If you’ve decided to take a closer look at an Employee Stock Ownership Plan (ESOP) for your succession plan, you may be wondering what the next steps are. The typical next step is an ESOP feasibility study. This process is important in providing information to shareholders considering selling shares to an ESOP. The scope of a feasibility study can vary, but several key issues should be addressed and outlined. The study should provide the foundation for the company and selling shareholder to determine if an ESOP is the right choice or if other options should be explored.
Key issues that must be addressed in a feasibility analysis include:
- What is the size of the company?
- Ideal ESOP candidates should have at least 20-25 employees and upwards of $2-$3 million in market value.
- What are the seller’s expectations for value?
- Owners need to have realistic expectations of value. The ESOP can pay no more than the fair market value of the interest it is acquiring. Just because someone at a trade show mentioned a competitor was sold for 2x revenue, doesn’t mean that is an accurate indication of fair market value. A feasibility study should contain a preliminary valuation with an estimate of the fair market value of the interest being sold to the ESOP. That value must be in sync with the target or goals of the selling owner(s).
- How will the transaction be financed, and how will this impact the cash flow of the company going forward?
- Do the sellers want cash up front, or are they willing to hold seller notes? Seller notes and corresponding warrants can be attractive to both the company and the seller, allowing for lower interest payments up front and potentially a higher return to the seller down the road.
- The proposed ESOP transaction must have cash flow. The ESOP is a financial buyer and, therefore, the company must be able to cash flow the proposed transaction.
- Overly cyclical companies may not be ideal candidates for an ESOP. This is especially true for companies seeking a leveraged transaction, in which an established track record of profitability and cash flow are essential.
- Management team
- Does the company have a team in place, or in training, to lead and manage the business going forward?
- What are the owner(s) goals and desires?
- Typically, closely-held companies are the best ESOP candidates. If the company has multiple owners, it may be difficult to get everyone on board with an ESOP. Another aspect of a good candidate includes the owner(s) being concerned about legacy and rewarding employees for years of service.
- Owners also need to consider if a sale to a strategic or financial buyer better meets their needs and desires.
- How long does the owner want to remain with the company? Often, selling shareholders wish to stay with the company long after the ESOP is formed. How long and in what role the seller wants should be considered.
- Employee demographics
- Understanding employee demographics is critical. The relative age of the workforce and employee turnover rates are important factors to consider.
- How many shares will be sold – 100% or some other interest?
- Some companies go from 0% to 100% immediately, while others prefer step transactions in which pieces are sold to the ESOP over time. This factor will be decided based on facts and circumstances specific to each company.
- If control is sold, how will management and the existing controlling shareholders react to voting/control issues going forward?
Key elements of the feasibility include:
- A preliminary valuation of the company to determine what the ESOP could potentially pay for the shares.
- An analysis to determine how the potential transaction financing will impact shareholders and the company’s financial performance in the future.
- Assessment of the management team.
- Evaluation of how the ESOP fits with the owner’s goals.
- Plan design to determine the best structure and plan features for the ESOP.
- An analysis of future repurchase obligations and how that will impact the company going forward.
If you’re a business owner considering succession plan options, contact me today to discuss if an ESOP makes sense for your company.