This post is excerpted from the forthcoming book The One Percent Solution, 2nd Edition.

In the last chapter we outlined the mechanics of a leveraged share repurchase as a means of obtaining partial liquidity from a business.  In this chapter, we’ll talk about using a leveraged Employee Stock Ownership Plan (ESOP) for a similar purpose.

Why Would You Use an ESOP for Liquidity?

If your company is similar to the kind of businesses I describe below, then you might want to consider an ESOP for partial (and, perhaps ultimately, total) liquidity for a number of reasons:

• A properly structured ESOP can provide liquidity for a portion of an owners’ shares at a reasonable price.  That reasonable price is “fair market value as determined by independent appraisal.”  That won’t be a strategic price and won’t reflect potential synergies.  But you might not get that anyhow, depending on the nature and position of your company within its industry.
• You don’t sell to outsiders.  You’ve heard the expression that: “Nothing will change after the sale/merger.”  What you know is that things will change.  When you sell to an ESOP, you typically have the same players doing the same things under a new ownership structure.  If things change it is because you and others want them to change.
• You may maintain “control” of the business, but if you do, you had better be open to transparent financial management if you want the ESOP to succeed and for your employees to have any faith that it is a real benefit.  This is an enormously important benefit, but it means that you and others in your company will have to communicate with your employees about the ESOP.
• The ESOP may provide time for smooth, internal management transitions.
• Contributions and distributions to an ESOP are tax-deferred (and ultimately taxable to employee beneficiaries), so a dollar of cash flow received pro rata is a dollar available to pay principal and interest on the ESOP’s debt.  I could put stars and exclamation points and other signs here, but this is a really powerful benefit.  Call me to talk about this.
• You didn’t sell to outsiders, so the benefit of ESOP debt paydown is allocated to employees (according to those danged rules).  An ESOP in a successful company can generate substantial long-term benefits for employees.  But don’t expect miraculous gratitude from all employees.  It won’t happen.  Company managements still have to motivate and incentivize employees and an ESOP is not a panacea to eliminate or substitute for this responsibility.
• Provide a very real benefit for employees, especially for S corporation ESOPs.

What is an ESOP?

An ESOP is a “qualified,” defined contribution employee benefit plan designed to invest primarily in the stock of the employing corporation (which establishes the ESOP Trust).  When I use the term, ESOP, I’m really talking about an ESOP Trust.  The qualified aspect means tax-qualified if the ESOP and the sponsoring company follow rules established to protect the interests of employee beneficiaries of the ESOP.

Simplistically, the ESOP borrows money, which is guaranteed by the sponsoring corporation, to purchase stock of the company (“the employer”) from one or more selling shareholders.  The ESOP then uses contributions from the company and/or distributions (S corporations) or dividends (C corporations) to repay the debt.

Employees accrue benefits in shares of the company as the debt is repaid and the shares are released from a “suspense account,” where unvested shares reside.  Benefits accrue, like with a qualified profit sharing plan, based on eligible compensation (one of the rules to be followed).  When employees depart the company for whatever reason, they are entitled to receive their allocated (vested) shares, or their fair market value in cash and/or a promissory note.

When Do ESOPs Work Best?

Based on my experience in working with ESOPs for more than 30 years and with having an ESOP at Mercer Capital since 2006, ESOPs work best if the following conditions are met:

• Companies are consistently profitable and have stable and, preferably, growing earnings.
• Companies do not require heavy reinvestment in working capital, fixed assets or plant and equipment to grow.  Service companies, professional service companies, distribution companies with decent margins, non-cyclical manufacturing business, and others may fit the bill.
• The owner(s) who desire(s) to sell have an interest in staying with the company for at least a period of years and assuring a smooth management transition plan is in place for the future.
• The owner(s) desiring to sell do not desire to sell all of their stock so that the ESOP can establish and the company can learn about the ESOP absent the pressure of leverage for 100% of the stock.  Note that ESOP transactions of whatever size are usually leveraged 100%.  It is just easier for the parties to get comfortable with and prove the concept with smaller transactions at the outset.

Books and chapters in books have been written about ESOPs.  I’m assuming, if you’ve read this far, that you have at least passing interest.  That’s what I’m trying to satisfy.  If you actually want to consider implementing an ESOP, you and others at your company and several advisers will have to do a lot of work to make it happen.

ESOP Players

While ESOPs can be quite beneficial in providing partial, and, over time, complete liquidity for selling owners, they have a number of moving parts and players.  You will have to decide whether the complexities involved are worth the benefits.

There are at least eight players in most ESOPs, or their functions must be filled if there are fewer.  Let’s go down the list and describe the functions:

1. (Sponsoring) Company.  A company and its board of directors must sponsor the formation of an ESOP Trust to purchase shares of the company’s stock.
2. ESOP Trust (ESOP).  The trust is a fictitious person that is responsible for administering the plan in accordance with applicable rules and regulations.
3. Trustee of the ESOP Trust.  The ESOP must have a trustee or trustees who accept a fiduciary liability that the ESOP will be run “for the sole benefit of the employee beneficiaries” and will be administered in accordance with applicable rules and regulations
4. Selling Shareholder(s).  One or more shareholders must be willing to sell their shares to the ESOP based on a price determined by qualified independent appraisal (see below).
5. Bank or Other Lender.  In most transactions, the Company will borrow money from a bank or other lender and will, in turn, lend the money to the ESOP (in a “mirror loan”).  The ESOP uses the borrowings to purchase shares from selling shareholders.
6. Employee Beneficiaries.  Generally, all full-time employees meeting certain hour of work and age requirements are eligible to participate in the ESOP.
7. Plan Administrator.  Like with profit sharing plans, the details of administration are often performed by third party administrators who are hired by ESOP trustees.
8. Business Appraiser.  Trustees are charged with purchasing shares for “not more than their fair market value.”  Trustees almost always retain the services of qualified business appraisers to provide independent appraisals as of the date of the ESOP transaction.  The appraiser then provides an annual revaluation of the shares for plan administration purposes.

Then, of course, there are lawyers.  In most transactions, the sponsoring company will retain a qualified ESOP attorney, as will the trustee of the ESOP.  In some instances, the selling shareholders will obtain their own counsel.  In any transaction, there are any number of things that must be negotiated between the parties and, of course, every transaction must be fully “papered.”

Finally, sometimes companies will retain the services of an ESOP expert to “quarterback” the process and its many moving parts.  These services normally reduce confusion and keep things moving on track and tend to reduce costs.

ESOP Transaction Mechanics

A diagram will help to visualize the mechanics of a leveraged ESOP transaction.  Below the diagram, we’ll talk about the various steps by number and color.

Let’s assume that a company and a large shareholder have agreed that an ESOP will be a good vehicle to provide shareholder liquidity and shareholder benefits (more on that later).  Further assume that the ESOP has been set up.  We can now enter the diagram.  Look first at the BLUE lines and follow the discussion by the numbers.

1. a) The company borrows funds to finance the stock purchase from a bank that approves the credit.  The bank provides the funds to the company.
   b) The company signs a note with the bank and agrees to guaranty the debt.
   c) The selling shareholder in all likelihood will be required by the bank to sign a personal guaranty for the loan.  If creditworthiness is an issue, the selling shareholder could be required to collateralize the guaranty with all or a portion of his net proceeds.
2. a) The company lends the funds it borrowed from the bank to the ESOP.
   b) The ESOP, in turn, provides a note to the  company which generally mirrors the terms of the company’s loan with the bank
3. a) The trustee retains the services of a qualified business appraiser who provides an independent opinion of the fair market value of the stock being transacted.
   b) The trustee uses the appraisal as the basis for setting the price that the ESOP will pay for the shares.
4. a) and b)  The ESOP, using the funds borrowed from the company (in turn borrowed from the bank) purchases the stock from the selling shareholder(s) and receives the stock certificates in return.  At this point, the transaction is done.  The bank holds the stock purchased by the ESOP as collateral in what is called a “suspense account.”  Let’s now switch to the ORANGE colored lines.
5. a) The company makes contributions to the ESOP based on eligible compensation.  If dividends are paid (C corporations) or distributions occur (for taxes or otherwise for S corporations), the ESOP will share pro rata.  Note that if S corporation distributions are made for pass-through taxes of non-ESOP shareholders, the ESOP will benefit pro rata, and will incur no present tax liability.  This is pretty huge if you company is an S corporation.
   b) The ESOP will use both the contributions and any distributions to make interest and principal payments on its loan to the company.  The bank will obviously want and/or perform an analysis to be sure that expected contributions plus distributions will appropriately amortize its debt.  Shares are released from the suspense account to the ESOP based on principal reduction (there are complicated rules here), and the released shares are eligible for vesting with eligible employees.
   c) The company, in turn, will take the funds repaid on its loan to the ESOP and make its interest and principal payments on its loan from the bank.
6. a) Each year-end, the trustee will retain the business appraiser to provide an independent opinion of the fair market value of the stock.
   b) The trustee provides the appraised price for the ESOP as the basis for any transactions and/or allocations, and provides it to the Administrator.
   c) The appraisal is used by the administrator as the basis for allocation and vesting of ESOP benefits.
   d) The ESOP uses this information as the basis
7. The Administrator’s report is the basis for transactions that occur as described in #6 above.

Other than that, there’s not much else to an ESOP.  Well, that’s not true.  There are any number of rules and regulations that must be complied with.  The maximum levels of contributions based on compensation and other tax-advantaged benefits.  There are reporting requirements to employees and to the “authorities,” including the Internal Revenue Service and the Department of Labor.  There are “repurchase obligations” associated with departed and departing employees.  And more.

And there are costs associated with some of the players.  The bank wants its principal and interest paid timely.  The Administrator wants to be paid for its services.  The business appraiser certainly wants to be paid.  And the trustee, if he or she is an outside, independent trustee, will want to be paid.

Frightened yet?

Should You Consider an ESOP?

Guess what?  I can’t tell you that you should consider an ESOP as a means of obtaining partial liquidity for your shares in your company.  But I can tell you that, after considering all of the information above, and more, since I’ve been working with ESOPs for 30-plus years, we installed an ESOP at Mercer Capital effective January 1, 2006.

The ESOP purchased 49.9% of the shares from me and our then-president, who is now retired.  Like in the chart and discussion above, we had all the players:

1. Mercer Capital retained the services of an experienced attorney who has formed many ESOPs to perform the role of “quarterback” for our transaction.
2. The Company formed an ESOP Trust.
3. We retained the services of an independent trustee to represent the ESOP’s and employees’ interests in the transaction.
4. The ESOP trustee retained the services of a qualified business appraiser, who provided the needed determination of fair market value, but also reviewed the transaction and provided a fairness opinion from the viewpoint of the ESOP and its beneficiaries.  He also retained a law firm experienced in similar transactions.
5. Mercer Capital also retained separate legal counsel for purposes of the transaction.
6. Mercer Capital borrowed funds from our bank and guaranteed the loan, signing a corporate promissory note.  The bank retained counsel to review the documents from its viewpoint (at Mercer Capital’s expense).
7. Mercer Capital then made a “mirror loan” to the ESOP in exchange for its promissory note.
8. The other shareholder and I each had to guaranty our respective portions of the loan personally.
9. The ESOP used the cash from the loan to purchase shares from me and the other shareholder.
10. The ESOP is now trusteed by two senior employees who have access to an independent trustee when and if needed.  The trustees retained the services of an administration firm and have continued to retain the original appraiser to provide the annual reappraisals for administration purposes.

I don’t recall exactly, but, because we used a good quarterback and worked to prevent disagreements while the deal was being negotiated, we were fortunate to be able to hold costs to a reasonable level.  My recollection is that the deal expenses were on the order of 3% to 4% of the transaction value.  Your results may vary, even significantly.

Here we are now, eight years later.  The ESOP has repaid its totally leveraged loan to Mercer Capital in its entirety and Mercer Capital has repaid its loan to our bank.  This means that all of the shares that were purchased by the ESOP in 2006 have been allocated to current (and a few former) employees.

Our employees are beneficiaries of substantial value represented by the 49.9% of Mercer Capital’s stock owned by the ESOP.  In addition, the ESOP, and the employees through it, receive 49.9% of the distributable earnings of our company in the form of allowable contributions and distributions to shareholders on a going forward basis.  This stream of cash flow will be used by the employees to purchase shares from departed employees, and perhaps from me, as well over time.  The ESOP should also be able to invest significant assets other than Mercer Capital stock for the benefit of the ESOP’s employee beneficiaries.

Wrap-Up

On the one hand, ESOPs can seem to be quite complicated.  On another hand, they can seem extremely complicated.  However, if you think this liquidity option fits your situation, you will, like some 11,000 other ESOP companies in the United States, be able to figure things out.

So, should you consider an ESOP to obtain partial liquidity from your investment in your closely held or family business?  I can’t answer the question for you.

If this option interests you, there are a number of people around the country who will be glad to work with you as you investigate the possibilities.  Feel free to contact me to talk about how you might get started.

As always, if you wish to talk with me about any business or valuation-related matters, or to discuss management or ownership transition issues in complete confidence, give me a call (901-685-2120) or email (mercerc@mercercapital.com).

Until next time,

Chris