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Alternative Liquidity Options: Leveraged ESOP

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Market Dynamics

M&A activity and public company valuations across the Defense and Government Services industry have rebounded from 2013 lows. Trump-related spending tailwinds in the DOD and IC sectors, in particular, should drive similar if not increased buyer interest in the sector in 2017 and 2018 once a more definitive spending plan is established. In many cases, however, the prevalence of small business set aside or other preferential contract awards for a government contractor negatively impacts their valuation or even eliminates the available buyer universe in a sell side process. This is especially true for companies that operate in historically small business friendly markets (e.g., Department of Education, Department of Energy) or lack differentiated capabilities and provide more commoditized service offerings with minimal barriers to entry. These firms typically have two options: (i) invest in business development resources, make strategic hires and attempt to transition the businesses into a full and open competitor over a 3 – 5 year time horizon, or (ii) evaluate alternative liquidity options, including a leveraged ESOP transaction.

Leveraged ESOP Overview

A leveraged ESOP enables the existing shareholders to sell all or a portion of their ownership to a trust and receive partial liquidity. The available cash at closing is driven by the amount of senior debt the Company can borrow to finance the ESOP. Certain tax attributes of ESOPs, as outlined below, can enable the Company to borrow more at closing from a senior lender than under normal circumstances. In a 100% ESOP transaction, the selling shareholders typically hold interest-bearing seller notes for the difference between the total Enterprise Value of the Company and the amount of senior debt available at closing. The Company acts as a plan sponsor, repays the senior debt and shares are allocated to employee accounts each year. Over time, as the senior debt is repaid (typically over 3 – 5 years), the Company can then repay the seller notes, often by refinancing the senior debt. After the ESOP transaction, the Company will retain its small business status (if it still applies in the relevant NAICS code) and will have the opportunity to pursue set aside awards in the future.

An example of the closing consideration for the shareholders of a $5M EBITDA company in a 100% leveraged ESOP scenario is summarized below:

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Pros & Cons of a Leveraged ESOP

A carefully designed and executed leveraged ESOP provides partial liquidity for selling shareholders while increasing the ownership participation of management and employees. In a highly competitive government services recruiting environment, the opportunity to entice new hires with an ESOP retirement plan can often times be a distinguishing factor. There are extensive tax savings opportunities with ESOPs that are more thoroughly described below. The ESOP also allows for preserved operational autonomy, a greater certainty to close, and the opportunity to continue to bid on small business set aside procurements. The challenges with an ESOP transaction include partial liquidity at closing, a leveraged balance sheet, and the incremental costs and compliance requirements associated with an ERISA plan.

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Tax Savings Opportunities

There are three primary tax attributes associated with ESOPs. The availability of these attributes depends on the entity’s tax status as summarized below.

  • Shareholders of C Corporations that sell at least 30% of their equity to an ESOP have the opportunity to defer capital gains taxes if they invest in qualified replacement property (“QRP”) 3 months prior to or 12 months after a transaction.
  • Corporations that have elected “S Corporation” status are flow through entities and there are no corporate level income taxes. All income and related tax liabilities reside at the shareholder level. Since an ESOP trust is a tax-exempt entity, there is no tax liability for the ESOP’s pro rata share of the income. Therefore, 100% S Corporation ESOP companies do not have any income tax liability, and can therefore typically service the debt borrowed in connection with the transaction in a more rapid manner.
  • Contributions to ESOPs are tax deductible for the Company making the contribution, up to certain limitation. This tax shield is particularly beneficial to C Corporation ESOPs and S Corporations partially owned by the ESOP trust.

Summary

An ESOP may be a good alternative if an outright sale is not achievable for a government contractor with a heavy reliance on preferential contract awards without a transition strategy to F&O status. Businesses with steady cash flows, strong management teams, large contract backlog and healthy borrowing capacities are ideal candidates, as outside financing is usually required to facilitate a shareholder liquidity event. Certain tax attributes of an ESOP-owned company can expedite the debt repayment and accelerate a selling shareholders full liquidity. The Company should have a sizable workforce and utilize direct labor (as opposed to subcontractors or 1099s) for a meaningful piece of the overall level of effort. Lastly, the opportunity for employees to be shareholders in their company can create a competitive edge in the highly competitive recruiting environment in the government services marketplace.

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