Many owners considering an ESOP focus on how it will fit into their transition strategy in exiting their business. This issue receives a great deal of attention (as it should), because a private company transition is normally the largest transaction a private business owner will ever undertake. Additionally, ESOP transactions have added complexity which deserves the time and attention of the owner, company, and advisors.
However, we feel it is important for owners considering an ESOP strategy to not only understand how it fits into their exit strategy but also understand how the ESOP works over the long-term as it has significant implications for future planning for the business. In fact, we believe an ESOP has three distinct phases. Each phase is unique and presents different focus areas.
The key in the transaction phase is proper transaction execution and structure.
This phase receives 90 percent of the attention and discussion since it relates to the owner’s planning around how the ESOP fits into their transition strategy. A good portion of the focus in this phase is the transaction itself including the financing, tax benefits, proceeds to the owner, etc. In fact, very little attention is paid to longer-term issues since the transaction takes so much time to complete. Well-advised ESOPs should have a high-level understanding of how the ESOP works over the long-term at this stage but that should not be the emphasis. Getting the transaction structure right and meeting the owner’s transition goals are the most important issues in this phase of planning.
The key in the deleveraging phase is debt reduction and de-risking the balance sheet.
The deleveraging phase can last 10 to 15 years, depending on whether the ESOP is formed in tranches or in one transaction with warrants, but most of the deleveraging should take place in five to eight years. Selling shares to the ESOP in tranches is one way to keep the leverage lower by spreading the transactions out over a longer period.
Since no third-party equity capital comes to the table in an ESOP deal, the transaction is basically a leveraged buyout with unique tax benefits. In fact, the tax-free S Corporation benefits are what allow third-party lenders to extend credit at the levels they do, since the company is paying back the debt with 100 percent of its earnings.
The important thing to remember in this phase is that due to the amount of leverage, the company’s normal capital allocation plans must change since a good portion of its earnings will be committed to debt service. From a long-range planning standpoint, and depending on the amount of leverage, this phase may require an adjustment to plans for acquisitions or large capital expenditures and projects. This is due to the need to work down the leverage and de-risk the balance sheet. This phase is also where a great CFO shines since they will be able to thoughtfully allocate capital and balance priorities between debt reduction and other uses of capital.
While the company takes on leverage to execute an ESOP transaction, there is often a reasonable level of flexibility in that structure, especially when the former owners are carrying seller notes as part of the transaction. Capital will be more scarce than normal after a transaction due to the commitments to repay the debt, so capital allocation planning has to be more thoughtful and precise during this phase so that the company can balance its debt obligations with its growth strategies.
The key in the mature phase is sustainability by planning and managing the repurchase obligation.
Planning in this phase must start early in the ESOP but takes on much more emphasis when a company begins to meaningfully reduce its transaction debt. As the debt is reduced in the deleveraging phase, the ESOP’s shares are allocated to the participants and they gain real equity in their ESOP accounts. The value of the company’s equity in employee’s accounts in the ESOP is called the repurchase obligation, and it needs to be carefully planned and managed if the ESOP is going to be sustainable over the long haul.
One of the things an owner has to realize when they form an ESOP is that at some point in the future they will have created a regular treasury function to manage the share transactions as ESOP owners retire or leave the company. The ESOP basically creates a market in the company’s stock which the company must fund.
Given that ESOPs are private businesses with limited access to capital (like the previous owners), preparing for and managing these share transactions is of monumental importance as such transactions require an allocation of the company’s capital that it cannot use for other elements of the company’s strategy.
There are a number of tools and methods the company needs to master if the ESOP is going to be sustainable, including the use of insurance and recycling versus redeeming shares. In this phase, most ESOP companies realize the S Corporation ESOP tax benefits come in handy to help fund repurchase obligations. The key to sustainability is to begin planning early – long before the repurchase obligation becomes significant.
In our work with mature ESOP companies, the CFOs claim that they spend as much as one third of their time on ESOP-related matters including planning, financing, and managing repurchase obligations, among other things.
The good news is that ESOPs take time to go through these phases so companies have time to learn how to plan and manage each phase. However, it’s extremely important to get phases two and three on your radar early in the process so that you put time on your side and are prepared to manage the ESOP for long-term sustainability while also being able to execute your business strategy. Well-run ESOP companies navigate this landscape effectively because they invest time in learning and understanding these issues and utilize the advice of solid ESOP advisors. While there is added work here, we find that the many benefits of being an ESOP company to the owners, employees, and community far outweigh the effort involved.
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