Last year, over there were 110 announced acquisitions of non-ESOP companies by existing ESOPs. That number significantly understates the actual number of acquisitions because most ESOP companies do not send out press releases or get press coverage for their acquisitions. It is likely, however, that the actual number is now a few hundred per year. In other words, at least as many companies are likely being acquired by ESOP companies as new ESOPs are being set up.
The reasons for this are straight-forward. Many ESOP companies are sitting on substantial cash reserves, both because they perform better than other companies and because so many ESOP companies are S corporations 100% owned by their ESOPs and pay no income tax. Sellers may also prefer to sell to ESOP companies, either because they may be able to take a tax deferral on the sale and/or because they like the idea of selling to an ESOP company better than selling to a private equity firm or large competitor, even if they could get a better deal.
The track record of ESOP company acquisitions has also been exceptionally good, as research by Suzanne Cromlish showed. Cromlish concluded that ESOP companies approach acquisitions very thoughtfully by making sure they have good systems in place for integration of systems and cultures and putting an emphasis on retaining employees. Very few ESOP acquisitions have failed, and they appear to have a much better track record than acquisitions by private equity firms and non-ESOP buyers.
Many ESOP company acquisitions are conventionally structured, with the company buying another company’s stock or assets and the seller paying capital gains taxes. This is especially true for smaller transactions.
It is possible, however, for a company (the “acquirer”) to use its ESOP to buy the stock of another company (the “target”) and have the target’s owner qualify for a deferral of capital gains tax (Section 1042 treatment). There are different ways to do this and different issues involved. A few general criteria must apply, however:
There are different ways to do this, but the most common is the “two-ESOP approach.” The target company first sets up its own ESOP. If that company is not a C corporation, it would first convert to C. The target company’s owner sells to the target ESOP in a transaction that may be financed by the acquirer and takes Section 1042 tax deferral treatment. Immediately thereafter, the acquiring company’s ESOP merges with the target’s ESOP. Typically, the acquiring company’s ESOP would now own a majority of the target’s shares (because the ESOP in the target had at least a majority), so that target company ESOP participants can now participate in the ESOP of the acquiring company because the target is a member of acquirer’s control group. Subsequently (at least one or two years later), the two companies merge. The delay is necessary to meet tax rules concerning tax-free reorganizations, although there may be specific exemptions for unusual circumstances.
This process adds costs and explains why it is only used when the value of the target is high enough to justify the added expense. Usually, the sales price will be somewhat lower than it would otherwise be to reflect the benefit to the seller and cost to the buyer.
The acquisition is a board decision. The trustee should be kept well informed, but the decision normally does not entail fiduciary issues. If the sales price is for substantially more than fair value, however, the trustee can (and possibly should) object as a shareholder over the possible wasting of corporate assets. We have not seen this issue arise, however.
Normally, the employees at the target will be included in the acquiring company’s ESOP—and indeed must be in most cases. But this may not typically take place right away. The two companies will start out with different benefit packages, and decisions need to be made about what to keep and what to change.
This process may take a year or two to complete. Meanwhile, if the acquisition is to succeed, there needs to be an integration team set up to handle management transitions, systems integration, lines of responsibility, and how the corporate cultures of information sharing and employee involvement will be handled. These are sensitive issues that demand careful attention.