ESOPs: Innovative Exit Solutions in Troubled Times

Michael Flock Managing A Competitive Position Leave a Comment

ESOPsMost people have no idea what an ESOP is, much less what the acronym stands for: Employee Stock Ownership Plan.

Many believe it is simply an arcane government program to encourage companies to transfer equity to employees, something nice to do if one is feeling particularly generous or eager to improve employee commitment to the corporation.

Few owners of businesses truly understand how ESOPs work. Few grasp how a leveraged ESOP is really a very creative way to recapitalize a business and transfer ownership on a “tax free” basis, with favorable tax treatment for both sellers and buyers. This tool is especially useful in depressed financial markets when private equity investors are waiting for some sign that we’ve reached the bottom of the market.

Private equity valuations during these times tend to approach rock bottom, reflecting the doom and gloom of current capital markets. While strategic and industry buyers offer higher valuations and better terms, they too believe the current credit collapse gives them negotiating power. Both private equity and strategic buyers will still offer a cash component to the purchase consideration, but tend to also look to stock and earn-outs tied to future performance to limit their risk in an acquisition.

A recent deal in the collections industry, a management buyout at Plaza Associates, a large collection agency in New York, illustrates well the compelling benefits of ESOPs. ESOPs can be an alternative solution for owners looking to diversify their holdings through a complete or partial sale of their ownership interest to the employee base.

But first, here is how a leveraged ESOP works

If selling shareholders sell their holdings representing 30% or more of equity in the company to an Employee Stock Ownership Plan, they are eligible to defer their federal (and state if applicable) capital gains taxes resulting from the sale and, if they structure their transaction properly, the deferment may be permanent. Typically the company will arrange bank financing to fund the majority of the purchase price. If the owners desire to sell substantially all of their ownership interest, it is likely that an additional tranche of mezzanine debt will be required or the sellers will have to agree to take a note to finance the balance not covered by a senior loan facility.

A trustee is hired to act on behalf of the ESOP, which is responsible for securing an independent valuation to validate the purchase price of the transaction. For a number of reasons, including the fact that the stock sold to the ESOP is preferred equity, an ESOP transaction usually results in a significantly higher purchase price than what private equity firms would be willing to pay. Sellers may elect to retain control of the business after the installation of an ESOP (even if 100% of the company is sold) or turn it over to management. Since the selling shareholders control every aspect of the sales process, the odds of success of the deal are much higher than with a protracted sales process to either a private equity group or a strategic or industry buyer.

Let’s look at a case study:

The management buyout at Plaza Associates in April of this year. The owners, all in their seventies and eighties, having started the business in the early 1960s were looking to liquidate their interests in Plaza and had tried several times over the last two years to sell the company to private equity groups or to industry buyers. Each time the transaction failed because of valuation, terms and conditions, financing, relationship issues with the prospective buyer, or simply because the management team or one of the owners didn’t like the deal.

In reviewing the history of Plaza, its financials, its competitive position, and the historic relationships inside and outside the company, Flock Advisors determined that a leveraged ESOP was the most viable alternative for both owners and management for three reasons:

First, it was easier to reach an acceptable valuation for the owners, because the sellers could benefit from capital gains tax savings—over 20% including NY State and federal taxes.

Second, the ESOP solution was very attractive to the management team, most of whom have been with the company for twenty years without any ownership interest in the company, since they are eligible to receive additional management incentive equity beyond the normal ESOP shares.

In this transaction, the management group also got control of the company. Under an ESOP structured purchase, the principal payments relative to the financing of the ESOP are tax deductible. This means that Plaza will not have to pay income taxes until the notes are paid off — several years in the future. Additionally, the ESOP will generate tax losses which the company will carry-back to recover tax payments made during the previous three years. These tax benefits reduced the effective purchase price for the employee group.

Third, because the sellers and management controlled the process and their interests were somewhat aligned, the odds of success were higher.

Management knew they were getting control and were comfortable and excited about being able to become owners. One of the keys to success was a national ESOP expert, Todd Butler, an attorney with Holland & Knight. With a background in mergers and acquisitions and deep experience in developing leveraged ESOPs, Todd not only helped the team navigate through some of the complexities of setting up the ESOP but also found creative solutions to issues raised by both the owners and the management. His mix of M&A and ESOP knowledge and expertise was crucial to overcoming many of the hurdles throughout the process.

The other key to success was the rigorous process we conducted among several national and regional banks to solicit the best possible financing terms for the ESOP. A detailed business plan was developed which included a solid business strategy for future growth. With our assistance, the management team was very effective in presenting the financing opportunity to the banks. As a result of the competition, Plaza had many alternatives to chose from, even in this difficult banking environment. The process was challenging. We negotiated several term sheets for the company. But, in the end, a lender offered good terms, competitive interest rates, and did not require personal guarantees from the sellers.

Given the historical solid financials, solid customer relationships, the strong financial performance in spite of the turmoil of 2008, and the fact that Plaza would not have to pay taxes for several years, the CFO supported the proposal. The deal closed in April. The company is doing well and the new team is energized and exceeding its forecasts while the owners have moved on at long last to enjoy the fruits of their nearly 50 years of labor.

ESOPs aren’t for everyone, however. If a company’s financial performance is questionable, and if a company already is loaded with debt, additional leverage may not be wise. Debt buyers probably would not be good candidates for leveraged ESOP’s given their traditional high rates of leverage on their debt purchases. Also, if owners want to sell 100% of their equity for immediate cash, it is unlikely a leveraged ESOP will work in today’s tight financing markets, when cash flow loans are being financed between 2X and 3X EBITDA.

But during these troubled times when you would like to liquidate some or all of your equity, consider the innovative ESOP solution. You can get cash up front, very favorable tax treatment, good valuation, control, and the ESOP can be customized for your particular needs.

You can have your cake and eat it too. Yes, you can.

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