Houlihan Capital’s whitepaper on ESOPs

Houlihan Capital’s whitepaper on ESOPs

What is an ESOP?

An Employee Stock Ownership Plan (“ESOP”) is a defined contribution retirement plan, authorized by the Employee Retirement Income Security Act (“ERISA”) similar to a profit sharing plan.
Passed by Congress in 1974, ERISA provides tax incentives to establish ESOPs in accordance with the Department of Labor (“DOL”) and Internal Revenue Service (“IRS”).

What are the benefits of an ESOP?

Benefits to Sellers / Company

  • The primary benefit is to provide liquidity to owners of closely held companies who desire to exit or partially exit (on a tax deferred basis) while providing motivation and incentives via an investment in the company to covered participants.
  • A C-corporation shareholder, who sells at least a 30% interest to an ESOP, can rollover (IRC 1042) the net sales proceeds into investments in qualified public securities deferring any income tax liability (e.g., capital gains tax).
  • An S-corporation seller does not get this advantage; however, for S-corporations there is no income tax liability for income allocated to the ESOP.
  • In a situation in which an ESOP acquires a 100% ownership interest, the ESOP can convert the company to an S-corporation on a tax-free basis thus creating a “for profit, non-tax-paying entity”.

Benefits to Employees / Participants

Shares in the trust are allocated to individual participant’s accounts. As participants accumulate seniority within the company, they acquire an increasing right to the shares in their account (on a tax deferred basis), a process known as “vesting.”
Participants must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.
When participants leave or retire from the company, they receive their stock, which the company must buy back at its then fair market value (discounted) or fair value (undiscounted) as per provisions in the plan, unless there is a public market for the shares.
Alternatively, departing participants may receive a cash buyout of the appraised value of their interest.

How is an ESOP Established?

To establish an ESOP, companies set up a trust fund for participants and contribute either cash to buy company stock, contribute shares directly to the plan, or have the plan borrow money to buy shares.
Contribution of shares or cash to buy the shares is tax deductible.

  • The company may be required to guarantee or secure any ESOP loan or borrow the funds directly then lend the funds to the ESOP.
  • Under the leveraged structure, the company will make (at least annual) tax deductible cash contributions to the plan to enable it to repay the loan.
  • Generally, both the principal and interest payments of the ESOP debt are tax-deductible, with the maximum allowable tax deduction equal to 25% of eligible compensation. However, if the company is structured as a “C” Corporation, the interest payments are not capped.
  • Dividends paid on ESOP stock which are used to service the ESOP loan may also be tax deductible, thus effectively increasing the 25% of compensation limitation.
  • Participants pay no tax on the contributions until they receive the stock when they leave or retire.
  • In private companies, ESOP participants must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through other voting rights, such as voting for the board of directors, or other issues. In public companies, participants must be able to vote all issues.
  • A drawback of selling to an ESOP may be that the shares are subject to a minority discount to meet the “adequate consideration” conditions (see below), thus providing a lower gross price per share than the gross sales price to competitive outside buyers. But after the comparative tax consequences are analyzed, it is quite probable that the net after-tax proceeds of the sale could be significantly higher with a sale to an ESOP.
Valuation Considerations
  • ERISA requires ESOPs to pay no more than “adequate consideration” when investing in qualifying employer securities (principally common and convertible preferred stock).
    • “Adequate consideration” is defined as either the assets’ market value or properly determined fair market value, depending on the nature of the asset (e.g., established public price vs. private company).
      • For securities in which there is a generally recognized market, Section 3(18)(A) of ERISA defines “adequate consideration” as either (i) the price of the security prevailing on a national securities exchange which is registered under section 6 of the Securities Exchange Act of 1934 or (ii) if the security is not traded on such a national securities exchange, a price not less favorable to the plan than the offering price for the security as established by the current bid and ask prices quoted by persons independent of the issuer and any party in interest.
      • For all other securities, Section 3(18)(B) of ERISA defines “adequate consideration” as “the fair market value of the asset as determined in good faith by the trustee or named fiduciary…pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary of Labor”.
  • Fair market value should be determined pursuant to the terms of the plan and in accordance with regulations issued by the DOL and IRS.
  • The DOL’s Proposed Regulations define fair market value as “the price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and bother parties are able, as well as willing to trade and are well informed about the asset and the market for such asset”.
  • The DOL’s Proposed Regulations require the fair market value of an asset (i) to be determined as of the date of the transaction involving the asset; (ii) to be determined without considering transactions resulting from other than arm’s-length negotiations (e.g., distressed sales); (iii) to reflect the application of “sound business principles of evaluation”; and (iv) to be recorded in a document meeting the requirements of the Proposed Regulation.
    • Generally, the definition of fair market value and the requirements are consistent with IRS guidelines for determining fair market value (IRS Revenue Ruling 59-60) which govern the valuation of closely held stock for estate and gift taxes and federal income taxes.
    • Revenue Ruling 59-60 identifies the following factors that are to be considered in the valuation of a closely held company:
      • The nature and history of the business;
      • The general and specific industry economic conditions and outlook;
      • The book value of the stock and its financial condition;
      • The earnings capacity of the Company;
      • The Company’s dividend-paying capacity;
      • The existence of goodwill or other intangible value within the business;
      • Prior stock sales and the size of the block being valued; and
      • The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
  • Both DOL and the IRS acknowledge that ESOP owned shares should be discounted in value for lack of control and for lack of marketability, if appropriate.
  • IRS Code Section 401(a)(28)(C) requires a non-publicly traded company to obtain a qualified appraisal of the ESOP shares:
    • Each time the plan acquires shares, and
    • At minimum, the end of each plan year thereafter.
  • A Qualified Valuation Practitioner is a person, among other qualifications,:
    • Is not a party to the transaction, is not related to any party to the transaction , is not married to any person with a relationship to the transaction, is not regularly used by any of the parties to the transaction and who does not perform a majority of appraisals for these persons;
    • Holds himself or herself to the public as a valuation practitioner or performs appraisals on a regular basis;
    • Is qualified to make appraisals of the type of property being valued including, by background, experience, education, and memberships, if any, in professional associations;
    • Understands that an intentionally false or fraudulent over-statement of value may subject the valuation practitioner to a civil penalty; and
    • Receives an appraisal fee that is not based upon a percentage of the appraised value of the property.
  • Under the Pension Protection Act of 2006, and in ERISA regulations, the appraisal procedures must be in strict compliance with the Uniform Standards for Professional Appraisal Practice, (“USPAP”) Standards 9 and 10 which apply to Business Appraisal procedures, and Business Appraisal Reports, respectively.
The Good Faith Requirement
  • To demonstrate that a fiduciary made a determination of value in good faith, the Proposed Regulation states that the fiduciary must establish:
    • The fiduciary has arrived at a determination of fair market value by the way of prudent investigation of circumstances prevailing at the time of the valuation, and the application of sound business principles of evaluation; and
    • The fiduciary making the valuation either:
      • Is independent of all parties to the transaction (other than the plan), or
      • Relies on the report of an appraiser who is independent of all parties to the transaction (other than the plan).
      • If the fiduciary is not independent, the fiduciary must rely on a report of a Qualified Independent Valuation Practitioner.
ESOP Specific Valuation Issues
  • Generally, the valuation of a private company for ERISA purposes is no different from the valuation of a private company for any other purpose.
  • However, there are four (4) key ESOP-specific factors that should be considered:
    • Excess Compensation: Consideration should be given to whether the plan expenses exceed normal pension or benefit plan expenses of a non-ESOP company. Because the IRS permits large tax deductible contributions to the plan, which effectively increase participant costs for tax purposes, an analysis must be made to determine if excess exists, and to appropriately adjust the historical and forecasted cash flows upon which the basic appraisal of the company is made. If this is not done, the basic fair value equity may be significantly understated.
    • ESOP Participant Put Rights: Under the terms of an ESOP, departing participants that have vested shares have the right to have those shares purchased by the ESOP at the then fair market value, unless the ESOP distributes commensurate benefits in cash. This effective put right provides a level of liquidity greater than an investment in a similar private company without an ESOP. This increased liquidity may reduce the applicable discount for lack of marketability (“DLOM”) in determination of the fair market value of the security. In the Proposed Regulation, the DOL suggested the impact on the DLOM should take into account the enforceability of the put rights and the company’s ability to meet its obligations (e.g., financial strength and liquidity).
    • Repurchase Obligation: The aforementioned put rights place a future contingent obligation on the sponsoring company. The requirement to fund this obligation is likely reflected as an on-going additional expense of the company and may limit its future growth and liquidity, which over the long term may reduce the value of its stock.
    • Impact of a Leveraged ESOP: In a leveraged ESOP, the ESOP or company borrows money from a bank or other qualified lender. The company usually gives the lender a guarantee that it will make contributions to the ESOP; or, if the lender prefers, the company may borrow directly and make a loan back to the ESOP. Two tax incentives make borrowing through an ESOP extremely attractive to companies which might otherwise never consider financing.
      • The ESOP contributions are tax deductible, a “C” corporation which repays an ESOP loan in effect gets to deduct principal as well as interest from taxes. This deduction can cut the cost of financing to the company significantly, by reducing the number of pre-tax dollars needed to repay the principal, depending on the company’s tax bracket.
      • The dividends paid on ESOP stock passed through to participants or used to repay the ESOP loan are tax deductible if the ESOP sponsor operates as a C corporation. If the ESOP sponsor is an S corporation, dividends may be used to pay the ESOP debt, but there is no tax deduction as the S pays no corporate income tax. This provision of federal tax law may increase the amount of cash available to a company compared to one utilizing conventional financing.

While there are many benefits of a leveraged ESOP as outlined above, it is relevant to point out that after the initial ESOP transaction, the theoretical appraised value of the shares may initially drop, commonly referred to as “Post-Transaction Value Drop”. Immediately after the transaction, the company will have additional demand on cash for debt repayments. The reduced value is often only temporary. If the company does not change significantly over the period the loan is amortized, this initial decrease in value is recouped as the debt is satisfied.


As previously stated, the primary benefit of an ESOP is to provide liquidity to owners of closely held companies who desire to exit or partially exit (on a tax deferred basis) while providing motivation and incentives via an investment in the company to covered participants. Additionally, higher capital gains tax rates have increase ESOP attractiveness along with recovering valuation multiples and continued low interest rates.

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