The Ins and Outs of ESOPs

Brooks Myhran, Managing Director, Verit Advisors

When Harpoon Brewery announced that it would transfer 48 percent of the company’s shares into an employee stock ownership plan (ESOP), many of our readers reached out with questions about how these transactions function.

An ESOP is an innovative liquidity tool that provides flexibility for shareholders, tax advantages for business owners and an opportunity for employees to grow retirement assets through company ownership.

But since we’re not financial experts with an understanding on the nuances of ESOP arrangements, we tapped an expert on the subject.

Brooks Myhran is the managing director at Verit Advisors, an ESOP-centric investment-banking firm. Myhran, who joined Verit Advisors in 2012, has more than 25 years of investment banking and valuation experience and has executed numerous mergers and acquisitions. While Myhran has extensive valuation experience and truly understands a wide range of sophisticated financial services, he specializes in middle market ESOP appraisals and transactions.

Brewbound asked Myhran to elaborate on the advantages and disadvantages of ESOP transactions and explain why they are becoming more popular amongst craft brewers.

The following is a condensed version of the conversation.

Brewbound: ESOP transactions are becoming more popular in the craft beer category. Why do you think that is?

Brooks Myhran: I think for a lot of reasons and some of those were articulated by the guys at Harpoon. One of the things that the ESOP structure allowed Harpoon to do was have a very asymmetric transaction. Some of the shareholders sold all of their stock. Some of the shareholders sold portions of their stock and others sold none of their stock. That is really difficult to do that in other transactions. ESOPs are a very flexible tool for providing liquidity on an “as-needed” basis.

BB: So what do you think brewers are considering when they decide to create an ESOP?

Brooklyn Brewery's Steve Hindy chats with Harpoon co-founders Rich Doyle and Dan Kenary in Boston

BM: I think the people who work in these relatively small businesses feel a lot of camaraderie with the owners. I think the owners feel a sense of family or duty to help reward everybody and not just the couple of guys that helped found the company in the first place. If a brewery sells to a MillerCoors or another buyer in the space, there isn’t a reward for any of the other employees.

BB: Some of our readers have asked how ESOP transactions function. Can you walk us through the basic process?

BM: A company borrows money from lenders and purchases share from selling shareholders. That company then issues shares to a newly formed ESOP in exchange for a promissory note. As time passes, the company will pay down the debt it used to purchase the shares of stock and, as that debt is paid down, the shares in the ESOP owns are released from a trust into individual employee ESOP accounts.

BB: So in Harpoon’s case, do the employees actually own 48 percent of the company now? How complex are these transactions?

BM: 48 percent of those Harpoon shares are now in an ESOP account and will be allocated to employees over time. Once all of those shares are allocated, the company has to decide what it does with the other 52 percent. Down the road, the management of the plan becomes very important but in the near term, it is more about the mechanics of compensation and the debt pay down.

BB: What happens when an employee decides to leave the company?

BM: The company has an obligation to purchase stock back from an employee at fair market value.

BB: So what are some of the advantages of an ESOP?

BM: People really start to think like owners. You want everybody on the team thinking like an owner and every employee is now literally an owner of the company. But it is up to the management to communicate that. ESOP companies tend to outperform non-ESOP companies (in the same industry).

BB: Are owners leaving money on the table if they choose an ESOP over a more traditional acquisition by a strategic buyer or private equity?

BM: The ESOP can pay no more than “fair market value.” Fair market value is what the quantitative validation methodologies turn out when you crunch the numbers. There isn’t a “premium price” that a private equity or strategic buyer might pay to realize synergies and, because the shares are purchased at fair market value, that number is almost invariably lower than what an outright sale to the highest bidder would yield.

BB: So then why would an owner choose an ESOP knowing that another buyer might pay more?

BM: The people who choose to sell to an ESOP are doing it because they have other motivations besides absolutely maximizing the purchase price.

BB: Any other advantages to ESOPs?

BM: It is a way of guaranteeing that the company is going to continue, more or less, the way it has been operated. There are some advantages to from a tax point of view as well. Most overwhelmingly attractive of those is if the company is an S-Corp, where they don’t pay income tax at the corporate level. For a 100 percent ESOP owned S-Corp, the company pays no federal income taxes. That is a hugely attractive feature of the ESOP laws.

BB: How about some of the disadvantages?

BM: If the ESOP becomes the only retirement benefit for the employees, which is often the case, it can be home run but it can be pretty devastating if the company goes under. It is clearly a risk. There are also some additional costs. There has to be an annual valuation of the company and you have to hire a third party to perform that valuation. Most ESOPs have an outside trustee because you want an independent fiduciary keeping their eye on the ESOP plan. There are a couple of extra people who get paid and more people that you have to be communicating with.

BB: Is there anything else important we should know about?

BM: Typically a company that does a partial ESOP transaction today will do another transaction tomorrow. It is almost a guaranteed transition phase. There are companies out there that have been partially owned ESOPs for years but most companies go from partial ESOPs to 100 percent eventually. Also, ESOPs do not solve operational or strategic challenges. It’s great for the owners and the employees but it doesn’t address the challenges of competition, supply challenges or pricing pressures, for example. Overtime, those strategic issues are going to trump the financial engineering benefits of the ESOP.

Additional information is available here.