By:  Douglas M. Schmidt
Partner, Chessiecap Securities

Faltering federal M&A market drives ESOP consideration
In recent months, we have fielded inquiries and assisted in evaluating and developing ESOPs (Employee Stock Ownership Plans) for companies that provide services to the federal government. ESOPs are front and center as a result of a slowdown in M&A activity in the government services industry, particularly for private company sellers. There are a few segments of the government market such as cyber security and health care IT that continue to command strong valuations. But for the majority of the industry, federal sequestration, reduced federal budgets, and a winding down of two wars have sent industry valuations, and subsequently, deal prices to their lowest levels in almost two decades.

Some companies or divisions have pressing reasons to sell, but most private companies would rather manage into the future than sell at current depressed prices. Although a few investment bankers are optimistically calling for a market upturn, we do not see the ‘supply & demand’ fundamentals changing any time soon in the government marketplace.  Without government spending, there is no growth in the industry.  Without growth, public and private values fall to reflect a restrained future—which is why our clients have been open to a different model for achieving liquidity.

A second contributing factor for an ESOP revival involves taxation, both on the corporate and individual levels (one explanation for the flurry of activity at the end of 2012). Capital gains and personal rates for successful business people are potentially going up. On top of higher rates is a yet-to-be-experienced new tax (3.8%) on unearned income for high earners as part of the new health care law. If you sell your business in 2013, you may go from 15% to 23.8% on the capital gain rate. An ESOP can address both the M&A and taxation issues as well as several other key concerns. An ESOP can provide a viable market, where no market currently exists, for an owner to sell some or all of his or her equity at a fair price. In addition, an ESOP can provide certain tax advantages both for companies and for individuals which can reduce or negate the impact of old as well as new taxes.

Who should consider an ESOP?
First and foremost, an ESOP is a regulated employee benefit plan. ESOPs have many remarkable advantages for both sellers and employees, but they have to be seen in the context of providing a good benefit plan for the participants. A potential ESOP has to answer this question:  Will your company be a long-term good investment for employees and plan participants?

What characteristics does Chessiecap look for in an ESOP candidate?

  • Owners who do not have to sell but who want to consider cashing out of a minority or majority of their shares.  Owners who want to remain with the company to help it grow and succeed.
  • Owners who are ready to retire or sell but have in place a solid next generation of leadership.
  • Steady companies with demonstrable future business to safely provide from cash flow for the critical first several years of contributions that must be made to the ESOP.
  • Companies seeking to solve the “minority ownership dilemma.”  One of the stickiest problems in a private company involves how to afford the buying      out of minority shareholders who are outside investors, retiring managers,      or employees who have left the business.
  • Owners who want to reward or motivate employees with equity participation.
  • Companies with a minimum of 20 employees and a minimum value of $5 million. This is a “rule of thumb” recommendation that considers the built-in costs of establishing and running a new employee benefit program.
  • Companies which may have excess cash that is trapped on the balance sheet and that will be taxed an additional time if dividended.

Some key benefits of an ESOP

  • Liquidity for owners without the necessity of surrendering control.
  • Employee participation in the upside of the business, a proven motivator.
  • Potential reduced tax liability with ESOP features such as deductibility of contributions to the ESOP, deductibility of loan principal & interest, and dividends to participants.
  • A continuous market for selling shareholders.
  • The potential to reduce and/or delay personal taxes using certain IRS elections and estate planning programs.
  • Potential inclusion of some ESOP expenses in a federal contractor’s rate base.

The Chessiecap approach
At the heart of an ESOP is the question of value.  What is a fair price for the sellers and what is a fair price for the ESOP which buys the shares and provides employees with ownership rights to those shares? In many instances, the sellers continue to run the company, so they are on both sides of the issue. They want a good price for their shares, but they also do not want the company saddled with unrealistic ESOP obligations.

Chessiecap serves as a guide and corporate finance advisor in helping companies assess the feasibility of an ESOP. We help our clients, step-by-step, to deploy the plan. There are complex choices to make which we address with analytical backup and conventional experience. We have a unique set of valuation skills that have been tested by major companies and funds in the industry. We know the markets for growth and technology companies, including being recognized experts in the federal marketplace. And most importantly, we have assembled a team of advisors and consultants who can create a state-of-the-art ESOP that will serve your company well for many years.

A properly instituted ESOP is a remarkable feat of corporate finance engineering that can help solve a host of personal and corporate concerns—from taxation to employee and owner wealth. An ESOP is not the right solution for every company, but if you want to evaluate its potential, please use Chessiecap as your experienced resource. That is what we do—provide superior financial and strategic advice to our clients as well as transactional services such as private placements and mergers & acquisitions.

Prospective clients and clients of Chessiecap Securities are advised to seek independent counsel with respect to the tax consequences of ESOPs.