Red Flags in ESOP Transactions

Ninety-two percent of people who sold their businesses to an ESOPs said in our 2024 ESOP transaction survey that they are satisfied with the transaction. Those sellers had a variety of goals for choosing an ESOP, but some common themes are safeguarding the character of the business, protecting the workforce and executive team, and wanting employees to have an opportunity to build wealth. 

Research from the NCEO and others over the 50 years of ESOPs provide extensive documentation that ESOPs do, on average, achieve those goals.

The same survey that found 92% satisfaction with the ESOP transaction also found that 2% of respondents said the ESOP had a “somewhat negative” impact on the business, and 5% said it had a “somewhat negative” impact on sellers. The NCEO’s prefeasibility toolkit, live events, and webinars provide best practices for managing an ESOP transaction, and the article below lists some signs we have seen over the years. Read this list and use it as raw material for a conversation with your ESOP advisor.

Always remember that ESOP transactions can be simple. If an advisor suggests an approach that’s beyond a simple ESOP, be sure you understand what value that approach adds. The professional advisors to the ESOP community have spent years developing their expertise, and, if you ask, they can clearly explain the pros and cons of what they are proposing.

Red Flags

The NCEO has been talking with sellers and ESOP professionals since our founding in 1981. Here are some of the warning signs that we’ve seen.

Inexperienced Advisors

While many people claim they have ESOP expertise, relatively actually few have meaningful or relevant ESOP transaction experience. For example, just because an attorney has ERISA experience does not automatically mean they have substantial ESOP transaction experience. Valuation firms that may have a lot of experience in your industry may know little about ESOP-specific issues, and ESOP appraisals have a unique set of federal requirements. ESOP valuation firms may not have done more complex ESOP transactions. Third-party administrators (TPAs) for 401k plans are not automatically qualified to be ESOP TPAs. Very few TPAs have specific expertise in ESOP administration.

You should not select your ESOP advisors because they are local, inexpensive, or just claim to have done this before. Inexperienced advisors are more prone to errors, not giving you the full array of possible transaction structure options, and may even cost more in the end. Hiring a local advisor is always easier, but in the case of ESOPs, you should always put more weight on ESOP-specific expertise. Experienced advisors may cost more but are likely to provide the most thorough and balanced ESOP guidance. Our service provider directory is a great place to start, and you should always ask for references.

Advisor Bias and Blind Spots

Some ESOP advisors may have a bias toward certain transaction structures or approaches. It may be what they believe is the "best" or most tax-efficient ESOP structure, but it may reflect either a cookie-cutter approach, the inexperience issue, or a bias connected to the fee structure in the transaction—if they do more, they charge more. Biases toward certain transaction designs often are accompanied by bias toward certain parties to the transaction and conflicts of interest. For example, is the fully leveraged approach the transaction structure that all parties, the company, the sellers, and the trustee would select? Or is it being presented as the only alternative because of the ancillary services, products, or investments the professional offers?

Unusually High Transaction Costs

The cost of ESOP transactions has increased over the last decade for several reasons. The NCEO 2015 ESOP transaction survey found that roughly one third of transactions in 2013 or later cost less than $75,000, but that number fell to 10% in our 2024 survey.  The overall breakdown of reported transaction costs from 2014 to 2023 is:

If your advisor proposes a fee toward the upper end of this table, and that proposal may be in the best interests of you and the workforce, but you should ensure that you understand what features are driving the cost and the benefits of those features. Complex and larger transactions necessarily cost more than simple and small transactions. Seller financing with warrants, management incentive plans, large number of shareholders, converting to a C corporation to allow sellers to defer their gain under Internal Revenue Code Section 1042, and tender offers are some of the factors that increase the complexity of a transaction.

Company financial advisors provide a variety of services, including creating realistic expectations of value, structuring the transaction to maximize tax benefits, sourcing the most effective bank financing, selecting the trustee team, managing costs, leading the negotiations, and coordinating the entire process to ensure the transaction gets completed on time. In some cases, most of the fee for the company's financial advisors is contingent on the transaction being completed. 

To make sure you are not overpaying, shop around. Talk to more than one provider in each key category (company attorney, ESOP attorney, TPA, and trustee team) to make sure you find the advisors who are experienced with ESOP transactions as well as the best fit for your transaction in terms of fee, style, and other factors.

Inappropriate Use of Floating Rate Notes

Floating rate notes (also called ESOP Notes) are long-term non-callable bonds often used as qualified replacement property for sellers selling to an ESOP. They allow the seller to meet the rules for tax deferrals under an ESOP. The issues with these notes are beyond the scope of this article, but they do not make sense for all sellers. Make sure you get advice from someone not selling the notes before proceeding. If you haven't done a complete personal financial plan before starting the ESOP process, you should.

Excessive Warrants with Seller Notes

Warrants are the right to buy shares in your company for some defined number of years into the future at the ESOP value. They are structured so the warrant holders receive the difference between the strike price when the warrants are issued and the appraised ESOP stock value when exercised. There is no intent for the warrant holder to own shares in the company.

Warrants are used in about 51% of transactions that include seller financing, according to our transaction survey. Sellers receive warrants in exchange for accepting a lower rate of interest than would be justified by the risk of the loan. The seller and trustee will negotiate the total internal rate of return, which is the sum of the cash interest, PIK (Payment In Kind) interest, and warrant return.

All parties to the transaction can benefit from warrants so long as they do not provide the seller(s) with too many warrants that would substantially dilute the ESOP's ownership interest. There are no regulations or guidelines published on the use of warrants in ESOP transactions, but there are tax and fairness issues in their design and use. Though the U.S. Department of Labor (DOL) has said privately that it is not opposed to warrant structures, it may be difficult to justify to the DOL that the ESOP's fully-diluted ownership is, say, 60% or less of the company the ESOP nominally bought. The DOL looks at transactions after the fact, and is certain to "know it when they see it" in this area as well. Most advisors will be cautious about how warrants are used, but some are too eager to sell the deal by making it more financially appealing to sellers. Ask your advisor where their position on warrants lies in the current spectrum of transactions that they are aware of advisors conducting in the marketplace.

Being Told You Will Get a Certain Price in Advance

Some advisors promise owners a specific price or value as part of the process of getting hired. While they can provide owners with their estimate of value, the trustee is the only one who can determine how much the ESOP will actually pay, and that determination must be based on an appraisal of fair market value from the independent financial advisor the trustee hires. The trustee can never pay more than this fair market value. That value is only determined as of the closing date of the transaction, not when feasibility studies are commenced.

Some advisors may try to work around the fair market value by using creative transaction structures. But using aggressive amounts of preferred stock, warrants with seller financing, board or consulting fees for owners, etc., may raise issues of the prudence of the transaction. The transaction must be at no more than fair market value, prudent, and fair to the ESOP. These are equal legal concerns.

Deal Terms and Structures You Don't Understand

Some advisors propose complex transactions. ESOPs are flexible, and that allows for complex transactions that do best meet the needs of the seller and the company, but you should always make sure you know exactly what you are signing on to. In many cases a simple transaction will suffice. If an advisor provides a thick deal book laden with terms you don't fully understand, insist that the advisor takes you step-by-step through each issue. "Just trust us" is never a good answer. 

Offers That Seem Too Good to Be True

The tax incentives for ESOPs are powerful, but some advisors may oversell them. If someone approaches you with an idea that sounds like a way to avoid the intent of Congress, it is probably not a good idea. Tax avoidance is legal; tax evasion is not. If in doubt, ask for a written tax opinion on the issues of concern.

Inflexible Plan Design

Good advisors work with you to find out what your goals are. Bad advisors have a one-size-fits-all approach that adopts standard deal terms and plan rules for every company. There are many ways to approach an ESOP. Knowing the various approaches will make your plan much more likely to succeed.

Independent Valuation Firms and Aggressive Valuation

The Process Agreement between the GreatBanc Trust Company and the DOL and subsequent agreements with other trustees offer insights into many of the factors the Department of Labor uses to determine ESOP valuations are independent and how they are not independent. The DOL made these process agreements public and stated that they "expect" all ESOP trustees to follow them. Many of these provisions are not new and have been followed by prudent trustees for many years. Your trustee and appraiser should already be familiar with them. For example, valuation firms should be selected by the trustee and should not have provided any services to the company or the seller. This means that preliminary appraisals may be not usable by the ESOP in the transaction. The process agreements also reflect the DOL's focus on the reasonableness of projections used to support valuation conclusions.

What to Do

You need to become educated about ESOP transactions and the seeming myriad of advisors available to support the multiple parties to the transaction. You're spending a lot of money on this transaction, and your life's work and legacy is on the line.

The following considerations will increase the likelihood of a well-run, well structured, cost-effective, less frustrating, and lower-risk transaction:

• Hire advisors with substantial ESOP transaction experience with strong references;
• Don't negotiate for the most aggressive price, terms for the seller note, and other deal elements;
• Don't design a transaction solely or overwhelmingly based on tax incentives;
• If a deal is too good to be true, it probably is.

Take advantage of our pre-feasibility toolkit, which includes a tax-advantage calculator, and our publications, especially Selling Your Business to an ESOP.

NCEO members can call us with questions or for feedback, and we can have a low-cost conversation to give advice to make sure you are on the right track. We also have webinars and live meetings.

Establishing an ESOP can preserve and protect your company, and many companies find that it makes them stronger than they were before, but all of those good effects only come when the transaction is done right in the first place.