At a time when many financial services companies have seen lending activity dwindle because of the weak economy and regulatory pressures, opportunities still exist to lend to employee stock ownership plans.
The owners of many privately held companies need to diversify their holdings on a tax-deferred basis and address business succession issues. Many companies can use their ESOPs to purchase outstanding shares of their stock, refinance outstanding debt, or make acquisitions with pre-tax dollars.
An ESOP qualified under sections 401(a) and 4975(e)(7) of the Internal Revenue Code is the only type of employee benefit plan that may be used to borrow money. But special issues arise in connection with the structuring of loans made to fund the acquisition of a company's stock.
The general structure is simple: The ESOP borrows money and purchases an agreed-upon number of shares at fair market value from the employer or shareholders. These leveraged shares are placed in a suspense account and are used as collateral. As the loan is repaid, the suspense account shares are released from pledge and allocated to employees' accounts based on relative compensation.
Two different leveraged ESOP structures are typical. In one, the ESOP gives a note to the lender, accompanied by a guarantee from the employer that it will contribute to the plan sufficiently to enable it to amortize the loan. The loan may be secured by a pledge of the newly acquired shares and, if the lender requires, a pledge of the corporation's assets.
The loan also may be made directly to the corporation, which can then lend the proceeds to the ESOP. This may reassure lenders who are uncomfortable about lending directly to such plans.
When shareholders of a C corporation sell company stock to its ESOP - resulting in the plan owning at least 30% of the corporation's equity - the selling shareholders may be able to defer taxation of the gain on the sale to the ESOP.
A C corporation can then make annual tax deductible contributions to a leveraged ESOP, up to 25% of aggregate participant compensation plus interest payments. One benefit: Reasonable dividends paid on leveraged shares that are used to repay the ESOP loan are separately deductible.
An S corporation is limited to 25% of aggregate participant compensation for its annual contributions to an ESOP.
The purchase price for the employer shares cannot exceed the fair market value of the securities. When the shares are in a private company, the law requires that an independent appraiser determine the fair market value. Lenders should study both the appraiser's qualifications and the methodology of the appraisal, to make sure that the price is no higher than fair market value.
Employer shares purchased with the loan's proceeds must be released annually from encumbrance as the loan is repaid. The formula for the release is usually set forth in the loan documents. Lenders who take the security interest in the employer's shares should pay careful attention to the release formula: A lender could easily find itself having to release more shares if the formula is based upon the repayment of principal and interest than if the formula is based on principal repayment only.
Because of the tax benefits, cash flow under ESOP financing is higher than it would be with conventional debt financing. Thus, an ESOP enhances a company's debt servicing ability.
While ESOP transactions can be complex, the loan itself should not be. The lender will usually conduct the same credit analysis as it would in a conventional lending situation, and the cash flow benefits should enhance that credit. In most cases, the loan is structured and documented like a conventional loan, with the addition of provisions and documents reflecting the special requirements necessary to ensure that all parties can realize the respective tax benefits and other advantages.
