What Is ESOP Funding?
ESOP stands for “employee stock ownership plan.” At a basic level, it’s a way for employees to own a piece of the company they work for. But how does the company make that happen? That’s where the funding part comes in.
Think of it like this: the company needs money to buy shares of its own stock to give to the employees. They can get this money in a few different ways, like taking out a loan, using some of their profits, or even selling some of their assets. Once they have the cash, they buy the stock and put it into the ESOP. Over time, employees earn shares of the stock, which they can sell for money when they leave the company or retire.
So, ESOP funding is just how a company gets the money to give its workers a slice of ownership. It’s like a way to reward employees by making them part-owners of the place they work.
Benefits of ESOP Funding
- Enhanced Employee Engagement and Motivation
- Tax Advantages
- Improved Company Performance
- Business Succession Planning
- Strengthened Company Culture
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 your employees. It should not be nearly as intensive.
ESOP Financing Structure
An ESOP financing structure involves a company borrowing funds to buy shares for its employees through a trust. The trust acquires shares using bank loans or seller financing, and the loan is repaid over time with company profits or dividends. As the loan is repaid, shares are gradually allocated to employees’ ESOP accounts. This structure promotes employee ownership, aligns their interests with the company’s success, and offers potential tax benefits. ESOP financing is an effective way for business owners to transition ownership while keeping the company independent.
ESOP Funding Options
Leveraged ESOPs
Leveraged ESOPs involve the company borrowing funds from a lender to purchase shares for the ESOP trust. The trust uses these funds to acquire shares, which are then allocated to employees over time. The company repays the loan using its profits or dividends, with shares gradually being distributed to employees as the debt is cleared.
Non-Leveraged ESOPs
Non-leveraged ESOPs do not involve borrowing; instead, the company contributes shares directly to the ESOP trust or uses cash to purchase shares. This method is simpler and avoids the complexity of debt but requires the company to have sufficient cash flow or available shares to contribute. It is often used by companies with ample liquidity or those looking to avoid interest costs.
Seller Financing
Seller financing occurs when the existing owners of a company finance the sale of their shares to the ESOP. The company borrows money from the sellers and repays the loan over time, typically with interest. This approach can offer more flexible terms compared to traditional bank loans and is often used in closely held businesses.
Combination Funding
Combination funding uses a mix of different financing methods to fund an ESOP. For example, a company might use both bank loans and seller financing to finance the purchase of shares. This hybrid approach allows companies to customize their ESOP structure to fit their specific financial situation and objectives.
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
Why would an ESOP borrow funds?
An ESOP borrows funds to purchase company shares, allowing employees to gain ownership while the original owners receive liquidity.
How are ESOP loans repaid?
ESOP loans are repaid using the company’s future profits or cash flow, often through tax-deductible contributions from the company.
Can I use ESOP as collateral?
Yes, the shares acquired by the ESOP can be used as collateral for the loan, but this is typically subject to lender approval.
What is a leveraged ESOP?
A leveraged ESOP is an ESOP that uses borrowed funds to acquire company shares, leveraging the company’s future earnings to repay the loan.
Who is responsible for the ESOP loan?
The company is responsible for the ESOP loan, and the ESOP itself does not carry liability beyond the pledged collateral.
Can an ESOP be used to buy out a retiring owner?
Yes, ESOPs are often used to buy out retiring owners, allowing them to sell their shares in a tax-advantaged manner.
How does an ESOP impact company control?
An ESOP can impact company control depending on the percentage of shares it holds, potentially giving employees significant influence over decisions.
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