The recent M&A market has been defined by many different types of buyers, but the most publicized has been the consolidators. The consolidation of the financial industry has dominated the headlines, only rivaled in press coverage by the reorganization of the auto industry. Step away from the public markets and the headlines and you see similar behavior taking place amongst privately-held companies. Whether a company is unable to survive in this economy or an owner wants to relieve some management responsibility, many business owners are seeking to sell their company or merge with strong partners. Due to the significant tax advantages that are provided to companies that have Employee Stock Ownership Plans (ESOPs), they often fill this position of strong partner and end up as consolidators.
The efficiency of cash flow in an ESOP-owned company makes that company a superior acquirer in any market, but especially in today’s environment where cash has become harder both to earn and to borrow. ESOP owned companies contain several qualities that make them effective consolidators:
- Employee first culture
- Strong Borrowers for bank financing
- Tax advantages to selling shareholder
- Cash flow of target more valuable to buyer than target
Consider the following example: The target company has $9 million in EBITDA, $3.3 million in free cash flow and has an agreement to be acquired for $60 million. The acquiring company is able to borrow $30 million (3.3x EBITDA) in a mixture of senior and subordinated debt and contributes $30 million of equity to complete the purchase.
Figure 1: Target Company Summary Financials
By all accounts, this is a fairly standard acquisition in which the acquiring company will use the target company’s earnings to repay the borrowed money and realize a return by benefiting from synergies, growing the business and repaying the debt. However, if the acquiring business is an ESOP, the acquirer can pay down the debt much faster by eliminating the $3.2 million the target was paying in income tax (see figure 1 above). In the chart below you can see that the value of the equity in the target company increases in value faster with an ESOP acquirer rather than a non-ESOP acquirer.
Figure 2: Equity Value Comparison
The result is a higher rate of return for the ESOP acquirer. In the above scenario the ESOP acquirer realizes a 21% rate of return while the non-ESOP acquirer’s rate of return is 14%. With the accelerated debt repayment, the ESOP acquirer can now use the target cash flow for bolt on acquisitions, organic expansion or other corporate needs, further adding to its return. These compelling economics are the biggest reason why we’ve seen companies that are owned by ESOPs become active acquirers.
The opportunity to accelerate returns to the buyer as well as the potential for favorable tax treatment on sales proceeds, the ability for the buyer to pay a little more for the business to win an auction and the benefit to a target company’s employees who become beneficiaries of the ESOP post-transaction all make the ESOP-owned company an attractive consolidator. In the best cases, the buyer wins with a superior rate of return, the seller wins by maximizing after-tax proceeds and the employees win by becoming owners through the ESOP.