An employee stock ownership plan (ESOP) are utilized by private equity (PE) firms and business owners as an alternative exit strategy to structure a business sale or acquisition. PE firms collaborate with ESOPs to secure investments and use it as a form of exit strategy for current portfolio companies. Majority owners can also use ESOPs as a means to transition ownership in a management buyout. The article will present an overview of ESOPs including the purposes, characteristics, structures as well as the benefits and disadvantages of structuring an ESOP.
ESOPs are tax-qualified retirement plans subject to the Employee Retirement Income Security Act of 1974 (ERISA) and are used in transactions for acquisitions. In a transaction, ESOPs can be used to buy shares and to acquire 100% of a company’s stock in one transaction. The main aspect of the ESOP is that it must be invested in employer stock.
The company uses the balance sheet to borrow funds from a senior lender. The borrowed funds are termed the “outside loan”. The seller shareholders will also often fund the balance of the equity portion of the total purchase price. Private equity group notes and warrants are also frequently to finance the transaction. The proceeds from the senior and subordinated debt are loaned to the ESOP, (the “inside loan”), enabling the ESOP to buy all the common stock of the target company.
Basic Structure of a Leveraged ESOP Transaction
Subsequent to an ESOP transaction, the company must annually make tax-deductible contribution to the ESOP to refund the inside loan. The ESOP trustee uses the funds to make payments to the company on the inside loan. In addition to the contributions, the company can announce and release tax-deductible dividends (C corporation) or dividends distributions (S corporation) on shares of the corporation’s stock managed by the ESOP. Principal and interest payment on the inside loan are made by the ESOP trustee and employees who engage in the ESOP to obtain shares of the corporation’s stock.4
Basic Structure of a Post-Leveraged-Transaction Cash Flow
ESOPs are sometimes used as an alternative strategy to structure a company sale. ESOPs are typically used to buy subsidiaries, divest, and/or acquire recently released corporate shares. The characteristic of a company determines the viability of structuring an ESOP. In a leveraged transaction, the company borrows funds from senior lenders to finance the transaction and the proceeds from the loan are used to buy the stock of the company, whereas in a post-leveraged transaction, the ESOP trustee uses funds to make payments to the inside loan. Companies, their shareholders, management and private equity groups have all used ESOPs to their benefit. However, the additional incurred costs associated with the ESOP as well as the potential risks with the transaction raises concerns over the suitability of an ESOP structure for every deal.
[*] Seller Financing often used
 JAMES R. HITCHNER, FINANCIAL VALUATION: APPLICATIONS AND MODELS, (2017).
 Matthew J. Hickro & Ira Starr, Private Equity and ESOPs: A Creative Combination, https://www.longpointcapital.com/site/assets/files/1220/private-equity-and-esops-a-creative-combination.pdf.
 Dickinson Wright, What is an ESOP, (2013), http://www.dickinson-wright.com/-/media/files/publications/2013/03/what-is-an-esop.pdf?la=en.
 Sharon B. Hearn, ESOPs: A Tax Advantaged Exit Strategy for Business Owners, (2015), https://www.americanbar.org/publications/blt/2015/03/02_hearn.html
 George D. Shaw ,The Pros and Cons of ESOPs, (Jan 28, 2013), http://ww2.cfo.com/tax/2013/01/the-pros-and-cons-of-esops/.
 Gary Miller, Advantages and Disadvantages of an ESOP, (July 5, 2016), https://www.axial.net/forum/advantages-disadvantages-esop/.
Jenn Abban contributed to this report.