A company’s prosperity depends on many crucial factors: maximizing growth and profitability, ensuring sound financial management, maintaining robust operations and processes, and paying attention to customer service, among others. If your company is organized as an employee stock ownership plan (ESOP), however, long-term success requires something more: the ability to shift your strategy throughout the company’s life cycle.
Over the past two decades, ESOP acquisitions have become increasingly prominent in the mergers and acquisitions market. According to the National Center for Employee Ownership, ESOP-related acquisitions have increased fivefold since 2011, and the number of ESOP acquisitions each year is now equal to (and may even outpace) the formation of new ESOPs.1 Read on to discover why this is such a powerful strategy—and to learn best practices for your company to achieve a successful ESOP acquisition.
Why ESOP-Owned Companies Make Superior Acquirers
Compelling economics are driving this significant trend of ESOP-owned companies becoming active buyers. First and foremost, if you are a 100% S corporation ESOP, your company does not pay income taxes. These tax savings can allow excess cash to accumulate very quickly, generally well above the ESOP’s repurchase obligations. And you can use that cash for other working capital needs, capital expenditures, and, importantly, acquisitions.
ESOP-owned companies have several additional advantages over other buyers:
- Sellers may prefer your company’s employee-first culture because it typically will benefit their employees and help to preserve the target company’s culture and legacy.
- ESOP acquirers can offer selling shareholders potential tax advantages.
- ESOP companies often have a better understanding of their own valuation and are strong candidates for bank financing.
- A target company’s cash flow is more valuable to an ESOP buyer than to a non-ESOP buyer.
Consider the following example describing the economic impact of an ESOP acquisition. Let’s say the target company is an S corporation with an assumed federal tax rate of 40%; $10 million of EBITDA; and a letter of intent (LOI) to be acquired for $60 million (6.0x EBITDA). The buyer borrows $30 million (3.0x EBITDA) of senior debt and contributes $30 million of company cash to complete the purchase. In this fairly common type of acquisition, a non-ESOP buyer 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, an ESOP-owned buyer can pay down the debt much faster by eliminating or reducing the amount of income tax the target pays—in some cases, without even having to borrow funds to complete the acquisition.
Because your 100% ESOP-owned S corporation does not pay taxes, you can accumulate money on your balance sheet to use for growth and acquisitions. Additionally, you can ultimately use tax savings accrued from the target company (approximately $4 million annually in this example) for additional acquisitions, organic expansion, or corporate obligations such as payments to retiring ESOP participants, further adding to the company’s return on the investment.
Now let’s modify our example to consider it from the seller’s perspective. Selling the company to a third party would likely mean the shareholders’ proceeds are taxed at a blend of capital gains and ordinary income tax rates (assumed to be 29%). So an ESOP buyer paying 6.0x EBITDA is equal to another third party paying 8.5x EBITDA!
To further expand, by selling to an ESOP company and electing IRC 1042, the seller has the ability to defer all capital gains taxes. Accordingly, the after-tax proceeds are equal to the sale proceeds of $60 million. In order to realize the same after-tax proceeds in a third-party sale to a non-ESOP company, the before-tax proceeds would have to be $85 million. It’s no wonder ESOP-owned companies have higher success rates in acquisitions compared with non-ESOP-owned companies.
How to Make an ESOP Acquisition Work for You
When pursuing an acquisition, it is imperative that your ESOP company’s management team and board members understand the effects of adding a new group of employees as beneficiaries of the ESOP. Following the sale, your company’s equity will most likely increase, but it will now be spread among a larger employee base, which will change existing employees’ ESOP account values. To avoid negatively impacting existing ESOP beneficiaries, company leadership should carefully consider options such as issuing new shares in conjunction with an acquisition, excluding or limiting the target company employees’ participation in the ESOP, and buying back shares allocated to existing ESOP beneficiaries.
Here are a few more best practices to help your company ensure a positive outcome:
- Don’t overpay. Many companies, in a frenzy of excitement during the negotiation, overpay for acquisitions. Do not underestimate the need to stay disciplined around the acquisition strategy. Be realistic about the impact of the target—and make sure the acquisition is accretive. You must conduct diligent financial analysis of the potential return on investment and cash payback. Take time during the negotiations to regularly review your assumptions.
- Keep your business on track. Acquisitions are very time-consuming, leaving little occasion to concentrate on the day-to-day operations of the core business. Most of the workforce should remain focused on existing customers while a select few work through acquisition and, ultimately, integration issues. Make sure you have a strong team of M&A professionals to assist your staff throughout this process.
- Don’t overleverage. Taking on too much bank debt can be disastrous. To avoid this situation, make sure that you understand how much capital to put into a deal and that you have strong, trusted relationships with lenders. Detailed financial modeling that addresses several different scenarios will help you avert potential failures.
- Plan for integration. The financial projections might make perfect sense, but they will not be meaningful without a solid integration plan. Realistic planning is critical to success; without it, you could lose the expected synergies. Establish a plan with set milestones for measuring the integration so you can make corrections as needed. Furthermore, if the ESOP is to have a positive effect on motivation, productivity, and success, it’s vital for management to maintain effective communication with both the acquiring and target company participants.
An Experienced Team Can Help You Maximize Value Through a Strategic ESOP Acquisition
Your ESOP-owned company has a variety of options as you explore strategic alternatives to achieve your growth goals. To gain enhanced value from an acquisition, it is crucial that your company conduct proper due diligence and carefully consider the terms of the deal. Engaging the services of an investment banker, financial advisors, and legal counsel can help protect everyone involved in the transaction process.
Some 98% of ESOP acquisitions are reported as successful.2 With the right team and the appropriate structure, your ESOP acquisition can be one of them. If you would like more information about making acquisitions, please contact us.
1. “ESOP Companies: More Successful Acquisitions,” Employee-Owned America.
2. Cromlish, Suzanne M., “Empowering the 99% ... One ESOP at a Time! A Mixed Methods National Study of Acquisitions by Employee Owned Companies (ESOPs),” Case Western Reserve University, August 2017.
