Benefits of a Second Stage ESOP Transaction

Employee Stock Ownership Plans (“ESOPs”) have become a popular way to transition the ownership of a business while simultaneously creating an incredible value opportunity for both the company and its employees. Every year, prospective selling shareholders set out to learn the ins and outs of an initial ESOP transaction, many of whom ultimately choose to sell 100.0% of their company to an ESOP. 

What is less well known is that a shareholder(s) who initially chooses to sell just a portion of their company to an ESOP can later choose to transition the company’s full ownership to the ESOP.  Commonly referred to as a second-stage ESOP transaction, this article will review how to increase an ESOP’s ownership stake in the company, the potential implications of a second-stage transaction to the existing ESOP and the possibility that, prior to closing a such a transaction, the Board of Directors may request a corporate fairness opinion. 

In short, as part of a second-stage ESOP transaction, the shareholder(s) sells their remaining shares of company stock to the ESOP, causing the ESOP’s ownership stake in the company to increase by a meaningful amount. Indeed, a second-stage ESOP transaction will often result in the ESOP’s ownership share growing from a minority position to 100.0%. 

Second-stage ESOP transactions are usually considered part of a company’s overall ownership transition strategy since they help the company sustain its independent, employee-owned structure.

Over the last decade, ESOP sustainability has become a mainstream conversation. The idea is that a company wants to continue its employee ownership culture, create long-term wealth for ESOP participants and provide ESOP value to future employees. This all needs to happen simultaneous to the constant evolution of factors impacting the business, including changing demands on company capital, management succession and variations in the overall economy, to name just a few. 

As with any corporate transaction, careful planning and effective execution are an important part of the process. Parts of the second-stage transaction may be similar to the initial ESOP transaction, including the planning process, execution cadence and parties involved. There are, however, several important points to consider:

1. Valuation and Feasibility: Once an ESOP is established, the ESOP Trustee needs to obtain an annual valuation of the stock held in the ESOP trust from an independent appraiser or valuation firm. At that time, the appraiser/valuation firm will conduct their own independent valuation and a feasibility study which will include a future value trajectory that considers various company objectives that could impact future cash flows, the company’s valuation and ESOP benefits. The  feasibility study for the second-stage transaction, much like in the initial ESOP transaction, will layer on the optimal transaction structure so the company can best evaluate its financial health, value prospects and ESOP benefits.

2. Financing Options: The feasibility study will also assess the financing options available to the company to fund the second-stage transaction. Often, the sources of funds include a traditional banking institution, promissory notes to the sellers and balance sheet cash. Unlike the initial ESOP transaction, there may be cash in the ESOP trust that can be used by the ESOP trust to purchase company shares as part of the second-stage transaction. If a bank is used, the company will need to work with its financing partners to enter into a new loan agreement for the second-stage transaction. This could also result in refinancing of any existing debt on the balance sheet.

3. Transaction Professionals: Once the selling shareholder(s) is ready to move forward with the transaction, a number of professionals will need to be engaged in order to complete the process. Generally, the second-stage transaction process—including typical due diligence and legal documentation—takes approximately two to four months, which is slightly shorter than the initial transaction since many of the professional parties are already familiar with the company. The parties which must be involved include:

4. Transaction Negotiation: While an annual valuation is done for ESOP administration purposes, the transaction price is still negotiated as specific valuation factors may have changed. All other deal points are up for negotiation as part of the second-stage transaction, including financing terms (Bank and Sellers), warrants, synthetic equity and internal loan structure, among others.

5. Opinions Needed by ESOP Trustee: As part of the second-stage transaction, the ESOP Trustee will be required to receive various opinions from its financial advisor. Typically, the ESOP Trustee needs both adequate consideration and fairness opinions. It should be noted that the fairness opinion obtained by the ESOP Trustee may not be relied upon by the company’s Board of Directors.

6. Impact on Existing ESOP Participants: Depending on how the second-stage transaction is financed, it may result in “suspense” shares that are allocated to ESOP participants. This is a benefit to existing and new employees as this provides a mechanism to continue delivering shares into the future. At the same time, however, the cost of the transaction (whether cash or debt) may result in dilution of the share price until such time as the debt is paid off or cash has accumulated. In order to protect participants who retire shortly after the second-stage transaction is concluded from the impact of the decline in share value, the company may consider adding “price protection.” Price protection essentially allows those participants to be bought out at a price that excludes the dilutive impact related to the second-stage transaction. Since this is a limited benefit generally afforded only to participants reaching retirement age shortly after the transaction, the company’s financial advisor and legal counsel should review the need for price protection during the feasibility phase. 

7. Tax Advantages: Under current tax laws, an ESOP trust is tax-exempt. Therefore, if the company is 100.0% owned by an ESOP trust, there will likely be significant federal tax savings and, in many—but not all—states, state tax savings. This additional cash flow can help pay down transaction debt and can also accumulate on the balance sheet for future reinvestment by the company.

8. 26 U.S. Code §1042 (“§1042”) Opportunity: If the initial ESOP transaction was structured in such a way that allowed for the selling shareholder(s) to elect §1042, then the seller(s) in the second-stage transaction may also elect §1042. This can create an incredible tax advantage for the selling shareholder(s).

9. Possible Need for a Corporate Fairness Opinion: There are numerous potential benefits related to second-stage ESOP transactions not only for the company but for existing ESOP participants and the sellers. That said, a second-stage transaction could potentially have material impacts on all existing stakeholders, including synthetic equity holders. As a result, it may be in the best interest of the Board of Directors to obtain a corporate fairness opinion in support of the second-stage ESOP transaction as evidence that they have fulfilled their fiduciary duties.

A well planned second-stage transaction can benefit the company, the sellers and the ESOP participants and perpetuate the company’s employee ownership far into the future.

Tom DeSimone is a Director at Prairie Capital Advisors, Inc. He can be contacted at 630.413.5578 or by email:

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