Every business owner must make a decision regarding what he or she will do with the business. If no family member is able or willing to assume ownership, an increasingly popular succession planning strategy has been to sell the business to an employee stock ownership plan (“ESOP”). ESOPs are popular in part because of the tax advantages they provide to the selling business owner, the company, and the employees. Smaller businesses who have considered adopting an ESOP, however, sometimes have faced challenges securing financing on acceptable terms. That could occur if the business’s assets (both tangible and intangible) did not provide sufficient collateral. Further, the Small Business Administration (the “SBA”) 7(a) Loan Guaranty Program often was of little help because Section 7(a) of the Small Business Act did not reflect modern ESOP loan practices.
The SBA hurdle just became easier to overcome with the Main Street Employee Ownership Act (the “Act”), which was signed into law as part of the 2019 National Defense Authorization Act. The Act should improve SBA lending to ESOPs in the following ways:
- Allow the SBA 7(a) program to make back-to-back loans. Currently, an ESOP loan from an approved lender and guaranteed by the SBA can be made only to the ESOP trust. Many commercial banks prefer instead to lend to the company that sponsors the ESOP rather than to the ESOP trust because the company has assets other than company stock that can be pledged as collateral. The company then makes an internal loan to the ESOP trust to purchase the shares of stock from the seller. This practice is often called a “back-to-back” loan arrangement. The Act amends the SBA 7(a) program by allowing the program to make back-to-back loan to align with industry practices.
- Clarify that SBA 7(a) ESOP loans may be made under the Preferred Lenders Program (the “PLP”). Currently, the SBA does not allow 7(a) ESOP loans to be made under the delegated lending authority of Section 5(b)(7) of the Small Business Act, also known as the PLP. This exclusion makes loan approval especially cumbersome and time consuming because PLP allows for a more streamlined loan application process and expedited approval, among other benefits that make lending smoother for both lenders and borrowers. The Act now allows the SBA Administrator to give authority to lenders participating in PLP to execute SBA 7(a) ESOP loans.
- Allow sellers to remain involved with the business. Often times, a seller may not want to become 100% ESOP-owned right away. Instead, the seller may want to take some chips off the table by selling a portion of the business to an ESOP, and then in the future selling his or her remaining interest to the ESOP. The SBA previously prohibited sellers from easing out of the business in this manner. The Act changes that and allows a seller to continue as an owner, officer, director, or key employee of the company when an ESOP or cooperative acquires a controlling interest (51 percent or more); however, any seller who remains as an owner, regardless of percentage of ownership interest, would be required by the SBA to provide a personal guarantee.
- Allow SBA financing to pay for ESOP transaction costs. Previously, the SBA 7(a) program would not allow SBA financing to help pay for the transaction costs associated with an ESOP transaction. The Act now allows for such transaction costs to be financed as part of an SBA 7(a) loan.
- Allow the SBA to waive eligibility requirements. The SBA’s 7(a) program previously required an owner to secure equity equal to at least 10% of the total transaction cost. The Act allows the SBA to waive this requirement on a case-by-case basis for loans that finance a change of ownership to employees.
We have yet to see how the SBA will administer its 7(a) program under these changes, but the Act is still welcome news. It is worth noting that the National Center for Employee Ownership concluded that only two out of 1,000 ESOPs default on a loan, which should encourage the SBA to administer the 7(a) program liberally under the Act. The Act should make it easier for business owners to consider an ESOP as part of their succession plans. Additionally, banks may find that lending to ESOPs could become more attractive under the Act.