They should know the general deal parameters—how much will be sold, the price being offered to the ESOP, the sellers’ desired level of cash proceeds, and the company’s overall comfort level with debt and how much it thinks it can handle. They should also make sure that the bank understands how the negotiation process around the ESOP’s price works and that it can fluctuate during the process. Make sure to understand what bank covenants (such as coverage ratios) are, what will trigger them, and what flexibility there is if you cannot meet a covenant in a quarter.
A company shouldn’t assume that all bankers will know how ESOPs work. Some do, and if you can find one who does, there is a considerable benefit to that. But most won’t and will need education on the structure of a leveraged ESOP, the tax benefits an ESOP provides that makes loan repayment easier, how an ESOP can improve or cement a good corporate culture, the ability to use deductible dividends to repay the loan, and how to understand the accounting treatment for ESOPs.
For example, the bank may need to be educated on is the impact of the “inside loan” on the company’s balance sheet. Since the economic effect of an ESOP transaction is similar to a traditional leveraged recap, GAAP principles require an accounting treatment that reflects that impact. Therefore, while it may seem logical that the “inside loan” be booked as an asset of the company (after all, the ESOP’s obligation is to the company), GAAP instead treats it as a contra-equity account in the shareholder equity section of the company’s balance sheet. This often results in a negative net total equity, which would make the company appear to be insolvent. A company may want its accountant to help explain why this isn’t really an issue.
It is important to emphasize to potential lenders that ESOP companies have a strikingly good track record for successful performance when they are employee owned. NCEO research on ESOP company performance during the 2009-2013 period (covering the period of the Great Recession) showed that among almost 1,700 ESOP loans studied in a representative sample, the default rate was two per thousand per year. A company working with its incumbent bank should also stress that doing an ESOP means the company stays independent to retain its existing financing and other relationships.
As with nearly all bank financings, the company will be required to satisfy certain covenants set forth by the bank. The covenants required and the testing frequency will vary based on the loan, however it is customary to see either a debt service coverage test (DSC) or a fixed charge coverage test (FCC) as well as a maximum leverage test and/or a minimum EBITDA requirement. Depending on how leveraged the transaction is at close, there may be a requirement for an annual excess cash flow requirement to be applied to the financing typically until leverage falls below a targeted threshold.
Similar to covenants, bank terms and loan rates are highly customized based on the loan request. Every bank has its own profitability model that is run for each loan request. Companies should appreciate that there is a direct connection between credit risk and pricing. Banks have capital requirements, and capital has a cost like it does for all companies. The higher the overall riskiness of a bank’s portfolio, the greater its capital requirements and the greater its capital costs. Therefore, the bank will use the risk grade that it concludes from its credit analysis as a discrete input into its pricing analysis. Pricing is typically based on Libor (to be replaced with another measure in 2021) and the spread above Libor will be determined based on the riskiness of the loan. While loan terms are also highly customized, as previously noted it is customary to see a five-year term for most ESOP financings, with amortization schedules varying between five and seven years depending on the situation.
As stated previously, not every bank has a dedicated ESOP team in place and therefore may not have a detailed understanding of how an ESOP affects the financials of the sponsoring company. The financial impacts vary based on the structure of the ESOP financing, whether it is a C or S corporation ESOP, and what other forms of capital (beyond senior debt) are deployed to finance the transaction. It is essential to understand all of these factors will not only impact the loan at inception but throughout the life of the loan. As a result, it is important to select a bank that has a detailed knowledge of these issues and can structure the loan and covenant package accordingly. Employee ownership organizations and your consultants have listings of the various financing sources active in the ESOP space. It is always good to solicit a few banks in order to compare and contrast the various terms and conditions each bank provides. This allows the company to see how banks/financing sources vary as well as provides the company with a competitive market deal.