An Employee Stock Ownership Plan (ESOP) is a company sponsored, employee benefit plan that is analogous to a profit sharing plan. For privately held business owners, ESOPs can be a liquidity strategy that offers numerous benefits to the owner, business and its employees. These plans are usually leveraged (using debt to acquire the stock), and the capital borrowed can be different than debt incurred in normal course of business.
Companies that borrow funds to establish an ESOP typically have several common attributes. These characteristics include strong and recurring cash flow, steady historical and projected growth and a strong management team, just to name a few. When these characteristics come together, companies have the ability to leverage the transaction through various capital sources. Leveraging the company through debt provides the ability to turn the shareholder(s) likely largest illiquid asset (private company stock) into liquidity while maintaining the legacy of the company and its employees.
Traditional Commercial Borrowing
When companies borrow funds from a bank in the normal course of their business cycle, they approach the lender with a request to establish a loan for a certain purpose. The most common requests are working capital needs (bridge gap of short term assets and corresponding liabilities) and acquisitions of fixed assets (equipment, real estate, improvements, computers, etc.).
The structure of commercial loans can take very different forms, but typically have one common attribute. Security. A working capital line of credit borrows against short term assets (accounts receivable and inventory, and possibly marketable securities). These assets are then margined at various percentages based off of eligibility, business cycles and current market indices. Fixed assets are also margined based on acquisition costs versus the characteristics of the collateral. New assets typically require less equity than those that are used and are often accompanied by a requirement for an appraisal.
Borrowing in a Leveraged ESOP
Borrowing to implement a leveraged ESOP carries the same principals of standard commercial lending. However, leveraged ESOPs typically have additional considerations. A company who establishes an ESOP will normally continue to have a working capital line of credit, but will also borrow funds (on a termed amortized basis) to buy the shares of the company. The term note used to acquire the stock and provide liquidity to the selling shareholder(s) is likely considered an “air-ball” to the bank. An air-ball loan is considered to have no collateral value assigned to it, resulting in lending only on company cash flow. In S-Corp ESOP transactions, the ESOP does not pay federal income tax on its share of earnings based on its percentage of ownership, resulting in increased cash flow to service debt. The bank’s comfort level to extend an air-ball loan can increase due to the added cash flow from not paying these taxes. While the ESOP purchases the shares, the loan is almost always listed at the company/sponsor level due to the assets and cash flow which are required to service the loan.
An ESOP transaction is complex and results in a significant change to the balance sheet, which requires careful consideration in establishing loan structure and covenants. While the loan covenants can be similar in nature for both types of loans, they do take on different characteristics which should be evaluated carefully. Download our quick reference guide to Leveraged ESOPs vs. Traditional Borrowing here.
When considering an ESOP transaction, shareholder(s) will want to ensure the company and senior management are united and ready for transition. Carefully selecting the right financial advisor who can guide the shareholder(s) and company management on all aspects of the transaction – from feasibility to providing capital to closing – is invaluable. Your lending partner in an ESOP transaction should demonstrate a history of experience and expertise, which will allow them to correctly structure the ESOP transaction’s terms and conditions. When all of these features align, borrowing for an ESOP transaction will prove to be a smooth and rewarding event for everyone.