The Benefits of an ESOP for Corporate Transition Strategies

By David Binns

Like many ESOPs, the Macfadden Employee Stock Ownership Plan was established as a means of transitioning ownership from the company's founder to its employees. Just over 12 years later, the Macfadden ESOP now owns 100 percent of the company with all of the shares fully allocated to the accounts of the plan participants. Along the way, the company has been able to take advantage of a number of ESOP benefits which have greatly facilitated our transition to an employee-owned company.  Macfadden's founder, Jim Macfadden, established Macfadden & Associates, Inc. in 1986 and grew its federal contracting business over the next 15 years to more than $10 million in annual revenues with more than 100 employees. As he approached retirement age he began to explore opportunities for selling the company. Though he had opportunities to sell the company to outsiders, he was attracted by the idea of selling to his employees and maintaining Macfadden as an independent business.

A feasibility study demonstrated how a leveraged ESOP could buy a minority stake in the company and allow him to defer taxable income on the sale based on the Section 1042 ESOP rollover. The Section 1042 tax-deferral to him as a seller, the opportunity to help ensure the company's independence and provide an attractive long-term incentive for employees convinced him that the ESOP was a viable alternative to an outright sale of the company. The Macfadden ESOP was established in 2002.

To reduce the financing costs for the initial ESOP transaction, the company opted to make cash contributions to the ESOP for the first two years. To accomplish this, the company temporarily froze its contribution to the 401K plan to enable it to make the contributions to the ESOP at a level sufficient to build up the necessary cash reserves for a prospective stock purchase. Though an ESOP is required to be invested primarily in the shares of the sponsoring company's stock, regulations are sufficiently flexible to allow transitional strategies to achieve that purpose. In 2004 the ESOP acquired a 35 percent stake in Macfadden, using the plan's cash assets plus a loan from the National Cooperative Bank, an institution established by Congress specifically for the purpose of providing financial support to employee-owned companies. Jim Macfadden remained as president of the company.

Three years later, in 2007, the ESOP exercised its option to acquire the remaining 65 percent of Macfadden's stock. The remaining debt from the original transaction was refinanced with a new loan. Jim Macfadden once again was able to defer income taxes on the sale by electing Section 1042 treatment and was able to retire, knowing that the company would remain independent and that the employees who had helped him build the company would benefit from the opportunity to share in the company's future success through the ESOP.

Soon thereafter, the company elected S Corporation status. Because ESOPs are exempt from federal taxes in S Corporations, the change to S Corporation status enabled the company to shield a significant part of its earnings from taxes which was a crucial advantage in implementing its growth strategies. So in addition to benefiting from tax advantages established to incentivize owners of private companies to sell to an ESOP, the S Corporation federal tax exemption gave our small company an important advantage in managing our ownership transition.

The following year Macfadden completed an acquisition that effectively doubled the size of the company. The fact that Macfadden had just recently completed a large leveraged ESOP transaction enabled us to assure the management team of the target company that they and all of their employees would benefit from continuing ESOP allocations as the company continued to pay down its ESOP debt. That was a key factor in negotiating the terms of the acquisition and in retaining key personnel as part of the merger of the two companies. We refinanced the ESOP loan as part of the acquisition.

When the company hit a rough patch and flat earnings put pressure on our cash-flow, we brought in mezzanine investors which proved to be an expensive solution. Though we were able to avoid giving warrants to the investors in order to preserve the ESOP's 100 percent stake in the company, the cost of serving that higher-interest mezzanine debt proved problematic. Fortunately, we were able to restructure that debt with an SBA loan to buy out the investors which cut the cost of our debt service in half. Again, the ESOP provided us an important advantage, as 100 percent ESOP-owned companies are exempted from the requirement for a personal guarantee for an SBA loan.

As business improved we were able to accelerate the repayment of our debt and by the end of 2014 we paid off the last of our ESOP debt obligations. As a result, the final ESOP shares acquired in the 2007 buyout were released from the ESOP suspense account and allocated to the accounts of the plan participants who now own the company free and clear.

The company's success in growing the business since our two-step ESOP buyout has resulted in significant appreciation in the value of the stock over the past decade. Those employees who have been with the company now have substantial holdings in their respective ESOP accounts. That success brings new challenges as well. Annual repurchase liability has grown from several tens of thousands of dollars per year to several hundreds of thousands of dollars.  Careful management of cash-flow is an essential discipline in a mature ESOP company to ensure our ability to provide shareholder liquidity on an ongoing basis. And winning new business remains a never-ending challenge to ensure continued growth in the value of the ESOP.

Having completed the initial transition of company ownership from founding shareholder to a wholly employee-owned company, Macfadden today is considering a variety of strategies for building future growth for its ESOP participants. Maintaining an employee ownership culture of mutual accountability and participation in the risks and rewards of ownership offers perhaps the ultimate long-term benefit of the ESOP.

David Binns

David Binns, president and CEO, Macfadden