ESOPs: In or Out?

I’ve always had a romantic relationship with ESOPs. I love the idea of the company’s employees being shareholders. The various tax advantages that have been extended to the vehicle to encourage that are great too (tax deduction on principal, tax free rollover over of proceeds). Thing is, I don’t know any (zero) middle market investment bankers that pitch these ideas to business owners as part of their liquidity alternatives. I am sure that’s for good reason – the fees for a banker on an ESOP may be less than that of a sell side – but I also hear from friends and colleagues on the legal and admin sides that they’re a pain to implement and maintain as well. So despite their theoretical benefits, I don’t think many advisors really like them.

With that said, I am also every familiar with the demographic shift as the baby boomer business owners retire and look to achieve liquidity with their business interests. I actually dealt with many of these situations first hand as an intermediary. In the lower middle market, the solution seems theoretically very straightforward. Do a thorough analysis of your alternatives, develop your income and wealth requirements, develop a tax strategy to minimize leakage, and execute. Problem is, (i) these rarely align and (ii) the myriad of soft issues always present problems. On the first item, lower middle market businesses ($3mm to $25mm) typically sell for 4‐5x EBITDA. That’s assuming the business is one that has buyers interested. Oftentimes there isn’t even that, for a huge variety of reasons ‐ declining industry, huge customer concentration, volatile operating history, etc, etc. Assuming for a moment that there is a market for the business – the owner does some quick math – I can put 2.5‐3x of debt on the business (usually) and dividend myself the proceeds, and still own the entire company. Why would I want to sell at 4x? Especially if I have management in place to run the business and I’ve alleviated myself of the day to day? And if I haven’t, shouldn’t I do that first so that I have that option? Then there’s the politics of the family and management.

To top it off, this economic environment has created huge downward compression on valuations. Two biggies are multiple compression as a result of a lock up in the credit markets (the less than can be financed, the lower the equity returns, the lower the price a buyer is willing to pay) and deteriorating operating results. Many business owners that did the above math and chose to spurn offers 3 or 4 years ago are now coming to grips with a real decline in their unrealized wealth as a result of the above. They’re still doing the same math mind you (why should I sell at 4x?) but the absolute number is smaller. In fact, many business owners are paralyzed by this logic. Personally, I think this will create a resurgence (or increase, whichever you like to call it) in ESOP structures. The after tax benefits to the selling shareholders of a leveraged ESOP address many of the concerns stated above, and there are incremental tax benefits to the company as well. To boot, it gives the owner equity to grant to executives and employees, a powerful incentive to protecting his residual wealth when stepping away from the business further. Last, and certainly not least, it installs a mechanism by which the shareholder can monetize his remaining equity, if he so chooses.

Without getting too esoteric, I think we are heading into a period of deep value investing, meaning more of an emphasis on cash flows and organic growth, less on momentum and trading. This will reduce, not increase, exit opportunities for private equity and venture firms, and drastically reduce multiple arbitrage opportunities based on momentum style investing concepts. All this will translate to lower business valuations for lower middle market companies, and as a result ESOPs will be on the rise.

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By |2018-06-20T18:56:47+00:00September 1st, 2010|Valuation|Comments Off on ESOPs: In or Out?