Susan Hoesly, CFA

Principal, Verit Advisors

Recently, there has been an uptick in the number of conversations ESOP companies are having about buying other companies, The NCEO estimates at least 400 acquisitions by ESOPs are done annually.

As ESOPs have grown and matured, in many cases, their internal growth has slowed. As a leader at a longstanding, mature ESOP said, “If revenues don’t continue to grow faster than expenses, share value for employees will decline.” When done strategically, inorganic growth, or buying other companies, can be a compelling tool to drive earnings growth and stock value.

There is a real opportunity for companies pursuing M&A for several reasons. First, it can increase revenue growth, either simply because the target has greater growth or the combination accelerates the acquirer’s internal growth through revenue synergies such as access to new end markets, new geographies, new products, or new technologies.

Second, it can lead to margin expansion. Again, this can be a result of the target contributing higher margins, or there may be something about the combination that reduces overall costs relative to revenues (cost synergies), such as economies of scale, consolidation of functions or overlapping capabilities, or improved efficiency.

An extremely powerful cost synergy, unique to 100% S corporation ESOPs, is buying a tax-paying business and paying no income taxes on the earnings once it is acquired. This synergy can give ESOPs a leg up in a competitive auction over other tax-paying bidders, facilitate faster transaction debt repayment, and ultimately lead to more value creation for the employee-owners.

Finally, there are other, more qualitative benefits to acquisitions, the most notable of which is diversification. When a company adds a market or product line, it reduces the risk that an event or shift in the market could negatively impact the entire business at the same time. Thoughtful diversification, when not dilutive to the company’s core, can be operationally beneficial; for example, it can increase access to credit, as well as add more directly to the ESOP valuation by supporting a lower discount rate.

Of course, there are challenges with acquisitions. Acquisitions take a lot of time, effort, expertise, and resources. Companies need a thoughtful strategy, management time to find and evaluate targets, an understanding of the market and how to execute transactions, teams and systems to integrate the assets and people once acquired, and the capabilities to drive combined future success.

Another key roadblock for companies considering acquisitions is having access to sufficient capital to finance the transactions. In the case of ESOPs, this can be even more challenging given the initial transaction debt early on or the eventual need to fund repurchase obligations. The availability of capital is also heavily dependent on external factors such as the health of credit markets and broader macroeconomic trends.

Last but certainly not least, growth through acquisition involves risk. While this is true for all companies, there is again a nuance for ESOPs that is important. As one ESOP CEO said, “When our company takes a large risk, we are risking employees’ retirement accounts, whereas private equity is playing with qualified institutional investors’ money.” This concern is incredibly valid and merits the weight that CEOs place on their decisions as a result. That said, it is a myth that any M&A is highly risky and therefore ESOPs should not engage in it.

The risk with M&A is not uniform and can be managed. Typically, companies that want to begin acquiring start small and close to home. For example, they acquire a smaller competitor they have known for years through a trade association. By doing this, the acquiring company can go through the process, learn along the way, and build its capabilities without betting the farm.

Additionally, while buyers need to understand and work within the broader transaction market if they intend to entice sellers to sell, acquirers can be conservative and thoughtful when they project the benefits of a given transaction. Importantly, acquirers also need rigorous policies in place so that they can make the decision to walk away when the economics do not make sense.

The other important piece of the risk conversation with M&A that often gets missed is that there can be risk to inaction as well. If an industry is consolidating and a company does not grow or evolve, it is likely to become less competitive over time. Likewise, acquiring a new technology or accessing a new channel to market can be necessary to compete in a shifting market. For this reason, it is important that all companies, including ESOPs, thoughtfully evaluate the risks of M&A relative to their own strategy, strengths, and weaknesses rather than buying into the myth that any M&A is too risky to consider.

Though ESOPs have not historically been significant buyers of other companies, the data is promising that they can be very successful acquirers. Studies show ESOPs have greater stability, better business performance through the cycle, and structural flexibility. Additionally, anecdotal reports from ESOPs that have pursued acquisitions indicate that sellers are often drawn to ESOPs as buyers for their culture, the way the target’s employees will be valued going forward, and the ability to continue to participate in equity growth if an owner chooses.

While many ESOPs are still in the early stages of capabilities learning about inorganic growth, the acquisition opportunity represents an exciting avenue for ESOPs to continue to grow and evolve—to continue their legacy of creating value for their employee-owners.