February 27, 2023 •Andrew Nikolai
As the name suggests, a leveraged ESOP sale is a financing-driven transaction. When an employee stock ownership trust acquires equity from a company, plan participants do not pay out-of-pocket. Instead, a pair of loans facilitate the transaction.
Internal ESOP Loans
At its core, an ESOP is an ERISA-authorized retirement plan that invests solely in a sponsor company’s securities. A plan has no assets when it's first established. To purchase equity, an employee trust borrows cash from the plan’s sponsor. This internal loan is central to most 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.
An employee stock ownership plan is formed to purchase $10 million in equity from a privately-held company. To complete the transaction, the sponsor company loans $10 million to the employee 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 plan’s purchased shares is allocated to employees. Immediately following a plan contribution, the ESOP will return that cash to the company as a partial repayment on the $10 million loan.
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 ESOP sponsor secures 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 paper, due to their close association with the lender and the relative flexibility of payment terms. Still, there’s a downside for selling shareholders: these notes generally do not deliver cash up-front. As a result, sellers assume greater personal risk in terms of wealth diversification.
Senior Debt
Typically offered by banks, senior debt is the most common source of third-party ESOP financing. Terms for these commercial loans vary based on borrower specifics, 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 a transaction closes, and financing terms can be negotiated without personal guarantees. These features make senior debt an attractive option for sellers who prioritize personal diversification. But leveraged ESOPs are rarely financed exclusively with senior debt. In most instances, seller notes and/or mezzanine debt will supplement a financing package.
Mezzanine Debt
When selling shareholders prioritize cash at closing, and 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 transaction…
Prior to finalizing the $10 million leveraged ESOP transaction, the company secures a $5 million loan from a senior bank lender. The sponsor also finalizes a $5 million seller note with the selling shareholder.
At the transaction’s close, the seller receives $5 million in cash (funded by the senior debt). The 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 cashflow, according to the loan’s terms.
Each ESOP financing option carries unique benefits and risks.
It’s important for shareholders and their companies to carefully consider leveragability, future capital needs, and risk tolerance before formalizing an ESOP financing package. An ideal strategy reflects the needs of all stakeholders and imposes a manageable debt load on the plan’s sponsor.
Employee stock ownership plans, in general, are complex. The interplay between internal and external ESOP loans is no exception. There are clear-cut tax implications and some lenders have greater familiarity with leveraged ESOPs than others. A knowledgeable advisor can make all the difference in structuring an optimal financing package and plan structure.