How is an ESOP Formed?

There is no one-size fits all ESOP structure and transaction, but there are plenty of similarities with most ESOP transactions.

The first thing that an owner who is serious about an ESOP transaction should do is get a feasibility study. This study is done by a CPA or financial professional, and it takes a deep dive into the company’s books and records to determine if the company’s income, cash flow and employee census will support an ESOP and if so, what percentage of ownership can be supported in an initial transaction.

If the ESOP is feasible, the owner next needs to determine how much of the company will be sold to the ESOP and a desired sales price. The company at this point will want to hire an outside trustee, who will purchase the shares on behalf of the still-to-be-formed ESOP and its participants. The trustee will hire its own valuation advisor to conduct due diligence and determine a fair price for the transaction, and there is typically some negotiation between the owner and the trustee.

At this point, the transaction documents (including the ESOP plan document and trust agreement) start to be drafted, but the trustee still needs money to buy the shares. In nearly all cases, the trustee borrows those funds from the company – but where does the company get those funds? If the company doesn’t have the cash available, it will borrow those funds from an outside lender, from the selling shareholder, or a combination of the two. Involving a bank brings in another layer of complexity into the transaction, but this may be the only source of liquidity for the owner who would like to receive some cash at the time of the transaction.

Assuming all goes well in that process, the documentation is finalized. The company adopts the ESOP and the trust agreement, while the ESOP trustee also signs the trust agreement on behalf of the ESOP, along with the agreement for the ESOP to purchase the shares from the owner. The ESOP acquires the shares using the funds that were borrowed from the company, so the company receives a promissory note from the ESOP that is paid out in installments over a period of time – usually between 10 and 20 years, depending on a number of factors. The ESOP also agrees to pledge the shares back to the company as security for the promissory note, but as the promissory note is repaid, a proportionate number of shares are released from the pledge, at which time they are allocated to the accounts of participants. In exchange for the shares that the owner is selling, he or she receives cash (which came either from the bank or the company’s reserves), promissory notes, or a combination of the two.