How to Find and Work With a Lender to Secure ESOP Financing

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Aug 03, 2021
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How does ESOP financing work?

Can I simply approach my business banker with an expectation they’ll finance an ESOP transaction?

Do I need to find a bank or lender that specializes in ESOP financing?

When evaluating exit strategies that involve the sale of a company, even experienced business owners may encounter situations that are entirely new to them. This can be the case during the process of deciding whether an ESOP is the best option for a controlled exit at retirement.

A key step in the transition to employee stock ownership is the purchase of company stock by an ESOP trust to create liquidity for the seller; that stock purchase may be seller financed and paid over time by the newly formed ESOP company. A bank or other lender may underwrite a business loan, usually to cover 30 to 40% of the total cost of the ESOP transaction.

ESOP financing may seem daunting because many companies that are good candidates for transitioning to an ESOP are healthy and thriving — so the need to borrow money from a lender is a new experience.

If you’re considering creating an ESOP company to sell your business, here’s what you need to know about securing ESOP funding.

Leveraged ESOP or non-leveraged ESOP?

An ESOP company whose stock purchase at formation is lender-financed is commonly referred to as a leveraged ESOP, while companies that use their own cash to purchase stock from the seller are considered non-leveraged ESOPs

That said, ESOP companies that start out as “non-leveraged” could at any time encounter changing business conditions. They could need to finance secondary stock sales or repurchase obligations in the future — so even if financing from a lender isn’t needed at outset, it’s wise to understand how ESOP funding works, and to do a little advance legwork to lay the foundation for a worry-free ESOP financing experience, should the need arise.

RELATED: How is an ESOP Stock Price Determined at Sale and Annual Valuation?

Do I need a specialized ESOP lender, or can any bank finance an ESOP?

While there are lenders that specialize in ESOP financing, no regulatory or legal requirement exists to borrow from a specific type of bank that has ESOP experts on staff. In short, it can be a great idea to start the conversation with a commercial lender where you have an existing business relationship, whether or not they are known to fund ESOP transactions.

Yet, to an inexperienced lender, the complexity of an ESOP transaction can require extra communication and transparency. Most commercial banks are accustomed to lending for working capital or to fund important assets like equipment or real estate — not shares of company stock.

When an ESOP company borrows money to fund a share purchase and create liquidity for the seller, the loan is not collateralized, or secured by assets. A lender with no ESOP experience needs clarification about ESOP tax benefits to understand the cash flow advantages that enable the company to repay the debt. A trusted advisor in the process can be helpful at this step, to help communicate the specific loan covenants and clarify that any debt the ESOP has to the seller is subordinate to the debt to the lender.

In fact, lenders that are unprepared to finance ESOP transactions may be missing out on significant opportunities to deepen and expand relationships with commercial clients, as many baby boomer business owners consider ESOPs as their retirement exit strategy. Numerous studies demonstrate that ESOPs perform well; in fact, a recent study shows that ESOP employees suffered far fewer financial setbacks (including job loss) amid the pandemic, compared with employees of non-ESOP companies.

Are there special ESOP accounting and business plan details to consider?

There are ESOP-specific accounting details to be understood by all parties involved in an ESOP sale. Among them is the fact that the long-term liability and negative equity created by the ESOP transaction negatively impacts the company’s balance sheet and financial ratios. A lender that lacks ESOP experience may need clarification on the following points:

  • An S corporation that is 100% owned by an ESOP pays no income tax, which supports healthy cash flow for loan repayment
  • The cash flow savings that results from an absence of income taxation makes the transaction cash flow neutral to the company
  • It is therefore appropriate to add back the impact of the ESOP transaction before computing financial ratios
  • The ESOP becomes the owner of the company
  • Any debt to the seller will become subordinate to the loan (i.e., the ESOP promises to pay the bank first)

It’s important to note that most ESOP loans are not collateralized, and that personal guarantees are not part of lending agreements with ESOP companies.

Business structure and succession plan details also need to be clearly communicated to any commercial lender, to provide an assurance of business continuity. Business plans shared with the lender should articulate the ways that control over operations will be maintained.

Keep in mind that ESOP transactions are highly regulated and involve independent oversight that includes CPA bookkeeping reviews and business valuation by an independent appraiser. This adds up to more intensive oversight than many typical commercial loans involve — and that should add up to extra assurance to the lender.

RELATED: EBITDA Multiples by Industry: What Matters in an ESOP Valuation Study

What about SBA loans for employee trusts?

The U.S. Small Business Association (SBA) offers an Employee Trusts program to provide limited financial assistance for ESOPs. SBA-backed 7(a) loans have specific requirements and conditions. According to the SBA, the maximum loan amount available is $2 million, but “the maximum dollar amount the SMA can guarantee is generally $1.5 million.” 

While it’s important to note the SBA program’s availability and recent changes that increase eligibility and somewhat streamline the borrowing process, many businesses might have smoother experiences with their commercial lenders — especially with the advice and help of a trusted advisor throughout the process.

Which bank should finance our ESOP transaction?

Ultimately, your choice of lender to fund an ESOP transaction should be a result of many factors. A longstanding, trust-based relationship with a lender that’s not an “ESOP financing bank” could very well open the door for banks willing to learn about ESOP tax advantages, succession planning and structural controls, and regulatory oversight. 

The most important factor in the process of securing ESOP financing is to work with an experienced advisor who knows exactly how to address a lender’s concerns, as well as how to guide your new ESOP through the steps needed to properly document and communicate the details needed for long-term success.

Every company’s unique attributes and circumstances make it impossible to recommend a lending process or refer businesses to a specific lender out of hand. But with information about some of your business specifics, ESOP Partners can help you explore the best fit for your transaction. It all starts with a free consultation with an ESOP Partners expert. Just click the link below to get the conversation started.

ESOP Consultation

Topics: ESOP Administration, ESOP Planning, ESOP accounting

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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