Hello Mr. Long… We’re thinking about doing an ESOP and heard that we need a feasibility study. Do you do that? That’s the way these conversations usually start. The client is thinking about an ESOP and may have been told that the first thing they need is a feasibility study, and perhaps an appraisal of their company, as the first step to “doing an ESOP.”
Does an ESOP Make Sense?
Well, I’ll tell you, over my 30 years of working with ESOPs, I’ve learned that often the first question isn’t can we “do an ESOP,” but should we. A feasibility study can tell you things like how much cash flow is available for financing an ESOP transaction, estimated tax savings and benefits to employees. Feasibility math is fairly straightforward. But, once the feasibility study is done, you are still left with the fundamental question of whether an ESOP is a suitable solution. In other words, the first question may not be “does the math make sense?” Instead, the first question may be “does an ESOP make sense for me? For my employees, management and any owners who may not be selling to the ESOP?”
Before diving into a feasibility study, in many cases, the suitability question should be answered first — would an ESOP be suitable for all of the parties, or “constituents” of the company? Can the constituents’ needs and objectives and objections all be satisfied? If not, what are the tradeoffs?
For a company new to ESOPs, the process can be entirely baffling. In many cases, they don’t know what a feasibility study does and they don’t know whether it will give them the information they really need to decide whether an ESOP makes sense in the first place. All they want to know is, can we do an ESOP, and what will it take. But, there is no such thing as ”doing an ESOP.”
Here’s why. An ESOP is an ERISA-governed retirement plan. It can also be an independent buyer of part or all of the company’s stock, all at once or over time, with or without bank debt and/or seller debt, and may involve margin-financed portfolios of stocks and bonds, or not. Or, it can be simply a stock bonus plan into which you contribute stock for your employees – and take a deduction for it. Oh, and there are about 20 different variations of ESOP and ESOP-like strategies to choose from. All of this flexibility means that an ESOP is not a “plug-and-play” tool. This is why I most often recommend that a company find out whether an ESOP is suitable (the right solution) before spending time and money on finding out whether it is feasible (a doable solution).
So, next, let’s talk about the fundamental differences between a suitability analysis and a feasibility analysis. Which should come first, or should they be done simultaneously? Neither analysis is wrong as a starting point, but each company is unique and should decide for itself what to do first to move forward.
About a Feasibility Study
In simplest terms, deciding whether an ESOP is feasible for a company comes down to figuring out how much money it can spend every year to fund a sale transaction and employee benefits. All of the sale price paid to the seller is deductible by the company. This makes buying an owner’s stock much cheaper and easier to finance than it is without an ESOP. In fact, it can be about 40% cheaper.
The directors of the company, the CEO, the CFO, perhaps the company’s banker, and most definitely the ESOP trustee, must determine how much money, either company money or borrowed from a bank, the company could prudently spend on a transaction and employee benefits without limiting the company’s strategic plan or CapEx needs.
So, if you forecast your financial statements out for five years and add various proposed debt loads, you can look at your lending ratios and your balance sheet and your retained earnings and ask, is this too disruptive to our business? Do we want to go this big, or do we want to do a transaction that is right size? Or do we even need to finance the sale because the company has sufficient cash for the size of the proposed transaction and/or the seller is willing to take a promissory note?
Different companies come up with different answers. Some conclude that as a starting point the classic 30% tax-deferred rollover transaction makes sense for the company and extra sense for the seller. They will then often map out subsequent transactions to sell the remaining stock to the ESOP.
But, even after the question of the size of the initial sale is resolved, the company may still face the decision of whether to remain an S corporation or C corporation. The feasibility study should look at it both ways, projecting the tax consequences of either (1) revoking an S election so that the seller can take advantage of a tax-deferred sale and then staying a C corporation until the five-year waiting period is up and the company can re-elect S status, or until the seller has sold all of their stock to the ESOP, or (2) staying an S corporation, which would prevent the seller from deferring capital gains on the sale, but would result in tax-free income to the company to the extent of the ESOP’s ownership percentage.
What else should a feasibility study do in crunching numbers? On the seller side, most want to know what value they need from the sale to meet their retirement goals. If they sell to the ESOP in a “1042 tax-deferred rollover” transaction, will the income from their qualified replacement property (“QRP”) portfolio give them enough to live on after the transaction? What are they willing to do to facilitate the financing in terms of personal guarantees, or pledging the QRP portfolio as collateral to the bank to finance the deal?
A feasibility study should also analyze how a sale to an ESOP will affect the seller’s compensation and what level of influence or control they can maintain as the shift towards ESOP ownership takes place. This question is certainly one of “feasibility” – how much, if any, will the company save in compensation expense going forward and who will be in charge? But for the selling shareholder, their family or the non-selling shareholders, this feasibility question can only be answered after the parties have determined whether the proposed transaction is suitable for everyone’s needs. This is one area where just doing the feasibility math may not give the constituents the information they need to decide whether to move forward with an ESOP.
It is true that some feasibility studies will incorporate suitability discussions. But, the study preparers may not have the skill set to explain how alternative transaction structures impact the ERISA fiduciary duties of each of the constituents. If there is an attorney involved in preparing the feasibility study, who does he or she represent? And who really should have their own counsel? Do you have counsel who is experienced with ESOPs and has worked through these alternatives before? Can they explain, impartially, who bears the ERISA fiduciary burden in each alternative?
When preparing forecasts for a feasibility study, be sure that the advisor is deeply experienced in the other phases of an ESOP’s life cycle – not just the initial transaction. Many feasibility professionals focus only on whether the company can afford the initial transaction, how much the seller will net, and the significant tax advantages. While these are important elements in designing an ESOP transaction, they miss the equally important elements of the size of the benefit being provided to employees and how soon the company will have to pay out retiring participants, among others.
You have to be sure that whomever you’re working with is perfectly willing to tell you that there are many different templates for how to use an ESOP. For example, say you closed a 30% tax-deferred rollover transaction, saved money on taxes and easily paid off the transaction financing. Then comes time to sell the rest in a 70% leveraged transaction. This is the time when many feasibility advisors will fire up the modeling software and stress test the transaction and the stock values. But, this is controlling-interest sale with all of the fiduciary risk that comes with a leveraged buy-out. What if there is a lower risk alternative? Maybe some or all of the shares should simply be redeemed by the company. The ESOP winds up with 100% ownership, and there is no fiduciary risk to the ESOP fiduciaries.
In this type of scenario, you have to trust that your advisor will know, and be willing, to propose a simpler solution than the “typical” majority ESOP sale transaction. What is their business? Is it selling and conducting ESOP transactions – “doing an ESOP”? Do they charge a success fee (which they explain will be covered by the tax savings)? If so, is that success fee warranted in a transaction with advisors who aren’t taking the company to market to find a third-party buyer?
About a Suitability Review
Do you have to start this approach with an appraisal? Actually you don’t. Often, a review of financial statements and tax returns with your CFO and CPA may be enough to get started. Some sellers and companies first want to know the range of pricing that an ESOP might pay, both for minority and change in control transactions – selling it all to an ESOP. In that instance you probably should engage an appraiser on behalf of “the ESOP to be formed.” To do that, appoint the ESOP’s trustee and if, after negotiation, you get an idea of the range of values you think you might be acceptable, engage your personal financial advisor to help you get to a price that is satisfying, yet doesn’t leave you or the company with ESOP issues down the road.
Bear in mind that if you start with an appraisal as part of a feasibility study, this is NOT the appraisal for the ESOP transaction. By law, the Trustee must have its own independent appraisal – dated as of the transaction date. So you may be better served by starting off with the trustee’s view of the price range. You can always negotiate.
When you move beyond the issues of suitability for the sellers, their families and the non-selling shareholders, don’t overlook the impact that the ESOP will have on management and your employees in general. Your workforce has likely not been involved with an ESOP before and there will be a transition. Brilliant entrepreneurs and growth-minded company owners are always looking for employees who have the right mix of individual drive and a view of the collective profitability of the company. But employees and key hires don’t always have both of these qualities. You need to be sure that your key employees are amenable to an ESOP. Will they see the transition to ESOP-owned as an opportunity for themselves and the other employees? Taken to the extreme, you need to be confident that your key people won’t leave the company because they thought of themselves as your successors and don’t want to share ownership or participate in an employee-owned culture. We have seen situations where presidents and managers quit. And, sometimes, new management can’t stand on its own.
On the management issue, the most common question owners face is, do you have the right horsepower in the C-suite to run an ESOP company with a more complex capital structure? Is your CFO really a CFO and up to the task? It’s not unusual for a company to have accounting personnel or a controller instead of a CFO. While many companies thrive with highly-qualified controllers, layering on an ESOP might be a stress test that sneaks up on you and makes the ESOP process more challenging.
The overall message here is that, the company and all the other constituencies need to be sure that they’re getting the right guidance and resources they need at the inception of the process, whether you start with a suitability review or a feasibility analysis.
In any scenario, you need to define your needs and those of all of the constituents. Then, you have to prioritize those needs. You can, of course, address priorities that surface during the suitability or feasibility analyses simultaneously. Run various analyses side by side, or in sequence, depending on what you view your largest challenges to be. Certainly, if your vision is to have a 100% employee-owned company and you want to do this as rapidly as possible with a complete buyout, there is more pressure on the financial feasibility analysis and greater fiduciary liability exposure for the board, the selling shareholder and the ESOP trustee to be considered.
If your vision is a minority transaction, or if you arrive at that conclusion in the suitability discussions, then the feasibility analysis will be much more straightforward.
If the selling shareholder’s most pressing consulting need is “how much will I get for my company?” then a feasibility specialist with a built-in appraisal department, or an appraisal firm hired for the seller, may be a critical first need. Remember that the ESOP cannot use this appraisal for the transaction and will need to get its own appraisal as well. That’s not a bad thing. If each side has its own appraisal, it can provide ultimate protection and peace of mind to both the selling shareholder and the ESOP trustee as they negotiate a deal. Just don’t assume at the outset that that any appraisal is being done from a buyer’s perspective – the ESOP trustee must conduct its own due diligence before it closes a deal.
The Bottom Line
Get the help you need to put a pin in your ESOP map and decide what you need to do first. Look to resources like the National Center for Employee Ownership when you assess potential advisors for a suitability review or feasibility analysis or both. Ultimately, both types of analysis will need to be done to some extent, depending on the transaction structure. As the classic strategic planning saying goes, begin with the end in mind. You, your company and your employees will all be better off.
For more information about the details of these two approaches and what you might need, let’s start a conversation