Dow Jones Daily Bankruptcy Review | 1 2 Wednesday, June 15, 2011
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One of a series of opinion columns by bankruptcy professionals
Using An ESOP To Exit A Distressed Portfolio Company
By Jonathan P. Friedland and David Solomon
Youre a private equity sponsor. One of your portfolio companies, which historically had strong financial performance, has been negatively affected by the great recession and is now distressed and deemed to be overleveraged. The prospects for the business, however, remain strong. The companys lenders are pressuring your fund to put in fresh money (something you cannot or will not do) or to get out of the way so the company can be sold in order to generate funds to pay off at least a portion of the existing debt, resulting in the lenders taking a haircut and leaving your fund with nothing. What do you do? There are a number of options and many factors to consider before selecting the optimal strategy. Anyone who has been down this road has been counseled about directors duties in the zone of insolvency; anyone who has concluded these negotiations has a true appreciation for that old adage, pigs get fat and hogs get slaughtered. One solution we like but that we think is underutilized is for the sponsor to cause the company to be sold to its employees using an employee stock ownership plan (ESOP). A well-structured ESOP transaction can enhance the cash flow of the portfolio company after the transaction as a result of various tax benefits afforded a company that sponsors an ESOP. This, in turn, can enable the company to more easily service its debt. Also, by implementing an ESOP, the companys employees will be provided with incentives based on the value of the equity of the company, which in our experience comports with studies that have shown that equity-based compensation significantly improves the ESOP companys financial performance and its retention of key employees. The cash-flow advantages of an ESOP company are generally derived as a result of the fact that an ESOP company is essentially able to repay its indebtedness on a pre-tax basis. When a company adopts an ESOP to engage in a stock purchase transaction, the ESOP typically borrows money from the company (which funds typically come, in turn, from a bank or other third-party lender) to purchase the stock (the ESOP loan). The ESOP loan is repaid with contributions made by the company to the ESOP and, because the ESOP is a tax-qualified retirement plan, the company receives a tax deduction for these contributions. The company, in turn, uses the monies it receives from the ESOP to repay its debt to the companys lender. This effectively enables the company to get a tax deduction for both the interest and the principal on its loans. Also, if the company is an S corporation, there will be no federal income tax (and, perhaps, no state income taxes) to the extent of the percentage of the ESOPs ownership of the equity of the company. The reason is that an S corporation is a pass-through entity, so the company does not pay any tax on its income. Instead, the companys shareholders pay tax on that income based on their pro-rata share of the stock of the company that they own. However, an ESOP is a taxexempt trust for federal (and in many cases state) income tax purposes. So, if the ESOP winds up owning 100% of the companys outstanding shares of stock, the company can operate on a go-forward basis as an entity exempt from federal (and, in many cases, state) income taxes. This, of course, can have a dramatic impact on cash flow. In addition, what we really like about this strategy when we represent the sponsor is that the sponsor can retain control of the board of the company it just sold to the ESOP even if it owns none of the stock of the company after the sale. This is because the stock held by the ESOP is not directly owned by the employeeowners but is controlled by a trustee who can be appointed by the current board of directors of the company and who can be required in the ESOP sale documents to retain the current board of directors and existing company management after the closing of the transaction. An additional benefit to an ESOP transaction is that it can be structured internally, without taking the company to market. The transaction can thus be more easily closed within a specific time frame that meets the sponsors objectives. Were not suggesting this strategy is likely to be a panacea. If the sponsor is out of the money, the sales price paid by a newly formed ESOP is not any more likely to go into the sponsors pockets than if the buyer is a third party. The difference, however, is that the continued on next page
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Dow Jones Daily Bankruptcy Review | 1 3 Wednesday, June 15, 2011
Viewpoint
One of a series of opinion columns by bankruptcy professionals continued from page 12 restructured company will be able to support more debt. This, in turn, may encourage the companys current lenders to remain committed to funding the company going forward rather than going to market to sell the company to a third party, particularly since such a sale is not likely to generate enough cash to pay the lenders in full. In addition, an ESOP transaction can be structured to enable the sponsor to retain a stake in the company after the consummation of the sale. This is far less likely if the company is sold to another sponsor or a competitor. A graceful exit from a troubled portfolio company is often easier wished for than achieved. Next time you have to deal with a troubled portfolio company, consider whether using an ESOP is a viable solution. Opinions expressed are those of the author, not of Dow Jones & Company, Inc.
Jonathan P. Friedland and David Solomon are partners with Chicago-based Levenfeld Pearlstein, a law firm representing businesses across the U.S. and around the world. Solomon's practice involves a great deal of ESOP work; Friedland's practice involves a great deal of restructuring work. Friedland can be reached at jfriedland@[Link], and Solomon can be reached at dsolomon@[Link].
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