You are the CEO of a very successful, tax-free, employee-owned company. The company is profitable and running very well. The employees are happy. Out of the blue, you get a very attractive offer from a private equity group to buy the company. What do you do? Must the company or the ESOP consider selling, given that the company is enjoying steady and steep increases in share value, has a strong balance sheet, and is well poised for growth? Who decides whether to sell?
The answers to some of these questions may depend on the structure of the proposed sale – will it be a stock sale or an asset sale? ESOP companies may also be sold to related parties who are existing shareholders. A sale to a related party raises additional issues that are not discussed here.
Where to Start
An ESOP may be the sole shareholder of a company owning 100% of the stock or it may own less than 100%. Shares held by an ESOP are generally voted by the ESOP Trustee, who may have the power to elect and remove Directors (or the entire Board if the ESOP owns 100% of the stock). At the same time, the Board of Directors generally has the power to appoint and remove the Trustee.
The best practice is to start with the Board of Directors. The Board should carefully review any offer to purchase the company, keeping in mind that Directors have a duty to maximize the value of the company for the shareholders. The Board should evaluate the business points of the offer, including:
- Proposed structure and timing
- The overall price offered
- The buyer’s ability to perform
- The specific terms of the offer
The Board should consider on behalf of the shareholders how the purchase offer compares to other alternatives. The ESOP Trustee may ultimately want to see the Board’s analysis or deliberations to ensure it is being offered a fair price for its stock.
- Will the shareholders do better to continue operating the company?
- Is this the right time to sell?
- Are there other buyers who might pay more for the company?
- Is this a strategic buyer who may be willing to pay more than other potential suitors?
- What is the threshold for considering any offer?
- What would be their “walk away price” (or range) for evaluating any offers
If the offer survives this analysis, the Directors and Management may begin negotiating with the Buyer. They will have to decide when to bring the ESOP Trustee and any other shareholders into the analysis. If the deal is structured as a stock sale, the ESOP Trustee and other shareholders decide whether to sell the shares. If the deal is structured as an asset sale, the company may negotiate the sale, but the Board may need shareholder approval under state corporate law. The Board would also need ESOP participant “pass-through voting” approval under the Internal Revenue Code.
Transaction Structure
A buyer may prefer to buy assets to avoid liabilities of the target company and other obligations. In some cases, an asset buyer may still pick up liabilities as a “successor” operating a continuing business.
The target company may recognize gain and be taxed on a sale of substantially all of the company’s assets. If the target company is a C corporation, the company would pay the tax on the gain on the sale of assets. For an S corporation seller, any gain or loss will be passed through to shareholders. The shareholders pay the taxes on the capital gain. An ESOP shareholder generally will not be taxed on its share of gain because the ESOP is a tax-exempt trust. For S corporations in California, the company may be subject to a 1.5% state tax on S corporation income, which may apply to any gain on a sale of assets.
In a stock sale, the shareholders may have a gain or loss on the sale of shares held. An ESOP shareholder generally will not pay taxes on any gain (and will not get any benefit from a loss) because it is a tax-exempt trust. The proceeds, at whatever value, will ultimately be paid to the ESOP participants as retirement plan distributions and taxed as ordinary income.
In some cases, a buyer may buy stock, but want to make an election to treat the sale as an asset purchase under Internal Revenue Code sections 336(e) or 338 or by structuring a reorganization. This allows the parties to treat the stock sale as if it is an asset sale for tax purposes. In these scenarios, the buyer receives a stepped-up basis in the assets purchased. Any proposed tax election or reorganization structure should be carefully analyzed from the perspective of the shareholders and the target company.
Representations and Warranties
In a stock sale, the selling shareholders will often give detailed representations and warranties regarding the structure and operation of the target company. These may include representations and warranties that the company is properly formed and in good standing, has no unusual or extraordinary liabilities for taxes, environmental issues, or employment issues, and has no undisclosed debts or pending litigation or government investigations. Buyers will rely on these representations and warranties in buying stock.
The selling shareholders may also be asked to indemnify the buyer for any undisclosed liabilities or if the buyer discovers information that the target company’s representations are untrue. Indemnification may be subject to a dollar threshold or a cap on losses/damages. It may run for a stated period after closing or it may run until the statute of limitations expires.
A buyer may also require that a portion of the purchase price be set aside (an indemnity escrow) as security for any breach of the seller’s representations and warranties. Some or all of the funds in escrow may be returned to the buyer as damages. If not, the funds will be released to the seller at some point after closing.
An ESOP shareholder will only give limited representations and warranties. It will not indemnify a buyer for any losses resulting from undisclosed matters discovered after the deal closes. Any indemnification of the buyer by the ESOP will be a prohibited transaction. This is because once the deal closes, the buyer will own the company and will be the sponsor of the ESOP. The company and its new owners will be parties in interest. Any transfer of ESOP assets to the company or the buyer, including payments to indemnify, will be a prohibited transaction. Indemnification by or recourse against the ESOP may also be impractical because the ESOP will usually be wound up and its portion of the sale proceeds will be distributed to participants once the sale closes.
In an asset sale, representations and warranties by the selling shareholder may be more limited. The ESOP may be in a position to give detailed representations and warranties, but as a practical matter, the ESOP Trustee may not be involved in the day-to-day operation of the business and may not have extensive operational knowledge. The target company may give representations and warranties and may agree to indemnify the buyer for some period of time. However, if the goal is to liquidate the target company soon after the asset sale and distribute the sale proceeds to the ESOP and to participants, then the target company should not agree to indemnify the buyer beyond a very short time frame. Similarly, the ESOP will likely be wound up after closing, so the ESOP will not be around to provide indemnification over a long period.
The ESOP Trustee’s Obligations
Regardless of the deal structure, the company and the ESOP Trustee should clearly understand who will be responsible for winding up the ESOP/Trust, paying expenses for terminating the ESOP, and completing all required reporting and communications with participants. An ESOP Trustee must act prudently, solely in the interests of participants and beneficiaries, and follow the ESOP/Trust documents.
If stock is sold to an unrelated third party, the ESOP Trustee is not required under the Internal Revenue Code to obtain an opinion from an independent appraiser that the sale price is not less than fair market value on the closing date. However, since the ESOP will want to know that it is getting a fair price, the ESOP Trustee typically gets a “fairness opinion” from its independent valuation firm to support the decision to sell the ESOP’s stock. The fairness opinion will state that the sale price and all of the deal terms are fair to the ESOP and its participants and beneficiaries. A fairness opinion supports the ESOP Trustee’s conclusion that a sale of stock is prudent and in the best interests of participants and beneficiaries.
The ESOP trustee will also obtain a fairness opinion in an asset sale. Typically, an asset sale will be negotiated and approved by the target company and the ESOP Trustee, subject to pass-through voting and approval by ESOP participants. Prior to closing, a complete description of the proposed transaction, similar to a proxy statement, will be provided to ESOP participants with their ballots to vote to approve or disapprove of the proposed sale. A fairness opinion can be a critical element of asking participants to approve a transaction that the Trustee has determined is in their best interests. Some time is required to distribute materials and collect and tally ballots. Once approved, the closing can go forward after voting is completed.
Winding Up the ESOP After the Deal Closes
In a stock sale, the ESOP/Trust will receive cash proceeds and will typically be terminated. All participants will become 100% vested in their ESOP accounts and will be eligible to receive distributions. Distributions to participants will generally be made in the form of lump-sum cash payments. The ESOP wind-up and distributions might be delayed if the plan sponsor requests an IRS determination letter or if payment of sale proceeds is subject to a purchase price holdback or an earnout subject to payment after the closing. In some cases, the ESOP will make an initial distribution to participants following the closing with a second cash distribution after all contingencies are resolved.
Once the stock is sold, the Trustee no longer needs an annual appraisal. The ESOP must continue to file Form 5500/Annual Reports until all of the Trust assets are distributed and all expenses are paid. If the ESOP is wound up mid-year, there may be a short plan year with a Form 5500/Annual Report due by the last day of the seventh month following the final distribution of assets.
In an asset sale, the target company receives the proceeds. In many cases, the target company is dissolved with the sale proceeds distributed to the shareholders (including the ESOP). The ESOP continues to hold stock unless and until the company is wound up. The ESOP Trustee must continue to obtain an independent appraisal of the stock until liquidation occurs.
Liquidation and dissolution of the target company may require shareholder approval. Pass-through voting by ESOP participants is required. If shareholder approval and/or pass-through voting are required to liquidate and wind up the company, it is most efficient to have the ESOP participants approve a plan of liquidation with their pass-through vote at the same time approval is requested for the sale of assets.
If the ESOP is not terminated immediately, participants may become eligible for distributions if their employment with the company terminates. ESOP participants all become fully vested and eligible for distributions when the ESOP is terminated. The ESOP must continue to file Form 5500/Annual Reports until all assets are distributed and all expenses are paid.
Questions?
The sale of a successful ESOP-owned company can be a positive event for the company and ESOP participants. It is the ultimate recognition of employees’ efforts to work hard and create value.
Please contact us if you have questions. Let’s have a conversation.
