Last month we sought to debunk some of the top ESOP fables. This month we seek to provide some of the issues which you might encounter. Here is a link to last month’s article debunking the top 10 fables about ESOPS if you would like to read it first.
Being prepared makes it much less daunting when you set out to establish an ESOP. Specialty providers are needed since most attorneys, accountants and trust departments may be aware of ESOPs but are not typically experienced with how best to address the issues.
The first question: Is an ESOP for the sale of your business worth the cost and effort? This is the essential question and it’s so difficult because the answer will likely be different for each situation. The complexities are intense and there are ERISA rules, IRS rules, and Corporate Governance laws to consider.
If your company has more than 30 employees and more than $1 million in payroll, then you have crossed the first hurdle. It’s not that you can’t implement an ESOP if your company is smaller, this is just the first “rule-of-thumb” to justify the costs.
As the CEO, are you an autocratic leader or is your management style more collegial? Benevolent dictators may truly want to their employees to behave like owners until the employees start acting like owners and criticize the boss’s expenditures and business decisions. This is important because of recent laws such as the one passed in August 2018 that allows former owners to remain as CEO and Chairman even after a 100% sale to an ESOP.
Is the financial viability and future prospects for the company sufficient to cover the debt costs that will be associated with the purchase of the company by an ESOP? An ESOP will not improve a failing company and an ERISA challenge on the unfairness of the transaction will be distracting, costly and time consuming.
The Key Component
The most essential component for an ESOP transaction is the Trustee. The Trustee acts in a fiduciary capacity for the ESOP trust and serves the role of “independent buyer” in the transaction. The Trustee must establish the value of the company and conclude the details of the transaction terms are fair to the ESOP. To accomplish this, they frequently hire an independent appraiser and an outside party to write a Fairness Opinion concerning the details of the transaction’s Price and Terms. Although it’s permissible for a business owner to act in the role of Trustee, it’s highly inadvisable due to the inherent conflicts of interest that exist. However, the Trustee is actually hired by the Board of Directors of the company, so if the owner remains as Chairman of the Board they will have a strong say in the selection of the Trustee.
Valuation and Fairness
Since the trustee is charged with identifying the value of the company as well as the fairness of the transaction, minority discount can become an issue when less than 51% of the owner’s shares are sold to the ESOP. Many independent appraisers use a 25% to 30% Minority Discount for less than control shares. If a group of five equal owners sell all of their less than control shares to the ESOP, is the price impacted by minority discount even though the ESOP is buying 100% control? Nope. This one has been answered. Likewise, if a staged buyout by the ESOP is such that 30% is sold in the first stage with a pricing mechanism for the ESOP to get to 51% or 100% in steps, then a minority discount does not seem to apply. However, if only 30% is sold to the ESOP by the owner who still remains in voting control of the company, many appraisers feel that a minority discount should apply. The answer seems to be focused upon does the ESOP have voting control after the planned stages of the transaction(s) are complete.
Of course, valuation and fairness remain an issue for so long as the ESOP exists. Each year the shares owned by the ESOP must be valued by an independent appraiser, and the trustee is charged with overseeing that fairness of allocation of shares to employee accounts as well as voting the company’s shares on corporate matters are conducted fairly and in the interests of the employee shareholders. In addition, there are ERISA rules on yearly allocation of shares to participants. Earnings above $265,000 for any one person are ignored when shares are allocated each year based upon salary. Plus, any person who owns 10% or more of the shares of the company outside the ESOP or 20% or more collectively with their family are disqualified from participating. However, stock warrants and phantom stock can be used to incentivize key management.
The Get ‘R Done Mechanics
— C corp -vs- S corp
After a Trustee is engaged and they have hired the Appraiser, the Owner/Seller must then engage their tax advisor in helping them determine if the Sec 1042 tax deferral is sufficiently attractive to structure the transaction with the ESOP purchasing a “C” corporation compared to the benefits of it being structured as the purchase of an “S” corporation. The “C” corporation choice allows the Owner/Seller to defer taxes on the gain by reinvesting the proceeds into US based equity securities. This tax deferral can extend as long as the owner’s life and their heirs can receive the proceeds at the stepped-up basis without triggering tax on the gain. If the transaction is structured as an “S” corporation, it provides for the ability of the ESOP/Company to grow without paying Federal Income taxes on the income associated with the shares owned by the ESOP. Typically, ESOP trusts are not taxable entities.
There are no provisions at this time for an ESOP to be structured as a partnership or limited liability company. However, what’s important is the form of the company actually purchased by the ESOP, not what its organization form was prior to the transaction. For example, a “C” corporation shares can be sold to the ESOP and then later converted by the ESOP to an “S” corporation without jeopardizing the Owner/Seller’s Section 1042 gain deferment. However, if an existing “S” corporation is converted to a “C” corporation for the transaction 1042 tax deferral benefits, it must wait 5 years before converting back to an “S” corporation. In addition, a new corporate entity can be created to be the buyer of the assets of the company when there are assets to be excluded from the transaction or contingent liabilities that should remain with the Owner/Seller.
With an “S” corporation, any profit distributions (dividends) on non-ESOP shares must also be made in equivalent amounts to the ESOP based upon the shares owned by the ESOP. If an ESOP owns 100% of the shares in an “S” corporation the company will grow without paying Federal Income tax on its profits. This can rapidly result in very large cash balances in the ESOP which can be used to repay acquisition debt early or accumulated for future acquisitions of other companies. In the later case, the engagement of a wealth management company may be desired to hold, protect and grow the ESOP’s cash.
— Raising the Money
Historically, ESOP leveraged transactions were funded by the operating company borrowing against the assets of the company based upon the cash flow of the company and relending the loan proceeds to the ESOP. This precluded service businesses from doing an ESOP because they tend to own few assets to borrow against. This changed with the approval in recent years allowing SBA 7A guaranteed loans to be made direct to the ESOP, and it keeps the debt off of the company’s books. This can be significant for Architectural, Engineering and Construction service businesses since not having the debt on their balance sheet helps them maintain their performance bonding levels.
We work closely with two SBA direct lenders who can extend up to $5 million in SBA 7A loans and can add up to $10 million of mezzanine debt on top of that. In addition, a seller loan of 20% or more of the transaction value which is subordinate to the SBA loan and Mez debt will be treated by the SBA as the 20% down typically required from the borrowers of an SBA guaranteed loan. Depending upon the overall aspects of the transaction and fairness opinion, in many cases the Owner/Seller can receive additional compensation for their level of debt risk by receiving warrants to buy stock of the company in the future in addition to the higher interest rate on their sub debt loan.
Since SBA guaranteed loans always require a personal guarantee of the borrower, any SBA loans to an ESOP requires the personal guarantees of any owner of 20% or more of the company shares. Even in those cases where the ESOP purchases 100% of the company’s shares, either the top management of the company or the Owner/Seller are required to provide their personal guarantee of the loans.
ESOPs do not always have to be leveraged with outside debt. If desired, the company can advance excess cash to the ESOP to purchase shares from the Owner/Seller. In addition, the Owner/Seller can extend a loan to the ESOP for 100% of the purchase price. When the company has excess cash and undistributed accumulated earnings, the transactions can be structured to distribute some of these previously taxed earnings to the Owner/Seller without any additional tax impact on the Owner/Seller.
–Repaying the Loans
The Company can each year pay to the ESOP up to 25% of payroll costs (W-2 payroll), plus the interest on the debt and receive a Federal Income tax deduction for the amounts paid into the ESOP. Basically, this allows for a tax deduction of both principal and interest on the loans to the SBA Lender, mez lender or for loans owed to the Owner/Seller. In addition, if it’s an “S” corporation ESOP any profit dividends paid into the ESOP can be used to retire the debt early.
— The Attorneys
As expected, there are few attorneys with ESOP training and experience. Fortunately, you will only need one to represent the ESOP along with the Trustee. However, the Trustee may also insist upon them being able to employ legal counsel. and, lastly a transaction attorney will be needed to represent the Owner/Seller. Whew! In many ways the transaction with an ESOP is similar to a typical sale to an outside buyer. You as Seller just get to fund the legal fees for both sides of the transaction. But you do get to create your buyer.
In addition to the annual appraisal, the ESOP will need to hire a third-party administrator to manage the employees’ accounts with the ESOP and manage the annual allocation of shares to each person’s account. The third-party administrator may also be charged with repurchasing the shares of any vested employee who leaves and redistributing the shares of any non-vested employee who leaves employment with the company.
Clearly the Owner/Seller will need to engage a wealth manager to watch over and grow the funds received from the transaction, but the ESOP of an “S” corporation may also need to hire a wealth manager to manage its cash build up of profits without tax.
–Board of Trustees
The ESOP Board of Trustees typically hires the independent Trustee and the members of the Board of Trustees are typically selected by the Board of Directors of the company. This is significant today since former Owners/Sellers are now allowed to remain as CEO and Chairman of the Board of the operating company. However, when this is the case, the Owner/Seller will also be asked to personally guarantee the SBA 7A loan.
So what’s Next?
As you can see, there are a lot of moving parts to accomplish an ESOP goal. Due to the few numbers of knowledgeable service providers, we have taken on the task to become acquainted with the players so that we can feel comfortable introducing them to our clients when an ESOP is the best exit methodology. As needed, we can run somewhat of a simultaneous track to test first what the marketplace will bring from strategic buyers and compare that with the after tax results of taking the ESOP route. If your company clears the three hurdles above, please contact us if you would like to evaluate your options.
- Len Russek, a former CPA has been a Mergers & Acquisitions advisor for over 25 years both inside large corporations and as an intermediary during which he has been involved in structuring and negotiating the sale of hundreds of businesses. Contact him at 727-894-7888 or LRussek@TransworldMA.com.