The financing landscape for ESOPs and employee-owned companies has expanded significantly in recent years. These financing alternatives include a broader menu of traditional debt sources and alternative forms of capital that had previously only supported private equity-owned companies.

Historically, senior debt from a commercial bank in the form of a revolving credit facility or term loan was the only source of financing for ESOPs and employee-owned companies. While commercial banks continue to be the predominant source of financing for both new and existing ESOPs, nonbank lenders, mezzanine debt funds, structured capital and even minority equity can serve to complement traditional bank borrowing as alternative forms of capital.

Commercial Bank Debt: Revolving Credit Facilities or Term Loan

ESOP companies most often partner with their existing commercial bank lender or pursue a capital raise process with new bank partners.  Commercial bank financing can take the form of financing under a revolving credit facility—whether asset-based or a cash flow revolver—or, more typically, under a term loan facility. Such a facility is secured by the company’s assets and generally leverages the EBITDA of the company. Revolving credit facilities and term loans provided by banks usually have five-year maturities with floating pricing based on the secured overnight financing rate (SOFR) plus an applicable margin reflecting the leverage and risk profile.

An ESOP company should seek to actively maintain a quarterly dialogue with its commercial lender or bank group around general business updates and understanding its debt capacity for organic and strategic capital needs. Typically, this represents a leverage threshold or multiple of EBITDA; or the ratio of senior-funded debt/EBITDA. While the financing markets continuously evolve based on economic and macro conditions, the bank financing market remains stable and constructive. After a relatively choppy and cautious lending market, banks have signaled that loan growth is a priority.  This has translated to favorable borrower terms from a leverage, pricing, covenant and terms standpoint.

The leverage environment largely depends on the size of the company, industry, and credit profile. Generally, senior debt/EBITDA ratios from banks top out in the 2.5x—3.0x range, with a strong underwriting focus on the ability to repay the loan contractually through structured amortization and to demonstrate covenant compliance under different sensitivity analyses. Banks usually focus on a maximum-funded leverage covenant and a minimum fixed-charge ratio as the primary financial covenants. General pricing for a bank facility will depend on the structure and credit profle. For instance, an asset based facility with full collateral coverage can be priced in the SOFR + 150-250 bps area while a cashflow loan would be priced around SOFR + 250-350 bps.

Nonbank Debt: Term Loan or Unitranche Facilities

The spectrum of nonbank financing alternatives for middle-market companies has expanded dramatically in recent years. Historically, this form of financing, provided by nonbank lenders, credit funds, business development companies, asset managers, and other institutional investors, was reserved for funding larger companies and companies owned by private equity funds.

Today, companies with as little as $50–100 million in annual revenues and $5–10 million in EBITDA can access capital from nonbank lenders as a complement to traditional bank borrowing or as an alternative source of capital. This universe of nonbank capital partners has further entered the ESOP space as a direct financing source for employee-owned companies.

Typically, nonbank financing embodies a term-loan structure or a hybrid unitranche credit facility that provides and facilitates funded leverage levels beyond that of a commercial bank. In exchange for this higher level of funded debt, nonbank credit facilities carry a higher cost of capital and can provide more flexible repayment terms.

A unitranche facility is a blended credit facility that combines senior and mezzanine financing or junior, subordinated debt into one credit facility versus having a separate senior bank and mezzanine debt facility. These facilities allow for higher leverage levels, typically in the 4.0x-5.5x area, depending on the credit, industry, and overall underwriting. In exchange for this higher financing level at close, nonbank financing can be priced at SOFR+500-600 bps with amortization or required repayment of as little as 1% per year with a bullet at maturity.

Mezzanine Debt

Mezzanine debt is a form of subordinated financing that can provide longer-term, incremental capital for M&A or other purposes beyond a company’s senior debt capacity. It is a highly flexible form of financing from a structure, rate, and tenure standpoint. Plus, it usually has customizable repayment terms that can be tailored to a company’s needs.

Mezzanine debt generally matures in seven-plus years and is priced with a combination of a cash pay coupon and payment-in-kind (PIK) component. In select instances, it includes warrants to provide incremental return opportunities. The all-in pricing for mezzanine debt is normally in the 12%–14% range, depending on the company size, credit profile, and other underwriting considerations. Mezzanine debt is also flexible from a repayment standpoint because it is typically interest-only for the first couple of years, providing the borrower with repayment flexibility.

From a leverage standpoint, mezzanine debt usually provides capital beyond a senior lender, up to 5.0x–5.5x total leverage. ESOP companies can use mezzanine debt to finance an acquisition when they have limited senior debt capacity or need to reserve their senior debt capacity for corporate operating purposes such as working capital. Accessing mezzanine debt for an acquisition does not require disrupting a current bank facility or relationship. Rather, it involves bringing in a mezzanine debt fund to provide junior or subordinated capital under more flexible terms in exchange for a higher overall cost of capital.

Mezzanine debt can provide that level of “hard to raise” capital to fund an acquisition instead of having to access equity capital that can prove challenging under an ESOP structure. Typically, mezzanine debt investors also like to get involved with supporting the company from a strategy and operating standpoint and will have board of directors observation rights.

Structured or Minority Equity via Drop-Down LLC

In select transactions, 100% ESOP-owned companies have secured structured equity or minority equity capital to complete a significant acquisition. This more transformative approach, as compared to debt financing alternatives, typically involves restructuring either the ESOP or the company to raise equity capital within the confines of an ESOP structure. Generally, this is achieved through a drop-down LLC structure. It permits an equity investor to provide capital while achieving the benefits of a pass-through structure and avoiding the complexities of subordinated notes, warrant/derivative structures, or second-class-of-stock issues within an S corporation. Within a drop-down LLC structure, the ESOP continues to own 100% of the S corporation, and a new LLC is created below the S corporation.

The LLC becomes the new operating company with the business’s assets, customers, contracts, and so on. The benefit of this structure includes the flexibility to establish outside equity for an acquisition, specifically for larger acquisitions where financing through debt alternatives would not be feasible. This maintains the benefits of the 100% ESOP-owned S corporation structure. However, many legal nuances exist, so it is important to thoroughly vet and understand the implications of the required restructuring and related costs in advance with attorneys and other advisors.

ESOPs enjoy more flexibility in raising equity capital under a C corporation structure since no restrictions exist concerning a second class of stock. As long as the ESOP owns the highest and best class of stock and the transaction meets the relative fairness guidelines for ESOPs, equity capital can be raised under a C corporation ESOP structure for an acquisition.

As ESOPs evaluate current or future capital needs, a broad and expanding landscape of capital alternatives exists. This menu of capital available to ESOPs is expected to continue to grow, reflecting the breadth of capital available today and the strong interest from lenders and investors in supporting employee-owned companies.