ESOP Boot Camp, Part 5: How ESOPs Are Financed

How are ESOP transactions actually financed?

In Part 5 of the ESOP Boot Camp series, Trevor Gilmore, CEO of Menke, explains the two primary ways ESOPs are financed: outside bank financing and seller financing—and how those approaches are often combined in practice.

Using real-world examples, this episode walks through how lenders evaluate ESOP transactions, what makes a company “bankable,” and how seller notes can function as a long-term liquidity and estate-planning tool for selling shareholders.

Topics covered include:

• The two primary ESOP financing methods: bank financing and seller notes
• How lenders evaluate cash flow, coverage ratios, and financial quality
• Combining bank financing with seller financing in ESOP transactions
• Seller notes as long-term annuities for owners
• When all–seller-financed ESOPs can make sense
• The role of lender selection and ESOP-specific expertise

This episode is designed for owners, CEOs, and CFOs who want a clear, practical overview of how ESOP financing works before diving deeper into structure or transaction planning.

Chapters

• 0:00 Welcome to ESOP Boot Camp Part 5
• 0:41 The two ways ESOPs are financed
• 1:01 Example: combining bank financing with seller notes
• 2:16 Seller notes as long-term annuities for owners
• 2:48 All seller-financed ESOPs and when they work
• 3:21 How lenders evaluate ESOP transactions
• 4:10 Types of lenders that finance ESOPs
• 5:10 Key takeaways and what’s next in ESOP Boot Camp

Transcript

0:03

Hi everyone. Welcome to ESOP Radio. Thank you for joining episode five of our ESOP Bootcamp how to Finance your ESOP. Our goal is to give you the owner, CEO, or CFO of a successful business. The lowdown on Esops in a quick, straightforward manner to save you time. Guess what? Your time is valuable. We're not providing investment advice today. I'm Trevor Gilmore, CEO of Menke. Since 1974, we have done thousands of esops. We've seen it all as an Esop ourselves. We are also Esop native. Today we'll cover the two ways Esops are financed. Number one, outside financing by a lender. And number two, seller financing. It's going to kick it off now. So in our first example we raised 20 million of outside bank financing for a client. Overall Esop value. And this is a negotiation value was 50 million. So to do the bank process we start off with what we call our Esop fit analysis. Taking a look at your cash flows historical and projections and going through and seeing what are the covers ratios and what the balance sheet and cash flows can truly support. From there, we talked to your incumbent bank and also do a bank shop to find the right lender. Who's going to be the right long term partner for a business like yours. Now, in the future with this client, we assess that 20 million was the appropriate amount and the company could cash flow nicely. Family trust owned all the shares through the entire process. And there's some negotiation here back and forth. We're able to successfully negotiate an interest rate below prime and also favorable interest rates on the excess cash held on the balance sheet and favorable covenants as well. This client had very clean financials. Think audits going back several years unqualified as well. So we're talking about clean financials and a top notch management team ready to take the company into the future. So in other words, is it very much a bankable company. So this 20 million bank financing package was possible. Fast forward to the transaction. Bank closes, transaction closes and the family trust gets the 20 million I close. Now, you might ask here, what about the other 30 million there? They talked about a $50 million price. Well, the family trust carried what is called a seller note over several years. Seller notes in conjunction with bank financing often are subordinated to the bank. The beauty, though, is that the family trust and many of our clients view the seller notes as a long term annuity. So in essence, you get a down payment from the bank and you have this annuity kicking out market rate interest, maybe a IRR that was a bit higher as well to compensate you for the risk. Second example $15 million company. We did no bank financing for because the seller was comfortable with carrying a $15 million seller note going for seller notes. Definitely an easier process versus raising bank financing. We raise bank financing for clients all the time. Last year, we raised amounts between 2 and 50 million for our clients with banks. However, when you go all SA notes, the transaction can be a bit smoother and quicker because you don't have the bank doing their due diligence, plus the banks legal team and so on. Part of our role in assessing what makes the most sense for you and your company is assessing the overall bankability of your business and determining if it makes sense to conduct a bakeshop. But it's not necessary. Things come into play, such as your reinvestment horizon, your liquidity needs, and what makes sense with your long term trust and estate planning. In summary, all Esop transactions are financed by one of two ways either with the outside lender meaning the bank or with seller financing. Let's talk a bit about banks to lend esops. So that universe is pretty wide, but there's some niche players as well. Some think large national and international banks, you know, the quote unquote too big to sells. They often have Esop financed teams. However, they have usually short criteria and it changes all the time in terms of what industry, etc. they want to lend to. Also, there are very sophisticated regional lenders who love esops. Our job is to play matchmaker and find the right lender with the right package. With our clients, some of our clients have gone through this process in the past and that makes it much easier. Of course, going through this the second time, many of them have not gone through this process, and that's where expertise kicks in here. There are also mezzanine lenders and private credit funds out there that like to lend Esop companies. You see some of that. Some of them will also often go higher than a senior bank. So in this example maybe we could have got, you know, 40 million or so to 20. However, the interest rates are much higher. And it's also more risky for the business. So you have to weigh the pros and cons and figure out what makes the most sense. There is also some SBA financing out there as well. Again, interest rates going down the SBA path, typically a bit higher, and origination fees are a bit higher as well. So in summary you have a few key financing options out there. Main thing is what is the quality of your financials. Do you have reviewed or audited statements. Banks are going to want to see that. How stable is the earnings and what's the plan for the future. And again these are all components that we take a look at and analyze and drive that decision in our easy, thoughtful analysis. Thanks for joining today. Hope you learned something new. Check us out on LinkedIn. ESOP Radio. Menke. Myself, Trevor Gilmore. And join us for episode six. Take care everyone. Have an awesome day.