Financing a first-stage ESOP transaction can take many shapes.
If your company is considering an ESOP transition, it’s important to know your options and the flexibility you have with structuring the transaction. You also need to be aware of key pieces of financing and how they could come into play post-transaction.
In this article, we’ll discuss the key components of ESOP financing. But before we begin, allow us to explain how an ESOP is intended to work as well as how it can be used for financing when selling or transferring ownership of a business.
What is ESOP Financing and Why Would You Finance an ESOP Transaction?
A private company employee stock ownership plan (ESOP) gives employees ownership interest in the company in the form of shares of stock. The ESOP acts as an additional retirement benefit to the employees.
Additionally, an ESOP is commonly used as a business ownership transition tool.
Financing an ESOP transaction is a vehicle to provide liquidity to selling shareholder(s) when selling a company. The ESOP takes out a loan to buy a specified number of shares at fair market value from the owner or current shareholders. The shares bought with the borrowed funds are held in a suspense account and can be used as collateral for the loan. As the loan is repaid, the shares in the suspense account must be released from the pledge and allocated proportionally to individual employee accounts.
To summarize, the purpose of ESOP financing is a leveraged buyout, and as such, the transaction may need to be structured differently from traditional loans to fund company growth.
How Does ESOP Financing Work?
If your company cannot fully fund an ESOP on its own, you will need to collaborate with a lender. The most typical source of financing will come through an institutional foundation like a bank, but if you’re structuring a 100 percent ESOP transaction — or have some leverage on your balance sheet already — you’ll likely need other sources of financing to cover the full value.
Additional Funding Through a Seller Note or Alternative Sources
Seller notes may be necessary if traditional financing can’t cover the full value of the buy-out. It often comes from the seller in the form of a seller note or alternative sources of capital such as mezzanine financing. These alternative sources are more expensive than traditional bank loans but could provide more flexibility and offer the liquidity the seller is seeking.
The extent of seller notes will vary based on the liquidity goals of the selling shareholder(s) but can also include an added layer of flexibility in the form of warrants. Warrants can provide the company with improved cash flow in the years following the transaction, while also giving the seller the ability to benefit from the future growth of the company.
Seeking a Lender with Direct ESOP Experience
Although not a necessity, working with a lender with experience in ESOPs will likely help the process move more smoothly. This is especially true in the underwriting process, as having a thorough understanding of how ESOPs work allows the lender to maximize lending capacity.
Tax Implications
One such instance is understanding the tax benefits an ESOP provides, and how that assists debt service.
An S Corporation that is 100 percent ESOP-owned now has 100 percent of its profits available to service the debt, whereas pre-ESOP, a portion of those profits were either paying taxes directly or making tax distributions to the shareholders.
The Role of Creating a Financial Covenant Agreement
Another key component of an ESOP financing structure is a financial covenant, which is a commitment or agreement made by the borrower.
Necessary Alteration for ESOPs
Traditional debt service and leverage ratios will need to be altered in an ESOP transaction due to the unique accounting implications for leveraged ESOPs.
On the balance sheet, debt-to-equity ratios take a double hit — first with the financing to buy out the seller, then also with the repurchased shares essentially being treated as a treasury stock transaction, being recorded as contra-equity.
Debt service ratios typically involve Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) as the benchmark, but often in ESOP financing, ESOP compensation is also an add-back (EBITDAE). This is due to ESOP compensation being largely a non-cash item during the de-leveraging phase.
3 Crucial Covenant Considerations
It is therefore important for lenders to understand the mechanics of ESOP accounting and to properly tailor covenants accordingly. ESOP compensation could spike in years of high growth and/or additional shares contributed, and a traditional debt service ratio could be tripped even in a high-profit year.
As you’re working through the overall ESOP transaction as well as the financing structure, it’s important to assess all of your options and weigh them against:
- Seller goals
- Future company projections and potential strains on cash flow
- Potential pressure on operations due to covenant considerations
Learn More About ESOPs and Business Transitions or Buy-Outs
An ESOP loan enables the financing of your company's sale to your employees, granting them ownership interest while creating liquidity for you. If your company is contemplating an ESOP transition, it's crucial to understand your options and the flexibility available in structuring the transaction.
You don’t have to do it alone. Our ESOP experts specialize in helping private companies and their owners prepare for and execute business transitions.
Explore our ESOP Services and reach out directly to see your options.