A leveraged ESOP borrows money to buy shares in the sponsoring company in order to buy a major part or even all of the company. It can be used to purchase shares from retiring owners in private firms, buy out entire companies, or finance new capital. With leveraging comes additional cost and complexity. This book discusses how ESOPs work and explains those complexities, providing comprehensive coverage of ESOP financing plus chapters on legal rules, valuation, M&A, and the tax-deferred ESOP "rollover."

In the seventh edition, the book has been extensively revised, with chapters updated, removed, and added to make it a more practical and straightforward guide for the business owner, executive, employee group, advisor, or lender. New chapters discuss frequently requested topics such as warrant strategies and seller financing, plus bank financing and alternative sources of capital. 

Product Details

Perfect-bound book, 128 pages
9 x 6 inches
7th (November 2020)
In stock

Table of Contents

1. A Primer on Leveraged ESOPs
2. Understanding ESOP Valuation
3. Section 1042 and the Tax-Deferred ESOP "Rollover"
4. Using ESOPs in Mergers and Acquisitions
5. Bank and Seller Financing for ESOP Transactions
6. Warrants in ESOP Transactions
7. Alternative Financing Sources in ESOP Transactions
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 an 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 2, "Valuation"

Whether or not any discounts and/or premiums apply to the indicated values derived using the valuation methods described above depends on numerous factors. In ESOP valuations, discounts generally fall into two categories: liquidity and control. These are discussed in more detail below. But before knowing whether to apply a discount, it first must be determined whether or not the valuation is being conducted on a controlling interest (or enterprise) basis or a minority interest basis. Then, depending on the method and data used within the valuation method, appropriate discounts and/or premiums are applied. Similarly, whether to apply a liquidity discount depends on whether the comparisons used to determine value are based on liquid or illiquid interests in companies.

From Chapter 3, "Section 1042 and the Tax-Deferred ESOP 'Rollover'" (footnotes omitted)

There is no prohibition against reinvesting in securities of closely held companies, but the QRP cannot include securities of the ESOP company itself—that is, the company whose shares were sold to the ESOP (e.g., a shareholder in Company X cannot sell 30% of Company X’s stock to Company X’s new ESOP and then buy more Company X stock to serve as QRP). Corporations controlled by the ESOP company or that own stock representing control of the ESOP company are also excluded from being QRP. However, it would be permissible for the QRP to consist of shares in another company owned by the seller that was not in the same controlled group of corporations, including a new corporation funded wholly with the ESOP sale proceeds.

From Chapter 4, "Using ESOPs in Mergers and Acquisitions"

In almost every M&A transaction, the acquirer will have to consider the disposition of existing (non-ESOP) retirement plans at the target company. The plans can either be (1) continued with amendments, (2) terminated, or (3) merged into the acquirer’s existing plans. If they are continued with amendments, basic principles of plan participation, vesting, and retirement will continue to apply. These principles can give rise to multiple plan issues (e.g., minimum coverage, combined plan limits, or using dividends or distributions to sidestep applicable limits).

If the plans are merged, the acquirer must also review the target plans for possible plan and/or statutory violations. The acquirer does not want existing acquirer plans to become tainted with problems from the target plans.

From Chapter 5, "Bank and Seller Financing for ESOP Transactions"

In addition to the above, which is standard for most financing requests, there are additional ESOP-specific requirements the bank will generally require. For S corporation ESOPs, banks will require a pro-forma 409(p) test (anti-abuse test) showing the company’s 409(p) position after giving effect to the transaction. For second-stage transactions (i.e., where an existing ESOP purchases some or all of the remaining outstanding shares of its sponsor), banks will likely require a current repurchase obligation study. Repurchase obligation studies provide the bank with an estimate of the liability the company (the plan sponsor) has to buy back stock of departing ESOP participants. While this is not likely to be a requirement for evaluating a financing of a new ESOP because repurchase obligations are generally not large enough during the first 7 to 10 years after the initial ESOP transaction, banks will often require that one be performed within the first few years after the transaction and then periodically thereafter. Finally, while the bank is not entitled to receive a copy of the valuation report prepared for the trustee in support of the fairness opinion, the bank will often seek to review the fairness opinion letter to understand the scope of the analysis performed and the breadth of the opinion. Going forward, the bank may request a copy of the annual update valuations and will be prepared to sign a non-reliance letter for the trustee if requested.

From Chapter 6, "Warrants in ESOP Transactions"

The starting point for determining the number of warrants to be issued is the targeted IRR (coupon plus warrant proceeds). The issuer must determine how soon its cash flow will enable it to pay the subordinated note. If the stated term of the subordinated note is 10 years but the issuer anticipates cash flow will enable it to pay the notes in 8 years, then the 8-year term should be used in calculating the number of warrants to be issued to achieve the target IRR.

The issuer then must estimate the projected share value of the stock subject to the warrant at the most likely date on which the warrant will be settled. The parties’ financial advisors must estimate the cash to be received by the seller on the repayment of the note (principal and interest):

  • Face value of seller note (initial outlay), plus
  • Cash received from repayment of principal and interest on the note, plus
  • Cash payment on the warrants

From Chapter 7, "Alternative Financing Sources in ESOP Transactions"

Mezzanine debt is the middle layer of capital that sits subordinated to senior debt and above equity on the balance sheet. This type of capital is usually not secured by assets and is lent based on a company’s ability to repay with cash flows. This form of capital is a great way to bridge the gap between the company’s cash needs and what traditional lenders are willing to provide. This is often described as more “patient” capital. Mezzanine debt does not require any principal payments and simply has a balloon payment at the end of its term. This debt typically matures six months or more after any senior debt on the balance sheet. Because this debt sits lower on the balance sheet, it is deemed to be riskier than senior debt and requires higher interest rates. As such, it is common for interest rates for this type of debt to be double digits and to have a component of it be “payment in kind” (PIK). This means that the interest is not paid in cash but added to the principal balance of the mezzanine debt instrument. Some benefits of mezzanine debt include: no amortization, longer maturity, and providing additional liquidity and or capital without diluting existing owners. Some considerations include higher interest costs, prepayment penalties if one desires to repay the debt sooner than required, stricter financial covenants, and, in some cases, board of directors observation rights and/or seats. Sources for mezzanine capital include traditional commercial banks, nonbank lending institutions, insurance companies, and some private equity firms.