Employee buyouts have been successful at many hundreds of small and large companies over the past twenty five years. Such transactions represent a meaningful percentage of all leveraged buyouts that have occurred over that time. Increasingly employees have come to expect participation in the ownership of the companies in which they work. Often employees become owners in the context of a corporate transaction. These transactions compete with the more common leveraged buyout sponsored by a firm specializing in such transactions. Employee buyouts have many advantages over these standard leveraged buyouts. This article describes many aspects of an employee buyout and compares such transactions with standard leveraged buyouts and strategic acquisitions.

B. The Rise of Employee Buyouts

Every year hundreds of subsidiaries, divisions, product lines, and entire corporations are sold. These sales are typically arranged through privately negotiated transactions or private auctions conducted by investment banks. The entities being sold range from healthy to distressed. Buyers are typically companies in the same line of business, companies with complementary product lines, or leveraged buyout firms. Selling a company to all its employees through an employee stock ownership plan (ESOP) transaction has been a growing trend.

The National Center for Employee Ownership (NCEO) estimates that from 1985 through 1993, over 750 companies were established through selling a company or through corporate divestitures to newly created companies that are at least 25% ESOP-owned. A few examples of these transactions follow:

Employee buyouts have become an attractive alternative to the standard leveraged buyout for several reasons.

First, there are the hard-to-measure but very real motivational effects of ownership. For the same reasons that managers who become owners in a management buyout are motivated to improve their performance, the workers as a whole are motivated to strive for the success and growth of an enterprise when they are equitably included in a transaction and their ownership shares are accompanied by participation and communication.

Second, ESOP transactions offer significant financial benefits unavailable under any other ownership structure. The substantial tax benefits of ESOP transactions, which are discussed more fully below, make an ESOP a strong bidder in a buyout by increasing cash flow available for debt service.

Finally, where employee concessions are needed for survival, such as at Northwest Airlines and particularly in unionized settings, employee ownership may be the only effective way of giving workers something of value in return for their sacrifices. Without sharing the "upside," employees may not be willing to make the sacrifices necessary for success.

This article describes how employee buyouts of corporations, subsidiaries, divisions, and product lines are typically structured. It demonstrates why employees may be the most viable buyers and why the resulting ESOP company may be the healthiest company relative to alternative transaction structures. It also demonstrates the impact an ESOP can have on the value of a company, and thus on the return, after dilution, to equity investors in employee buyouts.

The author hopes that more employee buyouts will be implemented as investors, owners, managers, unions, and employees learn that ESOPs can be competitive bidders and that multi-investor employee buyouts can provide a market rate of return to all investors.

Sellers have learned that they can often maximize their return if they sell to management in a leveraged buyout transaction. Management has learned that through leveraged buyouts they too can share in the ownership of their company. It is time for sellers to learn that the advantages of selling to management are compounded when they sell to all employees. And it is time for employees and unions alike to realize that the opportunity for ownership comes around only rarely, and that when it does, management alone should not reach for the brass ring; instead, every shop worker, clerk, engineer, secretary, supervisor, and manager should reach out and take a stake in his or her company. Only if this becomes the norm will we broaden the ownership of wealth in this country and maintain a vigorous and dynamic free-market economy.

C. Leveraged Buyouts of Corporate Divestitures

Why are buyouts of corporations, subsidiaries, and divisions common today? There have always been many corporate transactions as companies have been bought and sold and have divested operating units for strategic reasons. The number of these corporate transactions skyrocketed in the 1980s, declined in the early 1990s, and has now risen again. There are many reasons for the large number of these transactions:

Each of these trends has contributed to the growth in leveraged buyouts of public and private corporations and their subsidiaries, divisions, or product lines. Many transactions, of course, are still completed by strategic buyers or by senior management teamed up with leveraged buyout firms with their own equity to invest. However, an increasing number of buyouts involve all the employees through the use of ESOPs.

To fully understand the value that an ESOP can bring to a leveraged buyout, one must first understand how a typical management buyout is structured.

D. Standard Leveraged Buyouts

During the 1980s, it became more common for members of management, assisted by an investment group, to purchase their company, subsidiary, division, or product line. These transactions are commonly known as "leveraged buyouts" (LBOs) because the buyout group finances the transaction with funds borrowed against the assets and projected cash flows of the entity being acquired. These transactions usually rely heavily on senior debt and subordinated debt. The subordinated debt is provided by insurance companies, pension funds, subordinated debt funds, other institutional investors and often the seller of the company. Equity is provided by management and an investor group that specializes in leveraged buyouts.

Leveraged buyouts are financed chiefly with borrowed capital, not only because such funds are readily available, but also because equity reaps higher returns (subject to greater risk) when transactions are financed predominately with debt. Senior lenders are not prepared to lend 100% against the collateral value of assets. Subordinated lenders, however, are prepared to take second liens on assets and be paid from the cash flows of the company left over after servicing senior debt in exchange for a premium rate of return. Subordinated debt allows a company to be more highly leveraged and reduces the need for equity, thereby replacing equity with less costly debt.

Debt is less costly than equity financing for two reasons. First, equity is at greater risk. It is subordinated to debt, trade creditors, and others as to rights to cash flow, including cash flow generated in liquidation. Equity investors can therefore expect substantially higher returns on their investment than do lenders. Second, interest on debt is a deductible expense whereas dividends on equity are paid with after-tax dollars. Consequently it is more costly for a corporation to provide a certain return to equity than it is to provide the same level of return to debt.

How do these varying costs of capital impact the seller? A seller can frequently receive the highest price from a buyer who relies heavily on debt financing. Today, a corporate as well as an LBO buyer typically values a company based on the cash flowing to a capital structure composed predominately of debt. This kind of capital structure maximizes the potential return to equity, although it reduces the flexibility and increases the operating risks of the company.

The now-popular belief that companies are more competitive and profitable as independent units rather than as parts of conglomerates precipitated a wave of corporate divestitures in the 1980s. The 1960s and 1970s were periods of conglomeration, which by many accounts was a failed experiment. The 1980s was a time of "breaking up," "spinning off," and divesting corporate assets. The result is the de-conglomeration of corporate America. A standard leveraged buyout usually makes the new company an independent entity. This is frequently viewed as the most advantageous way to operate the company.

Corporations are still the most frequent buyers of other corporations, however. A corporate bidder with easy access to credit may have a powerful advantage over a standard leveraged buyout. To enhance the value of the entire corporation and therefore the value of the company being purchased, a prospective corporate buyer may want to integrate the new company into the rest of its operations. A corporation that believes it can attain economies of scale, greater market share, expanded product lines, additional operating capacity, or any other enhancements to its existing business because of the acquisition may bid far above the levels associated with the potential cash flows and earnings of the new company on a stand-alone basis. If the corporation has sufficient access to capital and believes it can achieve important synergies between its current business and that of the new company, then it will normally be able to outbid a standard leveraged buyout.

When competing for the purchase of a company, a standard leveraged buyout where an LBO firm has teamed up with existing senior management has a number of advantages over other bidders, including corporate bidders. At times, these advantages give management the edge in the bidding process. The existing management of the company usually understands the company better than any other prospective bidder. Management may know of hidden values in the company that will be hard for others to discover or realize. Management also requires less time to evaluate the company and generally knows in advance that the company will soon be for sale. Management often has well-thought-out plans for operating the company independently, including strategies to spur growth or reduce costs. An independent company requires less corporate reporting and can eliminate overhead costs associated with its parent. Management usually has close, personal ties with the company’s financing sources. And a management-supported bid is often viewed sympathetically by the board of directors, which must ultimately decide to whom to sell.

E. Employee Buyouts

An employee buyout is virtually identical in structure to an LBO, except that the ESOP becomes an additional investor that shares in the equity of the new company. An employee buyout generally is led by or has the support of senior management, and so all the advantages described above for standard leveraged buyouts apply for employee buyouts. Compared to the standard LBO, an employee buyout produces improvements in operations, reduces tax payments, and lowers the cost of capital. These advantages give the employees a better chance to win a bid, and, if they win, will result in a healthier company.

As explained below, an employee buyout can be initiated by the owner, by management, by a union or unions, or by a third part.

Owner-Initiated

A corporation’s owners or board of directors may realize that selling the company or divesting a division may be most effectively accomplished through an employee buyout. The board of directors may assist an employee buyout effort in either a privately negotiated sale or a private auction of the company.

Management-Initiated

A management-initiated employee buyout is typically initiated by senior management and can be supported by the board and owners of the corporation, even to the extent of providing corporate funds to conduct such an effort. Management can be a powerful bidder because it has all the advantages of an inside management group along with the attributes of ESOP financing. If management also includes union and non-union employees in structuring the transaction and gains employee sacrifices in exchange for ownership, it will be significantly more competitive in bidding for the company and, if successful, will produce in a healthier stand-alone enterprise.

Union-Initiated

Non-management employees can initiate an employee buyout. Typically, one or more unions representing the employees do this. The company can support such a buyout effort with corporate funds. The employees must team up with qualified management in implementing the buyout and then operating the company.

Union-initiated employee buyout efforts often invite existing management to join the union in buying the company. A union can also seek other, more qualified, management with which to participate, or it can selectively invite members of the existing management to its side.

Third Party Initiated

Any prospective bidder for a company can integrate an ESOP into the overall ownership structure of the transaction. Such an effort can reap the various tax and other advantages associated with ESOP financing and therefore enhance its competitiveness. However, without the involvement and support of the overall workforce and without sharing all the rights of ownership, particularly voting rights, it is unlikely that employee sacrifices can be attained in exchange for ownership.

F. Union Considerations

It would be nice for sellers if employees were always motivated to trade off concessions for ownership. However, workers usually have little discretionary income and even less desire to see it taken away. Workers generally wish to protect their current income rather than gamble on their company’s future. When a company undergoes a standard leveraged buyout, no one is more at risk than the employees.

The cash investment from an investor typically accounts for 10% to 20% of the total financing requirements of a standard leveraged buyout. Normally, such an investment represents only a fraction of the investor’s portfolio. If the company fails, the investors experience losses, not a catastrophe.

Management personnel typically invest a portion of their net worth in LBOs in return for a sizable equity stake and the continuation of their relatively high salaries. If the company fails, management personnel fall back on their accumulated resources and take their college degrees elsewhere.

In the standard LBO, the average employee invests nothing and receives nothing, but assumes enormous risks. For such employees, not only their ability to own their homes and provide their children with a good education but also their very livelihoods depend on their company’s success or failure. Stable income and accruing pension benefits form the bulk of their financial resources. If their company is leveraged, these resources are put at great risk. (However, there may be greater risk for employees if the company fails to undergo a buyout.)

If the company falters, the employees are asked to sacrifice. If the company fails, the employees enter the job market with limited or non-transferable skills and meager resources to relocate and retrain. In return for their risks, the employees normally receive no stake in the success of the company. Security of wages and benefits should be the foremost consideration of unions. Therefore, if a corporate buyer comes along with deep pockets, the employees, whether organized or not, generally opt for the role of wage earner and pass on the opportunity and risks of being owners. To out-bid such corporate buyers is tough and requires substantial concessions.

However, if a corporate buyer is a union buster or is someone who probably will move the facilities to Timbuktu, the employees will normally consider long and hard their willingness to take concessions rather than risk losing their jobs.

If the employees on average are near retirement and if their retirement benefits are substantial, they may view any efforts to gain ownership as a waste of time. Where a distressed company is for sale and employees are entitled to substantial severance or shutdown payments, they may consider it more lucrative to take such payments instead of supporting an employee buyout. In such cases, the union’s interest may be aligned more with job preservation through employee ownership than with the interests of existing employees.

If the alternative to an employee buyout is an LBO by a "financial buyer," then the employees should be concerned about the likelihood of workforce, wage, and benefit reductions being imposed on them so the corporation can survive its tremendous LBO-imposed debt load. If workers are operating under a collective bargaining agreement, they should expect demands for givebacks in the next round of negotiations. They may also fear that their highly leveraged company will be prone to failure in any future recession, or will fail simply due to lack of resources to invest adequately in capital equipment, research and development, and marketing.

All of these fears are well founded. If the likely buyer is a financial buyer who intends to use leveraged buyout techniques, the employees may as well buy the company themselves using an ESOP. If the company can be purchased on the same terms as a competing LBO, an employee buyout’s tax and other advantages will enhance the company’s viability. In this way, if the company is successful due to the workers’ sacrifices or any other reason, the employees will automatically reap the benefits of success through owning the company.

It is in the union’s interest to consider each bid before aligning itself with one particular bidder. Once aligned, however, it is not in the union’s interest to align itself with any other bidder. If the union did so, it would be bidding against itself. The union’s objective, if its members buy a company, is to pay the lowest possible price.

A union supporting an employee buyout with concessions will generally demand pass-through voting and representation on the board of directors for its membership. Typically, one third of the directors of such a board represent the salaried employees, one third represent the bargaining unit, and one third are composed of independent directors or directors representing cash equity investors.

In all of these cases, employees are faced with very personal and significant financial considerations and, like other buyers, will usually make their decision based on their assessment of the financial cost and benefits to them and their families. Employees virtually never invest their cash savings or pension assets in an employee buyout. Their "sweat equity investment" usually comes in the form of lower wages, salaries and benefits over a three to five year period.

G. Leveraged Buyout Financing Structure

Virtually all LBOs are financed with a combination of senior debt, subordinated debt, and equity. The amount of equity required in a transaction is determined in part by the amount of debt that can be borrowed. The following describes the various components of financing in a typical leveraged buyout.

1. Senior Debt
Typically 50% to 70% of an LBO’s financing takes the form of senior financing. A senior loan is collateralized by a first lien on the current and long term assets of the company. Senior financing is generally made available from banks, although privately placed notes to institutional investors are also possible, or a public issue of bonds is on occasion the source of senior debt.

2. Subordinated Debt
Typically 15% to 30% of the financing of an LBO is in the form of subordinated financing. These funds are subordinated to senior debt and generally have only second claim to the collateral of the company. Subordinated financing is generally made available directly from insurance companies or subordinated debt funds. Alternatively, it is raised with public offerings of high-yield ("junk") bonds to insurance companies, pension funds, and other institutional investors. In many LBOs, subordinated debt is given back to the seller, comprising a portion of the purchase price. The state or other public entities may be a source for such financing, usually on much better terms than market sources. The term of such financing is typically six to ten years, and principal payments are commonly deferred until after the senior debt is retired.

These funds are loaned based on the amount and predictability of cash flow exceeding that required to service senior debt. Interest costs can be anywhere from two to eight percentage points more than senior debt. Because subordinated debt usually has little collateral protection, it may be granted an "equity kicker" with the intention of providing the lender with a 18% to 25% compound annual total return over five years resulting from both the interest charges and equity kicker. (Figure 3)

3. Equity
Typically 10 to 20% of the financing of an LBO is in the form of equity financing. It is these funds that make up the difference in the financing requirement and the financing available in the form of debt. (Figure 4)

However, dividend and liquidation rights of equity investors are typically subordinated in an LBO to the interests of the secured lenders of the company. Liquidation rights are further subordinated to the unsecured creditors of the company.

Management usually invests in the equity of an LBO company together with a leveraged buyout fund, a corporate investor, or a group composed of institutional equity investors. The seller and subordinated lenders sometimes receive equity in the new company. An institutional investor investing in the equity of an LBO typically seeks a 30% to 40% compounded annual total return over five years, depending on the perceived risk. Note that these returns are only projections; the investor has no contractual rights to such returns like a lender has concerning interest charges.

In an employee buyout a similar proportion of equity capital in cash may be needed in the transaction. Such equity may come from management, from outside sources such as an LBO fund (ACS is a source for such capital) or other institutional investors, or from elections by employees to invest cash assets or to roll over a portion of their 401(k) or other pension fund assets into the new company’s ESOP (such direct investments by non-management employees is quite rare). Regardless of the source of the cash equity investment, cash equity investors must share ownership with the ESOP and the various rights of ownership must be carved up among all the equity investors. The dilution experienced by the non-ESOP equity investors is offset by the improved cash flows associated with ESOP financing and a favorable distribution of the various rights of ownership.

If the seller is prepared to take a subordinated note as part of the payment of the purchase price, or if local, state, or federal financing is available, an employee buyout can occur with little or no cash equity investments. Or, if the collateral value of the assets exceeds the purchase price, an employee buyout may be achieved without a cash equity investor. This is rare, however, and typically occurs in distress situations where the seller has no alternative buyers yet has substantial shutdown liabilities, and the workers are prepared to enhance the company’s cash flow by trading concessions for ownership (sweat equity).

H. Structure of a Typical LBO

The financing for an Employee Buyout is very similar to a LBO. The advantages for an Employee Buyout come from various improvements that can be achieved in the company's cash flows. These improved cash flows can be used to afford the highest price for the company or, more ideally, can be retained by the buyer to imporve the company's equity. The outline below models a typical LBO; the next section details how an ESOP can enhance the transaction.

         A Typical LBO

I. Advantages of Employee Buyouts over LBOs

The difference between the LBO described above and an employee buyout is that the ESOP will receive ownership rights to 51% of the common equity. The ESOP company will use the cash equity and proceeds from corporate borrowing, to pay the purchase price and cover other financing requirements.

The new ESOP company will make contributions to the ESOP over several years until the ESOP equity is completely allocated to the employees of the ESOP company. The amount of contributions to the ESOP must not exceed 25% of the company’s payroll, and could be lower if the company contributes to other benefit plans. Figure 5 illustrates the structure of a typical ESOP buyout.

The ESOP will enhance the cash flow of the company in a variety of ways but will also dilute the interest of any cash equity investor. Below are the ways an ESOP in the above example can enhance the transaction, offsetting the dilutive impact of the ESOP.

Principal Deduction
Contributions to the ESOP are deductible and the value of contributing stock to the ESOP will tend to rise annually as the ESOP company grows in value. These contributions will save the ESOP company taxes equaling approximately 40% of the amount contributed. Therefore, if the new ESOP company has equity value averaging $30 million over five years and the ESOP has a contractual right to 51% of the common equity, the ESOP company will have tax savings equaling approximately 40% of $15 million, or $6 million This increases the new company’s net worth by approximately $6 million over a five -year period.

Lower Interest Rate
The interest rate on the senior debt may be lower because an ESOP company has more cash flow available to service acquisition debt than in a non-ESOP leveraged buyout because of the tax savings noted above. Lenders recognize that this lowers their risk and as a result are prepared to charge lower rates. Interest rates are generally 85% of the rate charged in a non-ESOP leveraged buyout. Taking taxes into account, this increases the net worth of the new company approximately $300,000 over a five-year period. This is a relatively insignificant part of the enhancements the ESOP makes possible.

Enhancements to Earnings
The $5 million in earnings before interest and taxes in the above example can be enhanced with an ESOP because in exchange for the rights of ownership, employees and unions are often willing to make sacrifices in wages, salaries, work rules, and benefits. These sacrifices are often available only if the employees are involved in the establishment of the ESOP and their stock is endowed with all seven ownership rights described above, particularly voting rights. In addition, these sacrifices are generally more readily available if the future of the company is at stake or if the policies of the old company threaten job security. The enhancements are summarized below.

J. Debt Repayment

This dramatic improvement reduces the risk to the lenders, equity investors and employees, and makes the company much healthier. This improvement should also lower the projected rate of return thresholds that the subordinated debt and cash equity investors require. (Figure 6)

K. ESOP Financial Advantages

The financial advantages of the ESOP can be summarized by calculating the net present value of the cash flows associated with each advantage the ESOP brings to the new company. The tax savings associated with the ESOP contribution are available to the extent the company has income that can be sheltered from taxes. The risk of not having taxable income is taken into account by using a discount rate of 15%. There is little risk of the lower interest rate on the ESOP debt, so it is discounted at 10%. And there is little risk of the employee sacrifices not being obtained, especially if they are agreed to in a five-year collectively bargained agreement. We therefore use a discount rate of 10% for the cash flow associated with the employee sacrifices.

Since the debt is reduced more rapidly due to the various cash flow enhancements mentioned above, the company pays less interest than it would without an ESOP. The risk of this occurring is reflected by a discount rate of 15%.

The result of the discounting reveals that the ESOP provides an after-tax net present value of over $22 million to the employee buyout over the standard LBO. (Figure 7)

L. Net Worth

The net worth of the ESOP company in this example rises over a five-year period to nearly $35 million as retained earnings accumulate and the ESOP retires its debt. This compares to a net worth of only $13 million for the non-ESOP company. (Figure 8)

M. Enterprise Value

As Figure 9 illustrates, the enterprise value in the fifth year is projected to be only $39 million for the standard LBO whereas the employee buyout is projected to attain an enterprise value of $60 million. The enterprise value in this example is assumed to be six times operating income, plus cash, less outstanding debt. (Figure 9)

N. Stock Ownership Structure

The investor in the standard LBO must share equity only with the subordinated lender who, in this example, requires 11% of the equity. In the employee buyout, the equity investor must share equity with both the subordinated lender and the ESOP. The subordinated lender, however, needs only 5% of the equity to fulfill its required total return when all the advantages of the ESOP are accounted for. The employees receive stock whose value equals the present value of the ESOP-related tax savings enjoyed by the new company plus the present value of the after-tax value of the employee sweat equity sacrifices. In this example, these two values equate to the value of 51% of the total equity of the ESOP Company. (Figure 10)

O. Investor Returns

The internal rate of return to the investors who invest the original $6 million cash investment will be 34% in the employee buyout, which is 8% worse than in the LBO over the first five years. The various enhancements associated with the ESOP offset the dilutive impact of the ESOP on the cash equity investors’ return, but not enough to provide an identical rate of return. Offsetting the lower rate of return is the dramatically reduced risk to investors, since debt is retired twice as fast in the employee buyout as in the standard LBO. (Figure 11)

P. Employee Returns

The ESOP company would experience an approximately $6,309 reduction in compensation per employee annually. The after-tax, after-FICA impact to the employee would typically be about 87% of that number, or $5,475, depending on the form of the sacrifices. This would accumulate over five years to $27,375. The value of the ESOP account for the average employee will grow according to the projected enterprise value of the company to approximately $51,161 by the end of year five. The employees in this example achieve a 32% internal rate of return resulting from their sacrifices and the projected enterprise value of their ESOP account. (Figure 12)

Q. Conclusion

The many advantages of using ESOPs in the sale of corporations or divestitures of subsidiaries, divisions, or product lines are likely to continue to make this approach attractive in years to come. Aside from the substantial tax advantages described here, a sale to an ESOP can prevent a company from being on the market for an extended period of time, which can cause a decline in the company’s value; a loss of morale among employees; and uncertainty and concern among employees of the parent firm, who may wonder if they are the next in line.

The advantages of an employee buyout, however, may not be enough to outweigh other considerations non-ESOP buyers may bring to a transaction. If a buyer can gain a market edge or economies of scale by purchasing a company it may be willing to pay more than the employee buyout can pay for the same business based solely on earnings potential. Other outside buyers may be willing to pay more because they can realize special tax or other financial advantages that are not available to an employee buyout. In other cases, a company’s management may want to buy the company and may not want to share equity ownership with employees.

In many cases, though, an ESOP is not used simply because those involved with the sale do not know how it can be used beneficially. For the owners and the employees, this lack of familiarity with employee buyouts can come at the cost of a solution favorable to everyone. One hopes that as ESOPs become better understood they will assume their proper role as a major alternative in any divestiture.

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