Unlike other methods of raising capital, because an ESOP is also an employee retirement plan, the ESOP can also serve as a powerful engine for attracting and maintaining a competent and committed workforce. These goals are wholly complementary and achievement of the latter may well serve to insure the success of the former.  Here are some of the key issues to consider before deciding if use of an ESOP is appropriate for the company or for a particular transaction.

Using an ESOP in a Capital Transaction 

Normal Asset Purchase. A corporation has several options to raise capital to implement a company growth strategy, which can be used individually or in combination, including: (a) borrowing from shareholders or a third-party lender; (b) capital contributions by existing shareholders; and/or (c) selling equity to a third party. Consider a typical asset acquisition:

  • Buyer enters into an asset purchase agreement with Seller for $5,000,000. Buyer gets a commitment from Bank to lend 75 percent of the purchase price ($3,750,000) and funds the remaining 25 percent ($1,250,000) with additional equity investments.
  • Bank’s loan is a fully amortizing, 10-year term loan at a fixed rate of 6.0 percnt, payable in equal annual installments of $509,504.84 each.
  • Assuming an effective combined state and federal corporate tax rate of 25 percent, Buyer will need approximately $603,000 of pre-tax earnings to pay the loan in the first year, since the principal portion (over $281,000) is not deductible for federal or state tax purposes. By the tenth year, Buyer will need approximately $706,000 of pre-tax earnings to make the final loan payment. Over the entire term, the amortization of principal with after-tax dollars effectively adds $1,250,000 to the total cost of the transaction.

Adding an ESOP.  Buyer adopts an ESOP when it buys Seller’s assets and sells common stock having an appraised fair market value (after giving effect to the acquisition) of $3,750,000 to the ESOP on terms identical to the loan from Bank. Each year, Buyer makes a tax deductible contribution to the ESOP of $509,504.84. The ESOP uses that contribution to pay annual debt service on the purchase of employer stock back to Buyer, which Buyer then pays to Bank.

Using this structure, (a) the interest income received by Buyer is offset by a deduction for the interest Buyer pays Bank, (b) there is no income to Buyer on the principal portion of the stock purchase payment by the ESOP, so (c) Buyer can fully deduct the total amount paid to Bank because the loan payment equals the deductible contribution to the ESOP. Assuming the same combined 25 percent federal and state corporate tax rate, this should generate tax savings of $937,500 over the full term of the Bank’s loan. Ideally, the extra cash flow generated by the tax savings should be sufficient to pay most or all of the required return on investment owed to the equity investors.

Planning is Essential. These tax benefits are dramatic, but before proceeding with the ESOP (and well before closing), Buyer must address several questions, including:

  • Are the annual principal payments required on the “mirror loan” to the ESOP less than the 25 percent of compensation deduction limit (as discussed in Part One)? Note that interest payments are not a concern because of the special rule for interest on exempt loans.
  • Is the employer’s value high enough to sell company stock to the ESOP for $3,750,000? Even so, will the other shareholders (including any new equity investors) consent to the dilution of their interests?

If these questions are answered in the negative, the ESOP may not be feasible. But even if the analysis shows that the ESOP cannot cover the entire transaction, it might be worthwhile to sell less stock to the ESOP so the tax benefits can still be obtained for part of the deal.

Read the rest at Financial Executives International (FEI)