What Is ESOP Funding?
When an owner sells their company to an ESOP, the payment is typically structured through debt financing. Here’s how it works:
Bank Financing: The company takes out a loan from a bank or another lender to purchase the owner’s business. The funds are then used to pay the owner. Over time, the company repays this loan using the cash flow generated by the business. A key advantage is that the company can deduct loan payments from its taxable income, reducing the overall tax burden. Essentially, the company is using pre-tax dollars to pay off the debt. Additionally, if the owner sells 100% of the company to an ESOP, the company runs completely tax-free forever.
Seller Financing (Seller Note): In many cases, the owner finances the sale directly through a seller note. Instead of getting all the money upfront from a bank, the owner agrees to be paid over time with interest by the company. This is common when the company’s borrowing capacity with banks is limited or when the owner wants to offer more favorable terms to ensure a successful transition. The seller note can be structured with flexible payment terms, such as interest-only payments initially, followed by larger payments later.
Combination of Both: Often, the sale to an ESOP involves a mix of bank financing and a seller note. This allows the company to spread out its repayment obligations and reduce the pressure on cash flow in the early years of the transaction.
Tax Advantages: The IRS subsidizes these transactions through tax deductions. Payments made by the company to the ESOP to repay the loan are tax-deductible. This means the company can reduce its taxable income by using pre-tax dollars to pay off the debt, effectively lowering the cost of buying the business. And again, if the owner sells 100% of the company to an ESOP, the company runs completely tax free forever.
Benefits of ESOP Funding
- Tax Advantages: Owners can sell their shares without paying capital gains taxes, while the company itself pays no taxes going forward.
- Business Succession Planning: ESOPs offer a flexible way to transition ownership over time, allowing the owner to sell gradually while continuing to run and manage the company, just as before.
- Strengthened Company Culture: By giving employees ownership, they become more motivated, leading to better company performance.
ESOP Funding
How to Fund the Buyout of Your Company
One fantastic aspect of selling your firm to your employees is that you don’t have to find a 3rd party buyer. (See our Video here.) If you are selling your firm to an outside buyer, they will need to do their due diligence. They need to examine your books. They will scrutinize your customers. They will call your suppliers. With an ESOP, due diligence is done through a Trustee chosen by the employees that work for the company and the investment banking firm that works for the company. It is not nearly as intensive.
ESOP Financing Structure
ESOP Funding Options
Leveraged ESOPs
The company takes out a loan to buy shares. This loan is repaid over time with profits, while employees earn ownership without any out-of-pocket costs.
Seller Financing
The owner finances the sale themselves, offering more flexible terms compared to bank loans.
Combination Funding
A mix of financing methods, allowing the company to customize its approach to fit its financial situation.
ESOP Funding
How Can Employees Buy Out The Owner?
The employees DO NOT pay for the company. They DO NOT use their own money. They DO NOT use their 401Ks. They have no risk in this transaction – only upside.
Most ESOPs are funded with a mixture of outside debt along with seller notes.
Senior Debt
Outside debt could be a bank, like JP Morgan or Citibank, or it could be another type of institutional lender like a credit fund. These lenders will look at a company’s cash flow, assets, and liabilities and determine how much they are willing to lend. These lenders are what we call Senior Debt (See Blog explaining how debt works), and the interest rate charged will be in the lower range.
Junior Debt
If the senior debt isn’t enough money to fund the buyout, we can go to the next level of debt, which is called Junior Debt (also called Mezzanine debt). This level of debt has a higher interest rate than Senior Debt. The amount they lend is usually equal to one to two turns of cash flow.
Seller Notes and MBO
Seller Notes are the third type of debt. This is when the owner takes an IOU from the company. This third type of debt usually is comprised of a low interest rate plus something called warrants (See our Blog here). MBO Ventures will provide capital at the same terms as Seller Notes.
No personal guarantees
Most business owners need to give a personal guarantee for a loan. The correct lenders will understand the tax benefits of ESOPs. They can provide money without a personal guarantee required. Here’s the reason:
Loans taken out by an ESOP to buy a company are tax deductible.
This means the company pays back the loan in pre-tax dollars.
Pre-tax dollars means it is less costly to the company.
The company balance sheet, along with the principal deductions should be strong enough not to require this guarantee. If they require it, we can raise less money or go to another lender.
Management Buyout
Interested in a Management Buyout?
Frequently Asked Questions About ESOP Funding
How are ESOP loans repaid?
ESOP loans are repaid using the company’s future profits or cash flow, which is much greater than a regular company. A company sold to an ESOP can deduct the entire purchase price of the company. This significantly reduces the financial burden on the company. For example, if a company is sold for $50 Million, the company can take a $50 Million deduction.
What is a leveraged ESOP?
A leveraged ESOP is when the company borrows money to fund the ESOP. The company takes out a loan, uses that money to buy ownership from the current owners, and repays the loan over time using future earnings. For example, if a business is valued at $50 million, the company might take out a loan for $30 million, buy part of the owner’s equity, and gradually repay the loan using profits.
Who is responsible for the ESOP loan?
The company, not the employees, is responsible for repaying the ESOP loan. This is a key benefit because it doesn’t burden employees with debt. The loan is secured by the company’s future profits or assets, so while the employees become owners over time, they do not have personal financial responsibility for the debt.
Can an ESOP be used to buy out a retiring owner?
Absolutely. ESOPs are often used for succession planning when an owner wants to retire. The ESOP allows the owner to sell their shares in a tax-advantaged way, either all at once or gradually over time. This allows the owner to transition out of the company while ensuring it remains in trusted hands. For example, an owner could sell 40% now and the remaining 60% in five years, providing flexibility.
Who controls an ESOP company after the sale to the employees?
After the sale to the employees, the company continues to be managed by the existing leadership team. Typically, the former owners retain Board seats on the Board of Directors. While employees become owners through the ESOP, they do not directly manage the company. Instead, governance and strategic decisions are handled by the Board and management team, ensuring continuity and professional oversight.
Contact Us
Contact us if you have any questions.
We’re easy to reach and always happy to help
We invite you to call us with any questions you have or email us by filling out the form below. No question is too big or too small – whether you have a question about MBO Ventures or a question about ESOPs.
dgleeman@mboventures.com
Partner Phone: (646) 734-2035