Several founder owners who are considering selling their company to an employee stock ownership plan (ESOP) have asked whether ESOP-owned companies can make acquisitions. This question usually arises from an opportunistic perspective, where they wonder if they sell their company to an ESOP and then encounter a compelling acquisition opportunity, such as a competitor in need of selling, would they be able to capitalize on it.

The short answer is yes, ESOP-owned companies can indeed acquire other businesses. In fact, there are several large and mature ESOP-owned companies that have incorporated buying other companies into their business model and overall strategy. These companies have accumulated significant cash balances over the years or even decades under the tax-advantaged ESOP structure and are now seeking to redeploy that capital.

As acquirers, ESOP-owned companies enjoy several advantages over other buyers. The first advantage is intangible: the seller may prefer the ESOP as a buyer because it benefits their employees and preserves their company’s legacy. The second advantage is tangible: depending on the structure of the buyer and seller, the seller may be eligible for a deferral of capital gains through section 1042 on the Internal Revenue Code. This deferral can significantly boost the after-tax proceeds received by the seller compared to an alternative buyer. Although the structure of such transactions can be complex, with the right circumstances and advisors, these advantages create a win-win scenario for all parties involved.

However, the acquisition equation for newly formed ESOPs is quite different from that of mature ESOP companies, especially for companies that undergo a full 100% ESOP sale. Since newly formed ESOPs are typically funded with debt, the primary focus for the first several years is generally repaying those debt obligations and building equity value for the new employee participant-owners. Initially, newly formed 100% ESOPs have limited capacity for additional debt, and as the sole shareholder, the ESOP cannot provide equity funding for acquiring another business—like other owners can. Consequently, newly formed ESOPs (those transitioning from zero to 100% ESOP ownership) do not typically enter the structure with a plan to be immediately acquisitive. Owners who intend to pursue acquisitions in the near term would opt for an alternative variation of the ESOP structure, such as a phased approach where owners sell a portion of their company to the ESOP over several transactions, or a contributory ESOP structure.

Nevertheless, newly formed ESOPs may come across unexpected opportunities to acquire companies that are too good to ignore. Some, fueled by growth, may be able to fund small acquisitions relatively early on in the structure. More likely, if they lack the necessary cash or debt capacity for an acquisition, they can seek equity partners to invest alongside the ESOP or utilize various structuring techniques, such as deferred proceeds, to bridge any potential capital gaps.

While many ESOP companies are 100% owned by their ESOP, it’s important to consider that alternative ownership structures exist. ESOPs can successfully coexist alongside other equity capital partners, whether it be the original owners, or new equity investors. In this case, bringing on an institutional investor with experience and an appetite for acquiring other businesses could be an ideal fit. Further consideration can be given to sources of capital with investment criteria and values that align with the ESOP, including long-term, patient, and ESG-focused sources of capital. ESOP companies seeking acquisitions should work with capable advisors to establish a comprehensive plan and may discover the possibility for more profound options than expected. When appropriately structured, a hybrid ownership model not only offers tax efficiency and the capacity to deploy fresh capital for acquisitions but also brings together strong partners with aligned values and objectives.

If you are an owner considering a sale to an ESOP, you likely have many questions and concerns, such as the possibility for opportunistic acquisitions early in the ESOP structure. At ButcherJoseph, we understand the intricacies of ESOP transactions and have extensive experience assisting founder owners navigate the complexities of succession planning. We offer a complimentary feasibility study that examines all relevant considerations for a successful succession event. Our expertise and personalized approach ensure that owners have a clear understanding of all their options, whether involving traditional buyers or an ESOP, empowering them to make informed decisions that best align with their goals.