While not considered a traditional option for meeting private equity (PE) or family office goals, an employee stock ownership plan (ESOP) can offer creative strategies for institutional owners. ESOPs provide a unique opportunity for PE and family office portfolio companies to achieve liquidity, enhance operational performance, and foster a motivated workforce.
Growing Trend of Employee Ownership
Institutional investors are increasingly embracing employee ownership as a strategic approach to enhance company performance and employee engagement. This shift is exemplified by initiatives such as various nonprofit organizations dedicated to promoting broad-based employee ownership. These organizations collaborate with PE firms to implement employee ownership models that align employees’ and investors’ interests. By adopting these models, PE firms recognize the potential for improved operational performance, increased employee morale, and long-term value creation. This growing trend reflects a broader understanding that employee ownership can be a powerful tool for driving sustainable growth and achieving superior returns.
When Does an ESOP Make Sense for a Portfolio Company?
While an ESOP may not be a good fit for all portfolio companies, ESOPs can help investors meet their goals in many situations. An ideal portfolio company candidate would have some of the following characteristics:
- The company operates in a niche/bespoke industry, with a limited buyer universe.
- The company has not met growth expectations, resulting in a stable or underperforming investment.
- Investors are seeking liquidity for reinvestment or capital return without an immediate need for a total exit.
- Highly leveraged companies can benefit from the tax advantages of ESOPs to deleverage and strengthen their balance sheets.
- Sponsors with a longer-term investment horizon looking to enhance company performance and boost employee morale.
- A desire to increase environmental, social, governance (ESG) impacts for company and investors.
- A stable and competent management team.
What is an ESOP?
An ESOP is a qualified, defined contribution employee benefit plan, much like a traditional profit-sharing plan, that invests primarily in the sponsoring employer’s stock. It is unique among qualified benefit plans in its ability to borrow money and may be used as a corporate finance technique.
- Receive fair market value
- A common misconception is that ESOPs pay below fair market value. While ESOPs cannot pay more than fair market value or the value a strategic investor might be able to pay, an ESOP is a financial buyer that will pay fair market value for the business.
- Owner’s ability to sell any percentage of the company
- For investors looking for liquidity and continued upside in the business, a partial sale can generate needed liquidity while still providing a meaningful exit down the road.
- Minority ESOP stakes can be used to align the interests of employees and investors and enhance productivity and overall investment returns.
- Tax advantages
- Tax deductibility of contributions to an ESOP; can be cash flow-neutral depending on the structure.
- Potential for income tax-free entity (100% ESOP-owned S corporation), providing additional cash flow for debt service to accelerate buyout.
- Favorable tax treatment for certain sellers with the ability to defer capital gains under IRC 1042.
- High likelihood of close
- ESOP transactions provide a known buyer in the form of the employee stock ownership trust.
- In periods of high volatility, ESOPs can provide a higher likelihood of close than other third-party transactions.
- Improved operational performance
- ESOP companies tend to outperform non-ESOP companies. According to studies performed by the National Center for Employee Ownership (NCEO):
- ESOP companies experience approximately 2.4% higher sales growth and a 2.7% improvement in return on assets compared to non-ESOP companies.
- ESOP companies typically experience reduced turnover, which can lead to significant cost savings and provide a more mature and experienced workforce.
- ESOP companies tend to outperform non-ESOP companies. According to studies performed by the National Center for Employee Ownership (NCEO):
- Increased employee morale
- ESOPs provide a valuable retirement benefit at no cost to participants.
- Employees’ vested interest in the firm provides a sense of ownership and has been shown to increase employee morale.
- A study by the Employee Ownership Foundation found that 72% of employees would prefer to work for an employee-owned firm.
- Management incentive plans are often set up alongside ESOP transactions to incentivize key management above and beyond their ESOP participation.
- More complicated exit
- While all transactions have their challenges, setting up an ESOP involves multiple steps and parties that may be unfamiliar to the company and add complexity to the transaction.
- Limited cash at close
- While numerous liquidity considerations exist, an ESOP transaction will rarely offer the same level of cash at close that may be available in a private equity or strategic buyer transaction.
- No strategic premium
- ESOP transactions generally do not include a strategic premium. As a result, the sale price in an ESOP transaction may be lower compared to selling to a strategic buyer who sees additional value in acquiring the company.
Liquidity Considerations
- Senior debt
- Enhanced cash flow due to tax advantages can provide for increased senior debt capacity and quicker deleveraging to accelerate buyout timeline.
- For firms without significant collateral (such as professional service firms), the tax savings and enhanced cash flow can provide for a more attractive lending candidate.
- Mezzanine
- For financial sponsors looking for more complete exits and higher cash at close, there are a number of unitranche or mezzanine private credit options and alternative sources of capital actively lending into ESOP transactions.
- Seller notes and warrants
- For investors looking for a more gradual return of capital, seller note structures with detachable warrants or equity sweeteners can provide attractive market returns and complete exits in 5-10 years.
While ESOPs have traditionally been overlooked by PE and family office portfolio companies, they can present a unique and powerful strategy for achieving liquidity, enhancing operational performance, and fostering a motivated workforce. The growing trend of employee ownership highlights the increasing recognition of ESOPs as a viable tool for sustainable growth and superior returns.
Case Study
A niche insurance provider faced a unique ownership challenge when a PE firm, holding a minority stake, needed to exit as it unwound its fund. The majority owner, a family office with a long-term investment perspective, was not interested in increasing its investment but wanted to avoid bringing in a new shareholder with potentially conflicting objectives.
An ESOP emerged as a favorable strategy. It facilitated the PE firm's exit by providing a buyer at fair market value, creating liquidity without disrupting operations. The family office recognized the ESOP's potential to align employee interests with the company's long-term goals, while leveraging the tax advantages of an ESOP.
A comprehensive valuation provided fair market value for the PE firm's shares, and favorable financing terms supported the ESOP and future growth. A robust communication plan was implemented to educate employees about their new roles as company owners, emphasizing the benefits of the ESOP. This approach helped realize the family office's long-term vision by aligning employee interests with company success and fostering a culture of ownership.
The ESOP implementation effectively addressed the needs of both the exiting PE firm and the long-term family office owner. By leveraging the benefits of an ESOP, the company achieved a seamless transition, enhanced performance, and a motivated workforce, helping to ensure sustainable growth.
How BDO Can Help
For PE and family office investors considering the benefits of an ESOP, it is important to consult with experienced advisors who can navigate the complexities of ESOP transactions. BDO Capital Advisors, in collaboration with professionals from BDO USA, can provide guidance through the entire process, helping to align financial and operational goals.
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