Originally published in American City Business Journals
By Joe Rankin
Employee-owned companies are among the best investments because of their outsized returns, but for private equity investors, buying these firms has traditionally been out of reach. Now, however, some PE investors are leveraging an innovative financing structure to share in the rapid growth of these companies through warrant transactions.
S Corporation employee stock ownership plans ( ESOPs) are a type of defined contribution retirement plan that Congress exempted from taxes in 1998 to encourage employee ownership. They are typically used to help a business owner sell all or part of their firm to cash out, to facilitate management succession or to allow employees to share the profits of their labor.
ESOP-owned S Corporation companies — there are approximately 3,000 in the United States out of 10,000 total ESOPs — tend to have stable management teams and cultures that promote innovation. That leads to strong returns — 62 percentmore than other companies. A study by a major accounting firm found that the average S Corporation ESOP generated more than 50 percent greater returns compared to the S&P 500 total return index.
Such higher relative returns are desirable to PE investors. The historical problem for such investors, however, is that acquiring a company controlled by an ESOP means effectively buying out the very thing that has made the firm great in the first place — employees and managers motivated to grow profits as a result of their ownership.
Now, PE investors are using warrants to capture gains in the future value of the firm, as a corporate finance tool to invest in ESOPs. In recent months, we have seen deals concluded where PE investors took a stake in ESOP-controlled firms — previously, a seldom used strategy.
Warrants allow PE investors to indirectly invest in the future growth of an ESOP-controlled firm without disrupting the employee-led productivity advances that make the company attractive. Such deals are especially attractive to PE investors because S Corporations are exempt from federal taxes, boosting cash flow.
Rather than buying common stock from an ESOP, private equity investors can acquire a stake in the target company through lending the firm subordinated debt and receiving warrants in the future growth of the enterprise. Such a structure leaves the ESOP as the only common shareholder, thereby retaining the federal tax benefits, giving the employees a continued incentive to grow the firm while allowing the PE investor to share in the benefits of that growth. Warrants could come with floors and caps. For example, the warrants could yield a minimum return of 15 percent annually and a maximum of a 25 percent gain. Or, warrants could yield the full value of any appreciation.
Imagine the case of a manufacturing firm controlled by an ESOP that has been independently valued at $400 million. Bank financing of $200 million could be used to cash out current owners, who are also issued a note for another $100 million, while PE investors contribute $100 million of subordinated debt.
The PE investors would have the right to buy all or part of the firm outright at an agreed price at or before a certain time in the future, typically five to 10 years. If the PE investors did not exercise those warrants before they expired, they would be paid the cash spread between the fair value of the common stock and the exercise price of the warrants. The PE investor’s subordinated notes, plus a set interest rate, would normally be repaid before any other debt.
It’s a structure with three principal advantages for PE investors:
- It can produce significantly higher returns because of the fast growth rate of ESOP companies, the yield from the subordinated debt, gains from warrants (the difference between the original price and the firm’s eventual valuation) and the cash-flow benefits of being a tax-free entity.
- It can allow PE investors to spread their risk, helping them invest in more companies than would otherwise be possible by making outright acquisitions.
- Because of the improved cash flow inherent in an ESOP’s tax-exempt status, financing such deals through commercial lending sources is easier.
While the PE investor does not own any of the common stock (which remains controlled by the ESOP), its subordinated debt and warrants can come with board seats that allow it to manage its investment and the strategy of the firm.
This structure also works for other types of firms, such as C Corporations, that want to work in tandem with PE investors rather than sell outright. Such companies could convert to become an S Corporation, then establish an ESOP, and subsequently take subordinated debt and warrants from a PE investor as a way to sell part ownership.
It’s a structure that benefits the selling shareholder by deferring any taxes associated with the sale. It also allows sellers to gain a valuation similar to what would have been the case had they sold the firm outright while also benefiting from future growth. Employee-owners remain invested in the future growth of the firm, too.
Caution must be exercised. Company boards and ESOP committees must exercise prudent due diligence processes before entering any arrangement, especially a complex arrangement involving PE and warrants. The cash flow and dilutive effects of any financing mechanism must be considered. Utilizing knowledgeable legal counsel, financial advisers, and consultants are vital to ensure the continuing integrity of the ESOP.
With such an alignment of motivations for PE investors, managers and employees of ESOP firms, it seems inevitable that we will see a growing number of PE-ESOP deals in the coming years in such industries as manufacturing and construction.
Joe Rankin leads the employee benefits consulting practice at Plante Moran. He has more than 28 years of employee benefits and human resource consulting experience serving a wide variety of employers, including profit, not-for-profit and governmental entities as well as middle-market and Fortune 500 companies.