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Committees : Compensation

Using an ESOP to Raise Capital

November 10th, 2011 |

Privately held community banks have had a tough time raising capital during the financial crisis and its aftermath. Investors are cautious and community banks have been especially challenged due to the economy’s troubles and investors’ desire for liquidity. One option for those banks is an Employee Stock Ownership Plan, or ESOP. Basically, an ESOP is a tax-qualified retirement plan that benefits all employees who meet certain criteria, such as 1,000 hours of service. An ESOP can use the tax deductible contributions made by a bank or bank holding company to purchase newly issued stock, thereby returning the cash to the balance sheet of the bank or holding company. These funds improve capital strength and could also be used to repay funds to the federal government’s Troubled Asset Relief Program. W. William Gust, J.D., L.L.M. of Corporate Capital Resources and Andrew Gibbs of Mercer Capital discuss some of the benefits of ESOPs and how they might help a bank raise capital.

How does it work?

The bank or bank holding company makes contributions to an ESOP, either in stock or cash, subject to certain limits. These contributions are allocated among participants in proportion to compensation or compensation plus length of service. An ESOP may use its cash to purchase newly issued shares or existing shares held by non-ESOP shareholders, as well as to purchase shares from participants exiting the plan.

What are the benefits of ESOPs for a bank?

Unlike retirement plans such as 401(k)s, ESOPs can purchase shares of the sponsoring S or C corporation. An ESOP can borrow money to purchase stock. Principal payments on the acquisition loan are tax-deductible. The ESOP is treated as a single, tax-exempt shareholder. S corporation ESOPs do not face the tax liability that otherwise would pass through to shareholders. As a hypothetical example, if the bank contributes $100 to the ESOP, it could save $40 in taxes and use the savings to purchase more bank stock, either to repay TARP or meet other capital raising goals. Because contributions are tax-deductible, purchasing newly issued shares is accretive to total equity, although the transaction would dilute the ownership interest of non-ESOP shareholders. While TARP requirements preclude key executives from non-qualified and discriminatory plans, they do not apply to ESOPs.

Why do banks make more use of ESOPs than companies in any other industrial classification?

Closely held banks often need a mechanism to acquire shares efficiently. An ESOP permits containment of the number of stockholders through an untaxed mechanism ultimately under the governance of the board. Most bank ESOPs are minority-interest owners.

What benefits do they have for participants?

The participants receive a retirement benefit as an equity interest in the sponsor at no cost to themselves. ESOPs typically reward loyal, long-term employees through vesting schedules, eligibility rules and the like, which cause the bulk of the plan assets to accumulate in their accounts.

In what instances would an ESOP not be appropriate?

ESOPs require a profitable sponsor, the ability to create value over time and a sufficient number of employees to meet the various compliance tests. Companies with fewer than about 25 employees or profits below about $500,000 (pre-tax, pre-ESOP) are not suitable, though there are exceptions. Since they have a market, widely traded public corporations do not often use ESOPs. Highly leveraged ESOPs often are inadvisable.

Who controls the stock?

The trustees are the legal owners who vote the stock for private corporations, except for major transactions. Participants in public company ESOPs vote all shares allocated to their accounts.

How is value established?

The trustee establishes value. For privately held banks, the trustee engages an independent appraiser to value the stock. Valuing banks in the current regulatory and economic environment is challenging; banking industry and ESOP expertise should be key considerations for the trustee in appraiser selection. Appraisers will consider numerous factors and apply specific valuation methods considered most appropriate. Draft regulations from the U.S. Department of Labor provide guidance specific to shares held by ESOPs.

Bill Gust is president of Corporate Capital Resources and a partner in Gentry Locke Rakes & Moore. He has helped closely held corporations and financial institutions develop and integrate business succession and estate plans for over 20 years.

 

akgibbs

Andy Gibbs leads Mercer Capital’s Financial Institutions Group, where he provides valuation and corporate advisory services to financial institutions for purposes including ESOPs, estate and gift tax planning, corporate planning and reorganizations. 

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