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We have been exploring the many benefits of selling to an ESOP, including how selling to an ESOP can increase after-tax proceeds by over 40%, and selling to an ESOP enables a business owner to sell in 90-120 days.
If 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, selling to an ESOP can help manage a business owner’s investment and inflation risk and provide an expected rate of return (ROR) of 8%-10% or more.
Selling 100% of the company is the most cash and tax efficient solution because selling to an ESOP increases cash flow by eliminating income taxes and ultimately pays for itself. In today’s lending environment, it can be very challenging to obtain senior financing for 100% of the company. 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 mezzanine financing is also an option, 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%) 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 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 it 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.