The previous example can be expanded to include the purchase of another company. Let's assume that ABC Brush Works has an unusually good opportunity to buy a major supplier for $2 million over seven years, with a 20% down payment, and interest on the unpaid balance priced at prime plus two points. The supplier has a net worth of $1,750,000.
After negotiating terms with the sole shareholder of the supplier company, ABC decides to attempt an ESOP structure. ABC 's bank agrees to make an ESOP loan to the company in the amount of $1,600,000 for the express purpose of acquiring the supplier. Once again, ABC makes an immediate loan to its ESOP under the same terms and conditions. The ESOP then offers to purchase $1,600,000 of stock from ABC at fair market value. This being accomplished, the company once again has the proceeds of the original loan back in its cash account.
Now ABC management approaches the sole shareholder of the supplier company and negotiates a $250,000 reduction in selling price as a result of that company's being paid off immediately in an all-cash transaction. A quick computation of the time value of money will show that the seller still is getting a good price.
ABC then takes the loan proceeds of $1,600,000, places with them an additional $150,000 of its own cash, and consummates the transaction for a total of $1,750,000. Remember that ABC had intended to come up with a down payment of $400,000 in the original negotiation. The ESOP structure allowed an immediate cash savings of $250,000 or 13% of the total acquisition price.
As a result, ABC acquired the company using pre-tax dollars, was able to save an additional $250,000 in cash outlay immediately, and in all probability was able to negotiate a low-interest-rate loan with its bank. Dilution was not an issue because ABC acquired a net worth of $1,750,000 while it sold only $1,600,000 of stock to the ESOP.
The bank is happy because it was able to lend $1,600,000 to ABC toward the acquisition of a company with a net worth of $1,750,000. The bank also can see that ABC will be able to repay the loan with pretax dollars, thus greatly enhancing its cash flow. Furthermore, this loan possibly could have qualified under Sec. 133 of the Internal Revenue Code. If that had been the case, then ABC would have negotiated a low-interest-rate loan, and the bank would not have to report for tax purposes 50% of the interest income received from the loan.
The seller likewise is pleased. He or she did not have to accept a down payment and a seven-year payout. Also, financial risk was reduced to zero in that the seller received cash. This type of structuring makes a great deal of sense for all parties involved.
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