Understanding Warrants
An Employee Stock Ownership Plan, or ESOP, is a qualified retirement plan that gives employees an ownership interest in a company through employer stock.1 The Employee Share Ownership Trust, or ESOT, holds that stock for participating employees.
In a traditional ESOP transaction, the ESOT buys some or all of the stock in the business the owner already owns and operates. If the ESOT buys 49% of the company, the owner no longer owns that 49%. If the company becomes more valuable after the sale, the increase in value of the stock that was sold belongs to the ESOT.
For the owner of a growing company, that can mean giving up a substantial amount of future value. Depending on how much stock is sold, the owner can also give up control of the company.
Warrant Basics
An ESOT usually doesn't have enough cash to buy a large block of company stock outright, so the purchase often has to be financed. The money can come from a bank, the seller, other financing sources, or some combination of them.
Many owners are reluctant to sell all or part of a company they have spent years building, particularly when they expect the company to become more valuable. Warrants are sometimes included in financed ESOP transactions to give the seller some participation in the company's future growth after the stock has been sold.10
A warrant gives the seller the right to buy company stock later at a price set when the warrant is issued. The agreement also determines how much stock the warrant covers, how long it lasts, and when the seller can use it. Those terms affect how much of the company's later growth the seller can still benefit from.
Suppose company stock is worth $10 per share when a warrant is issued, and the seller has the right to buy a share for $10 at any time during the next ten years. Five years later, the stock is worth $25 per share. The right to buy a $25 share for $10 has $15 of value per share.
What the seller can do with that $15 depends on the agreement. Some warrants can be settled for their value without requiring the seller to buy and keep the stock. If the seller takes that value when the stock is worth $25, the warrant is settled at that point. If the stock later rises to $50, the seller doesn't participate in that later increase through the settled warrant.
The ESOP trustee represents the employees participating in the plan and must act in their interests.7 The trustee is not negotiating the transaction for the seller. The seller needs experienced advisers of their own who understand warrants and can negotiate those terms from the seller's side.
The 4ESOT Difference
4ESOT provides employee ownership without requiring the owner to sell the business they already own and operate.
Under the 4ESOT structure, employees receive their ownership benefits through a separate S corporation owned by the ESOT. The business owner and family continue to own the operating company.
The operating-company stock stays with the owner, so there is no need to negotiate warrants to recover part of the future growth of stock sold to an ESOT.
If the operating company becomes more valuable over time, the owner and family continue to own that value.