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Leveraged ESOPs and Employee Buyouts
by Vaughn Gordy, Neal Hawkins, Mary Josephs, William Merten, Rebecca Miller, Scott Rodrick, Corey Rosen, and John Solimine
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In the sixth edition, the book has been extensively updated and enhanced. It now features vastly expanded coverage of the intricacies of ESOP transaction financing (including seller financing), plus updates and additions to existing material on legal, valuation, and accounting issues.
Format: PDF, 204 pages
Dimensions: 6 x 9 inches
Edition: 6th (April 2013)
Status: Available for electronic delivery
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Part 1: Legal, Valuation, and Accounting Considerations
1. A Primer on Leveraged ESOPs
2. Understanding ESOP Valuation
3. Accounting for ESOP Transactions
4. Section 1042 and the Tax-Deferred ESOP "Rollover"
5. Using ESOPs in Mergers and Acquisitions
Part 2: Financing
6. The Changing Faces of ESOP Financing
7. ESOP Underwriting Considerations
8. Mature ESOP Considerations
9. Types of Capital
10. Providers of Capital
11. Seller Financing
Appendix: Financial Glossary
About the Authors
About the NCEO
From Chapter 1, "A Primer on Leveraged ESOPs"Essentially, a leveraged ESOP is an intermediary in a loan transaction. Rather than borrow the money directly, a company borrows money and reloans it to an ESOP.
The company first sets up a employee stock ownership trust. The trust then borrows money to acquire stock in the company. The stock can be shares already owned, treasury shares, or new shares issued specifically for sale to the ESOP. Proceeds from the loan can be used for any legitimate business purpose. The stock is put into a "suspense account," where it is released to employee accounts as the loan is repaid. After employees leave the company or retire, the company distributes the stock in their account, which it must offer to repurchase at fair market value if the company is closely held. In the typical ESOP transaction, the lender will loan to the company, which reloans the money to the ESOP. Provided certain rules are followed, this "inside" loan does not have to be on the same terms as the "outside" loan. Lenders prefer loaning directly to the company, but the accounting and tax effects of this two-step process are essentially the same as if the loan were made directly to the ESOP.
From Chapter 5, "Using ESOPs in Mergers and Acquisitions" (footnotes omitted)The principal advantage of an asset sale to the seller is that the seller may be able to get a higher purchase price if the acquirer is a tax-paying C corporation. The reason is that the acquirer will be able to depreciate the purchased assets from their transaction date fair market value (thereby increasing the acquirer's deductions). If all of the acquirer's shares are owned by an ESOP, the acquirer's deductions can be even further increased in such a case if its ability to depreciate the purchased assets at their closing date fair market value is financed by the acquirer's use of treasury share sale proceeds (with the ESOP loan undertaken to permit the ESOP's purchase of treasury shares effectively allowing the acquirer to deduct acquisition indebtedness principal payments).
Of course, to the extent that the acquirer is an S corporation that is wholly owned by an ESOP, deductions will be important to the acquirer group only to the extent they can be taken on applicable state tax returns. In such a case, the principal advantage of an asset purchase structure is that the acquirer may feel that it is acquiring fewer liabilities than it would were it purchasing the target's stock. (Whether this would actually be true would depend on the parties' relative bargaining powers in terms of purchase agreement representation and warranty and indemnification provisions.)
From Chapter 11, "Seller Financing" (footnotes and figures omitted)Paid-in-kind (PIK) interest is a unique tool to lessen the cash interest obligation paid by the company, relieving some stress on current cash flow. If interest is PIK (instead of cash), the unpaid interest is added to the principal of the note. PIK is used commonly to provide a company with cash flow flexibility, minimizing the required cash need on the company in the near-term in exchange for paying at a later period. PIK interest can apply either to the entire rate charged or, more frequently, to a portion of the interest. For example, an interest rate on a seller note might be 10%, of which 3% is cash and 7% is PIK.
While the increased flexibility of using PIK interest over traditional current-pay interest is attractive, it does come at a cost to the company and the selling shareholder. The company should understand, through longer-term capital analysis, the total cost that can, unfettered, exceed the future debt capacity of the company, suppress value accretion for the ESOP, and ultimately force a sale or liquidation (all being unintended consequences). Figure 11-1 shows the impact of compounding interest from PIK interest compared to cash interest over a 10-year period.
Figure 11-1 shows that over a 10-year period the 7% PIK interest will compound dramatically, with the balance of the seller note increasing from $10 million to over $18.4 million. To provide some context, if the PIK rate were increased by 3% to 10%, the principal balance of the seller note would grow to $23.6 million—over 2.4 times the original seller note balance for the 10-year period. This is the power of compounding interest that needs to be considered when using PIK interest. A look at the cumulative cost of financing as shown in figure 11-2 highlights the 38% cost increase.