The "Trifecta" Sale of a Federal Government Contractor

There is a lot of chatter these days regarding the fiscal Armageddon and the plight of government contractors. Notwithstanding the dire predictions, there are many thriving contractors that have and will continue to provide valuable products and services to the federal government. The entrepreneurs behind these companies are probably not aware of a uniquely lucrative transaction that they could execute when they are ready to sell their business.

Imagine a sale of a company where: 1) the selling shareholders pay no capital gains taxes, 2) the federal government reimburses the company for the cost of the stock buyout (plus interest!), and 3) the company becomes exempt from federal (and most state) income taxes. If you would like to wager that such a transaction is impossible or it will land you in jail, I'll be happy to email you my wiring instructions.

So, what's the magic? In a word- ESOP. An ESOP stock buyout can be structured so that the selling shareholders can indefinitely defer paying capital gains on stock sales. In addition, a 100% ESOP-owned S corporation pays no federal income taxes (and most states) because the company's sole shareholder, the ESOP, is exempt from paying income taxes. The effective income tax exemption provides substantial cash savings that the company can use to rapidly repay debt in the short term and invest in strategic initiatives in the long term.

The capital gains elimination and the corporate tax exemption are not unique to federal contractors. What is unique is the generosity of the federal government to reimburse the cost of the ESOP buyout of for many contractors. The reason for Uncle Sam's generosity is the longstanding provision on cost-plus contracts whereby the federal government will reimburse the cost of employee benefits tied to a particular contract, up to certain limits. As a qualified retirement plan, ESOP benefits fall into this reimbursement category. Therefore, if an ESOP borrows money to acquire stock, the principal and interest "cost" on that loan are legitimate employee benefit expenses that are subject to government contract cost reimbursement pursuant to Federal Acquisition Regulation rules.

Pilot Hill Advisors recently completed a 100% ESOP buyout of a federal defense contractor that serves as an excellent illustration of the various advantages unique to the ESOP. (Note: Although for confidentiality reasons we cannot share actual details, the illustration below details the actual relative benefits that our client derived). In this example, the ESOP sale provided the founder and sole shareholder with the option of indefinitely deferring the capital gains taxes on the sale, saving approximately $7 million in taxes on the total $34 million sale price. The company confirmed with the Department of Defense that, given that all of the employees participating in the ESOP were directly involved in executing the government contracts, the company would be entitled to receive reimbursement of the ESOP's principal and interest "costs" over the next several years. Not only will the government reimburse the principal and interest, but in the case of our client, the government will also provide the company with an additional 7% profit margin markup on the reimbursements. For example, in the first year the ESOP made $4 million in principal and interest payments and the federal government reimbursed $4.3 million ($4 million for the principal and interest plus a 7% profit margin). Hence, the company actually generated approximately $300K in additional cash flow beyond what the actual ESOP was required to pay in debt service. Finally, the company will save approximately $2 million per year in taxes resulting from the exempt status of the ESOP as the company's sole shareholder.

Prior to settling on the ESOP structure, the selling shareholders did consider a traditional third-party sale, but they quickly concluded that the ESOP structure's tax and reimbursement benefits far outweighed the attributes of an outright sale to a financial or strategic buyer. Other persuasive ESOP differentiators included the ability for the selling shareholders to preserve the company's legacy and independence, the opportunity for the selling shareholders to gradually transition out of the company's day-to-day operations, and the positive employee motivational benefits that were likely to occur.

Shareholders of a federal contractor seeking an alternative to a third-party sale should seriously consider the benefits of an ESOP transaction and contact us to talk about the details. The various meaningful benefits provided by the federal government also involve regulatory and tax compliance not found in traditional third-party sales. There is a substantial amount of nuance associated with ESOP transactions and federal contractors should engage an experienced financial advisor who can efficiently structure a transaction and guide the company and its various constituents through the ESOP transaction process.

AUTHOR:   James F. Higgins Jr.