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Updated: January 5, 2024

How to find and work with a lender for ESOP financing

An employee stock ownership plan (ESOP) is a benefit plan that allows employees to own a piece of their company in the form of company stock.

The decision to transition a company to an ESOP can make sense in several scenarios and benefit everyone involved. An ESOP transaction can create benefit options for dedicated employees in the form of an ESOP contribution, or for the company to buy out an owner who plans to make a transition to retirement.

Courtesy / Machias Savings
Jay Hood, Machias Savings Bank

Studies have shown that ESOP participants tend to have higher retirement account savings in comparison to non-ESOP counterparts and better job security. 

Whether you’re a business owner considering your succession plan and options for funding your retirement or a potential employee business owner considering a buyout, an ESOP transaction starts by building an advisory team including a banking partner who understands the nuances of ESOPs. 

Here’s what to know as you research ESOPs and lending options.

Leveraged ESOP vs. non-leveraged ESOP

In simple terms, if a company has the funds to purchase its stock outright it is non-leveraged, while stock purchased through financing is considered leveraged. Over time, circumstances may change – companies that began as non-leveraged ESOPs may need to seek funding in the future. It’s beneficial to understand how ESOP funding works during the early stages of formation in the event that it’s necessary in the future.

Choosing the right lender

Not many banks have a deep understanding of ESOPs, so it’s important to find a knowledgeable and trustworthy banking partner to support your company through the lending process.

From a banking perspective, once an ESOP is formed, the ESOP has zero assets on the balance sheet.  Generally, the principal/owner intends to leave the company in the near future. This means the ESOP transaction hinges on partnering with a bank willing to look past a lack of guarantors and a company that is — on paper — largely insolvent.

For this reason, it’s wise to start your ESOP process by reaching out to a lender that has an established history and banking relationships with several ESOPs. Keep in mind that while ESOP funding can be sourced from any bank, or from the business seller, it can benefit your company to work with a lender that has experience navigating the intricacies of ESOP transactions.

There are many options for structuring the buyout and finding one that benefits all parties (the seller, ESOP and the lender) takes a strong working relationship and a thorough understanding of the parties involved.

A knowledgeable ESOP lender, working in tandem with your CPA, will be able to help walk you through the process of answering these questions:

  • What are the ESOP tax benefits and cash flow advantages for the new owners to repay the debt? What are the tax benefits to the selling business owner?
  • How does an ESOP affect cash flow? How does it reduce tax liability? How does it offer employees ownership and profit sharing as a benefit? 
  • What requirements does a banking partner want to see from the transaction? (Such as a detailed business plan that includes management succession, certain amount of cash flow, projected liquidity, etc.)
  • Is there a business formation that’s more advantageous for transition to an ESOP? (LLC, S-Corp, etc.).

Are there any federal loan programs for ESOPs?

Yes! In fact, in May 2023, the SBA reworked guidance to remove certain barriers that may have previously prevented some businesses from pursuing an ESOP.

This included removing a required equity infusion of at least 10% when an ESOP bought a company as well as clarifying that personal loan guarantees in ESOPs will apply only if the ESOP is buying less than a controlling interest. ESOP loans can now be made through the 7(a) program by working with a qualified lender like Machias Savings Bank.

Just as with all big decisions, there’s no one-size-fits-all answer to the best path forward for your business. Partnered with the right team, you’ll be well on your way to determining if an ESOP makes the most sense as your next step.

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