According to the National Center for Employee Ownership, there are currently over 6,000 ESOPs.[1] Although the total number of ESOPs has remained relatively steady from year to year, there are around 250 new ESOPs formed each year.[2] Those numbers suggest that ownership of ESOPs is being transitioned to third parties at a similar rate to the formation of new ESOPs. ESOPs are not particular to any specific industry, but over half of ESOPs are in the professional services, manufacturing, and construction industries.[3] If your company is thinking about acquiring an ESOP-owned company, below are some initial matters to consider.
What is an ESOP?
An employee stock ownership plan (ESOP) is a company-paid retirement benefit that invests primarily in stock of the employer. An ESOP can only hold corporate stock, so an ESOP-owned company must be a corporation (as opposed to an LLC, for example).[4] You might hear ESOP-owned corporations referred to as “employee owned”; however, the actual shareholder of an ESOP-owned corporation is the ESOP Trust, which holds the shares of the corporation on behalf of the plan participants. ESOPs are regulated by the Internal Revenue Service and the Department of Labor.
What are the differences in the deal process when acquiring an ESOP?
As an initial matter, there will be several more parties involved in an ESOP transaction than a traditional M&A deal. Rather than dealing with an individual seller or small group of sellers, the shareholder of the ESOP-owned company is the ESOP Trust, which has a trustee. The trustee could be an individual or an institution with a committee of professionals that will consider the transaction. The trustee will have its own support staff and engage its own legal counsel and valuation firm to evaluate the potential transaction.
Prior to closing the transaction, the trustee must determine that: (1) the consideration is not less than fair market value (as such term is used in determining “adequate consideration” under Section 3(18) of ERISA); and (2) the terms and conditions of the transaction, taken as a whole, are fair to the ESOP from a financial point of view.[5] In connection with this determination, the trustee’s valuation firm must conduct its own financial due diligence, prepare a valuation, and deliver a fairness opinion at closing. The valuation firm will take into account the waterfall of payments (and will consider deductions to the deal proceeds such as transaction bonuses, contingent payments, and escrows) in determining whether the transaction is fair.
As further described below, the ESOP will be wound down following closing and the plan assets will be distributed to plan participants. That means that traditional indemnification structures with caps, baskets, escrows, holdbacks, etc. are less often included in ESOP acquisitions. Instead, many buyers obtain a representation and warranty insurance policy in order to bridge the gap between the lack of recourse against the ESOP Trust that is in the process of wind down and the potential for post-closing claims.
What are the differences in deal structure when acquiring an ESOP?
Most forms of transaction that would require a shareholder vote under state law (such as a merger or a sale of substantially all the assets of the company) require a pass-through vote of plan participants.[6] In order to conduct this pass-through vote, the company must deliver a disclosure statement to the participants that includes a summary of the deal and a solicitation of their direction to the trustee to vote for or against the transaction. Due to the administrative burden of preparing, printing, and mailing the participant statement and tabulating votes, most ESOP-owned companies would prefer a stock deal (which would not require a shareholder vote under state law) to an asset deal (which would require a shareholder vote under state law).
What different information or documents should be requested and reviewed in diligence of an ESOP-owned corporation?
Buyers should get comfortable in their diligence review with compliance of the ESOP at formation and ongoing compliance thereafter. As a starting point, buyers should request the closing binder from the original sale of shares to the ESOP, not only to track capitalization history, but also for some key documents that are entered into very frequently in connection with a sale of shares to an ESOP: promissory notes and warrants issued to the sellers as deal consideration, loans from the company to the ESOP and third-party lenders to finance the transaction, stock appreciation rights plans, and phantom stock plans. All of these documents need to be considered in the waterfall, funds flow, and payoffs.
Because ESOP-owned companies are more heavily regulated, additional due diligence requests should be included around Department of Labor and Internal Revenue Service investigations or litigation. Also, ongoing compliance diligence should be conducted through requests for the most recent favorable determination letter; the plan, trust, summary plan description, and all amendments; forms 5500; compliance testing; non-discrimination testing; and annual valuation reports.
What are the differences in conditions to closing and post-closing covenants?
As mentioned above, the ESOP will be wound down shortly following the closing. As a condition to closing, the ESOP-owned company should be required to start this process by amending its plan to freeze contributions and stop accepting new participants. As a post-closing covenant, buyer and seller will agree to cooperate in terminating the ESOP, filing a final form 5500, and obtaining a favorable determination letter. A percentage of the deal proceeds will be distributed to participants promptly after closing, but some funds will be held back to pay the expenses of the wind down, which can take up to 18 months to complete. A final distribution will be made once escrows are released, contingent payments are settled, and expenses of the wind down are paid.
ESOP-owned corporations also have agreements in place with the ESOP trustee to provide for indemnification against claims or suits brought against the trustee in connection with their service on behalf of the corporation. These liabilities can be insured against by the corporation with an errors and omissions policy that provides coverage for the directors, officers and service providers of the corporation, but a tail policy must be purchased at the time of a transaction to provide for this coverage following the closing.
Are there employee relations and retention considerations?
The deal proceeds in the acquisition of an ESOP-owned corporation will be distributed to the plan participants in proportion to their plan accounts. Employees who have had a long tenure with the company may have racked up significant ESOP account balances and will receive a large portion of cash in the wind-down process. If participants take the cash, they will be subject to ordinary income tax and may be subject to early pension distribution penalties.[7] Because of that, many buyers focus efforts on educating their new employees (i.e., the plan participants) to roll over plan balances into a 401(k) or IRA.
Human resources should be engaged early to review benefits packages from a retention perspective. If the buyer does not sponsor an ESOP of its own, employees will notice a reduction in their total benefits package unless compensation is otherwise increased. Human resources should also understand transaction bonuses to be granted to key employees early on in the process so that retention packages can be planned accordingly. Some consideration should also be given to post-transaction retention and engagement of employees, some of whom will receive ESOP distributions significant enough to allow the employees to retire sooner than they otherwise may have.
The above are only the initial, high-level questions to consider in the acquisition of an ESOP-owned corporation. If your company is thinking about acquiring an ESOP-owned corporation, hiring advisors, including lawyers, who have deep experience in acquisitions involving ESOPs is key.
[1] Employee Ownership by the Numbers, National Center for Employee Ownership (Feb. 2023), https://www.nceo.org/articles/employee-ownership-by-the-numbers.
[2] Id.
[3] Id.
[5] 29 U.S.C.§ 1106(a)(1)(A) and (D) prohibit an ESOP from acquiring stock of the plan sponsor from a “party in interest” unless the transaction qualifies under the exemption provided for in 29 U.S.C. § 1108(e). This exemption is allowed for employer stock if and only if the purchase is for “adequate consideration,” which in the case of assets for which there is no generally recognized market as “the fair market value of the asset as determined in good faith by the trustee or named fiduciary.” 29 U.S.C. § 1002(18)(B). See also, 29 C.F.R. § 2550.408(e). This standard is typically met by delivery of an adequate consideration and fairness opinion from a qualified appraiser pertaining to the transaction. Even though a third-party acquisition is not a “party in interest” transaction, trustees typically require such opinions as a demonstration that the transaction is prudent under ERISA.
[6] 26 U.S. Code § 409(e)(3).
[7] 26 U.S. Code § 72(q)(1).
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