Leveraged ESOP Financing

As the name suggests, a leveraged employee stock ownership plan (ESOP) is a financing-driven strategy. When an employee trust acquires equity from a company, plan participants do not pay out-of-pocket. Instead, a pair of loans facilitate these ESOP transactions.

Internal ESOP Loans

At its core, an employee stock ownership plan is an ERISA-authorized retirement plan that invests solely in a sponsor’s securities. A plan has no assets when it's first established. To purchase company stock, an ESOP will often borrow money from the plan’s sponsor. This internal loan is central to leveraged ESOP transactions.

In certain respects, this is a conventional loan. Terms include a set amortization schedule (generally 15-30 years) and interest rate. But there’s one big difference: the lender effectively makes payments on the borrower’s behalf.

Let’s use an example to illustrate.

A privately-held company creates an employee trust to purchase $10 million in equity for an employee stock ownership plan. To complete the transaction, the sponsor company loans $10 million to the ESOP trust.

Over the next 15 years, the sponsor will make annual contributions and/or dividend payments to the plan. With each contribution, a pro-rata portion of the ESOP's shares is allocated to employees. Immediately following a contribution, the plan will return that cash to the company as a partial loan repayment on the $10 million.

This roundtrip ledger entry creates a non-cash tax deduction for the company, much like a depreciation expense. Those funds are ultimately used to pay down the second portion of ESOP financing, also known as the “external loan.”

External ESOP Loans

To pay selling shareholders for their equity, an employee stock ownership plan's sponsor will secure external financing on the employee trust’s behalf. This can take the form of seller notes, third-party loans, or a combination of the two. There are considerable differences between these lending options, each with their own pros and cons.

Seller Notes

Issued directly by a company to a selling shareholder, seller notes offer a low-cost ESOP financing option. Sellers are paid gradually, with interest, but at rates typically lower than those offered by third-party lenders.

Debt-averse companies often gravitate to seller financing, due to their close association with the lender and the relative flexibility of payment terms. Still, there’s a downside for selling shareholders: a seller note generally does not deliver cash up-front. As a result, sellers assume greater personal risk in terms of wealth diversification.

Senior Debt

A standard business loan, provided by a commercial bank, is the most common source of third-party ESOP financing. Terms vary based on borrower specifics and the standards of commercial lenders, but pricing is generally set at a spread above a reference rate (e.g. SOFR + 2.0%). Securitization can either be asset or cash flow-based.

Loan-funded sale proceeds are disbursed when an ESOP transaction closes, and financing terms can be negotiated without personal guarantees. These features make senior debt an attractive option for sellers who prioritize an immediate net worth diversification.

But a leveraged ESOP transaction is rarely financed exclusively with a senior bank loan. In most instances, seller notes and/or mezzanine debt will supplement a financing package.

Mezzanine Debt

When selling shareholders prioritize cash at closing, and soon-to-be ESOP companies can reasonably sustain additional leverage, mezzanine debt options are considered. These loans are offered by private credit funds and other specialty lenders. Mezzanine financing is subordinate to senior debt and is commonly securitized by a company’s future cash flows and a second lien on company assets.

While mezzanine debt can enhance a seller's up-front liquidity, the financing may create a greater risk for a plan’s sponsor. Higher interest rates, up-front fees and prepayment penalties (relative to senior debt) increase the cost of the mezzanine financing.

Going back to our hypothetical employee stock ownership plan…

Prior to finalizing the $10 million employee stock ownership plan transaction, the company secures a $5 million loan from a senior bank lender. The sponsor also finalizes a $5 million seller note.

At the transaction’s close, the seller receives $5 million in cash (funded by the senior debt). The ESOP company will pay off the remaining $5 million over an anticipated five-year period. It will also satisfy the senior debt obligation, using pre-tax cash flow, according to the loan’s terms.

Each leveraged ESOP financing option carries unique benefits and risks.

A company should carefully consider leveragability, future capital needs, risk tolerance, and the cost of financing before it borrows money for an ESOP transaction. An ideal strategy reflects the needs of all stakeholders and imposes a manageable debt load on the plan’s sponsor.

Certain financing decision carry tax implications, and some lenders have greater ESOP experience than others. A knowledgeable advisor can make all the difference in structuring an optimal financing package and facilitating the long-term success of an employee stock ownership plan.