Key differences between ESOP and Management Buyout (MBO)

Employee stock options plan (ESOP) and management buyout (MBO) are two common options in planning an exit strategy. There isn’t a particular exit plan that is subscribed to work for every business owner moving forward. Helping ensure you comprehend the fundamental distinctions between corporate transition planning choices. This article will compare Employee stock options plan and management buyouts. With this article, the reader can understand ESOP and MBO differences, management buyout planning, management buyout financing, and how to cash out ESOP.

ESOP and Management buyout (MBO)

ESOP and MBO are common options for a company transitioning. They do, after all, entail the sale of an existing company to its present workforce. There are many reasons for selecting one transition route over another and the contrasts between MBOs and ESOPs. Evaluating the two side-by-side, as well as the vision and objectives of these two exit options, is encouraged when selecting between an MBO or ESOP. 

What is an Employee stock option plan (ESOP)?

An ESOP is a qualified retirement plan that designates an ESOP trust as a buyer to establish and fund the acquisition of company shares. Funding for the ESOP trust may come from seller notes, loans, or a mix of the two. ESOP of employees eventually becomes fully vested after allocating acquired shares to individual employee accounts.

How does an employee stock options plan work? 

Employee stock ownership plans (ESOPs) offer employees stock options to purchase shares, promoting business growth and fostering employee investment in the company’s success. As part of an incentive package, ESOPs encourage employees to increase share value, providing tax benefits to owners and helping retain top talent. To protect the business, a vesting schedule is often implemented; employees who leave before full vesting may lose their shares, while fully vested employees can become shareholders or have their shares bought back by the company upon departure.

Types of ESOP

Below are some examples of the various ESOPs currently offered to workers:

• Employee Stock Option Scheme (ESOS) – Employee ownership is most often expressed via employee stock option schemes. The employee is given a right, but not a requirement, by choice offered under the plan. Vested stock options demand continuing service for a certain amount of time. Employees may exercise their options to acquire shares once they have vested by paying the predetermined exercise price.
• Restricted Stock Units (RSU) – An employee is granted the right to acquire shares on a certain date under the Restricted Stock Units Plan, subject to the happening of a specific event or the satisfaction of a specific set of criteria. In these incentive systems, the employee only becomes a stakeholder following a predetermined event or the satisfaction of certain requirements.
• Phantom Stocks – Phantom stock is a kind of long-term deferred compensation where the value of the delayed payment is determined using the worth of the company’s equity. While it resembles Company stock in every way, actual ownership is not shown. Only the firm records these shares, and as the worth of the company’s stock grows and decreases, so does the phantom stock.
• Stock Appreciation Rights (SARs) – Even though SARs are not officially employee stock options, businesses utilize them similarly. SARs provide individual employees cash payouts equating to company shares growth over a certain period. SARs provide company workers equity gain without any downside risk, in contrast to other choices.
• Employee Stock Purchase Plan (ESPP) – Employees could buy the company’s shares via employee stock purchase plans, sometimes for less than fair market value. The plan’s provisions set out the duration and cost of the Employees’ ownership of Company shares. ESPPs are typically designed to provide shares as a component of public offerings.

Benefits of ESOP in companies

The following are some fundamental advantages of an ESOP:

• A corporation may be able to hire and keep highly qualified personnel with the help of an ESOP.
• Allowing people to get equity for their efforts fosters employee loyalty to the organization.
• Employee stock ownership plans (ESOPs) provide job stability, non-cash perks, and work satisfaction.
• Employees take on more responsibility for the business, encouraging them to engage in decision-making actively.
• It guarantees workers a decent retirement.
• Offer financial rewards like increased income, share perks, and wealth creation.

How can employees cash out ESOP after quitting? 

According to the ESOP plan, you would receive free company shares if you had an employee stock ownership plan. Additionally, following the terms of the ESOP plan agreement, you may anticipate receiving payments if you elect to quit the business, become incapacitated, or resign from your position. Additionally, you could not get payouts for up to six years if you were fired or left work.

What is a management buyout? 

A business’s existing key management team or employee can buy the company from the owners or stakeholders through an MBO. Most MBOs are leveraged deals since the acquisition almost always entails borrowed funds. Because an MBO may satisfy the requirements of both parties involved in the transaction, the management team and firm owner often accept one:

• The owner is confident in the management team’s dedication to the company’s long-term success, knowledge of the industry, and capacity to operate consistently.
• The management group is interested in the motivation and possible reward of overseeing the business’s continuous expansion.

How does management buyout work?

Management buyouts (MBOs) involve a company’s management purchasing the business they oversee, including its assets and liabilities, often to drive expansion and financial success. These transactions are common exit strategies for larger businesses streamlining assets or private owners looking to retire. An MBO typically requires significant funding, often through a mix of loans and stock from buyers, lenders, and occasionally the seller, resulting in leveraged buyouts that rely heavily on borrowed funds. Post-MBO, management gains ownership benefits but must adapt to increased responsibility and risk as owners rather than employees.

Benefits of a management buyout

Hedge funds and huge financiers see management buyouts favorably as investment opportunities. They often push the firm to go private to simplify operations and increase revenues out of the public spotlight. They are urged to go public at a considerably greater value eventually.

If a committed management team is in place, a private equity firm that supports an MBO will provide a competitive price for the asset.

Things to consider when approaching management buyout

If you’re a member of the management team looking to purchase the present company from the owner or owners, you’ll have to be careful how you go about it.

• Prepare a well-thought-out proposal detailing your motivation for purchasing the company, your estimation of its value, and your financing plan.
• Make sure you do due diligence, including developing a financial model and conducting careful business valuation research.
• It’s critical to understand which company’s executives will take part in the buyout and which won’t. 
• Decide on a fair method of allocating equity in the deal.

How to finance management buyout?

MBOs often demand significant capital. The following funding options are available for MBO:

• P/E financing – The management will often turn to private equity groups to finance most buyouts if banking institutions are hesitant to lend. The management can also get a loan, although private equity groups may provide financing in return for a percentage of the company’s shares. To bind the managers’ vested interest in the company’s performance, the private equity firms could demand that they contribute as much as possible.
• Debt financing – Borrowing money from a bank is one of the most popular choices. However, banks may not be prepared to bear the risk as they see MBO as too hazardous. Based on the financing source or the bank’s assessment of the executive team’s capabilities, management teams are often required to spend considerable cash. The bank then extends a loan for the balance needed for the buyout.
• Owner/seller financing – In certain circumstances, the seller could consent to fund the buyout with an amortizing note. The true price would be paid from the company’s profits over the next years, with just a nominal price being charged at the moment of sale.
• Mezzanine financing – Mezzanine finance combines debt and equity, strengthening the management team’s equity involvement by combining specific loan financing and equity financing characteristics without diluting ownership.

Similarities between ESOP and management buyout

Both MBOs (management buyouts) and ESOPs (employee stock ownership plans) are exit strategies involving the sale of a company to existing workers, potentially including family members. These methods often use borrowed money, such as leveraged MBOs, ESOPs, seller financing, or a combination of these. Both strategies rely on the company’s cash flow to pay off the original investment, including bank loans and seller notes, and require the businesses to remain successful with strong free cash flow.

MBOs and ESOP transactions might result in a lower acquisition price compared to a strategic third-party buyer, as management workers often lack the resources to pay a premium. ESOP sales guarantee fair market value, while MBOs can include arrangements for sellers to continue working in the company. Both methods emphasize operational continuity, company growth, and integrate succession planning into the long-term process.

Key differences between ESOP and management buyout

While there are similarities between an ESOP and an MBO, there are key differences between the two that are explained below:

Why choose Eqvista to manage your company ESOP?

Per ERISA regulations’ regulatory requirements, establishing ESOP requires an independent valuation expert to be involved in the process. The ESOP is subject to several considerations. You can only run an ESOP successfully if you pick the proper personnel to assist you. Experts from Eqvista who are familiar with ESOP and its criteria can help such business owners. Our staff at Eqvista has years of experience working with and managing ESOP-equipped businesses. You can be confident that your ESOP strategy will succeed with our experts’ appropriate resources and direction. Contact us today to learn more!