ESOP as a Financing Mechanism

2016
David R. Johanson, Rachel J. Markun

ESOP AS A FINANCING MECHANISM 

An ESOP is defined in the enabling legislation as a “technique of corporate finance.” A company may make tax-deductible contributions in cash or stock to the ESOP trust. If this contribution is made in company stock, the resulting tax deduction increases the company’s cash flow and the additional cash can be used for any corporate purpose. If the contribution is made in cash, the ESOP can use the cash to purchase stock from the company itself, from existing shareholders or from retiring or terminated employees who have received distributions of stock from the ESOP.

Upon termination of employment, a participant’s vested benefit may be paid from the ESOP in cash or in stock. While a participant may have the right to demand to receive his distribution in stock, to mitigate the problems associated with creating a group of outside shareholders through ESOP distributions, the corporate charter or bylaws of a closely-held company can often be modified to require that substantially all the company’s stock be owned by employees. This will allow the ESOP to make distributions solely in cash.

CORPORATE FINANCE USES OF ESOPs

An ESOP is mandated by law to invest its contributions primarily in stock of the sponsoring employer. It also is the only qualified employee benefit plan which is permitted to borrow funds on employer credit in order to acquire company stock. These differences provide significant flexibility for a company using the ESOP as a tool of corporate finance and make possible its use to accomplish a variety of corporate and shareholder objectives not readily achievable through other methods.  Some of these objectives include:

Acquisition Financing: ESOP contributions allow the acquirer to amortize the principal payments on acquisition debt with pre-tax dollars. Because the ESOP thus generates more capital internally, the company enjoys a much healthier cash position and financing is easier to obtain for various transactions, including leveraged buyouts of publicly-traded and closely-held companies. In recent years, potential lenders to ESOP companies have lobbied vigorously for the restoration of special tax incentives which may reduce the interest costs to the borrower.

After acquisition financing has been amortized, the ESOP can provide a market for stock of the founding shareholder group using pre-tax dollars. Without this market, it might be necessary to sell the company or take it public in order for the founders to obtain a return on their investment.

Acquisition Of Assets Or General Business Financing Using Pre-tax Dollars: ESOP contributions can be used to shelter principal payments on normal corporate debt, effectively allowing the corporation to take tax deductions on principal payments, which can significantly reduce the after-tax cost of borrowing. In a leveraged ESOP transaction, the company may effectively amortize the loan out of pretax income of the business because the corporation’s payments are treated as employee benefit plan contributions which are tax deductible (subject to applicable limits). In a conventional loan, only interest is deductible by the borrowing corporation. Assuming a marginal income tax rate of 40%, a corporation would have to earn approximately $10 million pre-tax to provide funds to amortize principal on a $6 million loan. Pre-tax income of only $6 million is needed to generate funds to amortize the $6 million principal of an ESOP loan. Thus, cash flow to service acquisition debt is increased substantially in a properly structured ESOP.

Purchase Of Stock From Major Shareholders: The ESOP can provide a market for stock of major shareholders and their estates. Using the ESOP to buy the shares of principal shareholders has advantages over direct redemption  by the company. The company’s contribution to the ESOP is tax deductible so that the stock purchase is accomplished with pretax dollars, thus conserving the company’s cash and net worth. Controlling shareholders receive capital gains treatment on sales of their stock to an ESOP when selling only a small portion of their holdings. Conversely, if the shares were redeemed by the company, the distribution may be treated as a dividend to the selling shareholder. If certain conditions are met, selling shareholders may defer or avoid capital gains tax on sales of stock to an ESOP.

An Alternative To Going Public: An ESOP can be used as a tool analogous to going public “internally.” The ESOP can provide a market for stock of current shareholders or for the purchase of newly issued shares. This  can  be accomplished  without the problems and expenses normally associated with being a publicly traded company. However, the ESOP does not prevent a future sale, merger or public offering of the company should that become desirable.

Publicly Traded Companies: In recent years, publicly traded companies have increasingly utilized ESOP financing to accomplish a wide variety of corporate objectives. Included are uses of ESOPs in leveraged recapitalizations, stock repurchase programs and as components of a takeover defense strategy.

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