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New Law Eases SBA Financing Rules For ESOPs

Small business owners looking to convert their organization to an employee-owned company may have an easier path thanks to a new law signed by President Donald Trump last year.

Before the law was passed in August 2018, the rules surrounding loans backed by the Small Business Association (SBA) used to create Employee Stock Ownership Plans (ESOPs) often discouraged small business owners from using this valuable succession-planning and employee-retention tool. The new provisions, found in the John S. McCain National Defense Authorization Act, streamline and modernize some of the rules that previously had made ESOP financing cumbersome—or in some cases prohibitive—for many small business owners.

ESOPs as an Exit Strategy

As baby boomers approach retirement, more small business owners are looking for ways to generate liquidity for their equity while also rewarding employees and maintaining the corporate culture that the owner worked so hard to build. ESOPs can be an effective tool for accomplishing all of these goals. According to the National Center for Employee Ownership, there are 6,717 ESOPs operating nationwide covering 14 million participants with $1.3 trillion in assets.

ESOPs are a type of qualified defined contribution plan that invests primarily in company stock, which is distributed to employees. The company either borrows money or uses cash on hand to purchase the owners’ shares on behalf of the employee participants. Then the shares are distributed to employees’ ESOP accounts, which are held in a trust, over time. When participants leave the company or retire, the stock they own gets cashed out of the ESOP.

How the New Law Encourages ESOPs for Small Businesses

The new law includes several significant changes that will make it easier for business owners to secure financing through the SBA to establish an ESOP. It also contains a provision for the SBA to create outreach programs as well as an interagency working group to promote employee ownership.

The most significant changes in the law include:

  • Business owners are now allowed to obtain loans through the SBA’s preferred lenders instead of having to go through the SBA itself, which can be a slow and bureaucratic process.
  • SBA loans for ESOPs can be made directly to the company, so long as the ESOP trust owns 51 percent of the organization. Previously, SBA loans had to go the trust, which made the underwriting process more difficult.
  • Business owners can remain involved in the business following the creation of the ESOP. Previously, owners were prohibited from easing out of the business over time if an SBA loan was used to create an ESOP. Under the new law, as long as the ESOP owns 51 percent of the shares, the seller shareholder can remain an owner, officer or other key employee in the organization. Sellers who remain as owners must provide a personal guaranty for the SBA loan.
  • ESOP transaction costs can be folded into SBA loans. Previously, these loans couldn’t pay for costs associated with setting up an ESOP, but the new law reverses this policy.
  • Previously, owners needed to contribute equity equaling at least 10 percent of the total transaction cost when securing an SBA loan. Under the new law, the SBA can waive this requirement on a case-by-case basis. 

Time to Take a Second Look at ESOPs

Now that the SBA loan process has been streamlined and some of the eligibility rules have been eased, owners of small businesses who previously feared that SBA financing, or even traditional senior financing vehicles, would not be available to establish an ESOP may want to take a second look. In addition to the more borrower-friendly underwriting process, the opportunity for the owner to remain involved in the company after the establishment of the ESOP may make the plans significantly more appealing for owners who want to gradually phase out of the business.

In addition to the new rules, there are many other factors to consider when evaluating whether an ESOP is appropriate for your organization. If you are interested in learning more, The MFA Companies® can answer any questions you may have about how an ESOP could affect your business, your employees and your exit strategy. Also, the SBA is still in the process of finalizing its guidelines related to the new law, so we will provide additional updates when those rules are completed. 

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