The challenges that many of the country’s banks are experiencing are very well publicized and are affecting financing for companies of all sizes and across all industries. Some companies that were once coveted credits of the banking industry are now having trouble renewing senior facilities or are having them renewed under more onerous terms in spite of continued performance. Banks have also pulled back on the amount of financing they are extending to buyers of companies that want to rely on financing to support the purchase (exhibit 1). This has had several effects on the M&A market; lower transaction multiples, more reliance on equity as capital for the acquisition and higher return expectations on investments.
Exhibit 1: Average Debt Multiple of Middle Market LBO Loans
The sale of a company to an Employee Stock Ownership Plan (ESOP) is designed to mimic the third party market, so these transactions have been similarly affected by the leverage markets. However, ESOP transactions are extremely flexible which makes the closing of a transaction more likely than a sale to a third party.
ESOP valuations are often heavily weighted towards a discounted cash flow analysis of the company’s five year projections. As a recovery is easier to predict within this time frame, valuation can be higher for an ESOP transaction today. One of the key elements that often plays a larger role in ESOP transactions and attributes to the aforementioned flexibility is seller financing.
In late 2007 and early 2008, banks were extending large amounts of credit at very flexible terms which caused M&A activity to rise to all-time highs. ESOP transactions followed suit and many were financed primarily with outside financing; both senior and subordinated. Seller financing also played a significant role in transactions during this time frame as it often provided the best tax profile for both the selling shareholder as well as the company.
ESOPs receive many tax benefits from the Internal Revenue Service, but the most powerful may be that the entity that holds the stock for the employees, the ESOP Trust, is exempt from federal income tax. This means that companies that are subchapter “S” corporations, and owned by an ESOP, pass their income through to a tax exempt entity and therefore the Company pays no federal income tax on any of its earnings. Seller financing is often needed to provide the ESOP with the funds needed to purchase 100% of the company, especially as outside financing has contracted.
Sellers have also been motivated to provide financing due to the returns that they can earn on this subordinated debt. In today’s market, seller financing that is behind a senior debt piece can return upwards of 20% annually through interest payments as well as participation in synthetic equity. Since an ESOP transaction is designed to mirror a 3rd party sale, a seller taking subordinated financing should be compensated similarly to an outside subordinated lender. The overwhelming majority of entities that provide this type of financing want part of their return in warrants or other synthetic equity vehicles that provide for a bigger upside than simply interest payments. The practical application for a seller providing subordinated financing in an ESOP is that they can get a second bite at the apple. Once the debt is retired, the seller holds warrants for a significant portion of the equity of the business; statutorily must be less than 49% of the company but practically between 20% – 40%. These instruments have value which can be sold to the ESOP and the seller can receive proceeds for a second time.
With the uncertainty of the lending environment, many deals have recently been structured with 100% seller financing. In this case, multiple instruments can be designed to create a senior like piece and a subordinated like piece. In this situation, the shareholder remains in complete control and can appease other interested parties like sureties. Additionally, the seller often functions as a flexible lender that can defer or forgive payment if the Company comes under financial duress.
Seller financing has historically played a significant role in ESOP transactions and has become more integral in today’s lending environment. The presence of seller financing often benefits the Company as well as the selling shareholder as they can earn a market return and have a greater certainty to close a transaction in an uncertain M&A market.