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Accelerating Employee Share Ownership Plans (ESOP)

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Accelerating Employee Share Ownership Plans (ESOP)

By , March 12, 2018
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A Business Succession and Exit planning tool.

Most ESOP models are based on a combination of the employer contributing to the plan (normally through some kind of profit share based on improved performance of the business) and employees contributing to acquire shares – either by cash or by salary sacrifice. As with all Business Succession and Exit plans, the funding is often the primary issue.

In this case, this is for two main reasons:

  • The profit share plan is normally a slow gradual contribution, often taking between 5 and 10 years for employees to take a meaningful stake
  • Employees are often unable to make substantial contributions – either from cash savings or from salary sacrifice – again a slow gradual process.

In many cases this slower timing does not suit the owners/founders who may need to exit their business more quickly than the ESOP allows. In this case we can accelerate the operation of the ESOP by introducing debt into the equation.

 


As an illustration, see the case study outline below which examines a fictional client Smith Engineering:

Smith Engineering is looking to sell down equity from the founders to a group of 8 key employees, to allow the founder to retire and the employee to buy-out the business – a typical management buyout – the employees have some limited ability to make upfront contributions and also in some cases additional ongoing contributions through salary sacrifice. However, given the business has recently been valued at approximately $4-million this is not sufficient to fund the acquisition quickly enough to facilitate the founders retirement

We need to be able to accelerate the Employee Share Ownership Plan (ESOP), via one of the below options:

  • One option is for the founders to vendor finance the purchase 

This is not normally a great option – the security for the loan will be shares in the business and if the business is unable to fund loan repayments this probably means the shares have also dropped in value and the security may not be of any real value- the last thing the owner wants to do is take the business back

  •  A better option is to introduce some external lending into the model 

For example, the ESOP could borrow $3million against the value of the business (most lenders will also require guarantees from the employees looking to buy-in) – this means the owners gets paid out for 75 % of the value of the business day one and can then allow an ESOP model to proceed, key employees are locked into the business longer term and the founder has some certainty about payment and the ongoing success of the business going forward.

Importantly, the cost of debt funding is substantially less than equity funding and so the Weighted Average Cost of Capital (WACC) is now lower – which means we need a lower overall return and with the focus of a larger group of key stakeholders and the ensuing improvements on performance, the dividends stream should be sufficient to payout the loan over time, after which the employees enjoy the benefits of employee ownership.

To find out more about leveraged/geared ESOPs, please contact us.

"Already popular in the overseas business arena, there is increased interest in Australia in accelerated exit options. A geared or leveraged ESOP is an Employee Share Ownership Plan that includes an element of debt funding. "

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Craig West

Craig West

Managing Director | Succession Plus

Craig West is a strategic accountant who has over 20 years’ experience advising business owners. His background as a CPA in public practice, provided invaluable experience in the key issues of concern to business owners. Following 6 years of study to gain two masters degrees, Craig focused on Capital Gains Tax (CGT) for business sales advising on strategic management of tax issues. This experience formed a very strong view that business owners (and often their advisers) were unprepared and unaware of the steps required to prepare a business for exit.

Craig now acts as a strategic mentor for mid-market business owners and has written four critically acclaimed books on employee incentives, succession planning, asset protection and exit strategies. Craig has conducted numerous seminars and keynote presentations throughout Australia & internationally, including adviser education programs for the Institute of Chartered Accountants and CPA Australia.