How Do Selling Shareholders Compromise To Enjoy ESOP Leverage?

Published on 16 Mar, 2016 Published under Valuation

Employee Stock Ownership Plans (ESOP) came into existence in order to grant partial or complete ownership of businesses to their employees. Here, the companies granting ownership to their employees enjoy hefty tax benefits.

Massive tax savings lured many closely-held businesses to use ESOPs as an exit option. However, any transaction involving ESOP goes through stringent scrutiny by the Department of Labor (DOL), and any move by business owners that compromises employees’ interest is heavily punished.

In a typical ESOP structure, an Employee Stock Ownership Trust (ESOT) is formed, which holds shares transferred by selling shareholders for employees. Selling shareholders receive seller notes, which are repaid by the Company on behalf of ESOT. The ESOT becomes indebted to the Company, for taking over the seller notes obligation. This indebtedness is reduced with the payroll contribution made by the Company towards ESOP. The company receives tax deductions for the payroll contribution.

ESOP Contribution

In an ESOP transaction, it appears as if the company itself funds its own acquisition. In leveraged buyouts, we see that the target company’s assets are used to raise funding for the acquisition. However, 100% of the funding cannot be raised through this route. So how does this work in case of ESOPs?

The ESOP sale transaction happens at Fair Market Value (FMV) of the company, without considering increase in the valuation of the company due to tax savings, post ESOP transaction. This implies that actual financial leverage does not reach the 100% mark.

Tax savings resulting from ESOP structure do not usually increase the company's value to the level that its financial leverage can be in a comfortable zone. However, ESOT-owned companies are often able to enjoy excessive financial leverage.

Selling shareholders play a very vital role in making such an ESOP transaction successful. While the DOL looks at this transaction with suspicion, the compromise in the backdrop often goes unnoticed.

An ESOP company can survive with very high leverage because of lenient terms offered by selling shareholders on their seller note. Selling shareholder accept very nominal interest rates on their seller notes, despite very high financial leverage of the company. At the same time, they allow repayment of loan based on availability of cash with the company.

The selling shareholders allow all these flexible terms in seller notes and still accept the seller notes without any downward adjustment in the value of the same. Any third-party investor would never offer such favorable terms without a reduction in the value of such notes.

The point to be noted here is that the selling shareholders do not receive full fair market value for their stake in the company. Hence, while assessing fairness of any ESOP transactions, DOL should consider the compromise made by the selling shareholders to make this structure work.

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