What Sam Zell Knows about ESOPs

Chicago real estate magnate and billionaire Sam Zell is using an employee stock ownership plan (ESOP) as the corner stone for financing his Chicago Tribune buyout. Mr. Zell knows ESOPs offer significant savings and benefits in financing transactions, though we understand Mr. Zell learned about ESOPs the hard way long before the Tribune transaction when a rival used the ESOP advantages to best him in an acquisition contest. Business owners can take the easy way by reading the following discussion of lessons learned from Ice Miller's extensive work with ESOPs. What all business owners should know is that an ESOP may offer them the same types of advantages and savings realized by Mr. Zell, no matter what type or size business they own or whether it is a C corporation or an S corporation.

Although the Tribune deal is a highly leveraged $8 billion transaction, most ESOP-owned companies can realize the same tax-advantaged financing whether they are financing $1 million or $100 million. Along with being an incredibly flexible financial vehicle, an ESOP can be a strong partner in reaching corporate as well as non-ESOP ownership goals. The unique employee, tax, and financing advantages of an ESOP can provide ongoing competitive advantages that are hard to beat.

ESOPs are traditionally thought of as a financing tool to fund the employees' buyout of a portion of ownerships shares. Typically, the company designs and adopts the ESOP, the overall structure of the ESOP buy-sell and loan transaction is developed, the financing is arranged and an independent professional valuation of the company shares involved in the transaction is obtained. The ESOP and company typically enter into "back-to-back" loans where the company borrows the needed cash from an outside lender (the "outside" loan), and the ESOP in turn borrows the needed cash from the company (the "inside" loan). The ESOP pays the borrowed cash to the selling shareholder in exchange for the shares, and the ESOP holds the shares in a "suspense" account as collateral for the inside loan.

The traditional benefits of ESOPs remain ownership diversification, succession planning, and the opportunity to reward and benefit the employee group. Company stock ownership through an ESOP offers employees a tangible economic benefit and owners therefore realize direct savings from not having to offer other or augmented compensation and retirement plans.

When used as financing vehicles, however, ESOPs also offer unique tax-advantaged solutions for difficult corporate, financial, shareholder and community issues, as ESOPs can provide tax-advantaged financing for corporate rebuilding, expansion, acquisitions, and management buyouts. Although a retirement plan, as Mr. Zell understands, the federal pension and tax laws expressly recognize the ESOP as a "financing" tool.

Particularly in the current capital market environment, business owners and management should consider whether an ESOP's unique advantages might provide the financing tool and competitive edge needed to secure adequate financing. As Kevin Keuper, Managing Director of Legacy Capital Advisors, LLC, Chicago, recently noted, "with tightening credit markets and the competitive nature of the middle market M&A, third party acquirers and partially-owned ESOP companies are using ESOP structures as a valuable tool in structuring Merger and Acquisition transactions."

ESOPS AS A FINANCIAL TOOL IN ACQUISITIONS

The key benefit of utilizing ESOPs is that transactions can be financed on a pre-tax basis. That is the key – fully deductible principal and interest that can be achieved only through an ESOP transaction! Both C corporations and S corporations may sponsor ESOPs, but the S corporation ESOP company has unique competitive advantages. S corporation ESOP companies pay no tax at the company or ESOP level to the extent owned by an ESOP: A 30% ESOP owned company pays tax only on 70% of the company's income; and, a 100% ESOP owned S corporation pays no corporate taxes. So who pays the piper and when? As with any other tax qualified retirement plan, individual participants pay ordinary income tax on the ESOP benefits paid out to them (and only to the extent not further tax-deferred through an IRA or other rollover).

The S corporation ESOP company has a distinct competitive advantage that can even further reduce or eliminate taxes. There also are additional significant ESOP advantages for company owners to consider.

1. Contemporary Use – An Established ESOP used to Acquire the Target

There are numerous strategies to use an ESOP as an acquisition tool. Along with a financial sponsor or management, an ESOP may own a portion of an S corporation that is used as an acquisition vehicle. Third party investors invest cash in consideration for a combination of equity and subordinated notes and/or warrants in the S corporation. The S corporation then borrows senior debt along with other mezzanine debt and subsequently re-lends the outside debt proceeds to the ESOP, which in turn buys the S corporation's shares after its Q‑sub's merger or acquisition of assets with the target company.

This type of acquisition could be structured as follows:

(1) $ Note (3) $

(2)

$ (1) 100% (2)

Acq. Q-Sub

Where: (1) Third parties infuse cash into Acquisition Company, which in turn lends the cash to the Acquisition Company ESOP for debt/note; (2) Acquisition Company agrees to exchange Acquisition Company shares for Target Company's operating assets transferred to Acquisition Q‑Subsidiary; and (3) Target Company sells its Acquisition Company's Shares to the Acquisition ESOP for the cash infused from the third party lenders/investors.

This acquisition S corporation pays no taxes on its or the Q-sub's operations' income and neither does the ESOP on its pass-through portion of the company earnings. Therefore, the repayment of the principal on the outside debt is with pre-tax dollars. Additionally, when a subsequent exit event transpires, the investor may exercise its warrants and accrues the benefit of both tax free debt repayment and of the appreciation in equity value of the business. This structure can provide superior after tax return for investors.

Typically, acquiring companies prefer to buy the assets of an acquiree because of the greater tax deductibility of more of the purchase price. However, the result of an asset purchase transaction is that the shareholders of the acquired company pay higher taxes on their proceeds. The selling shareholders prefer a stock sale to an asset sale. The ESOP may be used to acquire the stock and give these shareholders a tax advantaged transaction while the purchasing company may receive a tax deduction equal to the entire purchase price. Additionally, the improvement in the combined companies EBITDA may improve the ability to obtain financing for the transaction.

Because of this deductibility, many times the acquirer can afford to pay a higher price than a normal competitive bidding process would merit. Caution must be exercised here as an ESOP can never pay more than "fair market value" to a related party (such as company owners). Because of the tax advantaged treatment, however, selling shareholders may be willing to take a lower sales price. Additionally, the acquired company's employees will become participants in the ESOP. As a result, cash compensation and benefits costs may further enhance the EBITDA of the combined entity.

2. Progressive Use – An Established ESOP used to Acquire another ESOP Company

Here is a strategy we used with our client "Joe" who owned a lucrative services business with a highly competitive advantage in his market. Joe was ready to retire if he could get his "walk away" number – the cash price he wanted for his company. A local ESOP-owned company had a well–established complimentary business and was looking to expand into Joe's business. With the transaction described below, Joe not only got his "walk away" number, but it was tax-deferred (and potentially tax free); and, the ESOP Acquisition Company was able to use Joe's company asset base to help finance the transaction. The transaction was structured like this:

(3) (2)

(1)

(3) $ (1)

Acq. Co. Q-Sub.

(1)

Where: (1) Joe's C-corporation company sets up an ESOP, and we lined up third-party financing based primarily on Joe's company assets (a guarantee by the Acquisition Company ended up not necessary. (2) Joe sold his company shares to his company's new ESOP with the ESOP using the third party loan borrowed from Joe's company. Joe rolled the sales proceeds over into "qualified replacement property" on a tax deferred (potentially free) basis. (3) Joe's company ESOP merged into the Acquisition Company's ESOP which converted the Joe's former company's shares for Acquisition Company shares and Joe's former company became the Acquisition Company's qualified S-subsidiary, and the merged ESOP debt from Joe's old company and old Company ESOP was then debt of Acquisition Company with the ESOP debt owed to Acquisition Company.

3. ESOPs as a Leveraged Management Buy-out and Expansion Tool

As discussed above, the ESOP can borrow funds from the company, which borrows from an outside lender, to finance the debt on a pre-tax basis. The same components of ESOPs that are utilized to acquire another company using its ESOP may be used for management buyouts or capital expansions.

An ESOP can act as a financial partner to help management buy out current owners at a fair price. Management driven buyouts using an ESOP often occur at neglected divisions or subsidiaries of a larger parent company. They also often occur where there is an absentee or otherwise inactive owner no longer driving the firm's growth. Such a buyout can occur in a single transaction, or through multiple transactions spread over a number of years.

An ESOP also can help finance company expansion. For example, the ESOP can borrow funds, which are repaid on a pre-tax basis, to buy treasury shares from the company. In turn, the company may use the sale proceeds for internal expansion, acquisitions, research and development or other company needs.

ESOP transactions do have potential negatives which need full consideration. Typically, the ESOP company assumes an outside loan obligation that increases risk and affects cash flow. In addition, the company has a contingent obligation to repurchase shares held by the ESOP at their future fair market value. ESOPs are subject to complex legal requirements and substantial administrative costs, including fees for trustees, accountants, appraisers, and attorneys. Further, failure to comply with these legal requirements exposes ESOP fiduciaries, selling shareholders, and the company to potential liabilities. In addition, ESOPs with "all their eggs in one basket" have a riskier portfolio than is generally considered appropriate for retirement plans. The GAAP accounting rules include the ESOP loan on the company's balance sheet. This can adversely impact the company's credit facilities, loan covenants, bonding or reporting requirements tied to the company's financial statements.

Minority Owned ESOP And Owner Diversification

An issue for many companies partially owned by ESOPs involves selling additional shares to the ESOP. Owners still maintain a controlling interest in their companies may be evaluating:

1. Should they sell?

2. Should they sell to the ESOP?

3. Should the entire company (including the ESOP portion) be sold to a third party?

These maturing business owners often need "portfolio" diversification, for example, where they have 60% to 90% of their overall wealth tied up in their company. When the non-ESOP shareholders consider selling the business, the ESOP can be very useful to have in place. Legacy's Keuper comments "an ESOP can be used by the selling shareholders as a 'buyer-in-tow.' The ESOP can provide tremendous leverage when negotiating a transaction with an outside buyer."

However, some owners do not want to sell the company for any number of good reasons, including the desire to keep the business in the family or pass it on to the management and employees who have helped build the business, or they simply are not ready to retire or do not have the management team in place to turn over the company.

Questions Owners of Partially Owned ESOP Companies Should Consider

1. Does our ESOP give us a strategic advantage in making acquisitions?

2. Would these advantages be enhanced by greater ESOP ownership?

3. Does our ESOP improve the desirability as an acquisition target?

4. Does our ESOP offer the best alternative to meet our ESOP repurchase obligations to finance on a pre-tax basis?

5. Who should I choose to advise us on possible transactions that do not have potential conflicts of interests with the ESOP's representatives, potential acquisition targets, or potential acquirers?

6. Should the political landscape and the possibility of increased capital gains taxes lead us to consider a transaction sooner rather than later.

Owners, trustees and management should consider the myriad of factors and advantages available to their ESOP companies. This just may be the right time to take advantage of the unique tax and financing advantages ESOPs offer. If you have questions regarding this article, ESOP or ESOP companies, please contact our Indianapolis office or Mark Baggio in our Chicago office.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.