Leveraged ESOP’s are very popular in other countries, especially the US – this is mainly because the #1 issue with an ESOP (especially for succession) is that they are slow. Employees (normally) lack adequate funding to purchase equity quickly enough for the exiting founder/business owner – and so they need to be set up 7-10 years prior to exit. The best way to accelerate an ESOP is to use leverage (debt) to allow the employees to pay out the owners when they buy equity and then repay the debt over the normal 7-10 year period.
The typical leveraged ESOP model would be –
The founders set up an ESOP and invite key employees to join – thus locking in key staff, reducing risk and providing an exit strategy for owners (Management buy-in through a structured ESOP model).
ESOP is the preferred model as the individual employees do not become direct minority shareholders and the ESOP can include rules as to qualification, entry, valuation, exit, voting rights, control and management which are simply not possible thru direct ownership (which is governed by the Corporations Act) – these rules protect all parties – employees, employer and founders/owners.
Typically, an ESOP uses a profit share model to fund employee buy-in, though employees can and sometimes do contribute – many are not able to contribute substantial funds to buy equity and so either miss out altogether or are left with a very minor fractional ownership.
Introducing leverage solves this problem and typically works as follows:
a) The ESOP (a unit trust with a corporate trustee) borrows the funds required to purchase a substantial amount of equity in the employer entity.
b) Employees agree to repay the loan over a period of 5-7 years, including interest.
c)The lender will hold security over the shares owns by the ESOP, and often a guarantee from the employer and will also accept a personal guarantee from employees.
d) Employees agree that all dividends (and profit share contributions if applicable) are used to repay loans first.
e)The ESOP will normally include a restriction on sale until the loan is repaid – if the employee leaves the business then shares are forfeited (sold) and the loan is repaid – employee receives any surplus.
This model allows the business to attract, retain and motivate key employees whilst having those employees think and act like business owners adding value to the business, reducing risk and providing a viable and timely succession option.