You own a successful privately-held business which you may be thinking about selling. Very likely your business is your most important financial asset. You want maximum financial advantage when you sell, of course, but there are other concerns. For example, how will the sale affect your key employees? Will your firm continue as an independent entity or will it be absorbed into the buyer’s operations? If there are minority shareholders, how do you deal with them? And then there’s the psychological question: maybe you’re not quite ready to give up control.

These are all good reasons to consider selling your firm to your own employees through an Employee Stock Ownership Plan (ESOP). No other alternative combines maximum financial advantage with the flexibility that enables you to customize the sale to fit your own particular circumstances. An ESOP enables you to sell your business outright or gradually in installments. You can retain your executive role or delegate responsibilities, freeing you up for family and leisure. An ESOP can be your ultimate exit strategy!

Let’s look at the conventional alternatives. What if you sell your business to a competitor or third party? That would require an extensive due diligence process and the disclosure of confidential financial and operating information. Also, the buyer would want to acquire 100% of the outstanding stock. This might not be acceptable to younger stockholders who which to remain active for many more years. Also, many of your key employees are likely to be laid off as your firm is integrated into the buyer firm or downsized to reduce costs

Apart from these operational and personal considerations, however, selling to an ESOP, in most cases, is the alternative that gives you the best financial return. Two strategies are the key:

The first is based on the assumption that your company will continue to increase in value year after year. So you sell your stock to the ESOP on a year-by-year basis, each year at a higher price, until all of your stock has been sold. Using this strategy, you may wind up selling your stock for two or three times the price that any third-party buyer, including even a strategic buyer, would pay for your business today. (This assumes, of course, that the value of your company stock increases by more than the long term appreciation obtained from investing in publicly-traded stocks and bonds. According to research conducted by the Social Security Advisory Board, the long term real rate of return on equities ranges from 6% to 7% per annum).

I explain Strategy #1 more fully in my article, An Open Letter to Business Owners, which you will find on the home page of the Menke web site.

But there is a second way to sell your business for maximum financial return. I call it the fully-priced seller note strategy. It works like this:

First, of course, it is necessary to obtain an outside appraisal of the fair market value of the block of stock that is to be sold. If this is a control block of stock and you are also giving up control, this block will be appraised on the basis of a control premium. If, on the other hand, you are not selling a control block or you are selling a control block but retaining voting control, then the block being sold will be appraised on the basis of a minority discount. Either way, the base purchase price will be determined by the independent appraiser who is valuing your stock for ESOP purposes.

Once the stock value has been determined, the next step is for you to determine whether to take advantage of the tax-free rollover provisions of Section 1042 of the Internal Revenue Code (the “Code”). The tax-free rollover provision enables you to avoid paying the federal capital gain tax (currently 20%) plus whatever the state capital gains tax is in the state where you reside.

In order to obtain this tax benefit, however, your company must be a C corporation, the ESOP must acquire at least 30% of the outstanding stock, and you must sell your stock directly to the ESOP. If your company is currently structured as an LLC or as an S corporation, you can simply switch to C corporation status prior to the ESOP sale.

C Corporation Transaction Structure

Let’s assume that the stock value is $10 million and that you have decided to sell 100% to the ESOP and take advantage of the Section 1042 tax-free rollover provision. First, you determine how much of the purchase price can be financed with a conventional bank loan. Unless your company has pre-tax earnings of $10 million or more, you will only be able to obtain an asset-based loan. Under asset- based lending, banks will lend up to a certain percentage of each class of company assets. Generally, banks will lend up to 85% against accounts receivable, up to 60% against inventories, and up to 50% against land, buildings and equipment. Of course, any existing company loans and any amounts that need to be reserved for borrowings under a company line of credit count against the company’s total borrowing capacity. Thus, to the extent that your company has existing debt obligations and/or operating line-of-credit needs, your net bank borrowing capacity for ESOP purposes will be reduced.

Let’s now assume that your net borrowing capacity is only $2 million. This means you will have to take a $8 million seller note for the balance of the purchase price. The transaction would then be structured as follows:

First, your company would obtain a $2 million bank term loan and an $8 million bank “day loan”. The company would then lend the entire $10 million to the ESOP in exchange for a note payable over a term of 15 or 20 years, together with interest at 4% per annum. (The purpose of making the term 15 to 20 years is to stretch out the allocation of shares to participants over many years so that stock will still be available for new participants). The ESOP would then purchase 100% of your stock for $10 million of cash.

You would use $1 million to $1.5 million of this to purchase $10 million of floating rate ESOP bonds on margin in order to comply with Section 1042 of the Code. You would keep $500,000 to $1 million for personal needs and then lend $8 million back to your company in exchange for a 10 or 15 year promissory note. The company would then pay back the $8 million day loan from the bank.

You would now hold an $8 million promissory note from your company. This note would be subordinate to any existing bank loans. Nonetheless, it would have prepayment provisions that would allow accelerated repayment if bank covenants are met and if company cash flows permit.

The interest on your seller note will be taxable income. However, since you have met the requirements for tax-free rollover treatment, the principal payments on your note will be entirely tax-free. You may spend or invest these payments as you see fit. You can use them for living or retirement expenses, to pay down the margin loan, or to invest in stock, bonds, real estate, or any other type of investment. In either case, there will be no tax consequences other than for taxes on any additional earnings or gains these new investments yield.

After the ESOP buys your stock, your company would then switch to S corporation status in order to benefit from the ESOP tax shield. Since all of the stock would now be owned by the ESOP, all of the S corporation’s earnings would be attributable to the ESOP, which is a tax-exempt entity. Since all of the company’s earnings are now tax-exempt, the company will be able to repay your seller note much faster.

S Corporation Transaction Structure

But suppose you decide not to elect tax-free rollover treatment under Section 1042 of the Code. Then the transaction would be structured differently. If you are not electing tax-free rollover, then it is no longer necessary to sell all of your stock directly to the ESOP. This in turn eliminates the need to obtain a bank “day loan”. Instead, the transaction would be structured like this: First, you sell, say, 3% of your stock to the ESOP in exchange for a seller note payable over 15 to 20 years. Again, the purpose of making this note long term is to spread out the allocation of shares to participants over many years. Simultaneously, your company would redeem the remaining 97% of your stock in exchange for a seller note payable over a period of 10 to 15 years, but with prepayment provisions that would enable the note to be repaid much faster if company cash flows permit. The redemption of your remaining 97% interest would leave the ESOP as the sole shareholder while you hold a note for $9.7 million directly from your company. Since the stock would now be 100% owned by the ESOP, the company in effect becomes a tax-exempt entity.

Rate of Return on Fully-Priced Seller Notes

So far I have described the flow of funds, the term of the company loan, and the term of your seller note. Now comes the $64,000 question! What interest rate should be paid on your seller note? In the past, many sellers were willing to take a relatively modest rate of interest simply because they felt they had already enjoyed a substantial appreciation on their stock and because they feared the company would not be able to pay full-market rate interest. In effect, these seller notes were not fully priced. Rather, they were underpriced.

The reason that most seller notes are underpriced is this: Remember, in our example above, the bank was only willing to make a net loan of $ 2 million because any loan above $2 million would have been unsecured, and banks don’t make unsecured loans.

There are, however, other institutions willing to make cash flow loans unsecured by hard assets. These are nonbank lenders, and the type of loans that these lenders make are called mezzanine loans. This term comes from the fact that mezzanine loans fall between pure equity and senior secured debt. Because mezzanine loans are unsecured and not collateralized by hard assets, they are far more risky than senior secured loans. On the other hand, debt instruments have priority over equity instruments, so they are not entitled to equity rates. The arms-length market rate typically earned on mezzanine loans today is about 15% per annum. Because ESOPs provide additional corporate cash flow as a result of tax savings, the adjusted internal rate of return on ESOP-related mezzanine loans is about 13% per annum.

Clearly, most companies cannot afford to pay 13% current interest, especially if the note represents more than 40% or 50% of the total purchase price. How, then, can a seller ever expect to earn 13% on his note? The answer is that a seller to an ESOP can earn a full-market rate of return the same way that private equity firms do. Step one is to collect a current rate of interest that is affordable out of current cash flows, i.e., typically 8% per annum. Step two is to take warrants to purchase common stock of your company that, upon exercise, will give you the difference between a 13% compound rate of return and the 8% interest that you have collected during the interim. (A warrant is an option to purchase common stock, except that warrants are issued in connection with a note or other debt instrument, whereas options are issued independently.) The warrant is designed to be exercised and repurchased by the company once your seller note has been fully repaid. In many cases, the company will need to borrow additional funds from its bank in order to cash out your warrant. Alternatively, the company can give you a new note in payment for the redemption price of the warrant.

The enhanced rate of return on your original seller note comes from two sources. First, as explained above, you get a fully-priced return rather than a below-market return. Second, the number of warrants that you receive assumes a strike price at the current market value and a sale price at the projected value as of the projected redemption date. If, in fact, the fair market value of the shares exceeds the projected value as of the redemption date, then you will receive a windfall, and your total rate of return will exceed 13% per annum. (Alternatively, if the fair market value of the shares is less than their projected value as of the redemption date, your total rate of return will be less than 13% per annum).

Case Example

Now that I have described how a seller note can be structured to earn a full-market rate of return, let’s look at a real-life example of what a full-market interest rate adds up to in dollars and cents. The following case was recently closed by Menke & Associates, Inc.

This California-based company, engaged in manufacturing industrial products, was owned by a single shareholder. The business was appraised at $23.5 million. The owner received $5 million in cash financed with a bank loan and a 10 year seller note for the $18.5 million balance. The internal rate of return on his seller note was 13%, and the current-pay rate of interest was 8% per annum. The appraiser projected that the value of the company stock would, on average, increase at the rate of 6.9% per annum. Under these assumptions, the seller was granted warrants to purchase 11.2% of outstanding common stock of the company, exercisable at the end of 2020, the amount needed to give a full-market rate of return of 13% per annum. Assuming that the value of the company does in fact grow by 6.9% per annum, as projected, the seller will cash out his warrants at the end of 10 years for approximately $7 million.

The total amount that he will have received as a return on his $18.5 million seller note will be $11.5 million in current-pay interest and $7 million in payment for his warrants for a total of $18.5 million. This is probably far more than he would have received had he sold his company to a competitor or to a third party and reinvested the proceeds in publicly-held stocks or bonds.

Now let’s assume that the value of the company grows by 10.6% per annum rather than by 6.9%. In this case, he will cash out his warrants at the end of year 10 for almost $9 million. The total return on his $18.5 million seller note will be $11.5 million in current-pay interest and $9 million in payment for warrants for a total of $20.5 million. Again, this is probably far more than he would have received had he sold his company to a competitor or to a third party and reinvested the proceeds in publicly-held stocks or bonds.

Conclusion

Company owners are increasingly realizing that selling to any ESOP in exchange for a fully-priced seller note is often a far better strategy than selling to a competitor or third party. Seller notes can and should earn a quasi-equity rate of return. Covenants can be built into seller notes to provide additional protections and remedies in the event of an economic downturn. Unlike a sale to a third party, if your company has multiple shareholders, stock can be sold to the ESOP in stages over several years so that all shareholders don’t have to sell at the same time. Shares can be sold to the ESOP tax-free. And the ESOP can repay the debt with tax-exempt dollars. Clearly, selling your stock to an ESOP could be your smartest move.