In a previous post, we shared options and steps to consider if your company is an Employee Stock Ownership Plan (ESOP) and you have been approached by a possible buyer. Unbeknownst to some buyers, there are several unique aspects of structuring and executing an acquisition of an ESOP owned company in comparison to traditional M&A transactions. If your employee owned company is considering a sale to a third-party buyer, it is important that all parties are aware of the deal peculiarities that arise in acquiring ESOP owned companies.
The Presence of an ESOP Trustee
While most companies are controlled by their individual shareholders, the stock owned by an ESOP is overseen by a trustee who has fiduciary responsibilities with respect to acting in the best interests of the plan participants. As a result, a savvy buyer should be aware of the trustee and their role in the sale process. In order for company stock owned by an ESOP to be sold, the trustee must determine that:
- Adequate consideration will be received by the trust for the stock; and
- The offer is fair to the ESOP from a financial point of view.
ESOP trustees have increasingly become targets of Department of Labor and plaintiff counsel litigation. Much of this litigation is focused on whether trustees breached their fiduciary duties to the ESOP and engaged in prohibited transactions by either paying too much for the company stock in purchase transactions or not receiving a “fair” deal in sale transactions in comparison to other interested parties. Therefore, trustees are more cautious than ever in making their decisions to buy or sell company stock.
As part of being extremely diligent in making decisions, the trustee will hire an independent financial adviser and legal counsel to assist them in navigating the decision-making process. The role of the independent financial advisor will be to complete a valuation of the stock owned by the ESOP, which the trustee will compare to the proceeds to be received in a proposed offer. The financial advisor may also analyze the offer to determine if proposed employment agreements, management bonuses, severance agreements, payouts of synthetic equity, change in control payments, and contingent payments (i.e. escrows and earn outs) are fair to the ESOP from a financial point of view.
The legal advisor will review the proposed employment agreements, contingent payment structure, scope of the ESOP’s representations and warranties, and potential liability of the ESOP for indemnification claims to ensure that they are in the best interest of the ESOP.
The Board of Directors and executive team may feel that they have negotiated a fair purchase price and a strong deal for the ESOP; however, the ESOP trustee must also come to the conclusion that the transaction is in the best interests of the plan participants. Therefore, it is important for the ESOP trustee to be involved in the offer discussions as early in the process as possible.
Voting Rights
In traditional M&A transactions, the decision to structure a deal as a stock sale or an asset sale is usually a joint decision by the buyer and seller often driven by tax and liability related factors. Some deals make more sense as stock deals and others make more sense as asset deals depending on the legal, accounting, and tax circumstances of the parties involved.
In an ESOP M&A transaction, the parties should be aware that if the transaction is structured as an asset sale and involves substantially all of the company’s assets, then the selling company’s ESOP is required to pass-through the voting rights on the transaction to the individual participants in the ESOP. In other words, the ultimate decision of whether or not the transaction is approved lies with how participants decide to vote. Many times, the parties structure the transaction as a stock sale to avoid the time, complication, and expense associated with conducting a pass-through vote to the ESOP participants.
Escrow Issues
Escrows are very common in lower middle market M&A transactions as a risk mitigation tool for buyers against breaches of representations and warranties. However, escrows in ESOP transactions can be problematic and create adequate consideration issues. Most ESOP trustees take the position that because escrow funds are not guaranteed to be paid out to the ESOP participants, the trustee’s financial advisor should not include escrowed amounts as consideration. Therefore, it can be difficult to receive an adequate consideration opinion if there are substantial deal proceeds subject to an escrow.
Representations & Warranties
In nearly every M&A transaction, the sellers are required to make certain representations and warranties about the company and the stock that they own to a buyer. However, in an acquisition of an ESOP company, the issue of which party is making the representations can become problematic especially if the ESOP owns 100% of the company’s stock. In many cases, trustees prefer to make only the most basic of core representations to a buyer and prefer that the company or other shareholders make many of the ancillary representations that seller’s desire. This issue, in combination with the escrow complexities, often makes for a unique negotiation between the ESOP trustee, the buyer, the company, and other shareholders.
Post-Transaction ESOP Issues
What happens to the ESOP after the sale is complete? The buyer must work with its advisors to determine if it should merge the ESOP into an existing plan or terminate the ESOP and distribute assets to the participants. The trustee and the ESOP administrator must carefully follow the plan’s rules pertaining to the distribution of ESOP and plan assets at close. In addition, escrows and contingent assets must be monitored and distributed when appropriate. Many of these issues will need to be negotiated in connection with the sale of the company.
There are nuances with selling employee owned companies that add a layer of complexity to acquisitions of ESOP owned companies. We recommend that plan sponsors considering a sale work with an experienced ESOP attorney and investment banker that specializes in ESOPs to maximize the chances of a successful outcome for all parties.
Due to the nuances with selling an ESOP, it is extremely important to lean on qualified advisors throughout the process. For more information about ESOPs, or how SC&H Capital can support these and other transitions in ownership, please contact us or visit our site.