Employee stock ownership plans, or ESOPs, have not been a big part of the M&A discussion for many years, but a confluence of recent factors is changing that.

More sellers are turning to the ESOP as an alternative to a traditional M&A transaction, as baby boomers look to sell their businesses, tax rates continue to increase and bankers become more comfortable with the ESOP option. Also, private equity firms are more frequently willing to invest alongside an ESOP transaction, as they look for ways to differentiate themselves while buying into high-quality companies.

An ESOP allows employees to buy an interest in a company while giving the owner liquidity. Usually ESOP buyouts are an incremental benefit to employees, who bear no upfront costs: the owner sells the company to employees, allocating shares that are in a trust for the employee until he or she retires or leaves. The value of the stock is not taxed until the employee sells it back to the company, usually at retirement. Even then, employees can continue to defer taxes by rolling the proceeds of the sale into an individual retirement account, like a 401k rollover into an IRA.

"There's definitely more interest in ESOPs today. We have our Google Alerts set to send us news on ESOPs," says Keith Butcher (pictured), a managing partner with middle market M&A boutique investment bank Butcher Joseph Hayes, which specializes in completing ESOPs for its clients. "We used to get an article once a week; now it's about two or three per day."

Mosaic Capital Partners, founded two and a half years ago, is raising a $150 million Small Business Investment Company fund to focus on ESOP transactions. The Charlotte, North Carolina-based firm is expected to put about $20 million into each deal and complete four to five transactions annually.

In December 2013, Mosaic completed its first transaction, buying Lees Specialty Compounding LLC with the company's management. Lees Specialty Compounding is a multi-location, traditional compounding pharmacy serving the greater Tulsa, OK, market. The company provides pharmaceutical products to patients whose physicians prescribe medications specifically formulated to meet the unique needs of each patient.

"The owner was passionate about his employees and the business staying in Tulsa, and an ESOP allowed him to know that the company and employees would remain. He was also able to achieve his exit goals," says Stephen Buchanan, a managing partner with Mosaic.

An ESOP transaction with private equity participation allows the owner to sell his shares to the ESOP trust. Funds paid to the seller come from the private equity firm, which is paid back by the company over time.

"Private equity is interested in ESOPs today because firms are searching for yield and looking for different ways to deploy capital. More private equity guys are looking outside the box today and ESOPs are somewhat unique," says Buchanan.

Lees isn't the only company that has taken the ESOP route. There are 10,000 ESOPs operating in the U.S. today. These companies employ more than 10 million workers, according to Forbes. That's about a 12 percent increase from the number of ESOPs in 2007.

Butcher says about half his business comes from ESOP-related transactions. Sellers like the ESOP option for a number of reasons. First, it allows them to make sure their employees are cared for after the sale. In 2012, the founders of Dansko, the footwear company, were intent on implementing a transition strategy that preserved the company's legacy and culture while ensuring long-term financial success.

Because of the company's brand name, strategic buyers and private equity buyers were interested. But the owners, who had built the business up to nearly $150 million in annual sales with 180 employees, feared if they sold to a strategic buyer or private equity firm, the company's West Grove, PA-based headquarters could be shuttered. Instead, the owners worked with their advisers, led at Verit Advisors, to structure an ESOP transaction, enabling the owners to remain involved in the company, while taking some liquidity out of the business and ensuring the company would remain in Eastern Pennsylvania.

"They were able to make this work and it allowed the owners to take capital out, maintain the company's legacy and keep the company's culture intact. As a tax-free entity, the company is now paying off its debt very quickly," says Aziz El-Tahch (pictured), a managing director in the New York office of advisory firm Stout Risius Ross Inc., which represented the ESOP trustee in the Dansko transaction. The firm has also represented the ESOP trustees of Cliff Bar & Co., the organic energy bar maker, and New Belgium Brewing Co. during their ESOP transactions.

Butcher had a similar experience with Paschall Truck Lines, Inc. The company was the second-largest employee in Murray, KY, which has a population of about 25,000. The founder was being approached by everyone about a sale, but he worried a buyer would shut down the Murray headquarters, which would have been catastrophic to the city. He decided to complete an ESOP.

St. Louis-based Butcher Joseph Hayes created a competitive process to get the best financing terms for Paschall. Butcher Joseph Hayes was able to secure senior debt and four lenders for the transactions. "The owner took some paper and we raised a bunch of capital," says Butcher.

Tom Stephens, executive vice president, says the ESOP was the best option for the company. "We examined a number of alternatives to sell the company. In the end, the ESOP provided the best option. The formation of an ESOP ensured that the headquarters and primary administrative functions will remain in Murray, and the employees will control the future of PTL. This is a very positive outcome for the employees and community," says Stephens.

In addition to the benefits ESOPs can have for employees, ESOPs offer tax benefits for both the seller and the company. ESOPs allow sellers to defer and, in certain cases, avoid paying capital gains taxes altogether.

"Capital gains can be substantial, and in light of recent tax increases there's no question these structures are getting more attention today. ESOPs can lower sellers' tax payments and give them more cash at close," says Elizabeth Di Cola, vice president with Fifth Third Bank's ESOP Finance Group.

An ESOP allows the company to use pretax dollars to buy out the owners. The seller can also defer capital gains taxation on the sale proceeds. Under section 1042 of the Internal Revenue Code, the owner of a C corporation can defer capital gains taxation on stock he or she sells to an ESOP. The conditions: the ESOP must own 30 percent or more of each class of outstanding stock or of the total value of all outstanding stock, and the seller must reinvest the sale proceeds into qualified replacement property during the period from three months before to 12 months after the sale.

"When the owner who has set up an ESOP dies, those assets can be passed on to the family, tax free," says El-Tahch. "Also when working with an ESOP, you can deduct the principal and interest on the debt by making contributions to the plan. It's an enormous benefit,"

"It can really give a company a leg up on the competition. The company is actually retaining 40 more cents on the dollar than its competitors that are paying taxes," El-Tahch says.

Studies have also found that businesses with shared-ownership plans fared better during the recession than more traditionally structured firms, with fewer layoffs, higher productivity and stronger employee loyalty. Data from the General Social Survey shows businesses with employee stock plans laid off workers at a rate of just 2.6% in 2010, compared with 12.1% at companies without such plans.

"There's no question based on existing research that employee-owned businesses as a whole have done better over time," says Di Cola.

Still, while there are many advantages to an ESOP, there are challenges and risks as well, including the issue of getting employees all on the same page. "The message needs to be accurately conveyed to employees as to what an ESOP is," says Butcher. "It's not a get-rich quick deal where employees are suddenly given decision-making power. It's a trust that will generate incremental retirement income based on the company's success."

Additionally, funding the plan over the long term can be challenging. Repurchase obligations must be completed at the company's current ESOP valuation, which can put pressure on the company's cash flow. Administering an ESOP can add expenses to the company, for the transaction and as an ongoing cost, due to the need for an independent ESOP trustee, third-party administration and ongoing valuations. There are also additional tax-filing costs and reporting requirements that cost money. "It can be a burden administratively, but there are significant benefits, and as financial advisors and investment bankers get more comfortable with this option we are likely to see more ESOPs," says Di Cola.

El-Tahch agrees that ESOPs transactions will continue to grow in popularity. "We should see more of these transactions in the future. Lenders and private equity firms are aggressively looking to deploy capital. When you consider that in combination with increasing taxes and baby boomers nearing retirement without a clear exit plan in place. ESOPs provide a solution," he says.

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