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ESOP Dual Path Sale Process
A Unique Strategy for Business Succession
At RBG Capital, a boutique Investment Bank, we handle M&A engagements such as mergers, divestitures, acquisitions, management buyouts, structured growth equity or debt representations, etc. Primarily we handle sell-side engagements. In that regard, we need to discuss with the selling business owner, our client to whom we owe a fiduciary duty, whether to pursue a 100% acquisition, either from a strategic buyer (Competitor), a financial purchaser (Private Equity) or from an ESOP (Employee Stock Ownership Plan).
Selling a business is a major life decision. The owner’s objectives need to be fully understood,definedand a plan needs to be designed to achieve those objectives.
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A core focus of our process is the initial discovery phase. We take as much time as needed to meet with the business owner(s) and discuss:
Transaction objectives and priorities
Financial and estate planning
Other important issues1
Let’s look at some of the noteworthy features of each selling strategy.2
The selling price (often referred to as “Enterprise Value” in financial circles) is generally maximized through a sale to a strategic purchaser. They will often be able to create significant synergies by folding your Company into their existing operations. Typical synergies include:
Potential to eliminate back office or support personnel, including certain members of the executive team,
They bring scale which can result in efficiencies with purchasing costs, marketing reach and cost, management burden, additional resources for growth, etc.
Strategic buyers come in many forms; industry “gorillas”, businesses seeking geographic diversity & expansion, direct competitors, companies in your industry vertical that supply or buy from you, etc. These companies are often either publicly traded or owned by Private Equity. 3
While they can generally “pay” more for your business, as they can monetize synergies, the downside is loss of corporate culture and identity. Some clients will ask themselves; “how will our people thrive in a larger corporate culture?” This is a fair question and one that deserves careful consideration.
Private Equity firms, and lesser-known Family Offices (think Michael Dell), number more than 9,000 nationally. Their model is actually very simple; start with a larger company to acquire (referred to as a “platform company”), and then look to acquire/merge smaller entities into the platform to scale and diversify the revenue stream (geographically, product offerings, etc.) and create economic synergies.
As a Company diversifies and dramatically scales its revenue & EBITDA, the Enterprise Value increases dramatically. This is often referred to as “Financial Engineering.” Basically, they will look to purchase and merge your company into their platform and due to their scale, your EBITDA contribution is worth more to them, referred to as the “consolidation premium”, than it is to you. In that event, the process is akin to being acquired by a strategic purchaser. This is invariably a 100% acquisition, although sometimes the selling owner will be given an opportunity to make a small co-investment in the new entity.
If your company meets the PE firm’s investment criteria and they do not own a platform company in your industry, they will generally elect to purchase you as a stand-alone platform. As part of this strategy, most PE firms will want you to retain “skin in the game”, which is typically 20% of the post transaction equity value.3 It is important to note that PE firms will use as much leverage (debt) to acquire your company as they can, an inherent double-edged sword of financial engineering. Therefore, if the purchase price comprises 50% equity and 50% debt, you will be rolling over 20% of the equity which equals 10% of the purchase price. The purchase price is generally debt free/cash free.
As noted above, the PE firm will then strive to rapidly grow through integrating synergistic acquisitions while developing organic growth plans for your Company. The magic word is Scale; the bigger and faster the better, that way they can eventually (~ 3 – 7 years) sell the new, larger platform and monetize the high target return achieved for their investors and make buckets of money in the process for the PE firm managers. Other financial purchasers, like Family Offices, often have longer investment time horizons.
The PE Firm is comprised of financial experts, but they are not experts at running your business. Therefore, in most instances, the expectation is that you will be at the helm of the ship OR have a leadership team with the skills and experience to lead the company. Again, back to objectives – PE oversight will directly impact your timeline, work environment, and corporate governance.
The original owner will typically be tied up through the 2nd liquidity event, by way of an employment contract, but in certain cases a plan can be put in place to recruit new leadership. 4
Employee Stock Ownership Plan (ESOP)
First and foremost, an ESOP is a Qualified Pension Plan regulated by the Department of Labor and subject to ERISA rules. In a nutshell, the ESOP is a substitute for a synergistic or financial buyer. The company name, leadership, and operations all stay intact post transaction.
Simply put, the Business Owner sells her Shares in the company to the newly formed ESOP in exchange for cash and a seller note. If the company is taxed as an “S” Corp., the corporate income generated post-transaction, will flow through to the ESOP and no income tax liability will be due on earnings.4
Employee ESOP interest can benefit from tax advantaged growth and future redemptions by the company following departure from the company, subject to a vesting schedule. Typically, the employee will roll such proceeds into an IRA. The employee then only pays tax when taking future qualified distributions.
In selling to an ESOP, the owner significantly increases the likelihood of a successful transaction and a sale at fair market value or better, through active negotiations with a third-party trustee and their qualified appraiser. Many banks have dedicated ESOP lending teams seeking to finance ESOP transactions, generally determining their funding level based on a multiple of EBITDA. The funds generated in this fashion will not equate to 100% of the Enterprise Value. This is especially true if the company has existing debt, such as in the form of a Line of Credit since all corporate debt (purchase price and LOC) will be considered by the bank for determining new funding levels. The selling owner, therefore, will have to take a promissory note back for the difference. This debt is subordinated to the bank, which will take a first lien position on all company assets.
The Seller Promissory Note – A misunderstood opportunity
Attributable to the circumstances of an ESOP transaction, the seller is entitled to receive a materially higher interest rate than that typical of a senior lender. Further, in exchange for taking a subordinated position to the bank and accepting the illiquidity risk for not pursuing a 3rd party transaction, we have been successful in negotiating a synthetic equity sweetener (warrants) to bolster the seller’s debt IRR to double digits i.e., equity-like returns.
Did that sound good? Here’s something better: Capital gains taxes are deferred until the note is redeemed.
To be clear, the owner’s debt is on par with equity-type risk (often referred to as structured equity). The seller will receive interest payments, but his principal won’t start to get paid down until certain bank requirements (such as a partial or full loan repayment) are met.
The seller’s risk exposure can be further reduced (more cash upfront) through 3rd party investor partnership. There are financial investors seeking opportunities to take a portion of the promissory note at close. This is referred to as mezzanine financing. This is quality debt for an investor to own if the company is performing well and EBITDA is rising. In such an environment, the seller’s warrants increase 5
in value as their redemption price will be substantially greater than their strike price when they are exercised, which will only be possible after both the bank debt and the seller’s note are retired.
While the seller is holding a note, she will generally be motivated and interested in continuing to be engaged with the company to help ensure its success. It is important for the seller to maintain oversight via retaining a position on the Board of Directors until her note is paid in full. At that time, she will still have her warrants outstanding. The ESOP’s trustee, who is arm’s length to the owner, and represents the employees, but is directed by, and reports to, the Board of Directors, will now vote the ESOP shares for the successor board members.
As a seller, you want options. It is a fallacy to ever think you cannot pursue both an ESOP transaction and a 3rd party sale, simultaneously. In essence, the ESOP becomes another willing party in the sell-side process that we employ. Value is optimized through enhanced competition.
The goal is an auction, whereby the ESOP is a bidder along with institutional buyers competing to purchase the company.
The “Dual Path” solution is when ESOP and 3rd party acquisition strategies are launched in parallel. In other words, the company is taken “out to market” to both prospective Strategic and Financial Buyers, following the usual M&A process, as well as simultaneously engaging an ESOP Valuator and Trustee to place a competing bid in the process. Both paths require creation of a marketing package (Confidential Information Memorandum, Financial Model, and supporting data) to highlight the company’s value proposition.
Through the Dual Path process, the seller will be able to assess benefit tradeoffs between a 3rd party transaction and an ESOP, ultimately optimizing for their objectives.
For additional information and sharable resources please contact:
We have experience and hold necessary licenses for all aspects of Wealth Management. Complex estate planning integrating advanced corporate structures is a core strength. We are not licensed CPAs or Attorneys and do not purport to provide such professional advice. We point out issues, discuss options, develop and work on wealth & estate plans and bring in appropriate additional advisors (CPAs, Attorneys, Valuation Firms) to finalize and document.
These are common features, but not all the features. There are other considerations and these notes should not be relied upon as legal or other professional advice as no such advice is intended to be given here.
This 80/20 model is typical but I’ve encountered PE firms willing to require selling owners to roll over as little as 10% of their equity at time of sale, and as high as 40% when a majority interest is being purchased.
There will be no federal income tax liability by the ESOP indefinitely and no state income taxes payable in almost all states.