What an ESOP feasibility study covers, and what it does not

Before an owner decides to sell to an ESOP, someone has to answer a practical question: could this work for this company, at a price and on terms the owner would accept? That is the job of a feasibility study. It is a test, not a decision.

The National Center for Employee Ownership (NCEO) describes a feasibility study as an analysis of the business that lays out the options for transaction structure, financing, cash flow and the other factors that affect a sale. NCEO also notes that some feasibility assessment should be done before any ESOP transaction, even if only in-house.

What a Study Typically Covers

Studies differ by advisory firm and by company, but most address the same questions:

• A preliminary valuation range. An estimate of what the company might be worth to an ESOP. An ESOP can pay no more than fair market value, which NCEO describes as what a hypothetical financial buyer would pay, so this range frames everything else.
• Debt capacity and financing structure. How much the company can reasonably borrow, and how the purchase might be split among bank debt, a seller note, company cash and, in some cases, outside capital.
• Cash flow under the transaction. Whether the company can repay acquisition debt while still investing in the business and keeping a cushion, ideally tested against a weaker year as well as an expected one.
• The repurchase obligation. In a privately held ESOP company, employees who leave or retire have the right to require the company to buy back their shares. A projection shows how that obligation may grow over time and how it might be funded.
• Tax effects. For the company, contributions used to repay an ESOP loan, principal included, are generally deductible within limits, and an S corporation’s income attributable to ESOP ownership is generally not subject to federal income tax. For a seller, the study can show whether a Section 1042 deferral may be available.
• Plan design options. Who is eligible, how much to sell now and how much later, how distributions might be paid and how shares are allocated and vest.
• Transaction costs. Legal, valuation, trustee, financing and advisory fees. NCEO estimates the cost of setting up an ESOP for a business transition at about 2 to 4 percent of the total transaction.

A good study also says plainly where the numbers do not work. A finding that an ESOP is not feasible, or is feasible only for part of the company, is a useful result.

What a Study Is Not

• It is not the final price. In a transaction, the ESOP’s trustee, who acts for the plan’s participants rather than the seller, makes the final decision on price, relying on the work of an independent appraiser. The price cannot exceed fair market value, and it can differ from the preliminary range in either direction.
• It is not a fairness opinion. Some ESOP transactions also involve a fairness opinion, which addresses whether the transaction is fair to the plan’s participants. That is a separate opinion, which the trustee may rely on later in the process.
• It is not a commitment. Completing a study does not oblige the owner, the company or anyone else to go ahead.
• It is not a guarantee. A study rests on projections. Lenders, the trustee and the appraiser do their own work, and results can change with the company’s performance and the market.

Where It Sits in Our Process

Old Harbor Advisors’ process runs Educate, Understand, Explore, Introduce, Test Feasibility and Execute. The feasibility study is the fifth step, not the first. It comes after several conversations about the business, the owner’s objectives and the alternatives, and after we have introduced a leading national ESOP advisory firm, under an NDA, so the owner can judge whether that team is a good fit.

At the appropriate time, and at the direction of the client, we engage the selected ESOP advisory firm to conduct a feasibility study incorporating the information and insights gathered during the earlier discussions. The feasibility study provides a deeper analysis of the employee ownership strategy that appears most appealing to the ownership, including its potential structure, economics, and feasibility.

The feasibility study is provided at no cost to the client. Following the feasibility study, the client can elect to engage the advisory firm and proceed on its own timeline. The ESOP advisory firm and Old Harbor Advisors are compensated only upon the successful completion of the contemplated transaction. There is no obligation to proceed at any stage.

Owners should understand what that arrangement means. A study at no cost lowers the barrier to getting real numbers. Because the firms involved are paid only if a transaction is completed, it is also reasonable for an owner to have the findings reviewed by their own CPA and legal counsel.

When a Study May Not Be Worth Doing Yet

A feasibility study is most useful once an ESOP looks like a realistic option. It may be early when:

• Earnings are small, volatile or uncertain, making it difficult to support the debt that typically funds the purchase.
• The owner needs a significant share of the proceeds in cash at closing.
• There is no clear successor leadership yet.
• The company is small enough that the costs of setting up and running a plan would weigh heavily. NCEO suggests that companies with fewer than 20 to 30 employees and $1 million in EBITDA are generally not good candidates.
• The owner has not yet decided what matters most: employees, independence, liquidity, after-tax proceeds or a continued role. The earlier conversations are meant to settle that first.

In those cases, a third-party sale, a family transfer or a management buyout may be the better path, and we will say so.

Tax treatment depends on each owner’s and company’s circumstances; owners should review any transaction with their CPA and legal counsel.

Where to Go From Here

Is an ESOP the right fit? sets out the signals on both sides. Approach and Process describes each step of how Old Harbor Advisors works with owners, from the first conversation to the feasibility study and beyond, and our Frequently Asked Questions cover timing and the advisors involved. If you would like to talk it through, talk to us.

Sources

• NCEO, ESOP Pre-Feasibility Toolkit
• NCEO, “How long does it take to set up a leveraged ESOP?”
• NCEO, “How an Employee Stock Ownership Plan (ESOP) Works”
• NCEO, “What is the difference between a valuation and a fairness opinion?”
• 26 U.S.C. § 409(h), the right to require repurchase
• 26 U.S.C. § 404(a)(9), deduction of contributions to repay an ESOP loan

This post is for general information only. It is not legal, tax, or investment advice.