Financing a first stage ESOP transaction can take many shapes. If your company is considering an ESOP transition, it’s important to know your options and the flexibility you have with structuring the transaction. You also need to be aware of key pieces of financing and how they could come into play post-transaction.
It’s important to keep in mind that financing an ESOP transaction is first and foremost a vehicle to provide liquidity to the selling shareholder(s); it’s a leveraged buyout, and as such, may need to be structured differently from traditional loans to fund company growth. The most typical source of financing will come through a bank, but if you’re structuring a 100 percent ESOP transaction, or have some leverage on your balance sheet already, you’ll likely need other sources of financing to cover the full value. These other sources commonly come from seller notes or alternative sources of capital such as mezzanine financing. These alternative sources are more expensive than traditional bank loans, but could provide more flexibility and offer the liquidity the seller is seeking.
Although not a necessity, working with a lender with experience in ESOPs will likely help the process move more smoothly. This is especially true in the underwriting process, as having a thorough understanding of how ESOPs work allows the lender to maximize lending capacity. One such instance is understanding the tax benefits an ESOP provides, and how that assists debt service. An S Corporation that is 100 percent ESOP-owned now has 100 percent of its profits available to service the debt, whereas pre-ESOP, a portion of those profits were either paying taxes directly or making tax distributions to the shareholders.
Another key component of an ESOP loan is the financial covenants. Traditional debt service and leverage ratios will need to be altered in an ESOP transaction due to the unique accounting implications for leveraged ESOPs. On the balance sheet, debt to equity ratios take a double hit, first with the financing to buy out the seller, but also with the repurchased shares essentially being treated as a treasury stock transaction, being recorded as contra-equity. Debt service ratios typically involve Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) as the benchmark, but often in ESOP financing, ESOP compensation is also an add-back (EBITDAE). This is due to ESOP compensation being largely a non-cash item. It is therefore important for lenders to understand the mechanics of ESOP accounting and to properly tailor covenants accordingly. ESOP compensation could spike in years of high growth and/or additional shares contributed, and a traditional debt service ratio could be tripped even in a high profit year.
Seller notes may be necessary if traditional financing can’t cover the full value of the buy-out. The extent of seller notes will vary based on the liquidity goals of the selling shareholder(s) but can also include an added layer of flexibility in the form of warrants. Warrants can provide the company with improved cash flow in the years following the transaction, while also giving the seller the ability to benefit from the future growth of the company as a result of the ESOP.
As you’re working through the overall ESOP transaction as well as the financing structure, it’s important to assess all of your options and weigh them against seller goals, future company projections and potential strains on cash flow, and potential pressure on operations due to covenant considerations.
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