This article from The Journal of Employee Ownership Law and Finance, volume 20, no. 2 (spring 2008) describes how warrants are used as part of the financing structure of leveraged ESOP transactions and discusses key corporate finance and federal tax considerations in structuring ESOP financing arrangements involving warrants.
Many ESOP transactions are intended to create a 100% ESOP-owned S corporation. In an S corporation, corporate income is attributed to the shareholders for tax purposes. An ESOP is a tax-exempt trust that does not pay federal income taxes on attributed income from employer S corporation stock. A tax-free for-profit entity without any tax-driven need to distribute income to shareholders creates the unique potential for a highly leveraged finance structure to facilitate the purchase or redemption of larger blocks of company stock from non-ESOP sellers.
Companies generally prefer to accomplish leveraged ESOP transactions through relatively inexpensive senior debt. However, using senior debt alone is often not possible in highly leveraged transactions designed to result in 100% ESOP ownership. Subordinated debt may be required. Selling shareholders often hold this subordinated debt, and the subordinated debt instrument is often structured to address the particular needs and concerns of the selling shareholder. Third-party investors may also provide subordinated debt to fund an ESOP transaction. While this article generally describes subordinated debt in ESOP transactions as seller financing, the descriptions below apply equally to third-party investors who might provide subordinated debt.
Subordinated debt is generally issued by a company as an "investment unit" consisting of the interest-paying note with a separate warrant instrument. An ESOP cannot issue a warrant directly, so seller-financed leveraged ESOP transactions using this form of investment unit must use the company as a direct participant in the ESOP financing. These transactions can be done with both S corporations and C corporations, as described below.