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Leveraged ESOP Financing
February 27, 2023
Andrew Nikolai
As the name suggests, a leveraged employee stock ownership plan (ESOP) is a financing-driven strategy, designed to allow broad-based employee ownership without requiring individual workers to provide personal capital.
In practice, when an employee stock ownership trust (ESOT) acquires equity from a sponsor company, plan participants do not pay out-of-pocket for their shares. Instead, the transaction is typically structured around two distinct but connected loans: an internal loan from the sponsor company to the ESOT, and an external loan from third-party lenders or from selling shareholders. This dual-loan approach facilitates a meaningful equity sale in a single transaction while allowing for the gradual repayment of borrowed funds, leveraging future corporate earnings to satisfy the debt obligations.
In this article, you'll learn about:
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 funds from its 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 a fixed 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 establishes an ESOP trust to purchase $10 million in equity. To complete the transaction, the sponsor company loans $10 million to the 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 repayment of the $10 million loan.
This round-trip 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 transaction financing, also known as the “external ESOP loan.”
External ESOP Loans
To pay selling shareholders for their equity, a plan's sponsor will secure external financing on behalf of the employee trust. 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 its 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 provided 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 from 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 immediate wealth diversification.
But leveraged ESOP transactions are rarely financed exclusively by 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. Private credit funds and other specialty lenders offer these loans. 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 plan…
Before finalizing the $10 million transaction, the company secures a $5 million senior bank loan from an ESOP 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, per the loan’s terms.
Each leveraged ESOP financing option carries unique benefits and risks.
A company should carefully consider leverageability, future capital needs, risk tolerance, and the total cost of ESOP financing before borrowing for a transaction. An ideal strategy reflects the needs of all stakeholders and imposes a manageable debt load on the plan’s sponsor.
Certain financing decisions carry tax implications, and some lenders have more experience with employee ownership than others. A knowledgeable advisor can make all the difference in structuring an optimal ESOP financing package and facilitating a plan's long-term success.