In the Summer 2017 edition of BDO Knows Government Contracting, we broke down why government contractors might consider Employee Stock Ownership Plans (ESOP) as a way to incentivize company partners and encourage cash-flow. To better understand an ESOP in practice, consider a scenario where a government contractor owned by two individuals is looking for liquidity while continuing to operate the day-to-day functions of the business.
Client and motivation
The two owners are specifically concerned about getting some ownership into the hands of younger management team members, who will drive the business moving forward. However, the owners recognize the importance of the culture of the business and the key relationships they have developed with their client. Unlike an outright sale to a competitor or private equity firm, an ESOP guarantees the culture the company has built will stay intact, while the current owners can still control the board and run the business, if they so desire.
As mentioned in Part 1 of this article, there are a number of advantages for implementing ESOPs for government contractors. Similar to employer 401(k) contributions, ESOP contributions are allowable costs under the Federal Acquisition Regulation (FAR), even though payments may be designated for repayment of principal, and interest, of the underlying loans. Further, government contractors structured as S Corporations may benefit from the fact that any tax liability flows through to the ESOP Trust, which pays no income taxes. This benefit provides an important source of cash flow for the pay down of the ESOP loan. Finally, ESOP-owned government contractors that otherwise meet the applicable revenue or headcount limitations will be eligible for “small business” status and retain the associated competitive advantages.
Revenue Range: $25 Million
EBITDA Range: $3.0 Million
Transaction Value Range: $18 Million
Financing: Initially structured with approximately 25 percent senior (bank) note and 75 percent seller notes. The seller notes are structured to pay out a total rate of return commensurate with the current market requirements of mezzanine providers (since structured as subordinated debt to the senior note), and usually include detachable warrants.
Post-ESOP Value of Company: $2.7 Million (approximately 15 percent of pre-ESOP Value).
Value of Warrants: 25% of increase in value above $2.7 Million
Seller Take Home: Sellers receive $4.5 Million cash up front, $13.5 Million over 10-15 years plus interest, and 25 percent upside over post-ESOP value (approximately $3.8 Million if company value returns to $18 Million—very possible because of repayment of debt every year).
Effect on Company Cash Flow: While the company is levered post-transaction, if constructed as an S Corporation ESOP, there is more cash to service the debt and fund company growth – approximately $1.2 Million a year of tax savings with EBITDA of $3.0 Million.
Management Incentive Plan (MIP): A management incentive plan would reward key management team members outside of and in addition to the ESOP. The pool would be equal to a percentage of the equity of the company, and participation is usually limited to key management team members, but can be changed at any time.
Possible Issues of the ESOP for a Government Contractor: Negotiation of value and senior financing could be challenging, as the trustee/valuation firm and senior lender may have concerns about the company being too dependent on one client. However, if the owners plan to stay with the company and continue these relationships, and this fact is properly communicated, this may not be an issue, particularly with banks with a market presence in the government contracting industry. Repurchase obligation must always be a concern of business owners when considering an ESOP, but this can be somewhat mitigated for government contractors through the cost recovery of the ESOP contributions and S Corporation status.
Overall Impact of ESOP for Government Contractors: For business owners seeking liquidity and diversification while also continuing to run the day-to-day operations, there is no better option than ESOP. This is important for many government contractors because of the important relationships built with their government customers, and the unique corporate cultures best suited to support them. Owners getting closer to retirement can begin the transition of relationships to younger, key management team members while also rewarding them with ownership in the company. Tax incentives also make the ESOP enticing to both the company and owners.
Although each company is different, and potential issues must always be addressed, an ESOP offers a very flexible, smooth exit strategy for business owners who value company culture and legacy.
Jack Southers, Senior Associate, contributed to this article.
Jay Powers is the National Practice Leader for BDO’s ESOP Transaction Services and may be reached at firstname.lastname@example.org.
Christopher Carson is the Assurance Practice Office Managing Partner of BDO’s Center of Excellence for Government Contracting and Government Contracting Practice Leader. He may be reached at email@example.com.
Warren Averett is an independent member of the BDO Alliance USA. This article was borrowed with permission from BDO USA, LLP