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Selling Your Business to an ESOP
Formerly titled Selling to an ESOP
by Bill Brett, Christopher J. Clarkson, Ronald J. Gilbert, Stacie Jacobsen, Nathan Nicholson, Loren Rodgers, Corey Rosen, Paige A. Ryan, Kenneth E. Serwinski, and Brian B. Snarr
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Aside from updates to existing chapters and new material on investing the proceeds of the sale, the 10th edition (2017) features an analysis of crucial data from the NCEO's pioneering survey on ESOP transactions.
Format: PDF, 175 pages
Dimensions: 6 x 9 inches
Edition: 10th (February 2017)
Status: Available for electronic delivery
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1. An Introduction to ESOPs
2. Should You Sell to an ESOP?
3. Understanding ESOP Valuation
4. Financing the Leveraged ESOP
5. ESOP Feasibility
6. Investing After You Sell Your Business to an ESOP
7. Why I Did Not Use Floating Rate Notes as Qualified Replacement Property
8. The Prohibited Allocation Rule Under Section 1042
9. The 2015 ESOP Transaction Survey
About the Authors
About the NCEO
From Chapter 2, "Should You Sell to an ESOP?"The management buyout example assumes the company would be worth $10 million after 10 years. The ESOP example assumes somewhat slower growth for the ESOP-owned company because of the debt, so that after 10 years the company would be worth $8 million (in fact, this is almost certainly far too conservative because ESOP companies tend to grow faster than non-ESOP companies and will overcome the debt issue in several years, but we're being cautious here). Management would own 33% of that, worth $2.64 million, or about $533,280 each. In the management buyout case, they would net $300,000. In other words, the ESOP turns out to be a better deal for management, even with management owning less of the company. Moreover, the managers could roll their ESOP distributions into an IRA on a tax-deferred basis.
In some ESOP companies, management may also get some additional equity in the form of stock appreciation rights or phantom stock. Where this is done, it might add another few percentage points to the ownership of each manager, making the deal even better.
Table 2-1 summarizes this comparison. The assumptions here are meant to be realistic and modestly conservative. But every example is very different in terms of how many managers are involved, how the management buyout is set up, payroll differences, turnover differences, and what happens to the company after the buyout. The point is not that managers or sellers are always better off with an ESOP approach, but rather that the kind of calculation shown here should be made before making a decision.
As the next section of this chapter explores in more depth, it is common for the ESOP to own only part of the company, leaving flexibility for managers to purchase additional stock and/or receive additional equity as incentives. So the five managers here might buy 30% of the company, or they might acquire the rights to an additional 15% to 20% of the total equity value through stock appreciation rights, for instance, making the ESOP approach even more favorable to them.
From Chapter 6, "Investing After You Sell Your Business to an ESOP"There is a technique, however, that allows John and Jane to diversify their portfolio broadly, manage it in response to changing market conditions, and/or spend some of their principal without onerous tax consequences. To accomplish all of this, they would buy corporate floating-rate notes (FRNs) that qualify as replacement property (QRP) and hold them for many years. The couple can borrow against these bonds to fund a liquid portfolio at full basis that can be actively managed without the restrictions of Section 1042. Financial institutions lend against these specialized securities at a loan-to-value ratio as high as 90%, but since the credit crisis, loan-to-value ratios have typically been lower, often in the 75% to 80% range.
The FRNs are highly specialized to serve as both QRP and as collateral for a loan. Typically, FRNs are very long-term bonds with maturities of 30 to 50 years and not callable for many years because the deferred tax becomes due when the bond matures or is called. The interest paid by the bonds floats along with the London Interbank Offered Rate (LIBOR), usually with quarterly resets. The floating-rate coupon keeps the price of the bonds relatively stable and results in increasing cash flows in a rising interest-rate environment (and decreasing cash flows in a falling interest-rate environment).
Most FRNs are issued by highly rated companies and carry put options allowing the holder to sell the bond back to the issuer at close to par value on each anniversary date, if the bond's credit quality worsens materially. Issuers include established companies, such as GE Capital, Procter & Gamble, 3M, UPS, Colgate-Palmolive, and certain banks.
The FRN market is small and relatively illiquid, so it takes time to build a portfolio with even a handful of names. Thus, it is imperative for sellers to begin building a QRP portfolio as quickly as possible after closing the sale to meet the 12-month investment deadline.
From Chapter 9, "The 2015 ESOP Transaction Survey"There is a clear relationship among respondents between the number of services procured and the total cost of the transaction, as shown in figures 9-5a and 9-5b. For initial transactions, a majority (56%) of companies procuring only one or two additional services beyond valuation reported a total transaction cost of under $75,000, while just 19% of those procuring three or more additional services reported transaction costs under $75,000. For subsequent transactions, a large majority of companies (78%) reported transaction costs under $75,000 when procuring one or two additional services, compared to 21% who reported transaction costs under $75,000 when procuring three or more additional services.
Most smaller transactions (in which the company moved to less than 10% ESOP-owned) fall into the smallest cost category, as shown in figure 9-6.