Employee Ownership Buyout
What is a Private Equity Employee Ownership Buyout?
Through its inaugural fund, Mosaic Capital Investors I LP, Mosaic introduced the concept of a private equity fund fully dedicated to enacting ESOP transactions.
Marrying the benefits of private equity for selling shareholders (full liquidity event, strategic financial partner, rolodex of contacts, etc.) with the equally powerful benefits of ESOPs (income tax exempt, greater management team ownership and control, alignment of interest with all employees, etc.), the Mosaic strategy is truly revolutionary in the world of M&A. To understand why, consider the history of the ESOP:
The History of the ESOP
Famed economist and lawyer Louis Kelso is considered the “Father of the ESOP”, having developed the concept through a succession plan he created for Peninsula Newspapers in 1956. Two years later, Kelso and Mortimer Alder released the provocatively titled “Capitalist Manifesto”, a book stating the case for compensating labor forces with capital in addition to cash, thereby creating broader capital distribution throughout society. For the next two decades, Kelso and Adler trumpeted the benefits and necessity of employee ownership through subsequent publications with limited success.
The big break came in 1974. Russell Long, chairman of the Senate Finance Committee at the time and thoroughly convinced of the merits of ESOPs, became an internal champion of the structure during congressional negotiations around The Employee Retirement Income Security Act (ERISA), which would pass that year. ESOPs, due to their newfound tax advantages, suddenly were in vogue.
Since the passage of ERISA, the number of ESOPs in the United States grew as high as approximately 11,000 companies in the late 1990s, bolstered by S-Corp reform in 1997, before ultimately plateauing around 7,000-8,000 companies, where it stands today. Though the number of employees participating in ESOPs continues to grow, the limited growth of new ESOP plans over the past two decades is disappointing. Given the many appealing characteristics of employee ownership, why hasn’t the structure taken off? There are nearly 30 million small businesses in the United States after all.
CloseThe barrier to ESOP ubiquity is, in our opinion, inherent in the very nature of the traditional ESOP transaction. In 99.9% of ESOP transactions, the seller finances the ESOP’s acquisition by taking the majority of his or her proceeds in the form of a Seller Note, which is subsequently paid down out of the Company’s cash flow over the ensuing 5 – 10 years. Thus, relative to an alternative transaction where the buyer would pay cash up front for the business, selling shareholders are making a significant sacrifice to give their employees a piece of the pie. The appeal of a seller-financed ESOP is thus severely limited; especially considering that the selling of one’s business is often the seminal liquidity event in an entrepreneur’s life. A liquidity event without cash is hardly palatable.
A private equity ESOP offers full cash proceeds for the acquisition of the target company, opening up the structure to a whole new universe of business owners. In this style of transaction, a private equity firm such as Mosaic raises all of the capital to acquire the business and lends it through the company to a newly formed ESOP Trust, which then purchases the company from the selling shareholders. In effect, it is similar to buying a house with a 100% mortgage. Over the next 3-5 years, the company creates equity value by paying down the acquisition debt, including the private equity firm’s investment. Once this debt, which is very similar in structure to any company that has recently been acquired through a leveraged buyout, is fully paid-off, the Company is free of institutional stakeholders and can remain an ESOP-owned company in perpetuity. With a PE-ESOP, the sacrificial nature of selling a company to one’s employees is no more.
EO Buyout Highlights
EO Buyout Highlights
Full Cash Buyout for Existing Shareholders
Trust Owns 100% of all Outstanding Shares and Makes Annual Allocations to Employees
Creation of New ESOP Trust as the Buyer
Company is Generally 100% Income Tax Exempt Going Forward (Federal & State)
Mosaic and Financing Partners Supply all Capital Required by the Trust to Make Acquisition
Mosaic Invests Through Structured Equity (Subordinated Note plus Warrants)
$0 Contribution From Employees For Their Shares
Unlike Traditional Private Equity:
Ownership is spread amongst all employees with shares allocated annually by the Trust in accordance with the ESOP Plan Document (governed by ERISA). The Board is split between Mosaic, Management and Independent Directors with neither occupying a control position. Selling shareholders can indefinitely defer capital gains tax obligation on proceeds through a §1042 election on their tax returns.
Furthermore, the Company is 100% income tax exempt going forward. The Company does not need to be re-sold in 3 – 7 years but can instead re-pay Mosaic and redeem warrants through a recapitalization event, thus remaining an ESOP in perpetuity. The structure creates tremendous alignment of interest and a true partnership investment approach.
Unlike Traditional ESOPs:
Sellers receive their proceeds entirely in cash instead of financing the ESOP conversion with a sizable seller note. The Company receives all of the strategic and financial resources of Mosaic to accelerate growth going forward. Selling shareholders are encouraged to roll-over proceeds in the same security as Mosaic, creating a second significant liquidity event.