ESOP purchase of founder's stock

[Guest wwcLeapYear]

Our client is negotiating to acquire the stock of the founder's widow (90% ownership - 12M annual sales). Our client is President of the company, he was brought in after the founder's death -- after obtaining control he wishes to set up an Esop. I mentioned, that I've heard of the concept of an ESOP used on the front-end to acquire the stock. Any viability? I'm concerned as to how one would establish the same ownership % to our client through an ESOP. Thanks for the help,

Bill Carlson

[RLL]

If the ESOP purchases the 90% stake, the ESOP will own 90% of the company. Your client's interest will be limited to his share of the ESOP's ownership. Through creative uses of multiple classes of stock, it may be possible to get your client additional stock.

Why are you considering an ESOP? What will an ESOP add? Does the company want employee ownership? Are there capital gains to be "tax-deferred" through a Sec. 1042 sale to the ESOP?

If your client wants to own as much as possible of the company, an ESOP is probably not appropriate. Consider having your client invest some funds in a purchase of stock, with the company redeeming the major portion of the widow's holding (assuming there is sufficient capital for the redemption). This doesn't sound like a good use of an ESOP.

[Guest wwcLeapYear]

Thanks RLL,

regarding your questions:

Our client, the company President, wishes to implement an ESOP program for the employees.

There is significant gain to the widow available for §1042 rollover.

Because of the above, and the deductibility of the ESOP payments by the corp, this structure was considered.

I haven't participated in an ESOP transaction and was uncertain as to the ability to structure equivalent 'control'.

The present proposed structure is identical to yours: Our client acquires a small amount of stock; and the widow's stock is redeemed by the corp.

Bill

[RLL]

The use of an "up-front" leveraged ESOP is likely to be beneficial to your client only to the extent that the seller will agree to a reduced purchase price by reason of the Sec. 1042 tax-deferral available with a sale of stock to the ESOP.

If that is not available, your client and the company are probably better off using a "post-transaction" non-leveraged ESOP to provide the same corporate tax deductions and employee ownership. Less complicated, less costly and less dilutive to your client.

The situation is not a simple one for designing an ESOP appropriate to accomplish the objectives of your client. I recommend that you engage the services of professionals experienced in designing/structuring ESOPs for closely-held companies.

For good information on ESOPs, check out the National Center for Employee Ownership (www.nceo.org/). Also, The ESOP Association (www.esopassociation.org).

[Guest John Koresko]

I must respectfully disagree with those who would eschew use of the ESOP. In many cases, it would work well. First, and foremost, the acquisition gets made with tax deductible dollars. That is basically a 35% discount, and can compensate for any dilution of ownership control. Secondly, more often than not, the BUYER will be the HCE with the largest allocation of the ESOP stock. If it is a leveraged transaction, the stock will be subject to a security agreement which could be executed upon if there is a default on the acquisition loan. Thirdly, the BUYER/HCE will be in a position to grant himself stock options as part of a compensation package. Although it raises certain fiduciary duty issues, exercise of options will many times counteract some of the dilution which occurs by using the ESOP. Finally, as a practical matter, the employees take the cash, not the stock, when they retire. Therefore, dilution is often a more theoretical issue than a practical reality. After all, the HCE will directly or indirectly control the fiduciary who votes the ESOP stock.

I have a few more ideas which may appear "outside the box", but that's what gets the lawyers the big bucks.

[RLL]

A non-leveraged ESOP is likely to be far less dilutive to the President (the client) and can provide the same use of "pre-tax" corporate dollars. A leveraged ESOP would usually be beneficial to the corporation and the client only when there's a Sec. 1042 transaction in which the seller will take a reduced purchase price (reduced sufficiently to offset the dilution resulting from leveraging the ESOP).

Paying Mr. "Big Bucks" Lawyer to do a complicated leveraged ESOP transaction may benefit the lawyer....but isn't it the client we're trying to benefit here?