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ESOPs and Surety Bonds

January 22, 2022

ESOPs are a great way for companies to transfer ownership but they can create challenges for companies that need Contract Surety Bonds. Learn about ESOPs and how to make it easier to obtain bid bonds, performance bonds, and payment bonds


What is an ESOP?


An ESOP or Employee Stock Ownership Plan is a qualified retirement plan that invests in the stock of a particular company. 


When a company decides to sell to an ESOP, there are a few steps that take place:


  1. An ESOP Trust is set up
  2. The Trust purchases the company stock through borrowing from a lender, former shareholders, or both in many cases.
  3. Shares are allocated to employees as they are earned.
  4. Shares are repurchased from employees when they retire or employment ceases.


ESOP Structure - This graphic shows how an ESOP works with the selling shareholders, the company, the lender and employees and the ESOP Trust



What are Advantages of an ESOP




A huge advantage of an ESOP is that they are not required to pay Federal income taxes to the extent of the ESOP. For example, a company that is a 100% ESOP pays no Federal income tax. This is a huge advantage to any for profit company. In essence, the amount of money a company would have paid in taxes can be used to buy out the former ownership instead.


A company may also be partially owned by an ESOP. A company that is only 50% ESOP owned would only receive the tax benefits on 50% of their revenue.


A Buying Market for the Company


Some privately owned companies can be difficult to sell for fair market value. An example may be a General Contracting business that has many intangible assets and unpredictable cash flow. These companies may have difficulty finding a buyer. 


Additionally an owner may want to sell the company to an existing employee or employees, but they may not have the financial means or desire to purchase the company.


An ESOP can be a great way to create a market. By selling to existing employees, an owner can get fair value and take care of their employees at the same time. The employees also do not have to borrow money or have the financial burden of trying to purchase the stock individually.


Employee Retention and Recruiting 


ESOP companies often report better employee retention than other companies. It can also help recruit new employees. Once employees realize the value of the stock they are getting for free, it is easy to see why this may be the case.


Disadvantages of ESOPs


Additional Costs


Costs can be a disadvantage for ESOP companies. Because ESOPs are a qualified retirement plan, they require a higher level of compliance and responsibility. ESOPs must appoint trustees and most banks and surety bond companies require outside trustees. 


Companies must also get audited financial statements which carry a greater cost and time commitment than a company may be accustomed to.


May Provide a Below Market Purchase Price


For companies in very desirable industries, owner(s) may receive less by selling to an ESOP. This is especially true under current market conditions where capital is abundant and inexpensive.


You can learn more about ESOPs at NCEO and ESCA.


How to Get Surety Bonds for an ESOP 


Have Owner Financing


As mentioned earlier, ESOPs can use outside borrowing, owner financing, or a combination of both. Surety bond companies prefer as much owner financing as possible. 


Selling shareholders can carry a seller note. By Subordinating this debt to the bond company, the company can significantly improve it's surety bond capacity. Selling owners can also benefit because they usually get above market interest on these seller notes.


On the other hand, bank debt creates problems for Surety bond companies. They do not want to be in second position to the bank for the company's assets.


Have Realistic Projections


Both lenders and surety bond companies will want to see Projections for the ESOP and its repayment schedule. Unfortunately, these Projections are often unrealistic. Surety bond underwriters appreciate numbers that match the company's historical performance. 


Additionally, a company should stress test their Projections to show how they will meet their obligations if things do not go as planned.


Have a Plan for Owner Indemnity


One challenge for ESOPs and Bonding is Indemnity. Generally, bond companies like to have Indemnity on major owners and key people. This is usually difficult or impossible at an ESOP when key management may have very little ownership.


In some cases, the surety bond company may want former owners to Indemnity until some of the ESOP debt can be repaid. This is acceptable for some former owners. Others may refuse entirely and negotiating or finding a new bond company may be necessary.


Make Sure You are Working with ESOP Experts


Although they do not want to lose a client, most local contract surety bond underwriters are inexperienced with ESOPs and their company may be as well. ESOPs are complicated, and working with the wrong underwriter is common. 


It's also a major reason for complications. Ask your bond broker and bond underwriters about their experience and philosophy on ESOPs. It may save you from delays and problems. 


Get Your Bond Broker Involved Early


A major mistake we often see is that the terms and structure has been set up without getting the bond broker involved. This can be a big mistake. 


Many companies find out too late that their structure prevents them from getting contract surety bonds. At that point, it is expensive to change the terms of the deal. Make sure you get all your advisors to collaborate early in the process.


ESOPs can be a great strategy for owners, employees, and companies. They provide a much needed way to boost retirement savings in the U.S. and seem to be supported by the most politicians. As such, we believe ESOP transactions will continue to increase. 


Make sure if you are considering an ESOP, you contact an expert like Axcess Surety. You can contact us anytime or visit our Surety Bond FAQ page.


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