ESOP Financing During A Market Downturn

MAY 7, 2020

A seller-financed ESOP transaction provides a viable, flexible path to liquidity amid novel coronavirus, or COVID-19, uncertainty and a potential cashflow lending freeze.

As the popularity of using an Employee Stock Ownership Plan (ESOP) as a liquidity and exit strategy has grown, so too has the number of financing sources available for ESOPs. Companies that operate with a reasonable level of debt and demonstrate consistent earnings could reasonably expect to be able to source outside funds to partially or fully finance an ESOP transaction. The most common source of outside funding is commercial banks, although recently, private equity and mezzanine capital providers have shown interest in ESOP companies’ ability to shield cash flow from tax.

ESOP deals most commonly fall under a bank’s cash flow lending arm, meaning there is a collateral shortfall. In a typical cash flow loan, banks underwrite to the company’s historical cash flows, although a company’s projection and growth expectations are also important. However, a bank’s appetite to lend into ESOP deals is not immune to typical market fluctuations. The availability of cash-flow loans (as opposed to asset-based loans with no collateral shortfall) is more susceptible to market downturns, as bank policies can lead to lower leverage multiples, higher interest rates, shorter amortizations, or even a complete loss of interest in funding. Seller-financed ESOP transactions offer an attractive and flexible path to liquidity when cash flow loans from banks are scarce.

While most ESOP transactions involve at least some portion of seller-financing (the selling shareholders take a note back from the company in lieu of third-party debt), many businesses and business owners have discovered the advantages of 100% seller-financed deals. A 100% seller-financed ESOP is typically structured to mirror a transaction that uses outside debt, meaning two separate tranches of debt (some may have more, but two is most common). The first, or senior, tranche of seller debt has features similar to an outside senior note, such as a five to seven-year amortization, interest rates pegged to benchmarks, and some level of excess cash flow sweep. The second, or junior, tranche mirrors traditional subordinated debt terms. This may include interest-only payments while the senior tranche is outstanding, 10 to 15- year amortization, and a higher interest rate. Because the junior tranche is owed a higher rate of return than the senior tranche (for the greater risk undertaken), owners can still elect to take detachable warrants as part of their overall junior subordinated note package if they are willing to reduce their cash pay interest rate. Warrants are often referred to as a “second bite of the apple,” and any increase in their value is taxed at the capital gains rate upon exercise (whereas interest income is taxed at ordinary income rates).

The two-tranche seller finance ESOP transaction can be quite attractive due to its flexibility for both the owners and the company. A former owner may have one tranche of first security payments in a shorter term, while also having a tranche of higher-return payments over a longer term. Companies with multiple selling shareholders can especially take advantage of the two-tranche seller finance deal, as owners do not need to share in both tranches pro-rata. If, for instance, one or two owners are older and wish to receive payments quicker, they can elect to take more of the senior tranche, while younger owners who want to share more in the upside of the business through warrants can take a larger stake of the junior tranche. The flexibility of a seller-financed deal also extends to the Company, as it could elect to forego payments if future cash flow gets tight or make prepayments when cash flow is robust.

Another advantage of a seller-financed deal is that it may offer significant liquidity post-transaction. If a company chooses to structure a seller-financed deal due to a tight credit market and those conditions improve in a year or two, the company and its owners can look to refinance seller notes with an outside lender at any time. Furthermore, the company and its owners can look to refinance whenever they believe the timing is best for them. For instance, if an owner has an unexpected or sudden need for cash, they, along with the company, can look for a lender to refinance them out of a portion of their total remaining seller note balance. This refinance could also occur if the company produces a year or two of strong cash flow and feels it can receive favorable terms from a lender, thereby replacing higher interest rates with lower ones (assuming the former shareholders (who are now the current noteholders) agree to  a refinancing).

From a governance and reporting standpoint, a seller-financed deal does not place much burden on the company and its employees. Many times, a senior lender will require an audit to fund a transaction, and this would not be necessary in a seller-financed deal. Senior lenders also include terms like fixed charge and cash flow coverage ratios, placing further burden on the company and its reporting. Many companies, prior to a sale to an ESOP, aren’t used to operating with significant leverage, and the flexibility of a seller- financed transaction can be attractive.

Of course, if market conditions are not favorable for lending, one may wonder how it is favorable to an owner to pursue the sale of a business to an ESOP (or any sale). While valuations are subject to financial market fluctuations, businesses that continue to report strong earnings should expect fair market value consideration in a negotiated transaction and should be able to achieve a positive outcome now while reducing business risk. Evolving market conditions could create changes in legislation (particularly tax legislation), so it may be prudent to start thinking of a partial or full exit now, thus mitigating future legislative and market risks. The mitigation of these market forces, along with tremendous flexibility for both the former owners and company, can be achieved through the seller-financed ESOP transaction.