This year is expected to be full of opportunity for many privately held companies, including those owned by Employee Stock Ownership Plans (ESOPs). An essential component for companies to take advantage of these opportunities is a proper capital structure.
Recapitalizing or restructuring the balance sheet occurs in the public and private marketplace on a regular basis. Recent highly publicized examples include the government equity infusions in U.S.-based financial institutions and auto manufacturers. ESOP-owned companies should similarly avail themselves of opportunities to adjust their capital structure.
While this article addresses some of the unique capital structures of ESOPs, many of these capital restructuring strategies apply to all companies.
Reasons to recapitalize / restructure the balance sheet include:
- Reduce high interest cost and stop accruing interest
- Free cash flow for growth and expansion
- Comply with senior debt covenants
- Match return of seller instruments with risks
- Generate new capital to reduce debt or meet growth opportunities
The sale of stock to an ESOP is usually a leveraged transaction facilitated by outside or seller financing which is then used by the ESOP to buy stock in the company. In the case of seller financing, the former shareholders can choose to defer interest and principal payments to improve the cash flow of the business and, as a result, delay their liquidity event.
An alternative to deferring, or forgiving payments, involves writing down or exchanging a portion of the seller debt in return for equity or synthetic equity. This provides flexibility to the company by freeing up cash flow and offers the debt holder (seller) the appropriate return for reducing the amount owed. From a fiduciary perspective, the dilution of the ESOP by the issuance of equity (including synthetic) has to be weighed against the viability of the company (and value of the ESOP) if the debt was not exchanged.
If an ESOP-owned company is having trouble servicing debt held by an outside lender, an equity infusion might be the best course of action. In an S-Corporation, this can be difficult as many institutional investors are not qualified investors for S-Corporations but there are other strategies that work. For C-Corporations, the universe of potential investors is much larger. Investors familiar with ESOPs see this as a great time to invest in ESOP-owned companies, given the compelling economics and intangible factors that ESOPs provide.
Significant changes to capital structure may involve shareholder or board approval. In an ESOP-owned company fiduciary concerns need to be addressed for any action that may impact the employee-owners. This should be easy to achieve with a well-designed plan since any recapitalization or restructuring is executed to provide a better future for all parties involved.
If restructuring the balance sheet is important for your business, this is an opportune time to restructure seller notes, raise equity to reduce bank debt or execute growth strategies.