What constitutes a “feasibility study” varies significantly between advisors who recommend them and clients who believe they need one or ask if they need one. For advisors, the differences stem from what their professional skills are, what they propose their role in the ESOP transaction to be, and sometimes, services or product placement they may offer in addition to the ESOP. As the adage goes, “If you sell hammers, everything looks like a nail.”
For clients, expectations vary due to not knowing what an ESOP transaction entails and what they think they want an ESOP to do for them and their company. Most companies starting out have very little idea of what a feasibility study will do for them, but have high expectations that it will accomplish those goals. The scope and content of a feasibility study should be driven by the specific concerns of the individual client and should not be represented for more than it is.
ESOP advisors in the NCEO community are often very knowledgeable about the array of related tax, accounting, valuation, financial, and ESOP design benefit level and repurchase liability issues. However, one advisor cannot sign off on all issues. Any issues raised in the initial feasibility study and related transaction structuring should be addressed by a professional who is specifically qualified to address them. For example, is the advisor an expert in government contractor company issues that affect revenue? Is the advisor a CPA or tax attorney that can offer or is willing to offer written opinions about tax issues or IRS audit and controversy concerns or non-ESOP ERISA issues that are implicated?
What Should It Address
The key question for most companies and stakeholders is not whether an ESOP transaction is “feasible,” but rather “does it make sense?” A transaction might be possible, but not desirable. You could oversimplify the quantitative objective of determining whether the ESOP is feasible by simply saying that a study tells you whether you can afford the ESOP transaction. This begs the question of afford “what kind of ESOP transaction?” There are many types of ESOP structures, some of which are bank or seller leveraged and some which are not leveraged at all. A feasibility study needs to look at financing options, how much the ESOP should acquire, becoming (or staying) C or S, either to take advantage of the tax deferral on the sale of stock to an ESOP, different rules for participation in the plan, how much to sell in the transaction, and how much a transaction would cost.
ESOP feasibility should describe the “optimal” ESOP transaction to meet a company and its stakeholders’ needs. Adequate up-front consulting must be done to make the feasibility study truly valuable. Make sure that the “suitability” concerns of all the constituents are addressed first. The feasibility study should then measure achievable and reasonable outcomes. Leveraged and non-leveraged alternatives should be considered.
The Seller’s Issues
From the seller’s perspective, the feasibility study’s scope should be tailored to financial, tax personal financial planning, and ownership and control issues.
Some sellers “just want out now,” or “in three years with no ties to the company.” Others want to transition gradually and some just want to provide a benefit and ownership participation. Some want 100% liquidity, but also want to maintain control and stay active in the business. Others want to only sell a minority stake for the control issues. Suitability and objectives should precede the study. Many studies are simply geared to displaying 100% leveraged buy outs with maximized tax deferred rollover transactions.
Clients’ objectives and priorities will likely change as they move forward. Whether the feasibility study will be updated or not to reflect any changes in direction must be disclosed. Fees should be scoped taking this into account. The cost of the overall transaction and the feasibility study will be affected by the client’s tolerance for cost and their level of financial sophistication.
Fair Market Value for the Transaction
All sellers are focused on valuation. “How much can I get for my company?” Anticipated company valuation is at the forefront of the feasibility study analysis. Almost any feasibility study will entail a preliminary fair market value assessment, but most often not a full appraisal report – for good reasons, like changing company circumstances, revising deal terms, or the comparative available data in the marketplace and the cost.
The preliminary valuation will not be binding in any way on the ESOP trustee and should be looked at solely as a seller’s “expectation” of value. This means that at the outset you still do not know what an ESOP might pay for the stock. Most professionals will rest on deal experience and their knowledge of valuation methods to generate this estimate. As the transaction moves forward, the first issue will be how close the estimate is or in other words, “will an ESOP trustee go that high” in the purchase price. It becomes a negotiation issue to get the seller a price and terms for a sufficient return.
How close the expectation of the value given in the feasibility study is to the ESOP trustee’s ultimate opinion is critical to how smoothly the transaction process will run. To better ensure that the expectation of value is reasonable and close, consider a feasibility advisor that uses a CFA accredited ESOP appraiser who also performs or has performed numerous appraisals for ESOP trustees in transactions.
In some cases, it may make the most sense to appoint a “trustee of an ESOP–to-be-formed” to render its preliminary opinion of a range of value – a real range of what a trustee might pay. This is particularly true in smaller companies. There is a high likelihood that this will be a very conservative value. However, it will inform the company and seller of what the concerns and variables are in the ESOP’s perspective of what drives value. The seller and the company can then work to address those concerns or variables and structure the deal to accommodate them or postpone or halt the process entirely. The method and approach the trustee’s appraiser uses will be informing.
Whether you start with a seller side value or a preliminary ESOP value range, the absolute key driver of the number will be the forecasts. There is no single or propriety method or format for forecasting financial performance. However, ultimately the forecasts must be credible and supportable. Many smaller companies have never generated forecasts. They often budget and mistake this for a forecast. Companies should expect that this will take a meaningful amount of effort. The looser the forecasts, the lower the value. It is that simple because the ESOP trustee (as an investor and buyer) will only pay for what they believe and will be willing to count on.
For perspectives on the importance and approaches to forecasting, review these two NCEO articles.
Quantitative Analysis
This is what is most commonly in mind for the company and the seller when seeking a feasibility study. They know there will be debt and financing costs (because they most often are assuming it will be a “leveraged ESOP”) and tax incentives to help offset those. They don’t know how they will impact the ability of the company to pay for the ESOP.
This is one of the purposes of the Pre-Feasibility ESOP Calculator. You can see in broad brushstrokes what the tax benefits are and how they can reduce the cost of a transaction and a relative comparison of your choices for transaction types. Each of the inputs and assumptions in the Pre-Feasibility ESOP Calculator are jumping off points for deeper quantitative analysis of transaction design.
The transaction impact on the company should be analyzed with the company meeting working capital and capital expense requirements. The feasibility study should include a cash flow analysis, testing of leverage and covenant requirements, impact to existing benefit plans, value trajectory, and ESOP benefit distributions (if applicable). Key questions the analysis should answer are:
- Under a normal scenario, what is the impact to cash flow from the ESOP transaction?
- Can the company reasonably service the financing associated with the transaction?
- What happens in a downside scenario?
- What happens in an upside scenario?
- Does the ESOP benefit level match corporate goals for retirement benefits and overall compensation?
- What is the impact of management incentive plans? Is the value of the incentive plans in-line with expectations?
ESOP Benefit Feasibility
Many feasibility studies will address what the impact or output is from the proposed ESOP transaction on employee benefits called “Repurchase Liability.” The forecasts in these studies tend to go out over many years and show gradual acceleration of benefit liability. However, if the transaction is an initial transaction, with no ESOP in place holding stock accounts already, the long-term view of this type of forecast is of limited utility. If it is a “second stage” transaction with accrued and vested benefits in the ESOP, a more complete repurchase liability analysis should be performed.
The most important employee benefit liability timeframe is the term of any financing to the bank or the seller. Pay attention to the five year forecast of liabilities and keep in mind that benefits for terminated participants need only start to be paid five years after they leave and over five years. Distributions from the plan will be delayed after termination events that often defy forecasting with values that are speculative at best. It’s the potential retirement payouts that are most predictable and may be somewhat controlled in plan design.
Since ESOP loans (between the company and the ESOP) that represent the number of years that shares are allocated over are getting longer, share accruals in participant accounts will be quite gradual.
The feasibility study should analyze qualified payroll, anticipated ESOP allocations, and discrimination and S corporation anti-abuse compliance testing against the goals and concerns of the company and its shareholders.
What to Be Wary Of
- A free or very low cost-feasibility analysis that is not very transaction specific.
- Lower cost studies that are wrapped into a contract which includes a large contingent transaction fee.
- Overpromises about achievable company valuations or transaction structures.
- “Yes you can get 12x EBITDA and keep control forever and also get 49% of the company back in warrants.”
- Lack of consideration of downside scenarios and risk.
- Trustee-side advisors not maintaining independence and working in essence for the sellers.
- Focusing on tax-savings rather than company and shareholder goals.
What to Ask for When You Shop for a Feasibility Study
- Multiple quotes.
- A sample report copy from a recent transaction (redacted), which shows you what they will show you. Be sure the sample report is for a company of your size.
- References from two clients that have completed transactions in the last 12 months since the transaction market fluctuates and success rates are related to market forces.
- A reference to a company in your industry with a successful close.
- Fee quotes that include the success fee based on their represented percentage likelihood of success.
- Names of the sub advisors or strategic partners they routinely work with when putting together a “team” for your transaction and those they have in mind for your transaction. You are hiring them too.
