As we at Sharp have pointed out ad nauseam, the U.S. Cannabis sector is in dire shape and likely in the midst of a death spiral. Desperately in need of a kick-save and with waning expectations that one will come from Washington, Sharp has come to believe that Employee Stock Ownership Plans (“ESOPs”) just may offer the industry some new hope.
A brief primer on ESOPs. Intent on encouraging more employee ownership in corporate America, in 1974 Congress passed the Employee Retirement Income Security Act (ERISA), along with related IRC Section 401(a) and later IRC Section 1042, in effect creating the modern ESOP. The largest advantage Congress afforded to ESOPs relative to other corporate structures was tax-exempt status. As such, companies structured as S-Corps can be sold to an ESOP - established for the benefit of employees – and not have to make ANY future tax distributions, as its owner, the ESOP, is exempt. YES, you read that correctly. If an ESOP owns an S-Corp, no federal income tax will be due on the underlying earnings and 100% of cash flow can be used to support growth and/or debt repayment.
For a cannabis industry drowning under the weight of 280E (among other malignant externalities), creating an ESOP to avoid paying ANY federal income tax, much less avoiding the ridiculous and onerous 280E provisions of the Code, would appear to be a major lifeline. Additionally, selling to an ESOP creates an enormous new employee benefit that can be used to improve employee morale and, therefore, employee engagement and performance. So, upon learning that a sale to an ESOP can eliminate federal income taxes in the future AND provide a benefit for employees and a corresponding boost to employee performance, one might be inclined to ask...what’s the catch, Miles?
At the risk of making the ESOPs sound “too good to be true”, a fair synopsis needs to highlight some downsides to an ESOP sale. First, ESOP transactions are expensive compared to sales to third parties, and, to a lesser extent, listing a company’ s shares on a public exchange. In addition to higher closing expenses associated with the Trustee and its financial and legal advisors, there are incremental recurring expenses, such as paying the Trustee and valuing the ESOP shares annually. Secondly, ESOP sales need to be transacted at Fair Market Value (“FMV”), which eliminates the possibility of finding an “outlier” bid in a private auction process, but also, more importantly, may result in sellers’ remorse if somehow the industry gets all of the regulatory relief it desires and asset values spike. Lastly traditional ESOPs are financed by 3rd party debt, which in cannabis is not an easy ask. If a company is already burdened by debt, the probability of taking any cash off the table at closing is essentially nil.
Lastly, it is critical to understand that ESOPs are regulated. It is paramount to be compliant with ERISA and respect the fiduciary integrity of the transaction. To mitigate this risk, check and verify the integrity of your advisory team. The Department of Labor does not like it when ESOP deals are structured in a way that overpays and/or steers tax advantages to benefit selling shareholders at the expense of building retirement wealth for plan participants.
To illustrate how an ESOP transaction works, let's run through a quick example. Take a debt-free Company with $100mm revenue, $50mm gross profit, and $30mm of EBITDA. The company sells to an ESOP at a 5.5x EV/EBITDA, fetching an enterprise value of $165mm. To finance the transaction, the Company borrows from a senior lender at 2.0x EBITDA, or $60mm, and the remaining $105mm in enterprise value is financed via seller notes.
Where does this leave shareholders?
Step One - If the ESOP is completed as a C Corp, the selling shareholders immediately receive a cash distribution equal to the $60mm in senior loan proceeds plus any cash on the balance sheet at close less transaction fees and expenses. They then can roll their capital gains into “Qualified Replacement Property” (i.e. U.S. stocks and bonds of U.S. companies via 1042 exchange) and defer capital gains taxes. This is a personal tax benefit whereas the above referenced S-Corp tax benefit of being exempt from federal income taxes is a corporate tax benefit. Often times the Company can make an S-Corp election post transaction and enjoy the corporate tax benefits as well.
Step Two - Shareholders are left with subordinated seller notes. The notes can be structured in different ways but generally the senior lender will want to see a leveraged buyout (“LBO”) type structure in which all available cash flow pays down the senior lender’s principal before paying down the seller note principal. That said, the seller notes will be paid cash interest during the life of the loan. The business will be generating ~$30mm in EBITDA less ~$1-2mm in capital expenditures, and all this cash flow will go to paying principal and interest (not 280E taxes!). The senior lender is completely paid back in the first 4 years and then all of the cash flow will go to paying down the seller notes for the next 4 years. Often times the lenders are more than willing to refinance the seller notes early.
Step Three - To allow a fair return on the seller notes, selling shareholders often receive financing warrants – giving them the ability to participate in future upside of the company. The amount of warrants is bound by fairness to the noteholders on the one hand and fairness to the ESOP on the other hand, in terms of expected internal rates of return, and can average around 30% of the future value of the company.
So, the sellers are happy because they cash out the first $60mm without paying capital gains taxes, receive a $105mm seller note that earns interest from a tax-free entity, and retain some equity upside via the warrants. The senior lender is thrilled because they can be repaid with pre-tax dollars, dramatically reducing the risk and tenure of their loan. Finally, employees are happy because you just executed an LBO transaction on their behalf, and they did not risk or even contribute a dime! Talk about a win, win, win!
In summary, ESOPs present a compelling opportunity for the U.S. cannabis sector to navigate the challenging landscape imposed by federal tax regulations, particularly the burdensome 280E provisions. By leveraging the tax advantages of ESOPs, cannabis companies can significantly reduce their federal income tax liabilities, enhance employee morale and engagement, and create a sustainable path forward.
As the cannabis industry continues to evolve, exploring innovative solutions like ESOPs could be the key to unlocking new growth and stability. We encourage stakeholders to delve deeper into the possibilities that ESOPs offer and consider this potential “kick save”.
If you are interested in learning more about how ESOPs can benefit your business or have any questions about implementing an ESOP, please reach out to us. Our team of experts is here to provide guidance and support every step of the way. Contact us today to schedule a consultation and explore the transformative potential of ESOPs for your company.
