Published in the NCEO March-April 2013 Edition of the Employee Ownership Report SES Chairman & CEO Jim Steiker explains how warrants can be used to bridge the gap in a larger ESOP transaction between bank financing and the full price of the sale.

1. Closing the Deal
Using Warrants in ESOP Transactions
S
uppose you own a company, and
you would like to sell to an ESOP
as long as the price feels fair. The
CFO has done some projections, and
you believe that the best outcome
for everyone is for you to sell 100%
of the shares to the ESOP. The bank
will not lend the company enough
to finance the whole transaction,
and mezzanine lenders were not
willing to lend enough to fill the
gap, at least, not at a price you
consider reasonable. So you have
decided to take a note for 70% of
the shares. You call the trustee, who
says she is not comfortable with the
interest rate you proposed for the
seller note. What next?
Consider Using Warrants
Warrants provide the seller an
interest in the company’s future
increase in equity value, meaning
today’s nominal interest rate on
the seller note can be lower. If
the company does well, the seller
may end up with a greater return
than on a simple note, but if it
underperforms, the warrants may
become worthless.
A warrant is a security bundled
with another security—in the case of
an ESOP, the other security is usually
a seller note—into an “investment
unit.” In an NCEO article on warrants
in ESOP transactions, James Steiker
says a warrant is “a financial
instrument that gives the holder a
right to purchase issuer stock at a
specified price at a future date or
during a future period,” and notes
that they are financially equivalent
to stock options. The warrant holder
may eventually exercise the warrant
or may sell it back to the company
before exercise.
Some of the key terms in a
warrant are:
■■ Number
of shares. If the
holder exercises his warrants, what
percentage of the company’s equity
will he own?
■■ Warrant
price. The higher the price
the holder must pay for the shares,
the smaller the spread between the
warrant price and the future fair
market value and, therefore, the less
the warrant is worth.
■■ Time period. How soon and
for how long a period is the
warrant exercisable? One common
configuration would be warrants
exercisable in years 6 to 10, although
so-called European warrants have
much shorter exercise windows.
■■ Company call. Does the company
have the right to call the warrant?
Since the warrant is bundled with
the seller note, the terms of the
warrant are determined along with
the terms of the note, with the value
of the unit being allocated among the
note and the warrant. The trade-off
for making the warrant more valuable
would generally be a lower interest
rate on the note. When negotiating
the components of the investment
unit, the parties must consider not
only their own risk preferences, but
also the timing of the payouts and
the tax implications, since warrants
and debt have different timelines and
different tax treatments.
Philip Carstens, an attorney at K&L
Gates, says that a realistic 100% ESOP
transaction for a $20 million S corporation might involve $6–8 million in
senior debt financing, $8–12 million
in subordinated seller debt at a
coupon interest rate of 5% to 7%,
and warrants designed to enhance
the yield of the note.
Best Practices
Michael McGinley of Prairie Capital
Advisors notes that the Department
of Labor monitors transactions and is
especially interested in making sure
that warrants are used appropriately.
He says that the most important
factor in structuring a transaction
with warrants is to ensure that “both
the dilution caused by the warrants
to the ESOP’s interest and the ‘all-in’
return to the seller do not exceed
what is reasonable and appropriate
given prevailing capital market costs
for subordinated debt financing.”
Carstens believes that warrants
have been over used in ESOP transactions and warns that warrants
may not make sense in transactions
unless they are above a certain size,
roughly $15–20 million. There are
added professional fees for the
ESOP trustees and the board of
directors because of the intricacy
of structuring warrants properly.
He also notes that the best use of
warrants can vary between C and
S corporations, since the two have
different tax implications for the
company and the seller.
Transactions involving warrants
are inherently more complicated
than straight debt. Steiker notes that
ESOPs may not issue warrants, so the
portion of the transaction involving
warrants is generally structured as a
transaction between the seller and
the company, with the company
redeeming and retiring the shares.
The ESOP trustee has a fiduciary
obligation to fully understand the
value of the warrants and their
interaction with the other parts of
the investment in different future
scenarios. At a minimum, trustees
should educate themselves carefully,
though many companies prefer to
hire an outside trustee.
S corporations must be sure that
the transaction is designed in a way
that the warrants are not considered
a second class of stock, which would
void the S election.
Properly structured, warrants can
reallocate risk in a way that all parties
prefer and can also facilitate larger
transactions than would have been
possible without warrants, but they
can also cause problems.
Learn more:
■■ Kim Blaugher (Principal Financial
Group), Philip Carstens, and Michael
McGinley will be speaking on the use
of warrants at the 2013 Employee
Ownership Conference.
■■ James Steiker’s article on warrants
is in the Journal of Employee
Ownership Law and Finance
(Spring 2008), available at
www.nceo.org/r/warrants.
Tell us your experience with warrants.
We are looking for materials for a
future issue brief on the use of
warrants. Contact Loren Rodgers
(lrodgers@nceo.org; 510-208-1307). n
March–April 2013
Employee Ownership Report
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