Acquisition Advantages for ESOPs
From the BCC "Baton" - Volume 15, Issue 2 – 2018
The creation of an employee stock ownership plan (ESOP) presents unique benefits and risks. There are entire books devoted to these subjects, but here we will briefly focus on two advantages for ESOP-owned companies when growing through acquisitions.
An ESOP in its simplest form is a tax-qualified retirement plan that invests in the stock of the sponsoring employer. It can hold all or any percentage of the company's stock, providing a beneficial ownership stake to all employees. In the mid-1990’s, legislation was passed to allow ESOPs to own stock in S corporations. This opened up a significant tax advantage for ESOPs as they were no longer taxed on their share of profits from S corporations. This advantage is especially attractive for an S corporation 100% owned by an ESOP, because the S corporation retains cash flow that would have been distributed to pay income taxes, thereby providing additional cash to invest into the business or in acquisitions.
The second advantage relates to the financing of an acquisition. Generally, when a company incurs debt to finance an acquisition, only the interest payments on that debt are tax-deductible. However, when an ESOP-owned company makes the same acquisition, both the interest amount and the principal payments may be deductible. The result is that an ESOP-owned company generally has a much lower cost of capital making an acquisition than does a non- ESOP company. Theoretically this would enable an ESOP-owned company to pay a higher purchase price at the same cost, as shown in the table below.
The ability to use leverage and repay debt with non-taxed dollars is a substantial advantage that may allow an ESOP buyer to justify paying a higher purchase price in a competitive bidding process.
If an ESOP-owned company decides to acquire another company’s stock directly, an independent appraisal and/or fairness opinion may be required or advisable. The degree of fiduciary involvement in the acquisition process is highly dependent on whether or not the ESOP is the majority shareholder of the purchasing company.
The opportunity to accelerate returns to the buyer, the potential for favorable tax treatment on sales proceeds, and the benefit to the employees of a target company who will become beneficiaries of the ESOP post-transaction all make the ESOP-owned company an attractive acquirer.
Making an acquisition is no small feat in and of itself. When an ESOP is involved in a transaction there are additional complexities that must be considered. Having an experienced advisory team in place to help you navigate through these hurdles is highly recommended to ensure a successful closing. BCC has successfully advised ESOP companies on retained acquisition searches and has the added experience of providing dozens of business valuations annually for current ESOP companies and companies exploring employee ownership.