Tax-free ETA structure - is this attractive to searchers?
November 12, 2024
by a searcher from Indiana University, Bloomington/Indianapolis - Kelley School of Business in Indianapolis, IN, USA
I’m exploring a unique structure for searchers: using an ESOP (Employee Stock Ownership Plan) to acquire businesses. For those not familiar with ESOPs, they offer a powerful incentive for employees by transitioning ownership to a trust who they are the beneficiaries of. ESOP-owned companies are 100% corporate income tax-exempt—a huge advantage that increases cash flow for growth and stability. In the structure I'm envisioning, the searcher would become President of their target company, which would be owned 100% by the ESOP.
So, if equity goes to the employees, what's in it for the searcher?
1. 20% Stock Appreciation Rights (SARs): This setup would allow you to retain a 20% stake in the company’s future appreciation without needing to fund an equity position upfront. SARs give you the opportunity to benefit from the company’s growth over time, with a payout tied to the increase in company value, which aligns your incentives with the company’s performance. My research indicates that 20% is a permissible level under Department of Labor regulations.
2. Enhanced Appeal to Sellers: Business owners often respond well to ESOPs because of the opportunity to reward and protect their employees. This can make your offer especially appealing, potentially smoothing negotiations and accelerating the sale.
3. Greater employee incentive alignment: ESOPs financially incentivize every employee at the company to drive up its value, thus aligning your incentives (via SARs) with theirs. Studies show that this incentive greatly drives up worker retention and productivity.
4. Greater access to leverage: Because ESOPs are tax-exempt, many lenders (including several I am working on this with) will consider this in their lending decisions, thus enabling you to be more competitive with cash-at-close, without the hassle of either raising or investing your own equity.
Assuming salaries were equal for this structure vs. more traditional, is this something anyone here could see themselves being interested in? There are huge societal benefits (employee-owners have 92% higher median household wealth, for starters), but I really just want to know if this seems like a good deal to searchers.
from The University of Chicago in Chicago, IL, USA
1) ESOP is designed for employee ownership, not for entrepreneurship.
2) Lenders need collateral or PG. Who will give PG in ESOP? This is the deal killer. Either the seller has to take a big seller note or give PG to the bank for the cash received. One seller went broke doing so.
Example: 1) A $4 M EBITDA company with low assets. Everyone advised on ESOP b/c it is typical in the specific industry. Seller spent 4 years and lots of money to find out that either he would get large cash at closing but give PG or take a large note. 2) At a recent conference an attorney got a workshop for ESOP benefits. He did $80 M ESOP deal. When I asked if seller gave PG, he said no. Then later I met him for lunch. After 90 minutes of me asking questions, he disclosed that, based on the collateral, lender gave $30 M loan to ESOP and took a Note of $50 M.
3) ESOP is great in some situations, typically large and asset intensive businesses. The optics of ESOP is undeniably attractive. Managing ESOP is whole another world.
from Wesleyan University in Granville, OH, USA