The ESOP Advantage in M&A: What Buyers and Sellers Need to Know

ESOPs have a special place in the business world. There's a bit of mystery around them as they are outside of typical business structures, and many need to understand how they work, much less their role in an M&A transaction. Some ESOPs seeking to sell are curious if they can do so with an ESOP in place. Others looking to buy or be bought out by an ESOP aren't sure of the proceedings. Fortunately, Benchmark has managed both situations and can navigate deals with these added layers of complexity.

When it comes to ESOPs, even seasoned M&A professionals sometimes need clarification. For starters, we can discuss "What is an ESOP?" An ESOP is an Employee Stock Option Plan wherein many employees buy into ownership of the company's stock, which typically takes the place of an ESOP trust that holds the company's common stock. In a sale to an ESOP, normally, the company pays funds directly into this trust. The ESOP is typically managed by a trustee representing the interest of all employees who are beneficiaries of the ESOP trust. The trustee represents the interests of the employees as beneficiaries and makes decisions on company direction decisions, including M&A transactions.

What are some advantages of an ESOP? The most-touted benefits include employee retention and engagement. According to the National Center for Employee Ownership, employees with an ownership percentage of the company are encouraged to act like owners as it directly affects their take-home pay. ESOPS boasts higher retention, more productive employees, and higher growth than similar counterparts with more traditional ownership structures. On the other hand, ESOPs are complicated and require strong management teams to be managed appropriately. Additionally, they are an option only available to corporations, so smaller businesses typically do not entertain an ESOP as a whole or a partial sale option. Most importantly, ESOPs can be costly as there is a large amount of administrative and legal expense associated with the maintenance and annual valuations of the ESOP.

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How does an ESOP fit into a sale in an M&A transaction? Let's look at selling into an ESOP first. Often, in M&A transactions where a sale is made to an ESOP, the company takes out a loan directly. It pays back into the ESOP, which removes the need for third-party funding as the business finances the transaction with its leverage. The advantage is that your buyer is a known and trusted party, and because the business as your buyer always has its self-interest at its heart. A major con is that ESOPs are complicated and require legal advice to structure, and they cannot pay over (or under) fair market value. However, with proper transaction guidance and a vital M&A attorney, you can find several methods to mitigate these disadvantages. ESOPs can be tax advantageous for both the ESOP and the seller, are attractive to commercial lenders as safe investments, and can include considerable upsides with proper deal structure.

What about a potential purchaser valuing an ESOP company? Note that, per the above, the trustee of the ESOP effectively acts as the shareholder representing the company's interests for the ESOP's shareholding percentage. A purchase of ESOP shares must be made at adequate consideration and will require a more stringent third-party valuation than a more traditional operating structure. Suppose the company is determined to be selling for adequate consideration. In that case, the following steps will determine whether the ESOP will continue as a party to the acquisition or whether the shares should be redeemed. If the shares are redeemed, there will be a second transaction between the trustee and ESOP to purchase back the shares of the business, typically immediately before the sale of the company. By now, it should be evident that purchasing an ESOP is more challenging to navigate than a more traditional transaction, but it is certainly achievable. Having experienced advisors can be of great assistance throughout both the buying and selling process.

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