With proper planning and execution, a leveraged ESOP can provide benefits to all parties of the transaction, including the company, the owners, the employees and lenders.
The typical leveraged Employee Stock Ownership Plan (“ESOP”) transaction is described below.
The company borrows money from the lender, typically a bank (“Bank Loan”). The company then loans the proceeds from the Bank Loan to the ESOP, creating an ESOP Loan. The ESOP Loan is sometimes referred to as a “mirror loan” as the terms are often identical to the Bank Loan. The ESOP purchases stock from shareholders using the cash from the ESOP Loan. As a result, the ESOP holds shares of stock in a suspense account (pledged as collateral for the ESOP Loan), and the shareholder(s) now have cash.
Each year, the Company makes tax-deductible employer contributions to the ESOP (or pays tax-deductible dividends on the stock held by the ESOP). The ESOP uses the cash from the contributions to make payments on the ESOP Loan. As the ESOP Loan is paid back, shares of Company stock are allocated to ESOP participant accounts.
The Company has the cash it used for contributions and the ESOP has simply acted as a conduit for the cash. The Company can now use the cash to make payments on the Bank Loan. The contributions were returned to the Company as principle and interest on the ESOP Loan. If the ESOP Loan and Bank Loan are “mirrors”, the Company has received sufficient cash to make the Bank Loan payments.