Navigating the Current Landscape: A Q&A with ESOP Experts

July 13, 2020

Not surprisingly, the COVID-19 pandemic created significant challenges for business owners contemplating a sale of their business. Opportunities exist for those able to navigate the landscape and sell their company using an Employee Stock Ownership Plan (ESOP). 

Levenfeld Pearlstein partner David Solomon interviewed investment banking firms that operate in the ESOP space to get a better sense of what the market looks like to them in this current environment. The firms that participated in this survey were all asked the same questions. We have conveyed the responses in their own words below, edited for clarity.

 

Question #1: 

What are the biggest challenges of completing a sale of a company to an ESOP in the current environment?

 

Franco Silva, Director, Prairie Capital Advisors:

The recent pandemic has certainly created challenges for business owners contemplating a sale of their business to an ESOP, mostly centered around valuation and financing.   

Valuation serves the fundamental framework for any ESOP transaction, and the hurdles brought about by COVID-19 have had significant financial and valuation impacts on many companies. Lower valuations may not bode well for sellers and their valuation expectations. As a result, sellers may decide to delay the ESOP transaction time frame or search for an alternative option to selling their business. Given these dynamics, we are seeing more earn-out structures to help bridge this “Valuation Gap.” 

On the financing side, as banks contend with the uncertainty and perceived risk in the economy, it’s becoming more difficult to secure attractive debt financing for ESOP transactions. Banks are tightening lending standards and are less inclined to leverage companies with large amounts of unproductive debt. If a company is having difficulty raising bank financing, sellers may need to bridge the gap by accepting a greater percentage of the purchase price in the form of seller notes, minimizing their liquidity at close. 

 

Mike Morosky, Partner, Lazear Capital Securities:

The uncertainty surrounding the economy and the prospects of the company wanting to sell. This uncertainty can be addressed by isolating the aberrational impact of COVID and focusing on the more positive longer-term performance of the company.

 

Rick Hennessey, Vice President, Butcher Joseph:

We have several clients successfully navigating the sale process to an ESOP through the pandemic. These businesses are fortunate to have underlying fundamentals and demand profiles that remain intact. Clients in industries more heavily impacted have temporarily put their sale plans on hold while they focus on restoring profitability.

Typical, due diligence processes must be re-worked in the current environment. Restricted travel and social distancing limit the ability to hold standard in-person meetings. Video conferencing can support a lot of workstreams, but, for many, an on-site visit before closing may still be preferred. Further, due diligence is expanding as trustees (which represent employees as the buyer in ESOP transactions) seek to interpret the impact from the current environment on a business and its future.

 

Question #2: 

If you were talking to a potential ESOP candidate, what would you say are the reasons why now is actually a good time to transact?

 

Franco Silva, Director, Prairie Capital Advisors:

Businesses with strong fundamentals that have not been, to any great degree, negatively impacted by COVID-19 should expect favorable valuation and financing outcomes with an ESOP transaction. Also, there is the potential for tax legislation changes due to Federal stimuli and negative economic impacts related to the COVID-19 pandemic. Further, ESOPs can help business owners gradually begin the process of converting their closely held ownership over to liquid, diversified capital. 

Finally, with the challenges surrounding the COVID-19 pandemic, the upcoming presidential election, and the socioeconomic and political landscape, there is much uncertainty about the direction of the economy. With the future being unpredictable, now may be as good a time as any to move forward with an ESOP. 

 

Mike Morosky, Partner, Lazear Capital Securities:

Capital is inexpensive, and certain banks want to finance ESOP transactions. Valuations have remained strong as many people expect the federal stimulus to benefit the economy.

 

Rick Hennessey, Vice President, Butcher Joseph:

We have recently met with several companies that are candidates for an ESOP transaction and have found that those seriously exploring a sale to an ESOP in the current environment are among the businesses fortunate enough to have avoided distress. If you are among that group, the appropriate question to consider is, “why wait?” An ESOP transaction is most often pursued to address a need for succession planning and to provide a broader base of employees with an opportunity to participate financially in a business. For some, addressing these considerations need not be further delayed.

Many companies view now as the right time to “double down” on their employees. In certain industries, particularly those without remote workforce capabilities, employees are taking on more risk by coming to work each day. An ESOP is an effective tool to reward employees with a long-term, meaningful opportunity that can provide a competitive advantage in recruiting and retention efforts, and prove to be an effective investment in your brand.

 

Question #3:

What are the key attributes of a company that make it most attractive to form an ESOP for the purposes of the exit of the current owner(s) in the current environment?

 

Franco Silva, Director, Prairie Capital Advisors:

Companies with a sound business model and stable cash flows make good ESOP candidates in the current environment. Additionally, it is important for a company to have a strong and experienced management team that can navigate these turbulent market conditions. Having a strong business model, cash flows, and management team are critical to helping facilitate a successful ESOP transaction.

 

Mike Morosky, Partner, Lazear Capital Securities:

Companies with recurring revenue, large backlogs, long term customers, or contracts make great candidates. These attributes all equate to stability and help the company survive challenging environments.

 

Rick Hennessey, Vice President, Butcher Joseph:

In any environment, the most successful ESOP-owned companies have engaged employees and sellers that are genuinely looking to reward and incentivize their employees. ESOP ownership is prevalent in a variety of industries. Those businesses with strong leadership astute at managing a business and its various cash flow obligations (including debt) are generally good candidates.

 

Question #4:

What are the key considerations in integrating an ESOP post-acquisition in the current environment?

 

Franco Silva, Director, Prairie Capital Advisors:

One important consideration post-transaction is corporate governance. The most successful ESOP companies elect at least one independent board member. This individual is responsible for challenging executive directors, holding them accountable, and providing meaningful insights. The independent director may also have an ESOP background, in which case they can provide guidance and support for decisions related to running an ESOP company.

Another important consideration, post-transaction, is communication. Communication is important in any circumstance, but especially important post-ESOP transaction in the current environment. Communication at the board level, between managers, and amongst employees is critically important to be able to address challenges quickly during these difficult times. It is also important to communicate with the ESOP trustee team of advisors and the bank regarding everything from financial performance, risk and compliance matters, and the process for handling loans related to the Paycheck Protection Program or the Main Street Lending Program.

 

Mike Morosky, Partner, Lazear Capital Securities:

The successful ESOP owned companies prioritize employee communications. 

They want employees to understand what an ESOP is, how it impacts their retirement savings, and what they can do to create shareholder value, which ultimately benefits themselves. Said differently, when properly understood, an ESOP creates alignment among the stakeholders, which then turbo charges an organization.

 

Rick Hennessey, Vice President, Butcher Joseph:

A successful ESOP must have a capital structure that can accommodate current and future economic environments. As ESOP transactions are typically leveraged buyouts, companies should consider fixed charge requirements (principal and interest payments) and other financial covenants under multiple projection scenarios, including a downside case with variant paces of economic recovery. The first year, often the most critical of any leveraged buyout (highest fixed charge requirements), is even more important to appropriately plan for in today’s volatile environment. While ESOP ownership can provide tax efficiencies that benefit cash flow, and consequently compliance with fixed charges, managing de-leveraging alongside other working capital and capital expenditure needs should be considered.

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