Frequently Asked Questions

An ESOP is a qualified retirement plan designed to invest primarily in the stock of the sponsoring employer.

    • For owners of closely-held companies, an ESOP is a succession planning tool that allows them to transition ownership of their companies to employees on a tax-advantaged basis while continuing their legacy
    • To a company, an ESOP is a corporate finance vehicle that can create tax benefits not available anywhere else in the Internal Revenue Code
    • From an employee perspective, an ESOP is a defined contribution retirement plan designed to provide eligible employees with beneficial ownership of shares of company stock

Step 1:   The company borrows money from a third party lender (the “Outside Loan”)

Step 2:     The company loans the money to the Employee Stock Ownership Plan (the “ESOP”) and receives a note in exchange (the “Inside Loan”)

Step 3:   The ESOP uses the internal loan proceeds to purchase stock from the selling shareholder(s) in exchange for cash and/or a promissory note (the “Seller Note”)

Step 1:   Similar to contributions to other retirement plans, the company makes a tax-deductible annual contribution (and dividend, possibly) to the ESOP

Step 2:   Immediately after receiving the wire transfer with the annual contribution, the ESOP wires the money to the company as a repayment of the Inside Loan

Step 3:   The repayment of a portion of the Inside Loan triggers a proportionate allocation of shares to the accounts of eligible ESOP participants

Step 4:   The company can use its enhanced cash flows to service the Outside Loan and the Seller Note

Valuation

Valuation

Financing

Financing

Post-Transaction Governance

Post-Transaction Governance

Key Employees

Key Employees

Board of Directors:  Under state law, a corporation’s authority vests in its board of directors.  Other than a duty to appoint fiduciaries of the plan and the duty to monitor their compliance, there are no ESOP-specific legal requirements of the board of directors of an ESOP-owned corporation. The board is elected by the shareholders of a corporation and is responsible for making strategic decisions about the direction of the corporation.  The board will appoint the officers and hire the management team who will carry out that strategic direction on a day-to-day basis.  The board has a fiduciary duty to the corporation’s shareholders to protect their interests, which generally means growing shareholder value. Other responsibilities of the board include overseeing executive compensation, responding to offers, approving the financial statements, and hiring the ESOP Trustee.

ESOP Committee The board may appoint a committee to oversee the daily operations of the plan.  The committee’s responsibilities may entail fiduciary obligations if the committee has authority and discretion over the management of the plan.  However, not every ESOP committee is a fiduciary under ERISA.  The ESOP committee is created in the plan documents, but there is no legal requirement that a corporation have an ESOP committee.

ESOP Trustee:  The ESOP Trustee is responsible for managing the assets of the ESOP for “the exclusive benefit of” the ESOP Participants and in accordance with the plan documents and ERISA.  In order to satisfy this requirement, the ESOP Trustee will have a valuation firm that will complete the ESOP annual appraisal and a third-party administration firm to perform all of the IRS testing and issue account statements to the ESOP Participants.

The ESOP Trust – not the ESOP Participants – is the legal owner of the shares that the ESOP purchases.  Thus, in a 100% ESOP-owned corporation, the corporation has only one shareholder, the ESOP Trust.  The ESOP Trustee has rights like any other shareholder under corporate law, such as electing the corporation’s board of directors.  The ESOP Trustee typically will not serve on the board of directors, but will likely require that the board include one or two independent directors.  The outgoing board will usually present the ESOP Trustee with a slate of candidates and the ESOP Trustee will cast a vote to either approve or not approve that slate.

The ESOP Trustee is also responsible for voting all of the shares owned by the ESOP, regardless of whether those shares are allocated to ESOP Participants’ accounts.  The plan document will indicate how the ESOP Trustee determines how to vote.  In a closely held corporation, the ESOP Participants will direct the ESOP Trustee on how to vote allocated shares only on a limited number of major corporate issues, including a sale of all or substantially all of the corporation’s assets; merger; liquidation; recapitalization; reclassification; dissolution; and consolidation.  Pass-through voting by the ESOP Participants is not required for how to vote on other issues, such as voting for the board, agreeing to tender the stock, and selling the stock.

Income Approach Market Approach Asset Approach
  • Discounted cash flow method
  • Capitalized cash flow method
  • Prior transactions in company stock
  • Guideline public company method
  • Guideline transaction method
  • Net asset value method
  • Liquidation analysis
Overview of Approach Overview of Approach Overview of Approach
The earnings-based approach is appropriate where the business being valued is earning a fair return on its capital employed and the hypothetical purchaser wishes to acquire the future indicated earnings generated by the enterprise. Based on prices determined by the financial market. 

Estimates the value of the business based upon evidence of prices investors are willing to pay for companies in similar lines of businesses. 

Used as a valuation methodology when liquidation is contemplated because the business is not viable as an ongoing operation.

Asset values constitute the prime determinant of business worth (inventory, receivables, property and equipment, etc.) as opposed to cash flows generated by such assets.

Enterprise value

  • Historical and projected performance
  • Current industry trends
  • Current economic trends
  • Shareholder compensation
  • Non-recurring expenses
  • Weighted average cost of capital
  • Change in working capital
  • Depreciation and amortization
  • Capital expenditures

Equity value

  • Excess cash and investments
  • Debt and other liabilities on the company’s balance sheet

Price per share

  • Control premium and marketability discount
  • Number of shares outstanding

The table below illustrates the various financing sources available for ESOP transactions

Type Description Term Pricing
Senior debt Debt secured by the company’s assets 3-4 years LIBOR + 150-350bps
Subordinated  debt Secured debt, cash flow-based lending 5-7 years 8-10% cash interest
Seller notes Promissory notes to the shareholders 5-10 years 2–10% cash interest, depending on subordination, plus warrants to get to 12-14%
Company cash Non-operating cash the Company loans to the ESOP 3-20 years AFR
Royalty financing Unsecured, subordinated debt with a royalty component 8-10 years 5–12% cash and PIK interest and royalties to get to 18-22% IRR
Mezzanine debt Unsecured, subordinated debt with an equity component 8-10 years 5–12% cash and PIK interest and warrants to get to 18-22% IRR

 

 

This chart illustrates the amount of debt that is typically available to companies considering an ESOP:

 

Pre-Tax LBO

  • Tax Deductible Interest
  • Tax Deductible Principal

Tax-Free Stock Sale

  • C Corporation Only
  • Section 1042 Like Kind Exchange
  • Transferred Basis in QRP

Tax-Exempt Corporation

  • S Corporation Only
  • No Tax on Corporate Income

Tax Subsidies Encourage ESOPs

Stock Appreciation Rights

  • Similar to Non-Qualified Stock Options
    • Cashless Exercise
    • Settled in cash, not stock, when exercised

Additional incentive for key employees

  • Can be based on retention or performance

Portion of equity set aside as SARs

  • “Strike Price” cannot be less than fair market value
  • Post-Transaction Price Per Share

 

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