A Look at Funding ESOPs Via Pension Plans and Some Insights on Which Situations Might Best Fit this Approach
Earlier this year Taylor Guitars made big news when it became a 100% ESOP company. The business, which is well known for its high-quality instruments, suddenly was making news for its unique approach to becoming an ESOP. Taylor Guitars’ ESOP transaction employed funding from three different sources:
- A Canadian pension plan, named Healthcare of Ontario Pension Plan.
- A Canadian impact investor, Social Capital Partners.
- Company founders Kurt Listug and Bob Taylor.
This groundbreaking approach is believed to be the first time ever that a pension plan of any kind invested directly in a company’s transition to an ESOP. Is this potentially the start of a new approach to ESOP funding? Will other companies be able to follow in the footsteps of Taylor Guitars? And if so, what situations and types of firms are best suited to this funding option?
Succession planning is vital to Barbara Wight, CFO at Taylor Guitars. She once worked at a company that had no succession plan and suffered the consequences when a founder passed away suddenly and unexpectedly. To avoid that fate, she asked about succession planning when she interviewed with Taylor Guitars nearly 12 years ago. When she was hired, she actively addressed the issue.
Wight helped develop an initial buy/sell succession plan, but when the company outgrew that approach, it reached out to Chartwell advisors, which laid out the available options—including forming an ESOP. The sustainable, long-term approach of an ESOP fit the culture at Taylor Guitars extremely well, says Wight, who sums up the company’s view this way: “We plant forests that are going to be there 100 years from now, and we can’t even harvest that wood for 80 years.”
Chartwell introduced Taylor Guitars to Social Capital Partners (SCP), a non-profit impact investor in Toronto. After years examining various solutions to economic justice, SCP determined that ESOPs are the best way to increase access to wealth building on a mass scale. The problem: Current Canadian laws do not permit the formation of ESOPs as they are known in the U.S. (SCP is working to change the laws and appears to be having some success.)
What Canada does have is an unusual resource for funding. Taylor Sekhon, Director at SCP, says that “Canadian pension funds are quite active as direct investors,” an approach that is “less common in the U.S.” Sekhon says the Healthcare of Ontario Pension Plan (HOOPP) is particularly sophisticated at managing direct investments in businesses. SCP partnered with HOOPP to offer financing to Taylor Guitars, and the three organizations succeeded in finding rich common ground.
Wight says Taylor Guitars was able to select from a variety of funding options, most of which ended up being largely similar. But the pairing of HOOPP and SCP offered important benefits and a unique fit with Taylor Guitars’ values. The long-term approach inherent to a pension plan made it easier for the parties to agree on funding with a 10-year horizon (as opposed to the five-year options offered elsewhere).
The deal offered something of value to all the parties.
Taylor Guitars received funding that is flexible, enabling the business to retain options for investing in future efforts to innovate and to grow the company.
That flexibility is also vital for another reason: managing repurchase obligations. Taylor Guitars’ initial ESOP allocation is particularly generous, designed to reward long-term employees who are nearing retirement age and may have a limited number of years in which to grow their ESOP accounts. This approach means repurchase obligation pressures might materialize more quickly than a typical new ESOP company might experience. The flexible lending arrangement makes it easier to address repurchase concerns, which can be a significant financial strain for ESOP companies that fail to plan for them.
Taylor Guitars also felt good knowing that as it repaid its loan, it was helping to fund a pension for healthcare employees in Canada—an approach that helps fund retirement plans for employees on both sides of the border.
SCP was able to help bring attention to a new approach to financing ESOP transactions, one that benefits both the lender and the borrower. The organization believes that by demonstrating the viability of pension fund investments in ESOPs, a new, large pool of capital can be unlocked to help grow the market. The positive media attention also may be helping SCP’s advocacy efforts: The Canadian government has agreed to investigate the potential of new laws permitting the formation of ESOP-like employee trusts in that nation.
HOOPP receives a long-term reliable source of income from a mature, well-run business with low risks. One of the factors that made Taylor Guitars such an enviable partner for HOOPP, says Sekhon, is that its management team is deep and very experienced, leading to a comfort level with how the business is run.
Another factor, he says, is that founders Listug and Taylor also financed part of the deal, ensuring they’re aligned with HOOPP and SCP as lenders. The fact that both founders have no immediate plans to leave the company provided additional organizational stability.
A third element also certainly worked in the company’s favor: The instrument maker entered the deal with zero debt on its books, according to Wight.
Sekhon says there is a fourth group that can benefit from this new approach: service providers. The Taylor Guitars example provides another option advisors can offer to clients that are considering an ESOP.
Behind the Deal
Taylor Guitars spent seven years planning for their eventual ESOP transition. Wight is quick to point out that many companies can transition to an ESOP more rapidly, but for Taylor Guitars that careful and deliberate timeline afforded the business some significant advantages.
First, the company had time to transition from being a C corporation to an S corporation, prior to becoming an ESOP; that enabled the business to benefit from the favorable tax status afforded to S corporation ESOP companies.
The long timeline also gave the instrument maker time to shed debt. “We made sure we did not have one stitch of debt on our balance sheet the day we completed the transaction,” says Wight. That made financing easier and created a clear and powerful message to share with employee owners: “We built this house together, and the only debt we have is for this house,” says Wight.
Perhaps one of the biggest advantages of this approach is that the company had the ability to carefully consider all its options when becoming an ESOP—including pension fund financing. Because of the groundbreaking work of Taylor Guitars and its partners, other businesses may have an easier time working with a pension fund to finance their ESOP transactions.
Can Others Follow Taylor Guitars’ Example?
Pension fund financing for ESOP transactions is typically best for larger companies, says Sekhon, because pensions typically are geared to make larger investments, rather than smaller ones.
A large enough company might be able to meet the threshold even if it purchases ESOP shares in tranches; a medium-sized business might need its ESOP to purchase all the company’s shares in a single tranche, says Sekhon. SCP can also help mature ESOPs recapitalize and is working with pension funds interested in these kinds of investments.
The easiest match between an ESOP and a pension, he says, is one like the situation with Taylor Guitars that involves a larger company, a single transaction, manageable risk, a strong management team, and a well-considered succession plan.
Sekhon sees pension funds as merely another option ESOP companies can consider. SCP hopes that by bringing this additional capital to the ESOP market, they can increase the cash available to business owners on closing and make it easier for more owners to pursue ESOPs over private equity offers. For some selling shareholders, a different approach to ESOP financing might make more sense.
For Wight, the long-term view inherent to pension plans bred the long-term view on financing and the flexibility that worked well for her company, and for her as a CFO. “We did not want the debt from the ESOP transaction to tie our hands and prevent us from making the kinds of long-term decisions we have always made,” she says. Knowing that all the partners involved had the same timeline horizon “lets me sleep really well at night.”
She adds that finding financing partners whose values match those of the company is key. “I would say this type of financing is a match for a company that has a social dimension that is a critical part of the DNA of the company and that is really looking for a long-term horizon,” she says.
Cross Border Collaboration
The Taylor Guitars ESOP transaction includes interesting international elements.
For starters, the ESOP has been extended to the employees working at the company’s plant in Tecate, Baja California, Mexico—apparently the first time an ESOP has been offered to all of a company’s employees in that country. Taylor Guitars also has offices in Amsterdam, and while it was impossible to extend the ESOP there for legal reasons, the company has worked hard to mirror the ESOP for its employees in the Netherlands.
The funding for the plan, of course, came from a pension plan in Canada—leading to perhaps the most interesting long-term aspect of this ESOP transition: If the U.S. were able to adopt the direct investment approaches that are more popular in Canadian pension plans, and if Canada were able to adopt U.S. laws that make ESOP formation readily available, it could start an international surge in the number of businesses owned by their employees.