Illinois School Goes The ESOP S Route

The January acquisition of Alion Science & Technology Corp. by its employees in a rare not-for-profit to ESOP S transaction is a nice piece of financial engineering that spotlights a deal technique often overlooked by m&a pros. Alion was created by a $130 million employee buyout that recast the company as a for-profit Delaware corporation. It reorganized all the assets of the Illinois Institute of Technology’s Research Institute (IITRI), which had been a not-for-profit Illinois corporation. IITRI is the research and development wing of the Illinois Institute of Technology (IIT). “We felt the timing was right for a number of reasons,” says Lewis Collens, president of the Illinois school. “It was a tremendous opportunity for IIT to substantially increase its endowment. At the same time it presented IITRI employees with ownership in a new research entity.” About half of the company’s 1,650 employees elected to transfer funds from their eligible retirement account balances into a newly created employee stock ownership plan (ESOP). The ESOP in turn acquired all of Alion’s common stock. Of the $130 million purchase price, $26 million came from retirement funds. According to Bahman Atefi, Alion’s CEO, this percentage of the purchase price amounted to a down payment on the transaction. The rest of the funding came from term loans and a layer of subordinated debt. The deal uses an innovative buyout model, made possible by recent amendments to federal income tax laws, that combines the benefits of an ESOP with an S Corporation structure. Under this model, an S Corporation passes its income to shareholders who are liable for their pro-rata share of income taxes on the earnings of the company. In the case of an S Corporation that is 100% owned by its ESOP, like Alion, the company’s earnings should be substantially tax-exempt. Alion provides technology services to government agencies in fields such as wireless communications, defense operational support, chemical technology, explosive science, and information technology. Jim Waldo, a director and head of the ESOP corporate finance practice at Houlihan Lokey Howard & Zukin, Alion’s financial adviser, says, “Alion’s approach to implementing and defining the ESOP was groundbreaking because of the public nature of the transaction.” He says that his firm has done three other ESOP S deals. One characteristic of those types of deals, he adds, is that the organizations usually know each other. Atefi says that the ESOP S option allows the company’s employees to retain control of the business. For its parent, Atefi notes that the plan gives the school an immediate payout and a chance to profit from any growth Alion achieves under the new plan via a series of warrants that will become active in a few years. “We might have gotten more in the open market for the company, but the ESOP S structure gave us a number of advantages we wouldn’t have gotten from an outright sale,” he states. Among those advantages will be the role employee ownership is expected to play in retaining workers. Keeping people on board is a major challenge in technology and other fields, but Atefi believes that the new ESOP structure will significantly affect the way employees perceive their jobs and will reinforce employee loyalty. And as the company competes against larger, publicly owned corporations for contracts, it should stand out because of its structure, he adds. Atefi also points out that the ESOP S plan has the advantage in some situations of allowing sellers, if they take the proceeds in government-backed bonds or securities, to avoid any taxes on the transaction. Waldo notes that ESOP S transactions succeed when they meet the confluence of the objectives of the board and shareholders. At a time when corporate governance thresholds are being raised, the prospect of employee ownership may become increasingly attractive, he remarks.