October 28, 2020 •CSG Partners Staff
Questions about employee stock ownership plan structure, valuation, financing, and governance are common among business owners and advisors. These concepts may seem complex, but it doesn't take long to gain meaningful clarity on ESOPs.
Clarifying Essential Employee Ownership Concepts
Lawrence Kaplan, CSG's Founder & Managing Partner, recently led an hour-long Q&A session, hosted by Vistage Networks. Middle market business leaders, attorneys, accountants, and wealth advisors asked a number of pertinent questions, including:
- What is employee ownership, and what are the key benefits?
- How do ESOP valuation multiples compare with M&A or private equity?
- Can leveraged ESOPs be financed without personal guarantees?
- What are the potential downsides of employee ownership?
- How are shares distributed?
Employee Stock Ownership Plan Basics
"An ESOP is as a tax-advantaged leveraged buyout of your own company, by your employees. It could be for a partial amount of your company or the total amount, but it's a tax-driven strategy that benefits the owner, the employees, and the company."
"An ESOP offers liquidity and diversification for the shareholders, tax deductions for the sellers and the company, and it gets employees more engaged, giving them upside that's tied-in to the business. It helps foster an employee-ownership culture and can increase productivity."
Fair Market Valuation
"An ESOP transaction should be paying similar multiples to what financial or private equity buyers are paying. That's the definition of what ESOP fair market value is - it's what an independent buyer would be paying for that company."
"It's somewhat different if there's a strategic buyer, because they're going to get certain synergies in the transaction. That buyer might be willing to pay more in terms of EBITDA multiples. Of course, the numbers vary, and the details are industry and company specific."
Leveraged ESOP Financing
"Most of our leveraged ESOP transactions have no personal guarantees attached. There are plenty on lenders – where if the company is solid, has good cash flow, and potentially has assets – that are willing to negotiate financing without personal guarantees."
"If you're going into a liquidity transaction to get diversification, what's the point if the seller is getting that money, but they have to guarantee it back to the bank. In that case, why borrow the money in the first place? Why not do a seller-financed transaction?"
Potential Downsides of Employee Ownership
"It costs money to do any transaction, so you need to evaluate an ESOP in terms of implementation cost. You're also bringing on another shareholder, a trustee. This is governed by ERISA and regulated by the Department of Labor."
"It takes time to develop and implement an ESOP. Employee ownership can offer tremendous benefits to employees, but it takes an effort to communicate that. You can't simply put the ESOP in place and expect to see an increase in productivity."
ESOP Share Distribution
"When employees purchase the company, that stock is held in a trust, in a suspense account, but it isn't immediately allocated to the employees. Every year, the company makes tax-deductible contributions to the ESOP, up to 25% of its eligible payroll."
"The employee trust uses that money to repay the leveraged ESOP debt, and as it does so, shares are released and allocated to individual employees, based on their compensation. Shares vest over time, and every year, the company will continue to make that contribution."
Additional Employee Ownership Questions Answered:
- What is the recommended minimum company size for an ESOP?
- How are ESOP valuations determined?
- What are the debt implications of a leveraged ESOP transaction?
- Who makes decisions in a 100% employee owned company?
- Do employee owners have access to their company’s financial statements?
- Can an ESOP be used to buy out shareholders?
- What is a 1042 rollover?
- What is an ESOP termination or buyback?
- How do ESOP companies manage repurchase obligations?