M&A Considerations for ESOP-Owned Companies

Participants in employee stock ownership plans (ESOPs) have their eyes set on a few details at the turn of each new year. Most notably, they hope to see growth in their company’s share price from the prior year. With a focus on shareholder value creation, management teams and employee-owners look for growth strategies that emphasize long-term sustainability while mitigating external factors.

ESOP-owned companies considering mergers and acquisitions as part of their growth plans may have increased flexibility relative to their peers, as well as the potential to generate attractive outcomes for all key stakeholders.

Some key M&A benefits to buyers include:

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Diversification in the form of new services or product lines, geographic expansion, or increased market share Faster growth trajectory relative to organic expansion Immediate access to the acquired company’s profits	Potential for greater economies of scale and cost synergies Gains in skilled labor Access to proprietary technologies or intellectual property

While M&A can increase a business’ growth, it’s not without its share of considerations. For example:

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M&A uses a company’s debt capacity and liquidity, which may cause stress on the business in a down cycle Financing an acquisition comes at the cost of debt or equity Integrating the companies can be a distraction to management	Establishing cultural alignment with the acquired company may be a challenge Newly formed ESOPs may not have the incremental debt capacity to facilitate an acquisition due to the leverage incurred in financing the ESOP transaction Mature ESOPs may not have sufficient debt capacity or capital if a significant percentage of their cash flow is used to fund repurchase obligation

Nonetheless, being an employee-owned company offers several competitive advantages in an M&A process, including:

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  Employees of the acquired company can retain employment and become participants in the ESOP

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  The two company cultures are more likely to align if the treatment of the employees is important to the selling shareholders

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  The acquired company’s sellers can potentially defer their capital gains tax on the sale of their shares in an IRC 1042 transaction

To take advantage of 1042, the selling shareholders must sell directly to an ESOP. One possible acquisition structure involves the target company forming its own ESOP and the target’s shareholders selling to the newly formed ESOP. The buyer can then acquire the target company, merging the two ESOPs and the two corporations. This is a complicated transaction and requires experienced tax and legal advice.

In terms of financing a transaction, ESOPs may consider acquiring existing ESOP-owned companies. This transaction can be executed via a stock-for-stock exchange in which the buyer uses its company stock as currency instead of, or in addition to, cash. This allows the company to conserve its cash flow and dry powder for future strategic investments.

It’s worth noting that due to the legal and tax complexities involving multiple transaction steps and the need for increased involvement from advisers, both transaction types come with incremental costs, and you should evaluate each situation to determine if those costs outweigh the benefits.

Given some of the inherent advantages of being an ESOP, growth through an acquisition can be a powerful tool to maximize shareholder value, diversify your business and reach your growth targets quicker than expanding organically. ESOP-owned companies have a competitive advantage in offering a strong ownership culture and potentially providing the selling shareholders a tax advantage.