In Episode 5, we tackle the question of how to figure out if an ESOP is potentially the right strategy for you. Unlike 401(k)s or other common retirement plans, implementing an employee stock ownership plan generally requires a formal purchase and sale of shares, with preparation, negotiation, and diligence – much like a traditional M&A transaction. But in several ways, the ESOP implementation process can be faster, less intrusive, and more cost-effective than a third-party sale. Tune in to our latest episode to learn more about how we help business owners sell stock to their employees.
Hello, and welcome back to what’s next, hosted by Acuity Advisors, the show where we help middle market business owners understand and monetize the value of what they’ve built. I’m Chase Hoover and I’m back today with my co-host Chris Kramer. And today we’re going to be tackling the question of how to figure out if an ESOP is potentially the right strategy for you. And if so, so how to actually get one implemented. Good morning, Chris.
Good morning, Chase. Thanks. So hopefully at this point, you’ve at least decided that you want to explore an ESOP further, but maybe still unsure of what it all really means. So, the first thing that we would do is explain some of the similarities and differences to a third party sale, because in its implementation, an ESOP looks a lot like a third party sale with some key differences.
In a similar vein as a third-party sale, there’s a fair amount of planning that you want to do, a fair amount of preparation, a fair amount of assessment, and other things prior to the execution phase. Once you get to an execution phase, like a third party sale, an ESOP involves marketing the opportunity, and it involves drafting an information memorandum so you can explain the benefits and the opportunities of the company that will involve some amount of negotiation. In this case with a trustee. The information memorandum will involve an offer and acceptance, a term sheet, or an LOI, which is very common in a third-party sale as well. And then of course, once an agreement is reached in principle, due diligence ensues for some period of time, and then ultimately the financing of the transaction that gets lined up, and a closing occurs.
Some of the differences with an ESOP are that you kind of bypass the traditional auction structure that we would normally embark on in a third-party sale. And then of course you have a fair amount of regulation that is evident in an ESOP, vis-a-vis the trustee being the buyer and all of the constraints that go along with that. So there are also issues around conflicts and independence and how the process actually gets executed. Transaction costs are a little bit lower. I think the diligence can be done a little bit more streamlined and it generally will take a fair bit less time than a full third-party sale.
Those are some of the differences and similarities between an ESOP and a third-party sale. So assuming that you’re still interested, the question becomes, how do we move the ball forward with this potential ESOP?
Right. So overall, if you’re someone who’s contemplating an ESOP transaction and you’re trying to see what lies ahead on that pathway potentially, to summarize, think about it like a third-party sale with a few key missing pieces. Right? So there’s no auction, the transaction costs are lower, but there are a few nuances for the ESOP. So, figuring out those nuances starts with assessing basically the feasibility of an ESOP for your company. And so we as sell-side advisors would get involved at that point and begin a process that we would call feasibility and plan design.
So in that stage of the process, the first thing we’re going to tackle is trying to figure out what a reasonable valuation for the company might be that would inform a transaction price that gets negotiated. And at that value, what are we going to do in terms of structuring the transaction? What are the resulting outcomes for the various parties to the transaction? So in that stage of the process, we’re going to be looking at proceeds to you as the seller or group of sellers. What does it mean for the company in terms of post-transaction, debt financing, covenants, cash flows, etc. And then lastly, but not least, what happens to the actual employees because remember ESOP is an Employee Stock Ownership Plan. So what do we have in terms of a benefit level and what do we have in terms of eligibility? That all happens in kind of this initial stage.
But we take a fairly deep dive, and it really starts with something you alluded to earlier, Chris, which is the planning and preparation. So just like third-party sale, the first things we want to look at are anything that might fall into the category of clean-up or anticipation. In an M&A context, this is sometimes referred to as sell-side diligence, where we’re basically going to try and pre-vet or preempt the diligence that any potential buyer might do so that we can anticipate what the issues are going to be. And if there’s a remedy for them, do it on the front end so that there are no surprises later in the process.
So for an ESOP, it’s basically the same things that you’d be looking at for a deal. What do we have in terms of adjustments to the financial statements? Do we have good enough financial statements or do we need to go obtain them? Do we have a current budget that’s reliable? If not, can we create one? And how can we create a long-term forecast? It’s key to negotiating a transaction, which we’ll get to in a second. When we talk about execution, it’s generally presenting kind of the longer-term outlook for the business. Some business owners, some management teams create that in the normal course, always forecasting by virtue of the fact that you’re signing long-term commitments, but you may not actually have a formal, longer-term, multiyear forecast. So that this point in this sort of feasibility and planning stage is when we might do that.
And then lastly, in this kind of category, we may be looking at potential restructuring that might need to get done. ESOPs have to acquire stock in a corporation. You might be set up as an LLC. You might have multiple entities and we might want to set up a holding company. So these are the cleaning house, setting-up, anticipating, preparing aspects of the process that obviously we’re going to start out with.
Yeah. And then from there, we start actually doing the modeling, which is what we would call the plan design portion of the project. So we would talk to you as a business owner about, for example, the size of the transaction, meaning are you interested in selling a hundred percent? Are you interested in selling something less than that? How would we finance the transaction? How would we, for example, create management incentives to go along with the actual ESOP benefits. And then we would obviously model for you, what does it mean numerically and financially to you in terms of your proceeds either before or after tax. Because there are some strategies that we can help mitigate, or in some cases eliminate the capital gains tax. That’s generally a big selling point for a seller. We would obviously model the impact of the transaction on the company from a cash flow perspective. And Chase alluded to covenants and restrictions and debt service and the like, and then of course the employee benefit level.
Following that feasibility and plan design, you would be in a position to understand culturally and mechanically how an ESOP works, but more importantly, numerically and financially what the impact would be. To the extent that you’re still interested and the lights are all green, then we would go to the execution phase.
Right. And I think at the end of that feasibility process, in our experience, what generally happens is we’re going broad to narrow in terms of the flexibility and the options that you have. So there’s not one way to do an ESOP. You got to make adjustments that fit your specific constraints. But generally speaking, there are a few strategies that could be pursued. Where we generally end up at the end of feasibility is, we sort of have scenario A, usually scenario B, and then sometimes scenario C. And you as the owner are either saying, “Okay. I don’t like any of the scenarios. We’re done.” Or, “I like A. I like C.” And we as the advisor and potentially a couple of other advisors, which we’ll get to in a moment, help you narrow down that decision and ultimately choose a path that sets us down beginning the execution phase.
Yeah. So when we start off an execution, we’re pretty well committed that we want to at least go down the ESOP route because now you start spending some money on other advisors. Before we do that though we, not unlike a third-party sale, would create a document. We would call it a confidential information memorandum or a SIM or something similar that we would use as our presentation materials to a trustee or to several trustees, to not only select them and give them a heads up on what the transaction might look like, but then ultimately to help with the diligence process and set the table for who you are, why you’re a great company, why an ESOP makes sense and then mechanically how we’re envisioning the transaction would unfold.
So once we have that document created, around that time we would recommend that you retain seller counsel and that would be for the transaction. You would also need ERISA counsel to draft the plan documents. Oftentimes those are the same attorney because we know a fair number that are competent in both areas. Sometimes it would be a different attorney and we can work through that. But the next step in the process is generally for you to select a trustee that would be effectively the buyer in the transaction. We would help introduce the ones that we know and that we like, but ultimately you would be responsible for selecting the trustee. And in preparation of that process, we would be providing that information memorandum to several trustees and facilitating diligence on your part to actually select the one that makes the most sense and is the best fit.
Yeah. And it’s a pretty significant assessment because this is not just a provider. In some sense it is, but this is the party you’re going to be negotiating with. And presumably, if everything goes according to plan and the transaction closes, this is the fiduciary who’s going to be managing and overseeing the benefits on behalf of the employee participants. So this is someone that you’re presumably, as a company, not personally as a seller, but as the company at the board level, starting a potentially very long-term sustainable relationship with. This is somebody who’s likely to be at, at least, one of your annual board meetings and you’re going to have a lot of interaction with. So it’s a very important step in the process.
So once you’ve gone through that selection process and you’ve settled on a trustee, you can expect that they would have two key advisors on their team that you would not necessarily select, but you would be paying for as the sponsor of this ESOP. And that would be their financial advisor or appraiser, if you will, and their own trustee counsel. So their attorney would help with diligence and reviewing documents, etc. The financial advisor is in some ways our counterpart on the other side, where we are estimating value and helping you understand what we believe would be a fair price for the ESOP to pay, they would then on behalf of the trustee, do their own analysis, come up with a range of value and hopefully, our negotiations are somewhere overlapping and collectively within one another’s ranges and we settle on a price that makes sense.
The rest of the terms are also negotiated, and those could be the seller’s financing. In terms of that, it could be management incentives. It could be employment agreements. It could be any number of other things, not unlike a third-party sale that gets negotiated. So when you’ve got the trustee team selected and the diligence process starts, that’s their opportunity to get a high-level look, and then a more detailed look at the company with the goal really being that they can respond to an offer that we’re going to make to them.
Unlike a third party transaction, ESOPs generally result in the seller, meaning you in this case, making an offer to sell, as opposed to in third party sales, the buyer making an offer to buy. The primary reason for that is an ESOP generally has to be structured and that involves a lot of moving parts, such that the buyer, the trustee, who frankly, is more of a passive buyer if you will, is in a better position to respond to things that the seller is going to ask for in the way that the transaction is structured, as opposed to structuring it on behalf of the employees themselves. Because in between a transaction and an ESOP is the company. So you, as the selling shareholder are a party to the transaction. The trustee as the buyer is a party to the transaction, but in the middle sits what we call the sponsor … the sponsoring company. And so it’s a little bit of a hybrid as compared to a third-party sale.
Yeah. And that also has a different nuance to it here, which is typically the diligence processes in an M&A transaction commences once the terms in the form of a letter of intent have been agreed to, and that letter has been signed. Here the diligence process basically gets full steam before a signed term sheet is reached. There’s more diligence done after that, bring-down due diligence or closing diligence, but the respective counsels are involved, the lawyers are reviewing contracts. They’re looking at lease agreements. They’re looking at employee benefits documents. All the typical diligence categories are being assessed while the term sheets are being negotiated between the seller and us as a financial advisor, and the trustee’s financial advisor on the other side.
So it’s sort of a concurrent process that obviously comes to a halt if it becomes evident that we’re not going to get to an assigned term sheet. But everybody’s intent or expectation is that, with reasonable terms and a reasonable opening offer, if we weren’t going to be able to come to an agreement, we wouldn’t have started down this path much anyways. So there’s a fair bit of difference there in the process too.
So once the term sheet is signed and the transaction terms are largely negotiated, the rest of the process looks a fair bit like a third-party sale. Contracts get drafted. In this case, a stock purchase agreement, note agreements. Potentially, again with a third-party financing source, in those loan agreements, there might be a management incentive plan that’s drafted. There might be employment agreements. There might be leases that have to get executed between the selling shareholder and their entity that might own, for example, the corporate headquarters or some piece of real estate, and any number of other transaction documents. And then ultimately at the time of closing, the financing gets arranged. Term sheets and commitment letters are executed. Funding occurs, not unlike a third-party sale. Signature pages get released and the transaction closes. It’s sort of a virtual close. It just gets announced after a closing call that signatures are ready to be released and, similar to a third party sale at some moment in time, the transaction closes. So that’s kind of a fun event.
The question then becomes, what now? Now we’ve closed. What does it really mean? And what happens? One of the things that happens is you end up with some cleanup and post-closing items that have to be addressed. Generally speaking, there is, like a third-party sale, some amount of a purchase price adjustment mechanism sometime after closing – two, three months, 90 days, 120 days – that would be addressed. Oftentimes, the management incentives act to actually get granted. So there are some corporate actions that have to occur. And then a little bit later, you end up needing a third-party administrator (TPA) to actually do the allocations and the account statements. Not unlike your 401(k) provider, but a fair bit different because an ESOP administration process is a fair bit different than a 401(k) process. Oftentimes your provider can be the same party, but really only if they have fairly deep ESOP expertise.
In addition to the TPA, you will need an evaluation advisor and a trustee annually. So there are maintenance costs that occur on an annual basis. And so that advisor? It’s kind of an interesting dynamic. The trustee that you hire who was at the transaction date on the other side of the table as the buyer, now becomes aligned with the company post-transaction, because they’re responsible for administering the trust on behalf of the employees. The same thing with the valuation advisor. In the deal they’re on the other side of the table and then post transaction, you’re going to theoretically work with them over a long period of time because there is an annual valuation requirement.
Yeah. And I think in a later podcast, possibly not the next one, but later in this sort of ongoing series, we’ll do a little bit of a deeper dive into what the ongoing burden, if you want to call it that or process maybe more appropriately, to maintain an ESOP over presumably an indefinite period of time actually requires and what the roles and responsibilities are. Not only in hiring and retaining advisors, but really as a management team and as a board and as a leadership group. How do you promote the ESOP, maintain its health, and just manage it responsibly? But at the end of the day, we wanted to provide this walkthrough of how to get from assessing an ESOP very preliminarily to starting the execution process and ultimately getting through closing, and highlight where it’s very similar to a third-party sale process versus where it has its own nuances.
But at the end of the day, depending on how the deal ultimately got structured, we end up in a place that’s very similar to other scenarios, depending on how you structured it. After the deal, the ESOP owns either some or all the company’s equity. The seller or sellers have some cash proceeds or some promissory notes or both, and perhaps also some warrants or synthetic equity of some kind, and the company now owes some amount of debt to either a bank or the seller or both. So we always end up, depending on how the deal is structured, in that sort of boat.
So if you want to be in that boat, we’d love to hear from you, give us a call. Thanks everybody for listening. And thanks again, Chris.
And as always, we like to end on the fine print. This podcast is for general informational purposes only. It does not create an advisor client relationship between Acuity Advisors and the listener or reader, and is not intended as advice for a specific situation. And as always, we’d like to thank our wonderful sponsor Acuity Advisors. Thanks everybody.