Outlook for ESOP structures in 2014




FW moderates a discussion on the outlook for ESOP structures in 2014 between Gregory K. Brown, a partner at Holland & Knight LLP, and Maria Pencheva, managing director at Innovative Shareholder Strategies, LLC.

FW: How would you describe the appetite to utilise ESOP structures over the past 12-18 months?

Brown: I would describe the ESOP appetite as moderate to good over the past 12-18 months. This parallels the middle-market M&A activity for the same period. Larger deals are moving forward while smaller ones seem to be moving slowly, as lenders are paying attention to their best opportunities. ESOPs have retained their favourable tax treatment for sellers and sponsoring companies and money remains available for sizeable transactions while asset values continue to be attractive for sellers.

Pencheva: The effective increase in capital gains taxes in 2013 spurred tremendous ESOP activity at the end of 2012 which was followed by a more subdued first half of 2013. Demand for ownership transition plans increased in the second half of last year and has remained strong ever since. We are seeing more ESOP activity in the first few months of 2014 than during the same period in any of the past five years. The main drivers for this increase in demand are improving economic indicators, stronger company performance, healthy capital markets and a very favourable lending environment. Overall both ESOP volumes and market conditions are favourable and executions are very competitive for well positioned companies and shareholders.

FW: In what financing and transactional situations are ESOPs regularly employed? In what ways has their purpose evolved over the years, such as a means to achieve private equity exits?

Pencheva: The ESOP universe has been expanding significantly in recent years in both the scope of industries and the number of capital providers. ESOPs have traditionally been used as a succession planning tool for shareholders of privately-held companies who are looking for a full or partial liquidity event. An ESOP allows for the sale of company shares at fair market value, creates tax benefits on both the corporate and the personal level, and provides an important employee incentive. With the first wave of the baby boomer generation nearing retirement, we see a larger number of business owners exploring succession strategies. Many of these business owners are not only looking for a liquidity event but also for preservation of their legacy. Using an ESOP can be an ideal succession strategy in these circumstances as it also enables shareholders to reward their employees and the management teams that helped them develop and grow the business. While PE firms have started using ESOP structures as an exit strategy for portfolio companies, ESOPs are not the default strategy among PE firms given the preference for full liquidity events at exit. However, PE funds have increased their interest in providing financing for ESOP transactions. Mezzanine lenders to ESOP companies can receive higher returns on their investments due to the increased cash flows at the corporate level resulting from ESOP-related tax benefits and higher productivity levels resulting from the alignment of interests of the employees and the mezzanine lenders. Over the course of the past two years, an increasing number of PE funds have started co-investing in transactions that include the implementation of an ESOP. Another interesting trend that we have noted is a similar increase in interest and capital allocations from family offices in the ESOP financing space and their emergence as a source of capital.

Brown: Typically, in addition to providing a benefit to employees, ESOPs have been used as an exit strategy or as part of a succession plan. An ESOP provides the selling shareholders with the ability to ‘cash out’ completely or to diversify their assets while remaining a partial owner of the company. Over the past few years, private equity firms have begun to use ESOPs for both dispositions and acquisitions. In some cases, an ESOP can provide a private equity firm with a buyer for an asset which may not be a strong candidate for a third party sale. Private equity firms are also using ESOPs to acquire companies by implementing an ESOP at the target company prior to or contemporaneously with the acquisition. The use of the ESOP can transform a corporate acquisition into a tax advantaged transaction. Existing ESOP owned companies are using their ESOP as a vehicle to acquire a target company on a tax advantaged basis. This can allow the acquiring ESOP owned company to pay a higher price for a target. The cash flow enhancements to an ESOP owned company often means banks will loan more money to facilitate the acquisition.

The ESOP universe has been expanding significantly in recent years in both the scope of industries and the number of capital providers.
— Maria Pencheva

FW: To what extent is the ESOP model appropriate for companies of all sizes? Although traditionally popular with smaller, family-owned businesses, can larger companies also take advantage?

Brown: ESOPs remain popular with smaller, family-owned businesses, but transaction costs have raised the bar on the size of the transaction that is financially feasible. Larger companies are adopting ESOPs and operating them very successfully. These companies normally can absorb the transaction costs more easily, as well as the maintenance costs of ESOPs – fiduciary, appraisal, recordkeeping, legal and so on – and typically have a sophisticated HR function that can keep up with compliance issues.

Pencheva: The majority of ESOP companies in the US have equity valuations in the $10m to $100m range. Larger companies tend to employ outright sales to strategic buyers as this alternative can sometimes result in more liquidity at closing and higher purchase proceeds – strategic buyers often pay acquisition premiums for synergies that they can realise post-transaction. However, with an increase in both senior leverage levels and in the amount of financing provided by subordinated debt and mezzanine lenders familiar with ESOP structures, we see competitive and comparable terms available to shareholders using an ESOP as a part of their succession strategy. Furthermore, selling shareholders can defer capital gains taxes on the proceeds from the sale of stock to an ESOP when certain conditions are met. With an effective increase of long-term capital gains tax rates in 2013 and improving capital market conditions, more owners of large companies are choosing to implement an ESOP and continue their legacy as an alternative to selling to a strategic buyer.

FW: What key considerations do firms need to make when structuring an ESOP? What information should be analysed to determine the feasibility of an ESOP plan?

Pencheva: The main factors that companies need to take into consideration when structuring an ESOP are the shareholder goals, the depth of the management team and succession strategy, projected future performance, as well as the legal, tax and financial implications of the potential transaction structures. We recommend that companies have a feasibility study performed by a financial advisory firm to determine whether an ESOP structure best accomplishes their goals. During the feasibility study, a financial adviser analyses the business model of the organisation, its historical and projected financials including working capital requirements and capital expenditures, its capital structure and various industry trends and utilises standard valuation approaches to determine a range for the current fair market value of the company’s stock. The adviser performs debt capacity analysis and estimates the amount and types of financing available to the company at closing and provides indicative terms – such as interest rate range and typical covenant levels – of each type of financing based on market conditions. Different ESOP structures provide different benefits to the shareholders, the company and the company’s employees. A sale of a more than a 30 percent equity interest of a C corporation to an ESOP can provide for a potential deferral of capital gains taxes on the transaction proceeds. For S corporations, the portion of the equity owned by the ESOP is not subject to federal and state taxes at the corporate level as the company is a pass-through entity and the ESOP is tax-exempt. Therefore, a 100 percent ESOP-owned company does not have to make distributions for federal and state tax purposes. In order to recommend the most appropriate structure for a company, an adviser devises a pro forma sensitivity analysis for the company’s cash flows and illustrates the financial impact of each structure to the company and to its shareholders under different operating scenarios. The feasibility analysis is the stepping stone that enables shareholders and members of the management team to make a well-informed decision.

Brown: The structure of an ESOP needs to accommodate the goals and needs of the selling shareholders, the company and the future participants. The first step is to commission a feasibility study prepared by a third party which analyses the overall viability of an ESOP. The study will look at current and post transaction cash flow, how much lender debt the company can support taking into consideration the tax benefits available after the ESOP is in place, future repurchase obligations, management succession, the impact on employees, the impact on existing company contracts, tax issues and planning, litigation and other corporate contingencies. Depending on the amount of bank debt the company can support, selling shareholders will often need to finance a portion – or all – of the stock purchase by the ESOP through seller notes. It has become more common for selling shareholders to also receive warrants in conjunction with seller financing. Another consideration is whether the selling shareholders want to take advantage of a 1042 tax deferred sale. If so, the company will need to be or convert to a C corporation prior to completing the transaction, and the ESOP will need to purchase at least 30 percent of the company. If a primary goal is to avoid the payment of state and federal income tax in an ongoing basis, the company will need to be or convert to an S corporation contemporaneously with the completion of the transaction. If a company is a C corporation to begin with, the sellers can take advantage of a tax deferred sale and then convert to an S corporation to take advantage of the avoidance of income taxes.

The structure of an ESOP needs to accommodate the goals and needs of the selling shareholders, the company and the future participants.
— Gregory K. Brown

FW: Could you outline governance and regulatory requirements associated with an ESOP structure?

Brown: The board of directors is normally responsible for adoption of an ESOP and appointment of the ESOP plan committee and ESOP trustee and is responsible for monitoring their performance – and, if necessary, replacing them. For ESOP companies, it is desirable, although not required, to have at least one independent director to review and approve audited financials and to review and approve management compensation. From a regulatory standpoint, ESOPs are subject to regulation by both the US Department of Labor (DOL) and the Internal Revenue Service (IRS). Both agencies have audit and enforcement jurisdiction over ESOPs; the DOL oversees fiduciary issues and participant rights issues while the IRS reviews tax compliance issues.

Pencheva: The IRS audits ESOP plans to enforce tax compliance and plan qualification. In the event that the plan is not compliant, the IRS can impose taxes, penalties, and interest. The DOL resolves benefit disputes, conducts investigations and seeks corrective actions for violations of the law, including bringing lawsuits against fiduciary breaches and prohibited transactions.

FW: Could you provide an insight into recent government interest in ESOP valuations? What additional risks and challenges does this development present?

Pencheva: In the past few years, the DOL, in its regulatory and supervisory capacity, has placed great emphasis on the valuation that establishes the ESOP stock’s purchase price and the projections used to develop the valuation. The DOL is scrutinising financial projections, underlying assumptions, adjustments and discount rates. Given these developments, we advise companies considering implementing an ESOP to assume that their plan will be audited and their valuation report will be reviewed. It is our recommendation that they engage a reputable independent trustee with experience in reviewing valuation reports and conducting due diligence and they ensure that the valuation firm elected by the independent trustee is qualified.

Brown: In recent years the DOL has increasingly focused on investigating the valuations provided to ESOP trustees, especially with regard to financial projections and the method of valuation used in determining value. A primary concern is self-dealing by the principals in the transaction. The DOL has also stepped up its analysis of the ESOP trustee’s role in reviewing and accepting a potentially erroneous valuation. The DOL previously proposed regulations that would make the company performing the valuation and fairness opinion for the trustee a fiduciary in certain circumstances. While these regulations have been withdrawn for now, they are expected to be re-proposed in the future. Problematically, if these regulations are promulgated, the DOL is not expected to provide any guidance on how the fiduciary duty will be shared or allocated between the trustee and the valuation adviser. This would create uncertainty and put added pressure on trustees and valuation advisers in determining how they handle ESOP transactions in the future. In terms of the recent cut in tax incentives proposed in the 2014 US budget, thus far it appears that ESOPs will be largely unaffected. The tax-deferred rollover provisions applicable to sellers to ESOPs sponsored by C Corporations – regularly taxes – would be unaffected and the tax-exempt status of ESOPs sponsored by S Corporations – flow-through vehicles – would remain. It is possible that smaller employer contribution limits may be imposed, but that should not have a large impact from a big picture viewpoint. ESOP lobbying groups continue to make their case, though, and are not standing idly by during this process.

FW: What predictions can you make for the ESOP landscape through 2014 and beyond? What regulatory and legislative developments do you anticipate over the next 12-18 months?

Brown: We expect a continued increase in ESOP transactions in 2014 and 2015, due in part to what we perceive as pent-up demand. After the 2008 crash, numerous business owners tabled succession planning and implementing exit strategies due to the poor economy. As the economy has slowly improved and business valuations have rebounded, interest in ESOPs has increased dramatically. Another factor favouring more ESOP activity is that banks are lending more aggressively, and on more favourable terms, than in the past few years. With the recent increase in long-term capital gains rates, utilising an ESOP for a tax deferred sale has become an even more attractive option. But like everything, this all depends on the continued improvement of the economy. We expect the DOL to re-propose the regulations adding valuation advisers as a fiduciary in certain circumstances. The Obama Administration’s proposed budget for the 2015 fiscal year includes language which would eliminate the IRS Section 404(k) ESOP dividend deduction for publicly traded C Corporations. While this will not impact the vast majority of ESOP companies, it could have a major impact on some larger ESOPs.

Pencheva: Over the past two years, the DOL has proposed regulation to create fiduciary liability for the financial advisers to the trustees. As the valuation firms issue the fairness and adequate consideration opinions, the DOL wants to uphold them to the fiduciary standard of duty in an effort to increase accountability in the ESOP valuation process. Though this might increase the burden of regulatory compliance, we expect that in the short- to medium-term the ESOP space will continue to grow largely unaffected. The ESOP structure has gone through several economic cycles and multiple regulatory changes and has proven its benefit to both business owners and employees. As the economy continues to recover, company values improve, access to capital providers enhances and the baby boomer generation nears retirement, we expect ESOPs to continue to be a popular option for businesses in 2014 and beyond.


Gregory K. Brown is a partner at Holland & Knight LLP. Mr Brown has 38 years of experience in Employee Benefits and Executive Compensation, including extensive work with ESOPs and ERISA. He has authored and co-authored numerous articles; is a frequent speaker on ESOPs and all areas of employee benefits and executive compensation; and has represented clients as an expert witness on behalf of clients’ ESOP/Employee Benefits Plans both regionally and nationally. He has been a member of IPEBLA since 1995 and a former Steering Committee member. Mr Brown can be contacted on +1 (312) 578 6684 or by email: gregory.brown@hklaw.com.

Maria Pencheva is a managing director and co-founder of Innovative Shareholder Strategies, LLC (ISS). She has an extensive experience in providing corporate finance solutions to small- and mid-cap companies. At ISS, Ms Pencheva regularly advises clients on ESOP transactions, leveraged buyouts, refinancings and recapitalisations. She is a member of the National Center for Employee Ownership and the ESOP Association. Ms Pencheva can be contacted on +1 (718) 619 8501 or by email: maria.pencheva@issesop.com.

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Gregory K. Brown

Holland & Knight LLP


Maria Pencheva

Innovative Shareholder Strategies, LLC

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