In the last several years, the state of the credit markets and the availability of credit have been volatile and extreme. Loose underwriting standards and cheap credit led to record activity for mergers and acquisitions (M&A) and leveraged buyouts (LBO) in terms of both price and volume in 2006 and 2007. Beginning in 2008 and extending into 2009, a credit crisis materialized as the availability of credit all but disappeared as banks tightened underwriting standards in response to defaults within existing loan portfolios in conjunction with the worst economic recession in the U.S. since the Great Depression. Unfortunately, deteriorating economic conditions exacerbated banks’ unwillingness to lend to companies, which further restrained loan supply. As a result, it’s no surprise that M&A and LBO activity were at historically low levels at this time.
As economic conditions have improved in 2010, albeit at a slow pace, credit conditions have improved commensurately. Unfortunately, much of the improvement in underlying credit conditions has been limited to large capitalization companies leaving many smaller and middle market companies faced with continued loan supply scarcity. According to Federal Reserve data published by the Wall Street Journal, in the first quarter of 2010, debt outstanding for small businesses decreased by about $70 billion while larger companies increased debt outstanding by nearly $100 billion.1 As a result of the large disparity in loan availability between larger and smaller businesses, ownership transition through traditional M&A and LBO structures remains a challenge for owners of small and middle market companies. Moreover, with a Fed Funds rate near zero, banks have less economic incentive to lend to businesses preferring instead to borrow cheaply and invest in higher-yielding, safer, government-backed debt (i.e., a carry trade).
Nevertheless, many owners of small and middle market companies continue to seek liquidity of their ownership interest stemming from a desire for personal wealth diversification or in conjunction with retirement and management succession. Regardless of the motivation, given that most ownership transition is accomplished using a form of M&A or LBO transaction, unaccommodating credit conditions present a formidable obstacle. Unfortunately, these challenges come at an inconvenient time as prevailing capital gains tax rates are attractive relative to higher anticipated tax rates beginning in 2011.
Fortunately, Employee Stock Ownership Plans (ESOPs) remain a viable alternative for business owners seeking liquidity during today’s challenging credit environment. Given the flexible financing alternatives available in an ESOP structure relative to traditional M&A and LBO transactions, an ESOP structure may provide a business owner with an immediate exit strategy that might not otherwise be possible given challenging credit conditions.
Furthermore, an ESOP may also be the most viable way for a business owner to sell a minority position in a company, as most outside financial and strategic investors prefer to purchase a controlling interest.
In order to better understand how the ESOP structure can be used to facilitate ownership transition in challenging credit conditions, it’s important to first understand ESOPs and the many defining tax attributes that make it an attractive alternative in any credit environment.
The Evolution of the ESOP
ESOPs were created in 1974 as a tax-qualified retirement plan as part of the Employee Retirement Income Security Act (“ERISA”). Until 1998, the majority of the tax incentives attributable to the ESOP structure were available only to privately-held C corporations. However, in 1998, U.S. tax laws were modified to permit ESOPs to own shares of S corporations, which exempted S corporations owned by an ESOP from federal income taxes. As a result, since 1998 several ESOP owned companies have made S corporation elections and a significant number of new ESOPs have been formed to benefit from the tax attributes available through an ESOP structure. In fact, according to the ESOP Association, today there are approximately 11,500 ESOP companies in the U.S.
ESOP Tax Attributes and Structural Considerations
In order to increase employee ownership in companies, the U.S. federal government created compelling tax incentives for the formation of ESOPs for both the business seller and the sponsoring company.
C Corporation
Typically, when the owner of a C corporation decides to sell his/her interest in a company, the seller will be required to pay taxes on the sale proceeds at the prevailing capital gains tax rate, which is 15% through 2010. As previously mentioned, it is anticipated that the capital gains tax rate will increase in 2011 in conjunction with the expiration of the Tax Reconciliation Act. Naturally, many business owners express a desire to transition ownership before capital gains tax rates increase. Unfortunately, unaccommodating credit conditions present a formidable obstacle.
However, an ESOP structure may provide a means to facilitate ownership transition given its flexible financing in conjunction with compelling tax attributes. For example, sellers of C corporation stock to an ESOP may be able to defer, or potentially eliminate, all capital gains due at the time of the sale.
Under section 1042 of the Internal Revenue Code, a qualified seller of a closely held C corporation can defer capital gains taxes on the sale of stock to an ESOP (a “1042 Election”) if (1) the ESOP purchases at least 30% of the outstanding common stock of the company and (2) the seller reinvests the sale proceeds into qualified replacement property (“QRP”) within 12 months of the transaction. QRP primarily consists of stocks or bonds of U.S. operating companies. Capital gains taxes will be deferred until the time the selling shareholder elects to sell the QRP based on the tax rate prevailing at that time. In the meantime, the selling shareholder can invest these funds and generate a return on those very funds that otherwise would have gone to the U.S. government as taxes. However, if the seller retains the QRP until death, the QRP transfers to that person’s heirs at a stepped-up cost basis thereby avoiding taxation on the original capital gain. As you can see, the ESOP structure presents a compelling benefit to the selling shareholder in terms of capital gains tax management.
But, what about the tax benefits to the company? Since the ESOP is a tax-qualified retirement plan, contributions and “reasonable” dividends made by a company to an ESOP are tax deductible, which results in a lower tax burden at the corporate level. Obviously, this is a compelling benefit from the company’s perspective.
S Corporation
As is the case with the sale of an ownership interest in a C corporation, when the owner of an S corporation decides to sell his/her interests in the company, the seller will be required to pay taxes on the sale proceeds at the prevailing capital gains tax rate. Unfortunately, unlike the option afforded to sellers of a C corporation, a 1042 Election is not currently an available option when an ESOP purchases common stock of an S corporation. As a result, capital gains taxes will be due upon the sale at the prevailing tax rate. Therefore, it may behoove S corporation business owners to transition ownership before the capital gains tax rate increases. However, the S corporation ESOP structure shouldn’t be immediately disregarded since there can be significant tax benefits post-transaction that may enable the selling shareholder to ultimately earn an attractive total return in comparison to the benefits from a 1042 Election on the sale of stock in a C corporation to an ESOP.
More specifically, an S corporation is a pass through entity in which taxes on earnings are not paid at the corporate level but are paid at the shareholder level (i.e., the responsibility of taxes is “passed through” to the shareholders). As previously mentioned, an ESOP is a tax exempt entity. As such, earnings of an S corporation that are passed through to the ESOP are exempt from federal income taxes (and state income taxes in some cases). Therefore, if an ESOP owns 100% of an S corporation, the company would not be subject to any federal income taxes. This is obviously a compelling benefit for any corporation as any cash flow that normally would have been paid to the U.S. government could instead be used by the company for debt repayment, capital expenditures, acquisitions, or other working capital needs.
Although a selling shareholder would not be able to enjoy the immediate tax benefits of a 1042 Election when selling shares of an S corporation to an ESOP, financing alternatives may include a certain amount of reinvestment by the selling shareholder back into the company that could include a synthetic equity component allowing for participation in the future appreciation in the company’s equity value as it de-levers post-transaction. Such financing alternatives could provide the selling shareholder with a very enticing all-in return. Again, the benefit to the company from being owned solely by an ESOP is that it could become a tax exempt entity while the benefit to the selling shareholder is an economic interest in a tax exempt entity whose equity appreciates post-transaction in conjunction with the repayment of transaction debt (all else equal).
Regardless of how the transaction is structured, an ESOP is a form of LBO and, therefore, the availability of credit becomes an important piece of the puzzle. Flexible financing alternatives available through an ESOP structure may facilitate a sale that might not otherwise be possible given unaccommodating credit conditions. It should be noted that a 1042 Election for S corporation business owners is still a possibility if the company converted from an S corporation to a C corporation prior to the sale and met the requirements for this benefit. However, the company would be required to remain a C corporation for 5 fiscal years following the C corporation election.
ESOPs in a Challenging Credit Environment
Historically, ownership transition using an ESOP was financed using a combination of senior and mezzanine financing. In some structures, existing equity held in 401(k) plans of the sponsoring company was also a source of financing. However, as stock market and credit conditions deteriorated, so did much of the traditional sources of financing.
Today, for larger company ESOP transactions, some bank financing may be available to finance a portion of the purchase price. However, the amount of available senior financing will most likely not be enough to fully finance the entire purchase price. In these circumstances, commercial mezzanine financing may be considered. However, the presence of an outside investor may be unfavorable to a business owner given the requisite terms and conditions of this form of financing. As a result, in lieu of mezzanine financing, many sellers have elected to self-finance the remaining portion of the purchase price by providing a loan directly to the company (a “Seller Note”). In this situation, the selling shareholder is converting a portion of the equity proceeds received from the sale of common shares into subordinated debt. Given that the Seller Note essentially replaces the mezzanine financing that historically had been used to “bridge the gap”, the Seller Note may be structured using an equity component (e.g., a warrant) in conjunction with a rate of interest so as to provide a rate of return on the total security commensurate with subordinated debt rates of return. These rates of return can be very attractive relative to other investment opportunities for sale proceeds (e.g., the stock market, real estate, etc.) if the selling shareholder has confidence in the financial fundamentals of the company.
For smaller company ESOP transactions where a bank may not be willing to extend as much credit, the use of Seller Notes may also be a viable source of financing used to facilitate a transaction. Moreover, onerous lending rates and terms (including covenants and personal guarantees) may result in a conscious desire to minimize the total amount of senior debt used to finance a transaction in favor of a larger Seller Note. Regardless, the flexibility of using Seller Notes may ultimately provide the financing necessary to facilitate ownership transition today.
Flexibility of financing is not merely limited to the general use of a Seller Note, as there is also flexibility in structuring the terms of the Seller Note itself. For example, many note holders with minimal annual liquidity needs may wish to minimize the interest rate component on the loan in order to reduce the burden on the company’s annual cash flow in exchange for a greater number of warrants. This may be particularly important during periods of challenging economic conditions or for cyclical companies. Conversely, note holders with greater annual liquidity needs may prefer a higher interest rate component (to the extent permitted by the company’s annual cash flow) in exchange for fewer warrants. Regardless of the composition, the total rate of return on the overall security (interest plus warrants) must be “reasonable” based on prevailing market rates. Depending on facts and circumstances, the expected rate of return on the overall security could range between 15% - 25% based on prevailing market conditions, which may be very attractive relative to other investment opportunities. At a time of a challenging credit environment, any sources of financing that could facilitate ownership transition should be considered.
Of course, unaccommodating conditions persistent in today’s credit markets, particularly in the small to middle market, will not continue forever. At some point, banks’ propensity and economic incentives to lend to all businesses will return, and business owners wishing to liquidate their interest in a company will find more favorable financing terms and conditions. At this point, the Seller Note and equity component (e.g., warrants) can be refinanced and repaid using traditional senior bank financing. The refinancing of these investments may be accomplished in one simultaneous transaction or in multiple stage transactions depending upon the company’s borrowing capacity at that time. In the meantime, selling shareholders electing to pay capital gains taxes on the initial sale proceeds will have benefitted from the lower prevailing capital gains tax rate in 2010. In addition, in the years leading up to the refinancing transaction, the selling shareholder may have further benefitted from an investment (via the Seller Note and warrants) that offered a rate of return more attractive than other investment alternatives available at the time of the initial sale.
It’s important to recall that since an ESOP transaction is a form of LBO, the value of the company’s equity will increase post-transaction as the company repays transaction debt (all else being equal). As the equity of the company increases via debt reduction, any equity-linked security (e.g., warrants) will likewise increase in value. It is primarily through these means that an investor may be able to generate a rate of return more attractive than other investment alternatives available at the time of the initial sale.
At the time of a desired refinancing, the company should be able to utilize a senior debt facility given that its borrowing capacity will have increased from: (i) the repayment of senior debt used to finance the initial ESOP transaction, and (ii) the company’s growth in earnings. There are a number of lending institutions proficient at a refinancing of this nature. Obviously, the shareholder will no longer have an economic interest in the company upon the refinancing of the Seller Note and the repurchase of the warrants.
Conclusion
Unaccommodating credit markets present a formidable obstacle today for business owners seeking ownership transition. The flexible financing offered by an ESOP may facilitate a sale that might not otherwise be possible. As banks’ propensity to lend to businesses returns, companies seeking to refinance a Seller Note and repurchase warrants will find more favorable senior financing terms and conditions commensurate with an improvement in the company’s borrowing capacity. In the meantime, a selling shareholder is able to capitalize on a historically low capital gains tax rate that is expected to increase in the near term, and potentially benefit from an investment that generated a rate of return more attractive than other alternatives available at the time of the initial sale. Due to the unique tax attributes available through an ESOP structure, ESOPs should be considered by business owners any time ownership transition alternatives are being explored. Given some of the intricacies of the ESOP structure, it’s important to consult an experienced ESOP advisor to ensure the transaction is properly structured to meet the needs of the selling shareholder.
