Branching Out

When direct marketing agency Creative Direct Response Inc. decided to expand its nonprofit fund-raising business, the Crofton, Maryland, firm began looking for a company to acquire. It found Jeremy Squire & Associates, an Oakton, Virginia, fund-raising company. Jeremy Squire, the firm's owner, wanted to sell but was concerned about his employees. So Creative Direct Response offered a buyout proposal that was not only financially attractive, but also a means to reward loyal employees.

The $5.5 million firm urged Squire to sell his company stock to his employees through an Employee Stock Ownership Plan, or ESOP. Creative Direct Response would pay Squire for the $3 million stock purchase, acquiring the company as a wholly owned subsidiary. Because Squire provided financing, he could collect interest that would normally go to a bank. And since his company was a C corporation, he could defer capital gains taxes by using proceeds from the sale to buy securities of U.S. companies, a permissible practice when a business sells at least 30 percent of its stock to its employees.

Squire reaped big tax savings. His employees became shareholders in the expanded operation, and the acquirer, Creative Direct Response, was able to negotiate a lower purchase price. "If he had sold to some third party that wasn't involved in an ESOP, he would have ended up paying between $400,000 and $600,000 in capital gains taxes," says Geoffrey Peters, 57, president of Creative Direct Response. "By deferring those capital gains taxes by reinvesting in U.S. securities, we were able to purchase the company at a lower price."

Cheaper Capital

By educating the seller about the tax advantages of an ESOP, Creative Direct Response gained access to a cheaper source of expansion funds and secured the $3 million in financing more easily than it would have with a conventional lender. Fortunately, the tax benefits aren't limited to sellers of ESOP companies.

Here's how it works: A company issues new shares and sells them to an ESOP, which borrows funds to buy the stock. The company can use proceeds from the stock sale to its own benefit-say, by acquiring a company. The company repays the loan by making tax-deductible contributions to the ESOP. The interest and principal on ESOP loans are tax-deductible, which can reduce the number of pretax dollars needed to repay the principal by as much as 34 percent, depending on the company's tax bracket. That tax shield didn't apply to Creative Direct Response-as a subchapter S corporation, it doesn't pay corporate income taxes. But the capital gains deferral made an ESOP transaction appealing to its acquisition target.

Despite the significant tax benefits, the ESOP is an underutilized business financing strategy. Experts blame it on a lack of awareness and misconceptions about employee ownership. "The tax shield alone that the ESOP provides enables an ESOP to give a small business more debt, more senior credit, than they could get with other access to capital," explains Mary Josephs, senior vice president of the Leveraged Finance Department at Chicago's LaSalle Bank Corp., an ESOP lender. Lenders like ESOP loans because tax savings boost cash flow, making repayment more likely. Also, the lender's enhanced comfort level often translates into a larger loan than with regular financing. The fund-raising strategy, however, is not for the fiscally challenged; since business owners guarantee ESOP loans, their financial clout and access to collateral are key lender considerations.

While ESOP lending hasn't hit the mainstream, lenders are getting more familiar with it. Because underwriting hinges on the entrepreneur's credit quality, even untrained lenders can get up to speed quickly. "You're better off educating [your] bank on ESOPs because these loans are underwriting the individual," Josephs says. And besides banks, investment-banking firms, mutual funds and insurance companies may qualify as lenders as well.

Finding a lender is just one step in the ESOP planning process. First, the firm has to determine whether the tax perks outweigh the cost of setting up and administering a plan. "The business needs to be generating substantial amounts of taxable income because that's the benefit," says Spencer Coates, a CPA in Bowling Green, Kentucky. While costs vary depending on the number of employees-a minimum of 20 is recommended-installing a plan can cost up to $100,000 and run $10,000 to $15,000 annually, says Coates. But those expenses are often a fraction of the tax gains an ESOP can generate. "Usually, first-year tax savings offset the costs. That's what makes it palatable to small businesses," he says.

But if your goal is quick access to capital, an ESOP loan isn't advisable. You can spend up to a year working with legal and financial advisors to meet requirements, such as obtaining an independent appraisal to value the company's stock. Even with a specialized attorney, it still took months for Creative Direct Response to complete its ESOP merger. "Find a lawyer who is experienced," urges Peters, stressing that the complicated nature of the transactions results in heftier legal fees than for a straight asset or stock purchase.

Even if you've got time on your side, the financial strain created by buying back stock from departing employees is another limiting factor. "The company involved with an ESOP has to realize they have a repurchase obligation that can be a demand on cash flow as the company matures," says J. Michael Keeling, president of The ESOP Association in Washington, DC.

Broader Appeal

Though ESOPs are complicated to install and administer, about 10,000 companies now have the plans, up from just 200 in 1974. Insiders attribute much of the growth to a 1998 rule change that allowed S corporations to sponsor the plans. At the same time, companies recognize they can boost profits by giving employees an ownership stake, which studies have shown enhances morale and performance. "Statistics show if you have a meaningful percentage of ownership and some communication that the employee's job impacts the value of the shares they have in their accounts, these companies outperform their peers by a factor of 10 percent on a compounded annual revenue and [EBITDA] growth basis," says Josephs. "Although they give something up, what they have is going to be worth more."

Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.