An ESOP represents Superb Opportunities for Bankers and their Customers

Leveraged (involving a bank) ESOPs enable employees to borrow money using the corporate borrowing capacity of their company to buy stock in the company. ESOPs usually use loan funds to purchase stock from existing shareholders or from conglomerates divesting subsidiary companies. ESOP loans can also be used to purchase newly issued shares from the sponsoring corporation. Many financial institutions were leery of making ESOP related loans in the 1970s and early 1980s until ESOPs were recognized as the "ultimate instrument of corporate finance".

There are several banks throughout the country whose portfolio consists primarily of ESOP loans and this is an extremely profitable book of business with essentially a zero or almost zero default rate. When properly configured there are two reasons why ESOP loans represent almost no risk to bankers. First, fifty years of history validates what seems to be self-evident that owners work harder than employees, are more team-oriented, and better able to weather downtimes. Second, the ESOP loan proceeds are used by a stockholder to purchase "alternative securities" of a US corporation. This portfolio of blue chip securities will collateralize the loan.

Moreover, the securities can be held by the lending institution. As bankers this will be of particular interest to you, so I will expand upon the concept. Refer to the following diagram for clarity. The bank will (1) make a loan to the sponsoring corporation, who then (2) makes a "mirror" loan to its ESOP. The ESOP then (3) buys stock from the stockholder. The stockholder then purchases alternative securities (4) which are assigned to your bank as collateral for the outstanding loan. Your collateral interest reduces as the loan is repaid. The obvious advantage to the bank is that they have instant access to the securities collateralizing the loan. To summarize, the bank has booked a $1,000,000 loan and holds $1,000,000 of blue chip securities in an account within the bank. What is the advantage to your customer?

The customer has monetized $1,000,000 worth of equity in his corporation and he will forego all capital gains tax liability on this and future sales of his stock to his ESOP. As an example, if your customer would simply sell $1,000,000 of his stock at best he would net, after capital gains tax, approximately $600,000. Using the ESOP he has converted his tax liability into capital appreciation and his net is -- $1,000,000. $1,000,000 invested in a blue chip security over the long term will generate approximately a 10% annual return (average annual stock market return since 1929 has been 10.2%).

Additionally, the customer's cost for an ESOP loan is approximately 70% of what a conventional loan would cost him. This is a result of his ability to tax deduct both principal as well as interest on all debt service made to extinguish the $1,000,000 ESOP loan. Let me say that again. The Internal Revenue Code allows us to tax deduct the interest expense associated with a business loan. All payments made to an ESOP are deductible to the sponsoring corporation, and this includes debt service for both principal and interest on loans.

Evaluation of the company stock is required whenever an ESOP is being implemented in a closely held company (public company evaluation is usually determined by the stock market). The evaluation is the basis for the sale price and the amount of the loan. The lender will want to make sure that the evaluation methodology makes sense, that it follows the proposed Department of Labor regulations relating to the definition of adequate consideration, and that the price is reasonable.

There is much room for creativity and imagination in the design of an ESOP structure. As an example, the amount of cash that can be tax deductibly contributed by a sponsoring corporation to its ESOP directed at principal cannot exceed 25% of payroll. We are able to tax deductibly contribute more from the sponsoring corporation in the form of dividends. Interestingly enough, this is the only place where the Internal Revenue Code allows dividends to be a tax deductible expense of the declaring corporation.

There is good reason for ESOP being characterized as the ultimate instrument of corporate finance. The banking community is well advised to present this option to its customers as an extremely cash and tax advantageous opportunity. The bankers image is enhanced as the customer realizes that the banking relationship has much added value, in that the banker can bring creative financial strategies to the table. Very often the customer's review of the option results in a significant addition to the bank's loan portfolio. It's a win, win, win for everyone; the bank, the customer, and the customer's corporation.

ESOP - The Robert Morris Associates Bankers Journal, July 1998 Volume 20, Issue 3

Frank Amato is Managing Member of the Arizona ESOP Group, LLC located in Scottsdale, Arizona. He has spoken before the Arizona State Legislature and is member of the National Center for Employee Ownership. Mr. Amato can be reached at (480)222-0199 or (480) 227-3064.