MSP Acquisitions: ESOPs (Employee Stock Ownership Plan) Explained
Plenty of managed services providers (MSPs) explore mergers and acquisitions. But if you look closely enough, you'll also see MSP owners exploring another exit strategy. It's called the ESOP (Employee Stock Ownership Plan). The idea: Sell some or all of the company to its employees — the folks who built the business in the first place. I first heard about the ESOP strategy from IT Solutions CEO Ted Swanson in 2011. But in recent weeks, I've heard from three MSPs that are considering the ESOP strategy. Here's why.
Generally speaking, an ESOP can offer several key advantages, according to this Forbes article:
- Low risk of layoffs;
- Low risk of default on the acquisition debt; and
- Tax advantages to combate rising rates on ordinary income and capital gains.
According to the National Center for Employee Ownership (NCEO), about 11,000 companies now have ESOP plans — covering 13 million employees. The NCEO says there are three uses for ESOPs:
- To buy the shares of a departing owner: Owners of privately held companies can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to buy out an owner's shares, or it can have the ESOP borrow money to buy the shares.
- To borrow money at a lower after-tax cost: ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.
- To create an additional employee benefit: A company can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25% of covered pay) from taxable income. Or a company can contribute cash, buying shares from existing public or private owners. In public companies, which account for about 5% of the plans and about 40% of the plan participants, ESOPs are often used in conjunction with employee savings plans. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level.
The NCEO says the cost of setting up an ESOP can be $40,000 or more.
Where can you go for help? While I hesitate to endorse anyone specifically, Monroe Capital might have some insights. The company, which focuses on mid-market and lower mid-market companies, has launched a national ESOP lending practice. It's led by Managing Director Ty Dealy out of Atlanta, Ga.
Also, CSG Partners of New York and San Francisco has an ESOP practice — though I suspect most small MSPs operate below CSG's radar. The company says it has completed more than 100 transactions for companies valued at over $7 billion — numbers that might be too lofty for SMB-focused MSPs.
For more background, the Menke Group — an ESOP advisor — has in-depth information about designing, activating and administering an ESOP plan.
One favor: If you explore an ESOP approach let me know. I'd like to hear what path your company ultimately selects (ESOP, M&A or something else…) and why.