Best Practices: ESOPs Under SOP 50 10 7.1

SOP 50 10 7.1 has modified requirements on ESOP lending and made it easier for lenders to provide financing to ESOPs and/or financing resulting in the ESOP purchasing a controlling interest (at least 51 percent) in the employer small business.  An employee stock ownership plan (“ESOP”) is a type of employee benefit plan in which company stock is acquired by, and held in accounts for, the employees of the company.  ESOPs are authorized by the Employee Retirement Income Security Act (“ERISA”) and supported by the SBA as an employee-owned business tends to increase the growth and stability of the business.

Previously, all SBA 7(a) loans whose proceeds were used by an ESOP to purchase a controlling interest in the employer small business and all SBA 7(a) loans made to an employer small business owned by an ESOP were required to be processed under non-delegated authority.  SOP 50 10 7.1 allows lenders the freedom to “process loans to an ESOP or to an eligible small business owned or controlled by an ESOP under delegated authority.”  SOP 50 10 7.1 at page 29.  In addition, SOP 50 10 7.1 has removed all equity injection requirements for “[l]oans to ESOPs for the purpose of purchasing a controlling interest (at least 51 percent) in the employer small business…”  SOP 50 10 7.1 at page 29.  This is a welcome change as borrowers and lenders often had difficulty documenting equity injection on an ESOP transaction as ESOPs are entirely leveraged by design.  Removing the equity injection requirement from ESOP transactions has brought the nature of ESOP transactions in line with the current SOP.

There are still core requirements of ESOP transactions set forth in SOP 50 10 7.1 which need to be satisfied in order to lend to an ESOP and/or to provide loan proceeds for an ESOP to purchase a controlling interest in the employer small business.  First and foremost, the ESOP must comply with all applicable IRS, Treasury, and Department of Labor regulations.  If that requirement is satisfied, a lender may provide a 7(a) loan for two purposes: “i. Purchasing a controlling interest (at least 51 percent) in the employer small business; or ii. Purchasing qualified employer securities. The employer small business may use the funds received from the purchase of the qualified employer securities for any general 7(a) purpose.”  SOP 50 10 7.1 at page 29.

The SBA does not require the ESOP to guaranty the 7(a) loan as the IRS prohibits ESOPs from guarantying loans.  The SBA also does not require members of the ESOP to personally guaranty the loan.  However, the owners of the employer small business who hold an ownership interest in the employer small business outside of the ESOP are subject to the SBA’s guaranty requirements as set forth in SOP 50 10 7.1.  In addition, if the seller of the employer small business remains an owner outside of the ESOP, then the seller must guaranty the 7(a) loan regardless of the percentage of ownership interest.  If none of the above thresholds are triggered, then, unlike other SBA 7(a) loans, it is acceptable for a 7(a) ESOP loan to contain no personal guaranties.

Please keep in mind that transaction costs related to the formation of the ESOP are not an eligible use of proceeds, but costs related to the purchase of the controlling interest are an eligible use of proceeds.  Also keep in mind that an ESOP transaction cannot use an eligible passive company (“EPC”)/ operating company (“OC”) structure as SBA rules require each 20% or more EPC owner and each 20% or more OC owner to guaranty the loan, and no exception to this rule is permitted.

For assistance with ESOP transactions and other SBA lending matters, contact the attorneys at Starfield & Smith, PC at 215.542.7070 or visit us at www.starfieldsmith.com.