A business owner who is considering an ESOP typically wants to address three key issues very early in the process: valuation, financing, and control. He wants to know how his stock will be valued, how the ESOP will pay him for the stock it purchases, and who will control the company after the ESOP transaction closes.
Valuation. One of the most critical issues regarding valuation is the concept of adequate consideration. The ESOP trustee cannot pay more than “adequate consideration” for the stock it purchases. In the context of an ESOP, ERISA defines adequate consideration as the stock’s “fair market value . . . as determined in good faith by the trustee . . . .” The proposed Department of Labor regulations define “fair market value” as the “price at which [the stock] would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell . . . .” The regulations go on to say that the fair market value must be determined “as of the date of the transaction” and must be reflected “in written documentation of valuation.”
In order to establish fair market value for the stock of a company whose securities are not readily tradable on an established securities market, the trustee must – by law – hire an “independent appraiser.” In the context of an ESOP, an independent appraiser is someone who does not perform any other services for a party whose interest may be adverse to the ESOP, including the selling shareholder(s), and who meets an objective standard of impartiality. More simply, the trustee should select an appraiser who has no other business relationship with the company or its shareholder(s).
In order to determine fair market value for the stock that the trustee is purchasing from the company’s shareholder(s) on behalf of the ESOP, the independent appraiser engages in a thorough due diligence process in which he collects and reviews company documents and information such as historical financial statements and projections; material contracts and lease agreements; corporate legal documents such as articles of incorporation, bylaws, and buy-sell agreements; descriptions of past transactions involving company stock; and any relevant environmental or industry information. He also meets with company management and conducts on-site inspections and interviews. After the appraiser completes his due diligence, he reports a range of fair market value of the company’s stock only to the trustee and its legal counsel. The trustee negotiates the purchase price and the other terms of the transaction with the selling shareholder(s), and the final purchase price cannot exceed the top end of the range of value. It is important to note that the standard of value is the amount a “financial buyer” would pay, which in certain situations, may be less than the amount a strategic buyer is willing to pay. The trustee is legally prohibited from paying more than fair market value for the stock on behalf of the ESOP. The adequate consideration requirement places a great deal of scrutiny on the advantages that the non-ESOP parties (such as the selling shareholder(s) and the company’s key employees) could gain as a result of the ESOP transaction. In addition to the requirement that the ESOP cannot pay more than fair market value for its investment, the adequate consideration standard also requires that the ESOP transaction be “fair” to the ESOP relative to the other parties to the transaction.
The trustee can establish that he acted in “good faith” in determining fair market value if he relies on the report of a qualified independent appraiser. A qualified independent appraiser is one who (1) holds himself out to the public as an appraiser or performs appraisals on a regular basis and is qualified to make appraisals of the type of property being appraised; and (2) is independent with respect to the company and the other parties to the ESOP transaction other than the ESOP itself. The proposed regulations provide that the appraiser must apply “sound business principles of evaluation” and “conduct a prudent investigation of the circumstances prevailing at the time of the valuation.” The “sound business principles of evaluation” requirement includes the application of the generally accepted approaches to valuation, which are the income approach, the market approach, and the asset-based approach, along with the accompanying methodologies to the various approaches.
Under the proposed regulations, the “written documentation of valuation” must be signed and dated by the appraiser, and include the following information: a summary of the appraiser’s qualifications, a statement of the value of the stock that the ESOP trustee is purchasing and the methods the appraiser used in determining value, a full description of the stock that is the subject of the valuation, all of the factors the appraiser considered in making his determination of fair market value, the purpose of the valuation, the relevance or weight the appraiser gave to the valuation methodologies he used, and the effective date of the valuation, which is the closing date of the ESOP sale. Although not legally required, it is prudent that the trustee have the appraiser issue a fairness opinion as of the date of the ESOP transaction which states that the price and other financial terms of the transaction are fair to the ESOP participants. The ESOP is also required to have its stock appraised as of the last day of each plan year and upon the occurrence of certain activities.
Financing. Business owners often ask how much of the ESOP purchase price they should anticipate being able to finance with bank debt. The answer to this question depends on numerous factors, but the primary factors – known as the “Three Cs of Credit” – are cash flow, collateral, and character.
A bank wants to make sure that the company has enough cash flow to service the loan facility requested in connection with the ESOP transaction as well as the company’s other debt obligations. Typically, a company can borrow between two and three times its annual cash flow from a senior lender (for example, a bank). “Cash flow” is generally defined as a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA), adjusted for certain items such as non-recurring expenses and expense savings that the company will realize after the ESOP transaction, such as reductions in the owners’ compensation, benefits, and perquisites (Adjusted EBITDA or AEBITDA).
Collateral, the second “C of Credit,” refers to company assets, or those of a third-party guarantor, such as a selling shareholder, that may be pledged to protect the senior lender in the event the company defaults on its obligations. A bank would view a company with sufficient assets to cover a loan obligation as a safer credit than a comparable company with limited asset support. The bank will look at the company’s balance sheet assets and will apply applicable advance rates against those assets to determine the company’s “borrowing base,” which is a calculation that determines its asset coverage.
If the company’s asset coverage is insufficient to secure the full amount of the requested loan facility, which is common for service companies, the bank might extend the remaining amount of the loan as an “airball,” which is an uncollateralized portion of a loan. If the amount of the desired loan exceeds the company’s borrowing base and the amount of the airball the bank is willing to extend, the selling shareholder could offer a limited personal guarantee or offer to pledge a portion of his personal assets, such as the investments he purchases with his ESOP sales proceeds, to secure the remainder of the loan facility.
Banks also consider the “character” of the borrower, including the company itself as well as its senior management team. Especially if the selling shareholder is the founder of the company who is selling out or transitioning away from the company, the bank will want to be confident that the successor management team can continue to generate the earnings level that the bank is underwriting, as well as understand management’s experience with indebtedness and achieving quarterly covenants. Additionally, the bank will want to understand the impact of any key employees who might be leaving the company in connection with the ESOP transaction, since they might retain valuable information or key relationships that could affect business going forward. Any management risk the bank perceives could be decreased by the Trustee requiring key employees to execute employment agreements as part of the ESOP sale, which is common practice.
As part of its consideration of the company’s character, the bank will determine whether the company has a concentration issue with respect to its customers or suppliers. The bank may be concerned if more than 20% of the company’s revenue is attributed to one customer or if the company is dependent on one supplier for more than 20% of its raw materials or other assets used in its products or services. The bank will also want to be comfortable with the stability of the company’s historical earnings and with the degree of predictability of its projected earnings. Therefore, highly cyclical companies generally cannot borrow as much as companies whose earnings are more stable.
Many companies use a combination of excess company cash, senior bank debt, and subordinated Seller Notes to finance an ESOP transaction. Seller Notes must meet appropriate tests to be classified as debt instead of equity, including an interest rate at least equal to the applicable federal rate (AFR), a date certain of maturity, and other terms and conditions that reflect “commercial reasonableness.” Often, business owners initially object to the suggestion of seller financing. However, after learning more about how the seller financing may provide better risk-adjusted rates of return relative to a more typical market investment, business owners begin to embrace the idea.
Generally, in order for the subordinated seller debt to satisfy the requirement of commercial reasonableness, its terms must not exceed the terms one would anticipate in an arm’s length transaction with a commercial subordinated debt lender such as a mezzanine lender (mezz lender). Currently, mezz lenders generally require an all-in return of 12% to 18%, which is justified due to the increased risk associated with being a junior subordinated lender. For a subordinated note holder, the all-in return may come from two separate components: interest payments and warrants. A warrant is a security that is similar to an option that allows the holder to buy company stock at a fixed exercise price for a specified period of time. A company usually issues warrants in conjunction with a debt instrument. Debt holders require compensation for the risk of lending, and for traditional lenders, this compensation is interest expense. Subordinated debt is more risky due to its subordination to senior bank debt; therefore, traditional interest-only compensation might not be sufficient to justify the risk. Warrants provide a way for holders of ESOP Seller Notes to enhance their return commensurate with the risk. Typical subordinated debt terms might be a loan interest rate of eight percent plus warrants whose value results in an additional return of seven percent over the term of the warrants.
Once business owners understand that their seller debt may be entitled to the same return that a mezz lender receives, they often are willing to help finance a portion of the transaction. Their return on the subordinated debt might actually exceed their anticipated return if they received cash at closing and reinvested it in a more traditional manner. A Seller Note with warrants provides a selling shareholder a continued opportunity to participate in the equity appreciation of the company after the ESOP transaction; it provides the company with less stringent terms and covenants than commercial subordinated lenders; it helps to reduce the burden of interest payments to the company; and it provides a way for the warrant holder to be taxed at capital gains rates when he exercises his warrants in the future, instead of paying ordinary income tax on current interest payments.
Control. A common misconception about ESOPs is that the owner of a company will lose control of his company if he sells all or a portion of his stock to the ESOP. While control is certainly an issue that a selling shareholder should consider, ESOP trustees are typically passive financial investors (as opposed to active operating investors). The selling shareholder often continues to operate the company for the benefit of its new owners (effectively, its employees) after the sale; therefore, an owner can retain operational control after the sale, even though the trustee has exclusive authority and discretion over the plan’s assets.
It is prudent to engage an independent institutional trustee that will use its own judgment in making decisions related to the terms of the ESOP transaction, including the price to be paid and the terms of the stock purchase agreement; however, after the transaction closes, that same institutional trustee can operate as a directed ESOP trustee on an ongoing basis. Explicitly authorized by the law, a directed trustee is a trustee who is subject to the direction of another named fiduciary in the plan. That other “named fiduciary” is typically the company’s board of directors (or a subcommittee of the board). The board directs the trustee as to how to vote the ESOP stock, and the trustee must determine that those directions are proper, are made in accordance with the terms of the plan, and are not contrary to the provisions of ERISA. The ESOP participants and beneficiaries must be given the right to direct the voting of allocated shares only in the following situations: any corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution, a sale of substantially all of the company’s assets, or other similar transactions that the Treasury Department prescribes by regulations. Note that the participants have the right to direct the ESOP trustee in voting their allocated shares, not to vote them directly; the ESOP trustee actually votes the shares held by the ESOP.