April 18, 2022 •Richard Harmon
High profile private equity deals and strategic sales command attention. Although when it comes to formulating an exit or liquidity strategy, there's usually more than one path forward. Certain transactions may offer greater advantages, depending on the goals of a company and its shareholders. Once the dust settles, the real impact is better understood – often in ways that stakeholders didn’t anticipate.
To illustrate this concept, let’s examine a pair of hypothetical transactions, based on actual deals.
Private Equity Deal Grabs Headlines
A self-made entrepreneur sells her apparel company to private equity in a monumental transaction. The two decades-long journey from startup to category-defining unicorn culminates in a $1.43 billion sale.
For the company and for the private equity firm, it’s an opportunity to expand the product line and push further into global markets. For the founder, it’s also a massive liquidity event. She receives $1 billion for 70% of the company. Her remaining equity stake is rolled into the new venture.
In celebration, each of the company’s 500 employees is surprised with two international, first-class plane tickets and $10,000 in spending money. Video of the announcement goes viral, garnering millions of views across social media. But, beyond the hype, it’s important to assess each stakeholder’s gains and losses.
Founder Gains Massive Wealth – with Strings Attached
With sale proceeds totaling $1 billion and equity in the new venture, the founder reaps a tremendous reward for her years of hard work. There’s a good chance she’ll continue to accrue benefits. Her ongoing equity stake may benefit from private equity’s professional involvement as the firm.
She won’t keep all her capital gains, though. Approximately 30% ($300 million) will go to the IRS and state tax authorities. That leaves her with $700 million in post-tax earnings.
While that payout is still substantial, it’s important to note that the founder's relationship with the business will likely change. Although she'll continue to serve as executive chairwoman, she no longer determines the company’s destiny.
Private Equity Firm Adds Major Brand to Portfolio
Majority investment in the coveted company means control and upside. The private equity firm has relative freedom to hire, fire, craft strategy, and make M&A decisions.
The firm used minimal capital to fund the transaction. That’s common in private equity deals. Instead, it borrowed the remainder by leveraging the apparel company’s balance sheet with private debt. The deal is effectively a leveraged buyout.
Potential Upside and Added Risk for the Company
Private equity involvement presents an opportunity to professionalize operations, create efficiencies, and build a broader platform for growth. There’s a good reason to be optimistic about the business’s future.
But the company’s financial complexion has also changed. With significant new debt on the balance sheet, there’s an increased leverage risk. In a worst-case scenario, that debt – which must be paid down with after-tax dollars – could burden the enterprise.
Private Equity – All Things Considered
The Employee Stock Ownership Plan Alternative
In a leveraged ESOP transaction, shareholders can sell a portion or all their equity to an employee trust. Shares are purchased at fair market value and allocated periodically to full-time employees. In essence, it’s a retirement plan that invests solely in employer securities.
So, what if the company’s founder opted to sell a portion of her holdings to an ESOP? Consider a minority transaction where just 37.5% of outstanding shares are sold to an employee stock ownership trust.
Tax-Advantaged Shareholder Liquidity Event
Assuming the private equity firm paid fair market value, let’s set the company’s total equity value at $1.35 billion. That's equivalent to the PE deal, less a standard 5% marketability discount.
A 37.5% sale yields $510 million windfall for the founder. But what’s unique about the ESOP sale is that she can defer (and potentially eliminate) capital gains burdens on the proceeds. This is known as 1042 rollover, and it represents a potential tax savings of up to $150 million.
How can an Employee Trust Afford a $510 Million Acquisition?
The company funded the transaction on the trust’s behalf using a $110 million term loan and a $400 million public bond offering. This financing was secured without personal guarantees from the founder. Although many ESOP sales are facilitated with a combination of commercial and seller debt, this transaction structure enabled a full payout to the selling shareholder at close.
Meanwhile, the founder retains majority interest and significant equity upside in her still-independent company. She's also achieved portfolio diversification by unlocking a portion of her concentrated wealth position.
Corporate Tax-Breaks and Continued Independence
The company receives income tax deductions equivalent to the sale value: $510 million. That will likely eliminate its federal and state tax burdens for several years.
Beyond enhanced cash flow, a bump in overall corporate performance can also be expected. Research shows that ESOP-owned businesses, on average, outpace their peers in terms of staff retention, productivity, and overall performance.
Leadership still resides with the company’s board of directors. The board has the freedom and flexibility to make subsequent ESOP and M&A transactions.
A Potentially Lucrative Retirement Benefit
37.5% of the company is distributed to employees over the course of 20 years. Annual share allocations are based on a fixed formula, tied to an employee’s pay. There’s also a vesting period that’s akin to a 401(k). When employee owners leave the company, their shares are sold back to the firm at a current valuation.
To create additional incentives for key managers, the company also institutes a stock appreciation rights program. Like phantom stock, the SARs are discretionary, annually adjustable, and equivalent to 5% of the business’s total value.
Overall, employees have skin in the game and strong incentives to stick around with the company. If the company grows, or even sustains its value, the stock benefit could yield million-dollar retirement pay-outs for employees with longer tenures.
Employee Ownership Adds Complexity
ESOPs do require additional care and maintenance. In addition to Department of Labor oversight, employee-owned businesses need annual valuations, a designated trustee, and plan management by a third-party administrator. Annual costs typically range from $30,000 to $60,000.
To get the most out of its ESOP, the company will want to actively promote the plan to participants and find ways to embrace employee ownership as part of its broader corporate culture.
Looking to the Future as an Employee-Owned Company
As mentioned, the company maintains the freedom to engage in future transactions. That includes selling additional equity to the ESOP and sales to third-parties. In all instances, employee owners will be among the financial beneficiaries of a transaction, while the founder gains additional “bites at the apple,” potentially at higher valuations.
Additional ESOP transactions will again yield tax-deferred liquidity events for the founder and income tax deductions for company. In the event the company becomes 100% employee-owned, it can gain an added benefit: exemptions from federal and most state income taxes, in perpetuity.
Private Equity vs. ESOP
In summary, a majority sale to a private equity firm offers a big liquidity event for the apparel-maker’s founder, with significant cash up-front. Trade-offs include a reduced role with the company, a substantial capital gains tax hit, loss of corporate independence, and relatively modest rewards for team members.
There’s simplicity in this type of transaction, but potentially at the expense of employees and the company’s balance sheet. Nonetheless, those risks may be acceptable. Sometimes an owner just wants to take the best offer, move on, and trust their legacy will be preserved by someone else.
When a unicorn sells a minority share to an ESOP, the transaction provides shareholders tax-advantaged liquidity at a fair market valuation. Tax deductions are created for the company and financing (without personal guarantees) is paid with pre-tax cash flow. Selling shareholders can maintain meaningful roles and employees become stakeholders.
These benefits aren’t without potential downsides. The transaction process is highly structured, ESOPs are federally regulated, and the plans require ongoing maintenance. But for some owners, the tax efficiencies, continued upside, independence, and social benefits outweigh the costs.
Sometimes employee ownership simply doesn’t make sense. Companies need at least 10 plan participants to qualify for employee ownership tax benefits. The transaction and maintenance costs may overshadow the advantages, especially if the company’s adjusted annual EBITDA is under $2 million. But for many closely-held firms, a leveraged ESOP represents an attractive alternative.
Even with a better understanding of employee stock ownership plans, the entrepreneur in our story may still have opted to go the private equity route. Regardless, there’s tremendous value in understanding your alternatives. Buyer’s remorse can be painful – especially when a promising transaction option is never considered.