Major Improvements to ESOP SBA Financing

Under a special program sanctioned by federal law, the Small Business Administration (SBA) provided guaranties on certain senior bank loans used in leveraged ESOP stock purchases. The federal guaranties were designed to provide partial credit loss protection for banks that would otherwise shy away from such loans. On the face of it, this sounded like a lucrative government program for the ESOP world, however the SBA law's restrictions under this program were so onerous, obscure and, in many instances, counter-productive, that ESOP bank loans using the SBA guarantee were as scarce as hen's teeth. In fact, of all the leveraged ESOPs I've been involved in, only one transaction fell within the SBA ESOP loan program.


After many years of lobbying by the ESOP industry, modifications to some of the SBA ESOP financing law were amended through legislation that was signed into law on August 13, 2018. These changes were designed to make SBA ESOP financing more practical and generally the changes will foster more SBA financing for leveraged ESOP transactions. A summary of these enhancements follows:

  • Back to Back Loans

The vast majority of leveraged ESOPs involving external financing use a technique called a "back-to-back" loan. This structure involves a bank lending directly to the company (not the ESOP). The company then lends the proceeds to the ESOP which uses the cash to purchase company stock. The reason for this structure primarily threefold:

a) banks and other senior lenders want to lend to an entity that has assets and cash flow and the company accomplishes this whereas the ESOP does not;

b) loans made to an ESOP are difficult to restructure due to ERISA rules; and


c) the term of debt borrowed directly by the ESOP (as opposed to a loan taken out by the company) drives the allocation of the shares purchased by the ESOP. Banks typically finance over 5-7 years and therefore if the ESOP borrowed directly from a bank to purchase shares, then all of the shares would be allocated in the 5-7 year period. This might be fine for an ESOP buying a minority stake in a company, but with the popular 100% leveraged ESOP stock purchase this would allocate too many shares too quickly: employees who join the company after that 5-7 year loan period would essentially not be able to receive meaningful allocations of shares in the ESOP because shares would have been previously allocated. This causes an unsavory "have and have-not" situation amongst the employees. The compressed allocation period also may potentially create a concentration of ESOP repurchase obligation issue whereby the company is forced to buyout large blocks of stock from employees who leave the company. Hence, the back-to-back loan allows the bank to finance directly to the company and then the company can re-lend the proceeds to the ESOP over a much longer (sometimes 20-40 years) to avoid the "have and have-not" scenario and reduce repurchase liability issues. Under the prior law, the SBA required that the bank financing be made only to the ESOP and therefore back-to-back loans for the SBA guaranteed debt were prohibited.

The new legislation changed this requirement and now the SBA guaranteed bank loan can be made to the company directly, thereby allowing the back-to-back structure.

  • Selling Shareholder Involvement Prohibition

Under the previous law, the SBA prohibited the selling shareholder from remaining involved in the company after the SBA-financed leveraged ESOP transaction occurred. A vast number of leveraged ESOP transactions facilitate a gradual exit of shareholders who are actively managing the business. Furthermore, many selling shareholder will seller-finance the transaction and they are reluctant to throw the keys to an upcoming management team and simply hope to get repaid. Finally, from a management transition standpoint it is more prudent to keep the experienced managers involved. Hence, this SBA requirement was adversely restrictive.

The new law thankfully eliminates this impediment on leveraged ESOP buyouts whereby the ESOP acquires at least 51% of the company's stock, however the selling shareholder will be required to guarantee the SBA loan. While this personal guarantee is still suboptimal, the elimination of the overall restriction on shareholder involvement is a positive development.

  • Required Co-Investment

Under prior legislation the SBA required that a simultaneous "equity" investment equal to 10% of the ESOP buyout be co-invested at the time of the transaction. On the surface this looked problematic: it was highly unlikely that a private company would be successful in finding a co-investor to make a co-investment of upwards of $500K alongside a leveraged ESOP buyout. Upon further review it became clear that "equity" included any seller note financing (although cash interest payments would be prohibited for the notes to be considered "equity").

Under the new legislation the SBA will now have discretion to waive this requirement.

  • Use of Proceeds

Under the prior law, the SBA-backed financing could be used solely for the ESOP stock purchase.

The new law allows the company to use the proceeds to pay for transaction fees in addition to financing the ESOP's stock purchase.

There are other facets to the new law that provide some positive modifications, but the changes noted above are the most meaningful. While SBA financing will still be cumbersome, the added credit enhancement provided by the SBA will hopeful spur more ESOP bank loans and, as a result, more ESOP transactions.

AUTHOR:   James F. Higgins Jr.

POSTED IN:   Finance

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