The concept of an employee stock ownership plan (ESOP) as a strategic alternative transaction structure for seniors housing and care owner-operators started to gain in popularity in 2019, prior to the COVID-19 pandemic. Even then, merits of an ESOP were clear – a fair market valuation, path to liquidity, estate planning and tax advantages, and management and employee retention. These benefits are particularly compelling for an operating company (OpCo) where the real estate (PropCo) had already been monetized through a sale-leaseback transaction.
The COVID-19 pandemic has since exacerbated the challenges of an already tight labor market across the industry, with the most difficult operating environment in history prompting providers to search for creative solutions to drive employee recruitment and retention. In this environment, the ESOP remains one of the most compelling solutions available.
Employee Recruitment and Retention Advantages
The employee recruitment and retention elements of an ESOP structure are more relevant than ever, as the benefits span virtually all employees, from c-suite executive management to facility-level employees. For management, it is typical that a robust incentive compensation package for key executives is negotiated and structured. The package is in addition to the negotiated base salary and allocation of common shares the executives would receive as any other employee. The package typically includes both a performance-based cash bonus program as well as stock appreciation rights (SARs), including both retention- and performance-based SARs which effectively provide the potential for these executives to obtain additional equity shares. In certain circumstances, executives may also have the option to purchase warrants.
Each participating employee receives an allocation of equity shares as the debt from the company is repaid each year. Due to the financing limitations of an OpCo, the ESOP transaction is typically 100% seller financed unless the PropCo is also included, which provides capacity for third-party or bank financing. The employee’s shares will vest over a certain period and the share value tracks the performance of the company. As the value of the company increases – which occurs as the equity value grows as the debt is repaid and cash flows of the company increase – the value of the shares increase. A company valuation is completed each year by an independent financial advisor.
In a recent sale of an ESOP-owned company where Lument Securities served as exclusive financial advisor, a mid-level employee planned to retire following the sale. She was expecting to receive approximately $10,000, but ultimately received more than $50,000 due to the appreciation of the share value – a “life changing event” in her words.
These benefits provide meaningful recruitment and retention tools for providers in an ever-challenging labor environment. As a result of the ESOP, employees and management begin to think and act like owners. Studies suggest that employee engagement, motivation, and retention increase in ESOP companies as employees focus not only on their daily tasks, but also on the top and bottom lines of the business.
Why Consider an ESOP?
In addition to the employee recruitment and retention tools discussed above, there are several reasons to consider an ESOP transaction in the current market.
Seniors housing and care transactions have become more challenging than ever because the pandemic, as the operating environment remains fluid, directly affected pricing. According to The 2021 Senior Care Acquisition Report, the dollar value for publicly announced transactions decreased from nearly $17 billion in 2019 to less than $8 billion in 2020. The average skilled nursing price per bed decreased from $93,000 in 2019 (the second highest recorded) to $80,000 in 2020, and the median price per bed decreased from $96,000 in 2019 to $73,000 in 2020. On the seniors housing side (including assisted living, independent living, and memory care), the average price per unit decreased from $244,000 in 2019 (an all-time high) to $196,000 in 2020, while the median price per unit decreased from $225,000 in 2019 to $136,000 in 2020.
Unlike a more traditional transaction, the ESOP structure provides more certainty of close (as it is a direct negotiation with the ESOP trustee on behalf of the employees) while still providing a fair market valuation. Further, the ESOP structure is flexible and customizable based on the objectives of the current owners. The structure can be a minority, majority, or full sale – the transaction can also occur in phases over time. This is particularly useful if shareholders have different objectives (such as some desiring liquidity and others desiring continued equity upside), as not all shareholders must sell.
In addition, there are corporate and capital gains tax advantages. S-corporations that are 100% owned by an ESOP are fully exempt from federal income tax. Further, sellers may elect a Section 1042 rollover allowing sellers to defer capital gains by reinvesting the principal proceeds in a qualified replacement property (i.e., stocks and bonds), which will receive a stepped up basis and completely avoid capital gains tax if certain conditions are met. Philanthropic gifting can be structured with an ESOP as well.
The ESOP remains the most viable OpCo sale alternative given the limited buyer and lending markets for OpCo only transactions; but an ESOP can also be coordinated with a PropCo alternative, such as a sale-leaseback transaction with a REIT or private equity firm, or include the PropCo in the transaction.
Lument’s Proven ESOP Success Despite COVID-19
Lument Securities recently assisted one of the largest groups of skilled nursing providers with the successful sale and transition of approximately 36 operating affiliates, consisting of approximately 4,000 licensed beds, to a newly formed ESOP. As a result of the transaction, the company is now 100% employee-owned through its employee stock ownership trust.
The privately held company that completed the recent ESOP transaction operates over 30 skilled nursing and rehabilitation locations, as well as several assisted living facilities across the Midwest. The transaction will further strengthen the company’s legacy of providing seniors access to high-quality care in local communities.
“Turning over the 45-year legacy of this company to the employees in the form of an ESOP was an easy decision as employee ownership is a natural fit for a profession that is so labor intensive,” said the former chief executive officer of the company. “The harder part was the execution, and our banking and legal teams delivered.”
Lument Securities served as exclusive financial advisor to the company. As a result, Lument’s professionals have advised or financed four of the largest companies in the skilled nursing and senior housing sector that have transitioned to an ESOP or sold an ESOP.
An ESOP provides operators with a meaningful differentiator for employee recruitment and retention, a valuable tool in the challenging labor market and broader industry pandemic. Combined with a fair market valuation, transaction flexibility, estate planning and tax advantages, the ESOP solution is more relevant than ever in earning consideration as part of the menu of strategic alternatives for senior housing and care operators.
Laca Wong-Hammond, Managing Director & Head of M&A: firstname.lastname@example.org and Dominic Porretta, Vice President – M&A: email@example.com