Financial Forecast Considerations When Selling to an Employee Stock Ownership Plan (ESOP)

The efficacy of structuring corporate transactions, especially in the context of an ESOP, is fundamentally dependent on accurate financial forecasting.  ESOPs are tax-qualified retirement plans subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA). ERISA generally requires retirement plans to hold assets in trust. ESOP trustees typically have their own advisors to ensure that the ESOP is acting in the best interests of plan participants and is following ERISA’s fiduciary and other rules. 

For business owners contemplating a sale to an ESOP, financial projections serve as a foundation to assess the valuation and structure of the transaction, underpinning purchase price negotiations, total value received, and the transaction's feasibility. These forecasts, projecting at least three to five years into the future, should be grounded in a blend of the business’s historical performance, current operations, and an analysis of both company-specific and macroeconomic trends. 

Scrutiny from ESOP trustees is rigorous; inaccuracies or omissions could detrimentally affect both the sale price and the transaction's likelihood of completion. Many companies contemplating sales have historically not developed such forecasts and are uncertain regarding which strategies to adopt. Employing multiple forecasting methodologies, including bottom-up, top-down, and hybrid approaches, enhances the reliability and accuracy of these financial projections, enabling sellers to provide a compelling narrative regarding both current and anticipated performance in an objective manner.

Micro-Level Analysis: The Bottom-Up Approach

This method delves into the financial performance of individual products, services, and business lines, aggregating these insights to forecast company-wide outcomes. Historical performance of existing business lines and a thorough review of emerging business lines tend to be key factors in this approach, offering a granular view of revenue and expense drivers, while pinpointing specific improvement areas. The detailed nature of this method is valuable, but it may not fully encompass broader market influences on performance.

Macro-Level Analysis: The Top-Down Approach

In contrast, the top-down approach evaluates external factors that act as revenue drivers, including the total addressable market, economic conditions, industry trends, customer sentiment, and competitive dynamics. This high-level perspective is useful in identifying overarching risks and opportunities but might overlook the intricate details of business operations and the nuanced drivers of financial performance. Maintaining the sources of the data used to perform this analysis is important, to provide support for the financial diligence.

Integrating Approaches: The Hybrid Model

A combination of bottom-up and top-down methodologies, this approach yields the most comprehensive financial outlook. This hybrid strategy considers both internal operational metrics and external market conditions, offering a balanced view that addresses the limitations inherent in each standalone approach. It equips sellers with a robust framework for revenue and profit margin projections, bolstering confidence in future financial trajectories.

Revenue and Expense Forecasting

Initiating the forecast with revenue projections by adopting a hybrid approach allows for nuanced forecasts that incorporate specific product or service performance with broader market and economic indicators. This method explains revenue drivers, presenting a compelling narrative to ESOP trustees. Attention then shifts to expenses, including cost of sales and operational expenditures, where economies of scale play a pivotal role. Understanding the balance between fixed and variable costs, alongside the impact of scaling production, informs precise expense forecasting. Additionally, considerations such as payroll, rent, and non-recurring expenses demand careful analysis, particularly in light of potential operational changes post-sale and the assessment of fair market values.

Payroll Considerations

Each business is unique and the influence of the company’s growth on payroll may vary. Sellers should consider the business’s growth prospects and the business lifecycle stage they are in when forecasting payroll expense. A company anticipating a ramp-up in growth may expect to hire more employees to meet the demand, thus increasing payroll. In most cases, the largest payroll expenses come from the executives involved in the business operations, such as the CEO and president. If the sellers are the executives of the business, it is important to determine their role following a sale. For example, if the current CEO, a selling shareholder of the company, were to step down following a sale, the forecast should illustrate the net result of replacing the CEO. Companies should consider doing a compensation study for this reason, to determine the correct compensation for the replacement, based on industry, geographical location, and size.

Rent Expenses

If the seller is also the owner of the premises that the business operates in, it is important to consider the fair market value of rent and what the company would pay to an independent lessor to accurately assess the fair market value of the rent. Increasing the current rent expense at a steady rate in the forecast, as opposed to assessing its fair market value, could be inaccurate. To precisely assess this, companies have several methods at their disposal, such as conducting a real estate appraisal, undertaking a rent study, or performing a real estate valuation. In scenarios where the property is included in the sale, a thorough evaluation of the property is essential to ascertain the total purchase price a trustee is prepared to offer.

Non-Recurring Expenses

Non-recurring expenses can have a significant impact on a business. When assessing non-recurring expenses that should be excluded from the forecast, sellers should consider the context of the expense. Documenting these one-time expenses such as office renovations, litigation, or consulting engagements can ease the negotiation process between the trustee and seller. 

Capital Expenditures

It is common for businesses in certain industries to incur significant capital expenditures, such as the purchase of machinery and equipment to maintain or grow the business. Analyzing the differences between capital expenditures for maintenance and capital expenditures for growth can also help an evaluator make the proper assessment of a company’s true fair market value. 

Addressing Biases in Forecasting

Awareness of cognitive biases, including overconfidence, conservativeness, recency, and confirmation bias is critical in crafting balanced financial forecasts. Overconfidence can lead to an overestimation of future financial performance, while being too conservative can lead to an underestimation. Recency bias refers to the tendency to rely too heavily on recent events or data, while confirmation bias refers to the tendency to seek out information that confirms one's preconceptions. Sellers must strive for objectivity, acknowledging these biases to refine their projections. Comparing historical performance to forecasted outcomes through the analysis of growth rates and margins facilitates the identification and correction of potential inaccuracies, ensuring a grounded and realistic financial outlook. 

Cases Where Historical Forecasts Have Been Created

Numerous companies regularly project their financials to meet general business needs, presenting a valuable opportunity to leverage these historical forecasts as a benchmark for evaluating forecasting accuracy against actual performance. ESOP trustees and their advisors commonly compare these historical projections to actual performance as a measure of the company's proficiency in accurately predicting financial outcomes. The company should regularly evaluate these forecasts and ascertain whether modifications in their baseline assumptions are required to enhance their accuracy.

Management Incentives

Incentivizing the next generation of leaders is critical for driving continued growth. Management incentive plans (MIPs) are a tool to retain and reward key management personnel. These awards commonly come in the form of phantom stock and stock appreciation rights (SARs). These plans can be created to include both retention-based awards, which are time-vested, and performance-based awards, which are vested (or granted) based on the achievement of specific performance benchmarks. These awards align the interests of the management team with the company's growth and achievement of the forecast. As such, the process of setting performance targets is intricately linked to the accuracy of financial forecasts, where overly optimistic forecasts risk setting unattainable goals, leading to potential disenchantment among management. Thus, the balance between ambition and realism in financial forecasting is crucial for establishing appropriate and effective performance targets for the management team.

The Role of a Financial Advisor

Engaging a financial advisor can be instrumental, especially when debt financing is involved in a transaction. Considerations of a leveraged ESOP transaction necessitate sophisticated financial modeling to evaluate the financing amount and the expected rate of return for the sellers. Advisors play a crucial role in integrating these debt considerations into financial forecasts, ensuring sellers can confidently assess the transaction's feasibility and the business's capacity to meet financial obligations.


In the context of selling a business, the construction of a detailed and accurate financial forecast is not merely a procedural step but an essential determinant of success. A blend of analytical approaches, alongside an assessment of potential biases and a strategic consideration of financial nuances, forms the backbone of a compelling and credible financial narrative. This narrative not only sets realistic valuation expectations but also underscores the transaction's viability, guiding both sellers and trustees towards informed and mutually beneficial outcomes.

Next Steps

For any business owner or company contemplating a sale to an ESOP, it is important to consult with an ESOP advisor who possesses the experience to adeptly navigate the complex regulatory and tax challenges associated with ESOP transactions. BDO Capital Advisors, working in close collaboration with professionals from BDO USA, who possess a comprehensive understanding of the tax ramifications of various ESOP scenarios, is equipped to guide you through each phase of an ESOP transaction.

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