We have been discussing some of the many benefits of selling to an ESOP including how selling to an ESOP creates a built-in buyer and how selling to an ESOP can increase after-tax proceeds by over 40%. In addition to the higher after-tax return, selling to an ESOP can provide additional ways to add additional consideration and benefits for the selling shareholder above and beyond the sale proceeds.
ESOP Account Balance
In many cases the business owner will take advantage of the opportunity to sell to an ESOP while retaining control of the company or otherwise remain employed with the company. The seller will likely be the employee with the highest compensation in the company and will be eligible to participate in the ESOP. The seller would then receive annual ESOP allocations (usually the largest ESOP allocations) of the stock that was sold to the ESOP. This would accumulate in an ERISA-protected benefit that would be paid after the seller leaves the company.
The terms of a sale to an ESOP often include a synthetic equity instrument to provide an additional payment and incentive for the seller to remain employed and engaged, to grow the company, and quickly pay off the ESOP external debt. Additional synthetic equity may also be warranted to provide additional consideration when the seller is financing part or all the transaction, particularly when the seller is assuming subordinated debt. Synthetic equity is defined by the IRS as “any stock option, warrant, restricted stock, deferred issuance stock right, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future.” Stock Appreciation Rights (SARs) are one of the most common types of synthetic equity due to the flexibility they offer to meet the company's objectives and because they provide employees with the value of a stock award without requiring the employee to purchase the instrument. The actual type of synthetic equity instrument used and the overall size of the award are details that are determined by the company and should be negotiated with the ESOP Trustee as part of the ESOP transaction.
[NOTE: It is also important to understand the impact that synthetic equity has on the IRC Section 409(p) Anti-Abuse Testing.