Financial characteristics of companies that are strong ESOP candidates include high levels of profitability and low levels of debt. Because a company will typically utilize a leveraged ESOP in connection with the business owner’s succession plan, unused debt capacity is necessary so that the company is able to borrow the money needed to finance the ESOP transaction. It is also helpful for a company to have steady cash flows throughout its fiscal year and not operate in a declining industry. In terms of transaction amount (the value of the stock to be sold to the ESOP), the minimum amount necessary to produce an attractive cost-benefit result is generally $3,000,000. Typically, ESOP transactions range from $6,000,000 to $100,000,000, indicating that the company has at least $1,000,000 of adjusted cash flow represented by AEBITDA or earnings before owners’ compensation (EBOC). In addition, the tax benefits that an ESOP provides to its sponsoring company make it very attractive, so a company that pays a significant amount of corporate tax is usually a prime ESOP candidate.
Since an ESOP is essentially a sale to insiders, a company considering an ESOP needs to have a management team in place that can successfully run the company following the departure of the business owner, or at least have identified the individuals that will comprise that management team. An ESOP often works best for a company that has started to develop a management succession plan and whose owner has started to transition away from operating responsibilities.
A key planning objective of many ESOP candidates includes protecting employees’ jobs and perpetuating the company’s legacy. The owners of these companies are concerned that a third-party sale will result in the company being absorbed into a much larger entity that will not retain its key employees. Using an ESOP can be an ideal succession strategy in these circumstances as it also enables business owners to reward their employees and the management team that helped them develop and grow the business.