpercent federal income tax rate). Given that (i) many buyers in a traditional M&A transaction want to purchase assets, (ii) private equity and strategic buyers will generally pay a lower purchase price for stock than for assets and (iii) an asset sale typically results in a blended capital gains/ordinary income tax rate and sometimes a double tax if the corporation then liquidates, a Seller's ability to make a tax-deferred or capital gain stock sale to an ESOP is a real advantage. In a challenging economic environment it may be the principal factor or, perhaps, the only factor that encourages an owner to sell now rather than later. Putting more after-tax dollars into an Seller's pocket can also bring about "meeting of the minds" in terms of the transaction purchase price. It can further provide a competitive advantage to a purchaser that is offering the same price as competing buyers.

One of the great "ESOP fables" is that an ESOP won't pay as high a purchase price as an outside third party might. While it's true that an ESOP can't pay a true "strategic" purchase price, it can pay a price equaling a Company's full economic fair market value. As credit markets have contracted, so too have the pricing multiples paid by strategic buyers, with ESOP offers in the current economic climate sometimes even exceeding strategic offers when viewed on an after-tax basis.

c) ESOP Financing Which is Tax-Advantaged and More Flexible

(1) Structure of ESOP Loan (with Possible Reduction of Transaction Debt)
A corporation wishing to engage in a leveraged ESOP stock purchase transaction (the "Company") adopts an ESOP and the ESOP typically borrows its share purchase money from the Company and/or the Seller(s) (with the Company portion of the funds so borrowed by the ESOP sometimes having been sourced by the Company from one or more senior lenders). The amount borrowed is reduced to the extent employees are given, and take advantage of, an opportunity to transfer some or all of their 401(k), profit sharing and/or IRA account balances to the ESOP for investment in Company shares (with dollars coming into the ESOP (i) reducing the amount of both ESOP debt and Company debt and (ii) being viewed as transaction equity by senior lenders).

(2) Repayment of Both Interest and Principal With Deductible Dollars
The ESOP loan (whether from a bank, the Company which borrowed the funds from a bank and/or the Seller(s)) is repaid with (1) contributions made by the Company to the ESOP plan and/or (2) C corporation dividends or S corporation distributions paid on the ESOP's Company shares (the "ESOP shares"). In the aggregate, the contributions and dividend/distributions generally equal the transaction's debt service. Because an ESOP is a qualified plan, an ESOP sponsor receives a deduction for the contribution the sponsor makes to the ESOP. If a sponsor is a C corporation, it will also be able to deduct reasonable dividends paid on ESOP shares which are used to retire the ESOP loan.

Contributions and/or distributions received by the ESOP are used by it to repay its debt service to the Company, with the Company then using the monies it receives to repay its debt service to the bank or the Seller. Since the aggregate amount of deductible contributions and dividends is generally enough to service, first, the ESOP's indebtedness to the Company and, second, the Company's indebtedness to the bank, the Company is effectively able to deduct both the interest and the principal on its bank loan.

(3) Resulting Increased Cash Flow (Which May Last Beyond Loan Term with S Corporation Election)

Because the Company is essentially able to repay its indebtedness on a pre-tax basis, the Company's cash flow is increased. Moreover, if the Company is an S corporation or a C corporation as to which a post-transaction S corporation election will be made, the enhancement to the Company's cash flow need not be limited to the term of the transaction-related deductions. The reason is than an S corporation is a pass-through entity and an ESOP is a tax-exempt entity. If the Company remains or becomes an S corporation, there will be no federal income tax (and, perhaps, no state income taxes) to the extent of the ESOP's Company ownership percentage. If the ESOP winds up owning 100percent of the Company's outstanding shares (albeit that options, warrants or other forms of synthetic equity may, for example, be held by the Company's management team and/or private equity investors), the Company can operate on a go-forward basis as an entity exempt from federal (and, in many cases, state) income taxes.

(4) Benefits of Increased Cash Flow
The increased cash flow of the Company related to ESOP-generated deductions in a C corporation context or the ESOP's ownership percentage in an S corporation context can be used to make scheduled or accelerated transaction-related debt service payments. It can also be used for other acceptable corporate purposes (e.g., capital expenditures), which may provide the Company with continued growth and a significantly higher internal rate of return. In addition to increasing the Company's financial strength, the Company's enhanced cash flow will enhance its creditworthiness. Not only will senior and mezzanine transaction lenders be encouraged to loan more into the transaction, private equity group(s) may be encouraged to provide transaction financing (even, e.g., where the transaction is being structured to take out an existing private equity investor).

(5) Seller Financing is More Attractive in ESOP Structure
Another significant financing advantage of the ESOP structure is that seller financing is generally more attractive in an ESOP purchase transaction than in a traditional M&A acquisition. First, the fact that the Company’s enhanced cash flow will permit its senior indebtedness to be repaid at an accelerated pace means that subordinated seller financing can be repaid more rapidly. Second, if a Seller who provides a portion of the transaction's financing has made a Section 1042 election, the transaction can be structured so that the Seller receives a higher subordinated return and principal payments which are received on a tax-free basis (as opposed to traditional M&A installment payments for which only a portion of each installment constitutes a return to basis). Finally, because an ESOP company's management team generally remains in place to continue running the entity's day-to-day operations, Sellers may feel more comfortable providing financing than they would in a traditional third-party purchaser M&A transaction.

(6) ESOP Structure Provides Greater Financial Flexibility
The fact that ESOP purchase transactions can often be closed with a much greater percentage of Seller financing (which can, of course, be taken out in the future when credit conditions have improved) makes ESOP purchase financing definitely more flexible than traditional M&A financing in a down economy. This flexibility is accentuated when the transaction can be structured to roll monies into the ESOP from other retirement plans and/or IRAs. The fact that an ESOP transaction structure creates an inherent source of funding which can be used to repay transaction indebtedness (as described below) is yet another advantage of its financial flexibility.

d) Inherent Sources of the Funds Which Can Be Used to Repay Transaction Debt

The Company can, of course, take from its cash flow the dollars it will need to make the contributions or pay the dividends/distributions which will enable the ESOP to repay its loan. Other sources inherent in the transaction structure can include:

  • the annual use of dollars previously contributed as a matching contribution to the Company's 401(k) plan (with the Company continuing the "match," if desired, within the ESOP in the form of Company shares);

and/or

  • the use of the tax dollars saved by the Company due to either ESOP-generated deductions in a C corporation context or the ESOP's ownership percentage in an S corporation context.

e) Stable Company with Improved Performance

(1) Although Company Is Leveraged, Its Management Team Will Likely Remain
in Place and Enhancements to Cash Flow Can Provide Continued Growth
Like any other leveraged transaction, a leveraged ESOP purchase transaction puts a large amount of debt on the Company's books. However, unlike traditional M&A transactions, the Company's management team will in all likelihood remain in place to run the Company's day-to-day operations. Moreover, because transaction indebtedness is essentially paid with pre-tax dollars, the Company's cash flow is increased in a way that can provide the Company with continued growth and a sufficiently higher internal rate of return. In the event that the Company operates on a post-transaction basis as an S corporation, the Company's increased cash flow related to the ESOP's ownership percentage can continue well beyond the life of the transaction's term debt.

(2) ESOP Provides Employees With a Beneficial Interest In the Company Which
May Increase Production and Increase Company’s Chances of Survival
The fact that the ESOP will provide employees with a beneficial interest in the Company will also incentivize employees financially, providing the Company with positive effects in terms of attracting, retaining and motivating employees to increase the Company's productivity. Data referenced by the National Center for Employee Ownership (NCEO) also decisively shows that companies which share ownership broadly with employees are less likely to go out of business, that they generate more jobs and they create an average of three times the retirement benefits as comparable non-employee ownership companies. Tony Matthews, director of employee ownership at the Beyster Institute, has also said that "In tough times like these, giving employees a stake in the outcome inspires people to put in the extra effort required to insure the survival of a company."

III. Summary

With both M&A advisors and private equity groups needing to find new ways to compete in tighter credit markets, using an ESOP as a stalking horse and/or an acquisition tool may provide a competitive edge. The parties to a leveraged ESOP transaction can readily control its timing and 100 percentpercent of a company’s equity need not be purchased in a single transaction.

The ESOP purchase structure is also advantageous in that an ESOP can purchase shares with pre-tax dollars and it can access other qualified plan and IRA monies to both (i) reduce the amount of acquisition indebtedness and (ii) provide a partial funding source for periodic loan payments. The factors that make seller financing so attractive under an ESOP purchase structure also provide the structure with a competitive advantage in a down economy in which it is difficult to fund 100percent of a purchase with external financing. The fact that an ESOP purchase can close without going to market and pay up to a full economic fair market value provide additional advantages which greatly minimize the risk that a purchase agreement may never be executed.

Finally, the fact that ESOP financing can enhance cash flow which can be used for both debt reduction and periodic growth makes the ESOP structure worth considering not only as a down economy alternative to a traditional M&A transaction, but also as a go-forward investment and/or acquisition platform.

There are, of course, considerations to the ESOP transaction structure which must be explored and quantified (e.g., the requirement that a privately held company must repurchase shares distributed to departing employees at fair market value). With proper planning these considerations need not, however, become structural drawbacks. In a down economy in which M&A advisors and private equity groups are looking for flexible structures which can take an acquisition to completion, the leveraged ESOP purchase structure presents a compelling alternative.

Advantages of Using ESOPs To Structure Acquisitions and Divestitures In An Uncertain Economy

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions