A Leveraged ESOP Roadmap

The process behind forming and financing an employee stock ownership plan is unique among M&A transactions. Leveraged ESOPs can deliver profound benefits, but careful planning and execution are key. 

When private companies blindly rush to put plans in place, they risk lengthy delays, unrealized goals, and broader regulatory exposure.

As a result, these strategies demand a “measure twice and cut once” mentality. Before committing to a transaction, stakeholders should understand how a plan functions, internalize pros and cons, and determine whether the potential upside is worth the effort. A thorough roadmap can help companies efficiently reach the right destination.

11 Steps to a Successful Leveraged ESOP Transaction

The following isn't necessarily the road taken by all closely-held companies, and the journey doesn't always end in a completed transaction. But this framework offers a disciplined approach to plan consideration and realization.

1. Do your employee ownership homework.

Employee stock ownership plans are complex, and misconceptions are commonly held. Before you talk with an advisor, let alone begin a transaction process, do some studying. In addition to our resource library, the National Center for Employee Ownership offers a broad range of educational materials. You'll also find centers for ESOP scholarship at several major institutions.

2. Get transaction-ready.

Preparation is critical for any transaction. Leveraged ESOPs are no different. When a company has audited or reviewed financials, documented business practices, and a current quality of earnings report, it's better positioned to act on opportunities and close deals in a timely manner. My colleague, Richard Harmon, has written extensively about this often-overlooked step in the transaction process.

3. Consult an employee stock ownership plan advisor.

As mentioned, these transactions are nuanced. Structuring and financing considerations abound, and multiple federal regulatory bodies provide oversight. Even if your interest is purely exploratory, it's important to talk with a specialized subject matter expert.

An experienced ESOP investment banking advisor likely completes multiple transactions a year, is well-versed in financial modeling and analysis, and has extensive access to third-party capital sources. They should be capable of managing a transaction from end-to-end.

4. Run a feasibility study.

Detailed business analytics, combined with a clear understanding of stakeholders' goals, help ground a leveraged ESOP transaction process. A well-crafted preliminary analysis synthesizes these objective and subjective data to answer key questions:

• What is a company's anticipated fair market value?

• Is there a sale percentage and structure that maximizes income tax advantages, can meaningfully reward employees, and meet the goals of existing owners?

• How does an optimized ESOP compare to other M&A transactions and alternative equity compensation/profit sharing plan options?

• What are the potential financing options?

• What do all stakeholders stand to gain or lose in a transaction?

• How much will it cost to implement and maintain the proposed plan?

Answers should be presented in writing and in open conversation. Advisors can be expected to explain assumptions, field questions, enhance their analysis, and present their findings to multiple stakeholder audiences.

A productive feasibility study instills confidence and informs an educated decision to pursue an ESOP strategy. Ideally, it will also evidence compatibility between a company and an advisor.

5. Engage a transaction advisor.

When a company opts to move ahead with a leveraged ESOP, it will generally engage an advisor to quarterback the transaction. This is often the same individual or firm that led the prior feasibility study, but that's not a given. A strong advisor-client relationship is key driver of success, and a good fit is vital. Once both parties agree on the scope and terms on an engagement, the real heavy lifting begins.

6. Begin a due diligence process.

A modicum of corporate information is needed to complete a feasibility study. Due diligence for a formal transaction is more rigorous. In addition to tax returns, financial statements, and payroll data, an advisor should seek to fully understand how a business operates, its performance drivers and projected outlook, and broader market dynamics.

This process fully informs all ESOP valuation, structuring, and financing considerations. Clear documentation and easy access to management team members for interviews and follow-up questions can help expedite the process.

7. Draft a confidential informational memorandum (CIM).

This detailed report summarizes a company's history, finances, management, and outlook. A product of the due diligence effort, the CIM is primarily written for two audiences: potential lenders and the ESOP trustee. As in any M&A transaction, all parties will ultimately perform their own due diligence, but a comprehensive, well-crafted CIM can help contextualize opportunities and engender trust between deal partners.

8. Raise capital from institutional lenders.

While a leveraged ESOP can be entirely seller financed, these transactions are often partially or completely funded with third-party debt. Doing so helps selling shareholders secure a measure of liquidity at closing.

When a sponsoring company borrows money to facilitate a leveraged ESOP transaction, an investment banking advisor will likely begin a competitive capital raise process by reaching out to a range of potential lenders and circulating the CIM to interested parties.

Once preliminary term sheets are secured, an advisor can analyze opportunities, lead subsequent lender negotiations, and help its client select a preferred financing package.

9. Hire ancillary professionals.

Most companies will hire an attorney that specializes in ESOPs to work alongside their corporate counsel. Considering the ERISA-oriented rules and regulations of plan formation and maintenance, having a subject matter expert on your legal team can be extremely valuable.

Next, a sponsoring company will retain the services of an employee trustee. In general, the newly hired ESOP counsel will help form a committee of key employees to interview, select, and engage a third-party, institutional fiduciary.

The trustee represents employees' interests throughout the transaction process and afterward. To do so, they will independently hire legal counsel to represent the ESOP trust, as well as a valuation firm to run detailed due diligence and support transaction negotiations.

10. Negotiate a deal.

Once a trustee completes their due diligence process and finalizes their own valuation of the sponsoring company, both parties will come together to hammer out a transaction. The company (led by its ESOP advisor) will make a formal offer to sell a portion or all shareholder equity, and the trustee will likely counter.

Remember, the trustee has fiduciary obligation to pay no more than fair market value for company stock. Striking a deal isn't a forgone conclusion. Either side can walk away from the negotiations.

11. Close the transaction.

If an agreement is reached, the deal moves to a final stage. Transaction and ESOP plan documents are finalized. Credit agreements for third-party and seller financing are also codified. Once all the paperwork is completed, both parties set a closing date. The close is similar to any other M&A transaction: after all documentation is signed, the employee trust completes its company stock purchase and selling shareholders receive fair market compensation.

ESOP formations demand planning, patience, and protocol.

Leveraged ESOP transactions can take months to complete. Timing is often predicated on deal size, complexity, financing needs, and the speed at which all due diligence activities are completed. So, if you're contemplating related strategy, be prepared for an extended journey.

A successful plan transformative for plan sponsors, employee participants, and selling shareholders. The capital gains and income tax benefits alone can be robust, but the potential costs and complexities must be considered. A thoughtful, disciplined process can be the difference between an uncertain transaction and an optimized plan.