"Employee Stock Ownership Plan" being written on a sticky note
"Employee Stock Ownership Plan" being written on a sticky note

The Straightforward Guide to ESOP Financing

Creating an employee stock ownership plan (ESOP) is a complex financial transaction that not all lenders have experience with. However, an ESOP is a common ownership transition tool and employee retirement plan used in many industries.

Financing an ESOP usually fits two general categories: leveraged or non-leveraged ESOP. A leveraged ESOP is more common and occurs where the company creating the plan finances the initial stock purchase with money borrowed from a bank and/or selling shareholder(s). The company self finances a non-leveraged ESOP through cash or shares.

If these terms – or the entire concept of ESOP financing – feel overwhelming, a lender with ESOP experience can help you consider your options and navigate the process.

Key takeaways

  • An employee stock ownership plan (ESOP) can facilitate an owner's controlled exit at retirement. The smoother the process of creating and formalizing the ESOP, the likelier it is your business will thrive. ESOPs can also be used to provide diversification to owners or to buy out minority owners.
  • An ESOP can be either leveraged or non-leveraged. In the more typical leveraged ESOP financing scheme, the (1) company creates the ESOP trust and, (2) obtains lender financing, (3) the ESOP purchases stocks to be held in trust for the plan.
  • The ESOP plan also facilitates employee retention and retirement. Employees earn distributions from the ESOP based on compensation and years of service. Because an employee may not vest in earned shares until years into the future, awarding shares also encourages employees to remain with the company.

What Is ESOP Financing?

At its most basic definition, ESOP financing involves a lender providing liquidity to the seller(s) upon the sale of a company to an ESOP.

One of the most important foundational steps in this process is the purchase of company stock by the ESOP trust. This creates liquidity for the seller. A bank lender could typically provide a business loan that covers anywhere from 20% to 40% of the enterprise value of the company. If additional financing is needed (which is normally the case for a 100% ESOP sale), the seller will typically take back a note for the remainder. Sometimes, a third party junior or mezzanine lender may provide a small portion as well.

ESOP Financing Options

Unless your company can fund an ESOP outright, you'll need to work with a lender. The type of lender you should engage with depends on your business's financial condition and existing lender relationships.

ESOP formation is a highly specialized type of debt finance. However, there's no regulatory requirement that you work with a particular lender. For companies who've never needed external financing, the need for lender financing may seem foreign.

Generally, the process begins with obtaining a loan for a portion of the funds from an institutional lender, like a bank. If needed, the remainder of the financing usually comes from the seller, in the form of a seller note.

1. Obtaining senior bank debt.

Commercial lenders and other banks typically provide the first layer of ESOP financing.

You should begin your search with a lender that has deep knowledge of ESOP transaction financing. ESOP transactions have unique accounting and regulatory characteristics that could befuddle an inexperienced bank.

When you find an institutional lender like a bank, they will likely require their debt to be senior to all other lenders. Though this will be an unsecured loan, its senior status ensures that your company will pay this primary loan first in the event of bankruptcy.

While senior loans typically come with lower interest rates, the lender limits the funds provided to a multiple of the company's earnings.

2. Applying for subordinate debt.

In many cases, senior bank loans alone aren't sufficient to finance an ESOP formation. In that scenario, you'll need to secure additional funds. This may include mezzanine funding, and more often, seller financing.

These additional sources will be subordinate, or second-in-line, to the senior bank loan. Even though this funding could bridge a funding gap, be aware that an institutional mezzanine lender will likely charge a much higher interest rate to account for secondary status.

3. Arranging seller financing.

In many cases, the bank financing is not enough to cover the entire amount needed for the transaction. It is very common for sellers to finance the remainder of the ESOP transaction. The seller financing works just like any other secondary lender – their debt is subordinate to the primary lender.

Seller financing provides several advantages:

  • It fills a gap in financing that other lenders cannot provide.
  • The seller's note payments allow more flexibility when corporate cash flow is needed elsewhere.

Whatever your goals, creating an ESOP doesn't have to be a difficult process. Having the right professional advisors and the right banking team can help build the plan that’s right for you, ensure a smooth transaction, and set the company up for long term success.