The first step in the process is determining the company’s value, since the ESOP cannot pay more than fair market value for the stock it purchases. Both the IRS and the U.S. Department of Labor (“DOL”) have issued guidelines governing the valuation of company stock in ESOP transactions.
The next step is a feasibility study to analyze the overall framework for the transaction. Among the issues the study should address are:
- How much the company can afford to contribute to the ESOP each year
- Whether part of the contribution cost can be offset by eliminating other benefit programs
- How the ESOP will affect the company’s earnings and cash flow
- What the structure of the transaction will look like
- How it will be financed
If a leveraged ESOP is established, a loan must be secured to finance the stock purchase transaction. Financing an ESOP transaction can be difficult if the lender is not familiar with ESOPs. If the seller finances the purchase transaction, the company’s costs will likely be reduced.
Legal counsel should prepare the ESOP plan documents. An ESOP sponsor has many choices to make in designing a plan that will work well in its own corporate culture. For that reason, it is advisable to work with experienced ESOP counsel in designing the ESOP.
The next step is to negotiate a stock purchase agreement between the ESOP fiduciary and the selling shareholder(s). The stock purchase agreement sets forth the price and other terms and conditions under which the ESOP will purchase stock from the selling shareholder(s). As in any stock purchase transaction, the stock purchase agreement typically contains representations and warranties about the company’s assets, operations and financial condition.
Finally, before closing the transaction, request an opinion from an independent appraiser. This opinion is required under DOL proposed regulations and provides the necessary assurance that the ESOP is not paying more than fair market value for the company stock it purchases. In some cases, the appraiser will also be asked to give an opinion that the transaction as a whole is fair to the ESOP from a financial point of view.