New NDAA provision shines a bright spotlight on ESOPs

The 2022 National Defense Authorization Act offers a new reason for government contractors to consider employee stock ownership plans (ESOPs). The legislation’s Section 874 creates a five-year pilot program that enables 100% employee-owned, DoD contractors to receive sole-source follow-on contracts. It’s the first federal program to single-out ESOP-owned companies for contract advantages.

This is a victory for existing employee-owned contractors, as well as those considering a move to ESOP ownership. A long-favored mergers and acquisitions...

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The 2022 National Defense Authorization Act offers a new reason for government contractors to consider employee stock ownership plans (ESOPs). The legislation’s Section 874 creates a five-year pilot program that enables 100% employee-owned, DoD contractors to receive sole-source follow-on contracts. It’s the first federal program to single-out ESOP-owned companies for contract advantages.

This is a victory for existing employee-owned contractors, as well as those considering a move to ESOP ownership. A long-favored mergers and acquisitions alternative among government contractors, ESOPs offer liquidity opportunities for shareholders, employee incentives and substantial tax benefits. The pilot program is expected to enhance this value proposition and encourage more firms to pursue ESOPs.

Who qualifies for the program?

Companies that are wholly owned by an ESOP, with existing DoD engagements rated as satisfactory or better, are eligible to participate. The non-compete applies to a single follow-on contract per contractor; however, senior contracting officials are permitted to make exemptions on a case-by-case basis.

Program participants must verify their ESOP status with the DoD and prove that subcontractor payments on the contract will not exceed 50% of the total value. The program only pertains to follow-ons. But there are active lobbying efforts, led by the Employee-Owned Contractors Roundtable (ECR), to expand preferential opportunities for employee-owned companies. The ECR, a national coalition of government contractor ESOPs, was instrumental in the proposal and passage of the pilot program.

Why ESOPs matter for government contractors

Security clearances, novation requirements and Anti-Assignment Act obligations can significantly complicate a third-party sale or private equity transaction. ESOPs offer contractors a meaningful M&A alternative. The sale of equity to an employee trust is both a shareholder exit strategy and a business continuity measure that can preserve a firm’s independence, as well as set-asides and other critical designations.

In an ESOP sale, the buyer (an employee trust) is a known entity with aligned interests that pays fair market value for equity. Partial transactions are permitted that enable shareholders to maintain potential upside and stage out future transactions. Minority sales also can enable SDVOSBs and contractors with similar designations to maintain their preferential status.

Other key ESOP advantages include:

  • Businesses that are wholly owned by an ESOP are not subject to federal income taxes, which can significantly increase a company’s cash flow compared to competitors.
  • Shareholders can sell stock to an ESOP and avoid paying capital gains taxes (known as a 1042 rollover).
  • Full-time employees receive a meaningful retirement benefit in company stock, which is earned over time.
  • A contractor’s board of directors maintains ongoing management duties (instead of a competitor or private equity firm).
  • ESOP adoption helps instill an employee-ownership culture that can enhance a contractor’s ability to attract and keep talent and improve profitability.

Employee-ownership also affords additional benefits to cost-plus contractors. ESOPs are qualified retirement plans and plan contributions are allowable under Federal Accounting Rules (FAR). As a result, government contractors operating on a cost-plus basis can include ESOP contributions in their expense reimbursement submissions.

The value of ESOP ownership

The NDAA pilot program is expected to pave the way for additional legislation favoring contracts for ESOP-owned government contractors. Doing so may help drive increased consideration of ESOP ownership in the industry, which could translate to greater organizational stability, deeper employee engagement and smoother ownership transitions. In this highly competitive industry, those intangible benefits can be just as meaningful as an ESOP’s financial appeal.

George Thacker is a managing director at CSG Partners.

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