The Intersection of ESOP Transactions and Corporate Finance

March 7, 2023
ESOP Transactions and Corporate Finance

Employee Stock Ownership Plans (ESOPs) and the ESOP transaction process provide numerous corporate finance and tax advantages to businesses. Using the ESOP structure to finance business is not new. Under the Employee Retirement Income Security Act of 1974 (ERISA), ESOPs are referenced specifically as a technique of corporate finance. It turns out that these employee benefit programs are particularly beneficial for the sponsoring business too.

ESOP Transactions and Corporate Finance: A Perfect Match

At the most basic level, an ESOP is a trust that purchases stock in an organization, effectively making it an owner of the company. That stock is redistributed over time to employee ESOP accounts which function as retirement accounts. The stock and benefits accrue over time until the employee-participant becomes eligible for withdrawal, referred to as a distribution. Less well-known to the general public is the fact that ESOPs are also extremely effective and advantageous corporate financing tools. ESOPs can be used to:

  • finance an ownership transition or business sale,
  • raise new equity capital,
  • refinance outstanding debt,
  • finance an acquisition, or
  • funding capital requirements.

Contributions and some dividends paid to the ESOP are tax-deductible and a company can fund the principal and interest payments of an ESOP's debt with pre-tax dollars.

Advantage of an ESOP Over Other Financing Methods

The primary advantage of an ESOP over other corporate financing methods relates to tax benefits. Establishing an ESOP allows a business owner to sell their company stock without paying capital gains taxes. The business itself also enjoys tax benefits, which are significant and are serious advantage over other financing methods.

  • S-corps that are 100% owned by the ESOP pay no federal income tax. Many states offer the same benefit related to state income tax.
  • C-corps that contribute profits to the ESOP, will find that their contributions are tax deductible. This saves the company money and still transfers wealth to the account holders, who are employees.
  • If the ESOP is leveraged, the company can make contributions to the ESOP to repay the loan. This makes both the principal and interest fully tax deductible to the company. In a conventional loan, only interest is tax-deductible.

In all of the above situations, companies retain money that they would have otherwise paid in taxes. Those funds can then be used to reinvest in the business.

The Role of ESOPs in Mergers and Acquisitions

As an acquisition financing tool, ESOP contributions can be used to pay principal payments on the acquisition debt using pre-tax dollars. ESOPs also tend to generate more capital internally which creates a strong balance sheet. This can make it easier for ESOP companies to obtain financing for buyout transactions.

ESOPs as a Financing Tool for Mergers and Acquisitions

The tax advantages of an ESOP improve cash flow, making it more feasible to undergo an M&A by increasing an ESOP’s purchasing power.

The Advantages of ESOPs in M&A Transactions

In addition to the cash flow benefits, ESOPs provide other tangible and intangible benefits to both companies.

  • Market for Stock. An ESOP provides a ready market for selling the stock of shareholders. Sellers benefit by obtaining guaranteed fair market value for their shares. The acquiring company benefits by using pre-tax dollars to fund the purchases.
  • An Alternative to Going Public. The selling company may be faced with going public in order to access funds, but may not want to do so. An ESOP makes it possible to sell the business without the complexity of going public. At the same time, it does not preclude the possibility of going public in the future if the time comes.
  • Fiduciary Review. Any acquisition undertaken by an ESOP must be reviewed and approved by the ESOP trustee. The ESOP trustee has a professional fiduciary duty to the employee-owners of the company. They are unlikely to approve an M&A that is not in the ESOPs best interests, which provides some added protections for both the buyer and the seller.
  • Succession Planning. ESOPs are often formed as part of an exiting owner’s succession plan. That means leadership succession is usually in place which can make it easier to for an outside investor to acquire an ESOP.
  • Financial Clarity. ESOPs must meet strict regulatory requirements. This means they have excellent financial records, which can simplify the due diligence process.

How an ESOP Transaction Process Helps Employee Retention in M&A

ESOPs are incredibly effective as an employee retention tool. Every employee has a real, tangible financial advantage to ensuring the company performs at its best. That advantage only increases with time, making it advantageous for the employee to stay with the company. The ownership culture of an ESOP helps ensure everyone works together in support of company goals and creates a motivated and productive workforce. Turnover is generally at a lower rate than non-ESOP companies and ESOPs tend to be more stable and avoid layoffs in hard times which is rewarded with employee loyalty.

Leveraging ESOPs for Post-Merger Integration

The advantages of acquiring an ESOP continue well after the merger. When an ESOP is acquired, employees generally know about it beforehand thanks to the communications transparency that is so common in ESOPs. The knowledge that the acquisition is in the company’s best interests can ease fears, helping employees accept and even support the changeover so that business continuity is uninterrupted.

ESOP Transactions & Corporate Finance Potential Risks and Challenges

All of the above is not to say that there are no risks or challenges associated with ESOP transactions and corporate finance.

  • Selling companies must find a buyer who is willing to acquire a company that is established as an ESOP and all of its corresponding rules and regulations.
  • Establishing an ESOP requires an upfront investment, annual business valuations and appraisals, strict tax and record-keeping compliance requirements, and the services of an ESOP trustee.
  • Once established, the company will be required to create a succession plan and may need to re-think how it communicates, interacts with, and rewards employees.
  • While the tax advantages are worth noting, they only apply if the company remains profitable and meets certain payroll ratios.
  • The ESOP company may need to offer a 401(k) retirement plan in addition to the ESOP plan in order to allow employees to diversify their retirement holdings.  
  • There will be accounting challenges, particularly related to the balance sheet. Although the ESOP holds the debt, accounting practices require the debt to also be reflected on the company financial statements. This can create the appearance of a company holding more debt than it does in reality. Accounts Payable and Receivable and the income statement are also affected.
  • If you are buying an ESOP, you will likely have to terminate the existing plan and replace it with one of your own. This requires you to pay distributions to all existing plan participants of the ESOP or roll the accounts in a 401(k), which can be expensive and must be handled with care.

How Aegis Integrates Employee Ownership With Financial Strategy

The ESOP transaction process can be extremely advantageous to the right company, but it cannot be entered into blindly. Aegis Trust Company specializes in ESOP transactions and consultations. We help business owners evaluate the risks and benefits of ESOP formation, help them navigate the formation process, and can provide ESOP trustee services afterward.  Contact us to find out if an ESOP makes sense for your business.

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