INTRODUCTION TO THE ESOP BUYOUT

WHITEPAPER | MAY 2017

Leland Miklovic | Managing Director

[email protected]
(404) 476‐4470

MER GER S & A C QU IS I TIONS | BU YO UT S | COR PORA TE S TRA TE G Y | CA P I TA L W W W .OP U S A P .C O M

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Introduction
The ESOP buyout is a An employee stock ownership plan (ESOP) is a tax‐qualified defined contribution employee
creative and flexible benefit plan that invests primarily in the stock of its sponsoring company. Structured as a
transaction structure that management or shareholder recapitalization, the ESOP buyout can be a compelling liquidity
allows shareholders to mechanism for company owners/shareholders while offering numerous economic and tax
generate liquidity through a benefits to the sponsoring company, selling shareholders and employees.
buyout of their stock in a
tax‐advantaged manner, Although an ESOP provides unique ownership opportunities for employees, it also creates a
while allowing employees to market for the stock of closely held company owners/shareholders. Shareholders are also
share in company ownership able to defer and potentially eliminate taxes on capital gains arising from the sale of their
at varying levels. ownership interests to an ESOP under certain conditions.

Moreover, the ESOP provides unique and flexible financing options

that allow a company to finance the buyout of departing owners
while generating significant corporate tax incentives. In this regard,
the ESOP buyout can be used as a corporate finance tool to
recapitalize the company.

There have been over 10,000 ESOPs implemented in the U.S. since inception in 1956. Various
rulings and acts from 1974 to 2001 have expanded the overall benefits and tax advantages to
company owners, thus making the ESOP an appealing alternative.

The Shareholder’s Dilemma

Owners and investors of closely held companies work hard and take big risks to grow their
companies and generate value. But often, much of a shareholder’s net worth is tied up in the
business. Generating liquidity can sometimes be difficult or time‐sensitive, and options may
be limited when selling shares of a closely held corporation. Selling to a third‐party buyer,
often a larger competitor, might not yield the intended results given the length of process,
extensive diligence and overall risks. In addition, other traditional liquidity options might not
be feasible, are too challenging, or do not yield the desired proceeds.

Alternatively, an ESOP buyout/recapitalization may be a solution to generating liquidity more

efficiently with greater certainty and a more attractive economic outcome. And more
importantly, selling shareholders are able to diversify their net worth while still maintaining a
partial equity interest if they desire.

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ESOP Buyout Structure

An ESOP buyout offers An ESOP can be established through direct cash or stock distributions over time, or
meaningful funding and alternatively, through borrowed funds in an upfront transaction—often referred to as a
structuring flexibility “leveraged” ESOP. In a leveraged ESOP transaction, one or more shareholders will typically
through a mix of third‐party sell all or a portion of their stock to the ESOP at fair market value. Based upon the amount of
and seller‐based financing, equity being sold, the transaction is financed with new debt from a third‐party lender or, in
either upfront or over time, some cases, from the owner directly. The ability to use owner (seller‐based) financing
in multiple transactions provides added flexibility and enhanced income potential to the shareholder.
depending on a
shareholder’s particular LENDER(S)
needs. COMPANY

Loan

Principal + Interest
Repayment

Internal Loan / Principal + Potential Collateral

Stock + Cash Interest Pledge
Contributions Repayment

Stock

SELLING
ESOP TRUST
Cash SHAREHOLDER

The leveraged ESOP is uniquely structured to achieve a particular shareholder’s goals and the
Company’s desired after‐tax cash flows. Moreover, the debt is structured to accommodate
flexibility in amortization and allow for organic company growth. And there are compelling
tax savings associated with financing the ESOP using a leveraged structure.

The shareholder can choose to sell its equity interests in one upfront transaction or gradually
over time. In the case of an owner/CEO, irrespective of the percentage of equity sold, the
owner may continue to retain control of day‐to‐day operations in his current position or
transition control to other senior management.

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Tax Advantages
Sponsoring companies Unlike other types of buyouts, an ESOP buyout can generate some very attractive and
benefit from the tax compelling tax benefits for the sponsoring company, participating employees and selling
deductions associated with shareholders.
ESOP‐related principal,
interest and dividends. When structured properly, the ESOP creates recurring corporate tax incentives for the
Moreover, if structured sponsoring company. Subject to certain limits, tax deductions may include principal and
properly, selling interest paid on ESOP debt obligations, as well as dividend contributions (although dividends
shareholders can indefinitely may be subject to AMT). These corporate tax deductions result in greater relative operating
defer capital gains taxes on cash flow, reduced taxes, and more rapid growth in equity
their proceeds resulting in value. The reduced corporate tax liability allows the
greater after‐tax proceeds company to free up more cash flow to reduce debt or fund
compared to other internal growth initiatives.
alternatives.
The accounts of employees who participate in the ESOP will
grow in value on a tax‐deferred basis as the company’s value
increases. Departing employees who sell their stock back to
the company may roll over such proceeds to a qualified
retirement plan (on a tax‐free basis).

Selling shareholders are also able to take advantage of powerful tax incentives if certain
criteria are met. Under §1042 of the Internal Revenue Code, selling shareholders are eligible
to indefinitely defer capital gains taxes under the following general conditions:

 The ESOP must own at least 30% of the company’s equity post‐transaction and
generally must retain the stock for at least three years following its purchase;
 The company must be a C‐Corporation (or have converted to a C‐Corp.) immediately
before ESOP implementation;
 Each selling shareholder must have owned his stock for the preceding three years
(irrespective of entity type); and
 The equivalent amount of sale proceeds must be reinvested, within a reasonable
time period, in qualified replacement property (QRP), which is defined as debt or
equity securities of qualifying domestic companies.

The selling shareholder determines what percentage of his sale proceeds will be invested in
QRP and thus subject to tax deferral. Through the use of a 1042 margin loan, the large
majority of the amount invested in QRP can be advanced to the owner without penalty or
taxation. The annual net interest cost of the 1042 margin loan (offset against interest income
on the QRP) varies over time but is often less than 100 basis points, which is meaningfully
lower than the tax savings.

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Employees
The ESOP buyout provides Similar to a 401(k) plan, the value of the ESOP grows over time on a tax‐deferred basis as the
employees the ability to value of the underlying investments (in this case, the sponsoring company’s value) increases.
become indirect owners, Moreover, an ESOP also creates powerful productivity incentives as employees become
upon vesting, through a tax‐ indirect owners of the company at no upfront cost to them. It’s no surprise that companies
advantaged retirement with ESOPs have been proven to outperform their peers.
savings vehicle that can
increase in value over time Employees are able to participate in the ESOP if they meet certain qualifications. In general,
as the company’s value participating employees are often 21 years of age or older with one or more years of company
increases. service and at least 1,000 hours of service within 12 months of ESOP initiation. Independent
contractors (1099 employees) are not eligible.

Following ESOP implementation, shares of stock are initially held in

a suspense account within the ESOP trust. Over time, as the
company makes ESOP contributions and the ESOP pays down its
debt, shares are released to individual employee accounts. Over
time, employees become indirect owners of the company subject to
a vesting schedule.

When employees retire or leave the company, their ESOP stock is

typically repurchased by the company within a defined timeframe. The company has a
“repurchase obligation” that is determined by multiple factors such as the ESOP’s vesting
schedule, ages of the employees, estimated repurchase valuation, etc. Since this obligation
can grow over time, the company will need to plan accordingly.

At the owner’s discretion, the company may also establish a separate management incentive
plan (MIP) that provides senior executives with additional equity incentives. The MIP is
separate from the ESOP and subject to certain limitations.

ESOP Buyout Considerations

There are a number of factors to consider when choosing to implement an ESOP. It is
important to work with a corporate finance advisor who can properly structure the ESOP and
manage the lender and valuation diligence processes. In addition, the advisor should have
existing relationships with ESOP lending institutions, legal counsel and valuation experts, and
have possess leveraged buyout/recapitalization experience.

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ESOP Buyout Considerations (cont.)

Compared to other liquidity One of the key attributes of the ESOP buyout is the company valuation. The basis for the
alternatives, the ESOP valuation is a fair market appraisal by an experienced, independent valuation firm. Such
buyout can offer appraisal forms the basis of value in the initial sale of stock to the ESOP. Every year thereafter,
substantially greater the company must obtain a valuation by an independent appraiser.
advantages including
flexibility in structure, speed At the time of ESOP implementation, a trustee must be hired by the company to represent
to close, greater after‐tax the ESOP employee participants. The trustee is appointed by the company’s board, which is
proceeds, company tax typically controlled by the owner. For corporate matters requiring a vote, the trustee will
incentives, and retained typically vote on behalf of the employees without specific direction. For major corporate
control, among many other issues, such as change of control, voting preferences/responsibilities may pass through to the
factors. individual employees.

Comparison to Other Alternatives

There are a number of internal and external liquidity alternatives available to
owners of closely held companies. Options such as a sale of stock back to the
company or to senior management often require outside financing and do
not provide corporate or shareholder tax incentives. In addition, a third‐
party company sale or buyout/recapitalization is highly dependent on
outside variables such as buyer demand and valuation levels, negotiating
leverage and posturing, and many other risks and uncertainties.

Compared to these alternatives, however, the ESOP recapitalization may provide some
compelling advantages:

 Speed—ESOP implementation generally takes two to four months;

 Structure—owner flexibility in transaction structure and financing options;
 Confidentiality—no sharing of information with competitors;
 Stability—reduced customer concerns and employee uncertainties; and
 Governance—minimal changes in post‐transaction control without outside conflicts
of interest or disparate agendas.

Finally, the ESOP buyout may generate higher net after‐tax proceeds on both a cumulative
and present value basis, compared to other exit options, including an internal company
buyback, external sale or third‐party recapitalization.

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The Process
The ESOP process begins Once a decision has been made to formally evaluate the ESOP alternative, there are several
with a highly detailed key steps in the process:
feasibility analysis and
valuation, where multiple 1. Initial Feasibility Analysis and Valuation. A qualitative and detailed analytical analysis of
ESOP structures are analyzed the ESOP buyout is undertaken, utilizing multiple transaction structures to determine
in depth based on various the after‐tax consequences, risks and advantages. As part of this exercise, Opus works
operating assumptions,
closely with management to construct detailed financial projections with supporting
goals of the selling
shareholder(s), and any assumptions as well as a full company valuation. A third‐party fair‐market valuation is
limiting factors. also initiated.
2. Supporting Due Diligence Materials. A confidential information memorandum (CIM) is
constructed with supporting due diligence materials. These materials, which include
much of the information from Step 1 (above), are utilized by external lenders, third‐
party appraisal firm and the ESOP trustee.
3. Lender and ESOP Trustee Approvals. Direct communication with lenders and other
constituents is initiated to evaluate the transaction and agree on the proper
capitalization and structure. Legal documentation is also initiated.
4. Closing Process. Employees are notified and are provided the opportunity to formally
participate, transaction documents are finalized, and funds are wired.

Frequently Asked Questions

How do I know if an ESOP is worth consideration?

The determination of which type of ESOP buyout to implement, and how it is specifically
structured, is dependent upon the corporate entity type, goals of the selling shareholder(s),
and the amount of proceeds being sought, among other aspects. The ability to structure an
ESOP is based on multiple factors, some of which include the company’s pre‐tax profitability
and outstanding debt level, equity ownership composition, employee makeup (number of
employees, compensation level, etc.), as well as other company‐specific attributes.

It is important to work with an advisor who can identify the key drivers of an ESOP transaction
based on a particular company’s characteristics and limiting factors. Given that the ESOP is a
customized solution, discussing a company’s situation in depth with an advisor is the most
prudent first step in determining whether consideration of an ESOP is warranted.

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Frequently Asked Questions (cont.)

In order to qualify for an ESOP buyout, does the company need to be a certain entity type?

Any company can structure an ESOP as long as it is a C‐Corporation or S‐Corporation

immediately before ESOP implementation. A limited liability company (LLC), for example, can
convert to a C‐Corp. or S‐Corp., depending on its specific circumstances, thus offering
significant flexibility with regard to implementation and structure. In some cases, an S‐Corp.
may wish to convert to a C‐Corp. immediately before implementation for a number of
reasons, which include the ability to defer income taxes on capital gains from proceeds. An
advisor will be able to explain the specific advantages and considerations of each scenario.

How does a C‐Corp. ESOP differ from an S‐Corp. ESOP?

Both C‐Corp. and S‐Corp. ESOP structures offer varying advantages and disadvantages
depending on the circumstances. Because each company and specific shareholder situation
is unique, and because there is significant flexibility in how to structure the transaction,
multiple scenarios need to be modeled in detail to determine the structure that provides the
greatest risk‐adjusted advantages.

A C‐Corp. ESOP offers both selling shareholders and sponsoring companies the opportunity
to reduce or defer income taxes. With regard to individual tax benefits, if the ESOP is
structured properly, the selling shareholder may indefinitely defer capital gains taxes on
transaction proceeds. From a corporate tax perspective, a C‐Corp. may deduct principal
payments on ESOP‐related debt and dividend payments up to a threshold, thus reducing its
pre‐tax income and corporate tax liability. In addition to these deductions, the C‐Corp. can
deduct an unlimited amount of interest expense associated with all of its debt obligations.

While an S‐Corp. ESOP does not provide the same tax deferral benefits to selling shareholders
as in the C‐Corp. scenario, it does provide other noteworthy tax benefits. Similar to a C‐Corp.
ESOP, an S‐Corp. may deduct principal and interest payments on ESOP‐related debt up to a
threshold, thus reducing pre‐tax income and requisite shareholder tax distributions. An S‐
Corp. ESOP is not required to pay its pro rata, shareholder portion of federal income taxes
(and, in many cases, state income taxes) since the ESOP is considered a tax‐exempt entity. In
the case of a 100% ESOP‐owned S‐Corp., there are no income tax distributions made, and
much of a Company’s pre‐tax income is retained internally (except for the necessary funding
of repurchase obligations). As a result, cash flow that would otherwise be distributed for tax
purposes is often used to aggressively pay down debt or invest in growth initiatives. In this
case, growth in shareholder value can often be accelerated.

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Frequently Asked Questions (cont.)

Under what circumstances would selling shareholders be eligible to defer taxes on capital
gains?

As mentioned above, a C‐Corp. ESOP, if structured properly in accordance with §1042 of the
Internal Revenue Code, allows the selling shareholder to indefinitely defer capital gains taxes
on transaction proceeds if invested within 12 months following the transaction (or the
equivalent proceeds three months before the transaction) in low‐risk, low‐yield U.S. securities
that are commonly referred to as qualified replacement property (QRP). While the yield on
QRP is low, the selling shareholder can often borrow against the QRP at a high advance rate
and therefore re‐invest or use the proceeds however he/she sees fit. If the selling shareholder
were to pass away while invested in QRP under §1042, his/her invested proceeds would
receive a tax‐free, step‐up in basis prior to being distributed to heirs.

In some cases where states have high state income taxes, the total capital gains (including
other related net investment income taxes) blended tax rate can approximate 30% or more.
Therefore, the additional net proceeds, which would otherwise be paid in taxes, makes this
ESOP structure very compelling compared to other traditional alternatives.

What advantages does an ESOP buyout provide compared to a third‐party sale or majority
recapitalization (private equity buyout)?

An ESOP buyout allows selling shareholders the ability to structure a transaction that is highly
flexible, taking the form of a minority or majority recapitalization, or a 100% sale. The key
advantages of an ESOP compared to other more traditional third‐party exit transactions
include the following:

 For selling CEOs, the ability to maintain full control of day‐to‐day operations, most
corporate decisions, and the makeup of the board of directors, irrespective of the
amount of equity sold
 Flexibility in what percentage of the company is being sold to the ESOP, how the
transaction is financed (third‐party financing, company cash, seller notes, etc.), the
ability to put in place warrants or synthetic equity as an enhancer to selling
shareholders, etc.
 Potential individual tax savings through the deferral of capital gains taxes (for
qualifying C‐Corp. ESOPs) resulting in greater after‐tax proceeds
 A transaction structured as a sale of stock versus a sale of assets
 Reduced corporate taxes as a result of ESOP‐specific corporate tax deductions
 Employees become owners (on a tax‐deferred basis) and overall productivity tends
to increase

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Frequently Asked Questions (cont.)

How does an ESOP buyout compare to an inside sale of stock to other shareholders or senior
management?

Whereas an ESOP buyout allows more flexibility, control and negotiating leverage for selling
shareholders, the inside sale may be subject to ongoing negotiations between seller(s) and
buyer(s) on future valuation, governance/control and major corporate decision‐making. In
addition, an inside sale often requires the purchasers to use after‐tax proceeds to acquire the
stock and may also require 100% financing from the selling shareholder(s). An inside sale
would not allow the company to maximize tax deductions as is the case with an ESOP, nor
would it allow for tax deferral of shareholder proceeds. For these reasons, an ESOP will most
likely provide more compelling qualitative and economic advantages than an inside sale.

Does it matter that a shareholder can defer taxes upfront through an ESOP structure since
he/she will be paying taxes eventually on any future exit proceeds?

Compared to a transaction that is taxed upfront, total proceeds from a tax‐deferred ESOP
structure are greater by as much as 30% (or more) of total pre‐tax proceeds. Therefore, there
is an opportunity to invest 100% of pre‐tax proceeds upfront through QRP, thus generating
returns on greater amounts of principal over more time, versus the alternative. Moreover,
selling shareholders have the option to fund a portion of their buyout through seller notes,
which typically pay a rate of interest of 8% to 12% in addition to potential additional return
from warrants or synthetic equity. For these reasons, an upfront ESOP transaction can
provide greater economic value.

Why should a shareholder hire a corporate finance advisor to analyze, structure and complete
the ESOP…why not just work with a bank directly?

Because of the flexibility in structuring an ESOP buyout to meet the goals of selling
shareholders as well as the unique operating performance of each company, care must be
taken to analyze various alternatives. The right corporate finance advisor can proactively and
creatively structure the most advantageous transaction, including the appropriate level and
type of debt financing, among various structures that are analyzed. The advisor will also work
with multiple third‐party lending sources in order to implement the most preferred structure
at the most favorable economic terms. The advisor manages the process from start to finish,
coordinates communications with all constituencies (owner, lender, attorney, ESOP trustee,
etc.), and represents the best interests of the selling shareholder(s). Having an advisor that
has significant leveraged recapitalization experience working on the selling shareholders’
behalf allows for a more seamless transaction with fewer negative surprises.

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Frequently Asked Questions (cont.)

Is a company required to borrow third‐party financing to finance an ESOP buyout? How much
can be borrowed? Can an ESOP be structured if a company is adverse to large amounts of
debt?

An ESOP can be funded by any source of capital, including outside equity or cash on the
balance sheet. However, many ESOPs are funded almost entirely through debt, including
third‐party bank debt, third‐party subordinated debt (mezzanine financing) and/or seller‐
based financing. Financing an ESOP buyout with debt allows for upfront and future liquidity
to shareholders on a corporate tax‐advantaged basis (i.e. using available pre‐tax income that
would otherwise be used to pay taxes).

In low‐rate environments, the use of third‐party financing is a particularly attractive option.

Third‐party lenders will often lend primarily on a company’s collateral value, and secondarily,
if large enough, on EBITDA (earnings before interest, taxes, depreciation and amortization)
and operating cash flow. Any additional financing needs are typically sourced through
subordinated debt (third‐party or seller‐based). The use of seller‐based financing can be
attractive given the inherent rates of interest, flexibility of amortization, and the ability to use
warrants or synthetic equity to further enhance the seller’s returns and income. Irrespective
of the type of debt utilized, there are significant corporate tax benefits available through the
deduction of both principal and interest of ESOP‐related debt. In this respect, utilizing debt
to finance an ESOP can offer noteworthy benefits in terms of taking advantage of excess pre‐
tax income while still maintaining reasonable coverage ratios.

While we don’t recommend that a company employ excessive debt, it is important to

acknowledge both the advantages and risks to such a structure where there might be sizeable
post‐transaction debt on the balance sheet. The optimal capital mix and sourcing is based on
a particular company’s circumstances. In one case, it might make sense to use all third‐party
senior bank debt to fund the transaction. In another case, using a combination of third‐party
senior debt plus seller notes is most optimal. In some cases, financing the transaction with
mostly seller‐based financing is the only option available.

The use of seller‐based financing, which is inherently more flexible and modifiable than third‐
party debt, can provide the cushion required to reduce risk to the selling shareholder(s) if
future company cash flows are unexpectedly reduced. It is important to note that each
company and situation is unique and should be evaluated accordingly by a corporate finance
advisor that can analyze the risks and considerations, both quantitatively and qualitatively.

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For More Information

Under the right circumstances, a leveraged ESOP buyout can
provide some very compelling advantages, including structuring
flexibility, maximizing after‐tax liquidity, and maximizing
corporate tax deductions. If you believe an ESOP transaction
might be an alternative worth consideration, Opus Advisory
Partners can provide you with more specific qualitative and
analytical guidance to help you evaluate this decision.

For more information about the ESOP buyout and how it might apply to your specific needs,
please contact Leland Miklovic, Managing Director, at (404) 476‐4470 or
[email protected].

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D IS CLO SURE
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