Acquiring other companies can be a good strategy for any company. Acquisitions can open new markets, create more efficient operations, or provide a more diversified customer base. S corporation ESOPs especially have good reasons to consider acquiring businesses to find a good use for cash. But most acquisitions do not live up to expectations. This book provides a general framework to evaluate acquisitions, specific ways to limit their risk, alternative transaction structures of special use for ESOP companies, and some best practices in making acquisitions turn out well, especially when one ESOP company acquires another. The second edition (2021) includes revisions to the text, plus a new chapter. Also see our publication on the other side of this issue: Responding to Acquisition Offers in ESOP Companies.
Table of Contents
Using ESOPs in Structuring Acquisitions
ESOPs and Acquisitions: Making It Work
1. Acquisitions as Part of Business Strategy
Defining and Determining Value
Value Creation, Preservation, and Destruction
Building EBITDA for Value Creation
Building Growth Versus Buying Growth with Acquisitions
The Acquisition Process
Pricing the Acquisition
Financing the Acquisition
2. Managing Risk
Due Diligence and the Purchase Agreement
Fiduciary Issues for the Board of Directors
Issues for Trustees to Consider
3. Transaction Structures for Acquisitions by ESOP Companies
When Section 1042 Treatment Is Desired by Target Shareholders
When Section 1042 Treatment Is Not Desired by Target Shareholders
4. Issues for ESOP Companies Acquiring Other ESOP Companies
Factors That Cause Mergers to Succeed or Fail
Valuation of the Combined Entities
Protecting the Interests of Each Company's ESOP
Reconciling Plan Differences
Other Employee Benefits and Compensation
Combining a Mature ESOP with a Young ESOP
Communicating the Transaction
Appendix: Survey Questions for Key Participants to Assess Mergers and Acquisitions
5. How to Make an Acquisition by an ESOP Company Successful
About the Authors
From "Acquisitions as Part of Business Strategy"
One special issue is the ESOP repurchase obligation. If the acquisition works in the way the acquirer intends, the value of the buying company’s shares will be increased. This will result in a higher level of repurchase obligation as the increased value will flow into the employees’ retirement accounts. Companies doing acquisitions need to make some assessment of this as part of the due diligence process. If the target company’s employees are included in the buyer’s ESOP, the value per share will be spread among a larger population of employees. The impact of the added employee population on repurchase liability will be a function of the demographics of the acquired employees and the vesting provisions of the plan. If the target’s employees are not included, the incremental value will be spread among a smaller group of employees, resulting in a higher level of repurchase obligation per employee. The “lumpiness” of that obligation will depend on the demographics, salaries, and tenure of the existing employee population. Of course, acquisitions do not always work, which would affect the repurchase obligation in the opposite direction and potentially create cash flow issues.
A second issue is that ESOP companies often have above-average contributions to retirement plans and will increase the target’s contributions after the acquisition to create a unified compensation policy. If a buyer wants to have an above-market retirement program, it cannot expect the seller to bear the cost of that program. The retirement program is in effect a negative synergy. This should not be problematic for the buyer because the buyer is imposing that negative cost burden on its company as a whole before the transaction. On the other hand, if the seller has a below-market retirement program, then the cost of bringing that program up to par should be deducted from the seller’s EBITDA and should result in a lower purchase price. Underlying these points is the assumption that the buyer has had a professional analyze industry norms for compensation by grade and that the conclusions are derived with reference to that normative study.
From "Managing Risk"
The purchase agreement will include representations and warranties to the acquiring company by the selling shareholders regarding their shares and the condition of the target company itself (the “reps and warranties” for short). Many of the reps and warranties are considered to be standard in almost all purchase agreements, while others depend on the industry and the actual facts and circumstances of the target company. The reps and warranties are heavily negotiated because they are the primary means of allocating risk between the acquirer and the target’s selling shareholders. The reps and warranties require the target company and its shareholders to make certain factual representations about the target.
The reps and warranties are qualified by the disclosure schedules, which set forth any exceptions to the reps and warranties. The reps and warranties and the disclosure schedules work hand in hand to create a record of the selling shareholders’ statements of facts about the target company, which if untrue create liability after closing for the target shareholders under the indemnification provisions described below. For example, a common representation is “except as set forth on the Disclosure Schedules, the target company is not a party to any Litigation nor, to the target’s knowledge, are there any facts or circumstances that could reasonably be expected to result in Litigation.” If there are any facts that would make this representation untrue, those facts should be listed on the disclosure schedule so that the acquiring company is made aware of them.
From "Issues for ESOP Companies Acquiring Other ESOP Companies"
If the goal is consolidation, integration needs to move quickly. Generally, if there are going to be cost savings, if they do not show up in the first 12 to 18 months, these kinds of mergers are not likely to succeed. That means that there should be highly directive, top-down leadership. It is not a merger of equals. Ideally, a team is assigned to identify where the cost savings will come from. Of course, these strategies come at a cost—there is likely to be a significant decline in morale and possibly an increase in voluntary turnover in the target (or in a merger, the areas where the cost-cutting occurs), including key people. That can mean that any cost savings generated may be quickly overwhelmed by losses in long-term performance. This is part of why acquisitions have such a low rate of success. In the NCEO’s view, ESOP companies will generally not benefit from making these kinds of acquisitions because they will create two very different and possibly antagonistic cultures. Our experience is that ESOP acquisitions or mergers are much more common in situations where there are perceived complementarities in products, technology, or marketing, such as when one company can help expand a market, add a needed technological capacity, or diversify product lines. Most ESOP acquisitions are of the first sort. Based on a tabulation of ESOP acquisitions reported in the press over the last several years, it appears about 80% were of companies where the acquirer purchased a company doing the same thing but in a different market with a goal of expanding its operations.