Incorporating an ESOP in your Business Exit Strategy will Increase the After-Tax Proceeds for the Seller, Providing a Greater Overall Return. The ESOP Exit Strategy also Pays For Itself, because Incorporating an ESOP Increases Company Cash Flow by Eliminating Income Taxes that can be used to provide for most or all of the funding of the sale of the company to the ESOP.
2If you were to sell your company today, what would you do with the proceeds? In addition to providing a business owner with Liquidity and Diversification, incorporating an ESOP in your Business Exit Strategy can help manage a business owner’s Investment and Inflation Risk and provide an expected rate of return (ROR) of 10-12%, or more.
In today’s lending environment, it can be very challenging to obtain senior financing for 100% of the company. [The 100% sale is the most cash and tax efficient solution because it Eliminates Income Taxes.] Even if a business owner is able to secure bank financing, they will likely be asked to take back a note to “have skin in the game” and help with the bank’s financial ratios. The company will be subject to the bank’s financial covenants and the business owner will also likely have to provide a personal guarantee and/or pledge back a portion of the proceeds to the bank.
While private equity or mezzanine financing may also be good options, it means more restrictions for the company. Even with mezzanine financing, there may still not be sufficient funding to finance the entire transaction and the business owner may still need to take back a note.
We are finding that business owners that have no or limited immediate liquidity needs are opting to structure the transaction to seller finance the entire transaction. This approach protects the company by avoiding the banks many restrictive covenants and providing a more flexible and friendly lending partner for the company. At the same time the business owner gets to enjoy a steady and healthy ROR (expected ROR can exceed 10-12%) while managing their investment and inflation risk. This ROR is obtained through a combination of an interest rate on the seller note and synthetic equity. The synthetic equity provides an opportunity for the business owner to continue to share in or otherwise be compensated for the future growth of the company and is can be paid using many different instruments, including stock options or stock warrants, PIK (payment in kind) loans, and/or stock appreciation rights (SARs). There is a lot of flexibility in determining the makeup of the interest rate and synthetic equity instruments and varies from transaction to transaction based on the facts and circumstances of each situation and the liquidity objectives of the business owner.
Many business owners have found the overall ROR of a seller financed ESOP more favorable than the investment alternatives of real estate and the stock market in today's economic environment. If lending conditions change in the future or the liquidity needs of the business owner change, then the option for the company to obtain financing and refinance all or a portion of the debt is still available.