Executive Education Series: The Role of ESOPs in Private Equity Firms

Presenters: Hal Hunt and Cindy Dwyer – MHM Shareholders

Brooks Myhran – Managing Director, Verit Advisors Mark Welker – Partner, Husch Blackwell

October 24, 2013

Co-presenters from:

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Today’s Presenters Hal Hunt, CPA Shareholder 913.234.1012 | hhunt@cbiz.com

Hal leads MHM’s Employee Benefit Plan (EBP) Audit Practice. With over 25 years of diverse experience with EBP accounting, auditing and compliance issues, he is also a member of the firm’s Professional Standards Group as EBP subject matter expert. As the EBP National Practice Leader, Hal is responsible for providing internal training, along with providing technical support to engagement teams, serving as engagement quality reviewer and developing resource tools for our EBP audit professionals. He served on the AICPA’s Employee Benefit Plan Audit Quality Center (EBPAQC) Executive Committee and is currently a member of the EBPAQC ESOP Task Force.

Cindy Dwyer Shareholder 913.234.1022 | cdwyer@cbiz.com Cindy is the President of MHM Retirement Plan Solutions and a Shareholder of Mayer Hoffman McCann P.C. She supervises staff, oversees technical research, and provides quality control services. She has previously served as the national Chairperson of the American Institute of Certified Public Accountants Employee Benefits Technical Resource Panel (TRP) and has recently been reappointed as a member of the TRP. Additionally, Cindy has been a recurring speaker at the American Institute of Certified Public Accountants National Conference on Employee Benefit Plans. Cindy is also a committee member and current chair of the Employee Benefits Institute sponsored by UMKC School of Law.

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Brooks Myhran Managing Director, Verit Advisors 612.766.4055 | brooks@verit.com

Brooks has more than 25 years of investment banking experience executing mergers and acquisitions, going-private transactions, and recapitalizations, as well as extensive valuation experience providing a wide range of sophisticated financial advisory services, including all manner of fairness opinions, solvency opinions, and ESOP and non-ESOP appraisals and related valuation consulting. Mr. Myhran has broad industry experience with particular expertise in the consumer products, education, ethanol, financial services, household products, plastics, specialty retail, transportation, and travel-services industries.

Today’s Presenters

Mark D. Welker Partner, Husch Blackwell 816.983.8148 | mark.welker@huschblackwell.com Chair of the firm's Tax & Benefits Department, Mark is considered clients’ go-to advisor on any important benefit or compensation matter. He focuses on all benefit and compensation matters, including the creation and operation of employee retirement plans, deferred and equity executive compensation, employee stock ownership plans, and health and welfare plans. Mark is highly regarded for his strategies and management of fiduciary and tax disputes.

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The information in this Executive Education Series

course is a brief summary and may not include all the details relevant to your situation.

Please contact your MHM service provider to further

discuss the impact on your financial statements.

Disclaimer

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Today’s Agenda

1

2

3

4

Intersection of Private Equity and ESOPs

ESOP Overview

Private Equity as a Buyer, Seller and Investor

Key ESOP Considerations for Private Equity

5 Case Studies

6 Summary

INTERSECTION OF PRIVATE EQUITY AND ESOPS

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Where Private Equity and ESOPs May Intersect

Sale of a portfolio company to an ESOP As a Seller

Purchase of a company that has an ESOP in place As a Buyer

Provide capital to a company implementing an ESOP or to an existing ESOP company in need of financing

As an Investor

There are a number of interesting and unique strategies for private equity firms that may involve ESOPs.

ESOP OVERVIEW

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What is an ESOP?

ESOPs, which can and do pay fair market value, often compare favorably to more traditional transition alternatives such as private equity, a strategic sale, or a dividend recap, depending on transaction objectives and current market dynamics.

Transition Alternative

An ESOP is an innovative liquidity tool that provides tremendous flexibility for shareholders.

Liquidity

An ESOP provides distinct tax incentives to businesses and their owners. Tax Advantages

An ESOP provides an incentive for employees to grow the company’s value because they share in company stock appreciation.

Employee Benefit Plan

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(1) Company sets up an ESOP Trust. (2) Company makes annual tax-deductible

contributions in cash or stock to the ESOP.

(3) Cash is used to buy stock from current shareholders.

(4) Shares are allocated to the accounts of eligible employees within the ESOP based on salary.

(4) ESOP holds stock for employees and annually notifies them of how much they own and how much the stock is worth.

(4) Employees receive stock or cash after they retire or leave the company, a vesting schedule applies.

How Does an ESOP Work?

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The ESOP receives a loan and uses the proceeds to purchase stock from current shareholders.

These shares are held in trust and are released into employee accounts at a rate corresponding to debt amortization.

How Does an ESOP Work?

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1) Lender lends to company. 2) Company lends to ESOP. 3) ESOP buys stock from existing shareholders. 4) Company makes annual tax-deductible contributions to ESOP. 5) The ESOP then repays company and company repays lender -- although those two amortization

schedules are usually different, so the repayments won’t be the same dollar amount. 6) Employees receive stock or cash when they retire or leave (vesting schedule).

How Does an ESOP Work?

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Owner/Selling Shareholder Take back a note in exchange for shares Taxed on principal upon receipt at capital gains and interest as ordinary

income (if installment sale treatment is elected) Advantage: Entitled to higher interest rate; subordinated to bonding

company and bank Disadvantage: 1042 Tax Free Roll over requires proceeds to be reinvested

within 12 months Bank

Loan is to the company which makes a loan to ESOP Typically 7 years Assessment of company credit Advantage: Selling shareholder ends up with cash up front Disadvantage: Lenders look to collateralize short fall with proceeds, Bank will

not subordinate to bonding company The Company

Cash rich company can make loan to the ESOP Advantage; Company repays itself with market rate of interest

ESOP Lenders

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Approximately 11,000 ESOPs in the U.S., covering 10.3 million employees (10% of the private sector workforce) across a wide spectrum of industries About half of ESOP companies are majority-owned by the ESOP

At least 70% of ESOP companies are or were leveraged, meaning they used borrowed funds to acquire the employer securities held by the ESOP

Total assets owned by U.S. ESOPs is estimated to be $870 billion

ESOP Overview

Source: The ESOP Association

ESOP concept developed

Employee Retirement Income Security Act of 1974 (ERISA)

2001: Clarification and definition of abusive S-Corp ESOP structures – 409 (p)

ESOP TIMELINE ~4,000 ESOPs by

1980

~8,000 ESOPs by 1990

3,700 S-Corp ESOPs 57% of S-Corp

ESOPs are majority owned

~1,600 ESOPs by 1975

ESOPs used as a hostile takeover defense – selling or contributing equity to an ESOP

ESOPs become eligible to hold shares of S-Corporations Jan. 1998

1950’s 1970’s 1990’s Today

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Company Characteristics Strong cash flow and debt capacity Labor is a significant contributor to company value Company currently pays meaningful income taxes (e.g., service businesses with few or

no available deductions) Strong and experienced management team Significant employee ownership is operationally beneficial through culture and best

practices Little or no presence of aggressive strategic acquirers or an initial public offering

alternative Modest but reliable growth prospects Failed M&A process

Where ESOPs Work Well

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Seller Characteristics Confidentiality, certainty to close, and abbreviated process length

are highly valued Diversification and some liquidity at closing is sought but ongoing

operating and governance influence is desirable Desire to sell business today and retain the opportunity to

participate in significant future equity appreciation

Where ESOPs Work Well

Over the decades ESOPs have been in place, certain characteristics , including both industry and company

dynamics, have contributed to ESOPs being a superior transaction alternative.

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S-Corporation ESOPs Company

ESOP is a tax-exempt shareholder of an S-Corp. 100% ESOP-owned S-Corps pay no federal income taxes ESOP counts as one shareholder Per IRC 409(p), there are anti-abuse provisions to ensure the company cannot dilute

the ESOP’s claim below 50% via warrants or other forms of synthetic equity while paying no federal income taxes

C-Corporation ESOPs Company

Tax shield (i.e., deductibility of principal and interest) up to 25% of payroll Dividends are tax-deductible (to the extent they are used to repay the ESOP / “inside”

loan) Selling Shareholder

Tax-free rollover (IRC Section 1042) At least 30% of company equity must be sold to the ESOP Sale proceeds are subject to certain reinvestment restrictions

Special ESOP Tax Incentives

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Implications: ESOP valuations are competitive with other alternatives. Private equity values are frequently constrained by their LBO models’ comparatively high

IRR targets (as well as the vicissitudes of the credit markets).

ESOP vs. Private Equity Valuation Methodologies

In our experience, both ESOP trustees and private equity funds rely upon public-company and transaction comparables for valuation purposes (to a lesser extent for ESOPs). Their use of income approaches, however, varies. ESOP trustees employ DCF analyses that

rely upon management growth forecasts and ascribe considerable weight to their implications; private equity does so to a limited extent. Conversely, ESOP trustees do not

consider LBO models, whereas private equity relies on this methodology extensively.

Market Approaches Income Approaches

Transaction Structure

Guideline Public Company

Precedent Transaction

Discounted Cash Flow (DCF)

Leveraged Buyout (LBO)

ESOP Yes Limited Yes No

Private Equity Yes Yes Limited Yes

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Valuation Multiples of Verit’s Recent ESOP Transactions

Project Name IndustryTotal Enterprise Value /

EBITDA Multiple

Oregon Packaged Food & Meats 10.0x

Colt Consumer Products 9.4x

Carly Transportation 9.2x

Black Swan Heavy Electric 8.1x

Spike Office Furniture & Supplies 7.7x

Shared Values Plastics & Packaging 7.6x

Timberwolf Construction & Engineering 7.0x

Echo Government Contractor 5.6x

Razorback Metal Manufacturing 4.5x

Average: 7.7xMedian: 7.7x

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Traditional ESOP and M&A Deal Terms Comparisons

ESOP trustees typically rely heavily on extensive representations and warranties, so the due diligence process is generally simpler than other corporate finance

alternatives.

* Deal terms are subject to market conditions and change over time

Traditional M&A Deal Terms* Traditional ESOP Deal Terms Trust Factor/Due

Diligence Third party sale; more complex contract, generally forensic due diligence

Unless seeking third party junior capital, “forensic due diligence” is not a requirement and highly unusual

Transaction Form Buyer preference to purchase assets, or 338 (H) 10 election

ESOP can only buy stock, cannot buy assets

Purchase Price Adjustment

Typically based on working capital or earnings targets Generally not part of ESOP transaction

Earn-outs Median earn-out can exceed 15% of purchase price Earn-outs are not generally part of an ESOP transaction

Escrow/Holdbacks Ranges from 5% to 30% and is dynamic for specific companies and specific times

Varies from transaction to transaction; generally an ESOP has either no or significantly fewer holdbacks

Basket Average is +/-1% of transaction value About the same as an M&A deal

Indemnification Cap Average is +/-15% of transaction value About the same as an M&A deal

Survival Period 18 months to 36 months Generally 18 months

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An efficient ESOP transaction can be completed in approximately three months ESOP transaction can provide greater certainty of closure and shorter process M&A transaction requires more steps, third-party due diligence, and a less certain

outcome In M&A process, there is risk that the potential acquirer may delay or change the terms

ESOP vs. Traditional M&A Timeline to Close

1 2 3 4 5-8 8-12

Due Diligence, Valuation and Design Feasibility

Negotiate with Trustee, Credit Underwriting and Legal Documentation begins

Final Documentation, Implementation, and Closing

Due Diligence and Offering Memorandum Preparation

Contact Potential Acquirers

Receive Initial Indications and Hold Management Presentations

Data Room, Due Diligence and Final Offers

Negotiations and Final Due

Closing

Months

ESOP Transaction

M&A Transaction

Close

Close

Diligence

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Initial interest Owner or management learns about ESOPs Education period Conduct feasibility / alternatives analysis ESOP financial advisor or investment banker prepares debt feasibility analysis ESOP advisory team presents feasible transaction structures Desired structure selected ESOP appraiser presents preliminary valuation Prepare transaction description Form ESOP trustee team Interview and select trustee and ESOP advisors Secure financing arrangements Advisor prepares confidential memorandum, pursues funding sources, and initiates process to

raise senior, mezzanine, and/or junior capital Negotiate with trustee Client and advisor present transaction structure to the ESOP trustee team Client and its advisors negotiate transaction terms with trustee and its advisory team Manage investor due diligence ESOP advisory team manages due diligence for all transaction parties Manage documentation and closing

ESOP Transaction Process

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ESOP Transaction Timeline

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Transaction Steps: Portco borrows money from lender(s) (“outside loan”). Portco exchanges debt-raise proceeds with private equity firm (i.e., the seller), along

with other types of consideration (e.g., seller notes with warrants), for Portco stock. Portco issues shares of stock to a newly formed ESOP (i.e., the buyer) in exchange

for a promissory note; the ESOP will pay for the shares over time by retiring the note with cash contributions treated as an employee benefit from the company (typically 20 years).

How an ESOP Works - 100% ESOP Transaction Overview

3

Portco

Lender(s) — Senior — Mezzanine — Other

ESOP TRUST*/

Employee Benefit Plan

Stock Sale

Private Equity Firm

Cash and Seller Financing

Promissory Note (“Inside Loan”)

*The ESOP Trustee is represented by independent legal and financial advisors

Stock Sale / Redemption

2

Cash

Debt (“Outside Loan”)

1

PRIVATE EQUITY AS A BUYER, SELLER AND INVESTOR

PRIVATE EQUITY AS A BUYER

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ESOP-controlled companies offer many of the same opportunities for improvement as traditional privately-held businesses

Succession planning for founder who has stayed involved since the formation of the original ESOP

Roll-up opportunities Professionalization of organization Access to capital for shareholder liquidity and growth capital Shift in industry dynamics challenges firm’s competitiveness on a

stand-alone basis Opportunity for employees to have asset diversification Could keep partial ESOP in place

Private Equity as a Buyer – Why?

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Fundamentally the same process as traditional M&A; however, an ESOP is a different kind of seller Earn-outs are unusual Fewer seller representations and warranties in many cases Primarily cash deals

Partial ESOP companies may be interesting from two points of view Take out the ESOP Take out the non-ESOP shareholders

Private Equity as a Buyer – How?

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0

2

4

6

8

10

12

14

16

Equity Value Enterprise ValueTime

Value

ESOP Creation

Equity Value

Enterprise Value

Valuation Observations Over Time

While a privately held business may have selected an ESOP for its original transaction, such companies may see their enterprise value grow more slowly over time due to the impact of leverage, ESOP repurchase liability and a lack of proactive strategies to grow value (e.g., operational engineering, strategic acquisitions, brand development). The impact of these realities may be substantial and can offer a unique buying opportunity for private equity.

Once transaction

debt is repaid (and cash begins to

accumulate), absent a robust

strategy to grow share

value, ESOP companies can see diminishing

IRR.

PRIVATE EQUITY AS A SELLER

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Traditional M&A process has been unsuccessful Portfolio company is neither “star” nor “dog” Management team has significant equity stake and a clear, well-

articulated vision for the future Certainty and timeliness of close at fair market value highly

desirable; all cash at close less important ESOP valuations are competitive with other transaction

alternatives

Private Equity as a Seller – Why?

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ESOP pays fair market value Portfolio company borrows senior and subordinated debt on a

tax-advantaged basis Additional, unique capital sources (e.g., 401(k) raise, direct

investment by management/others) may be accessed “Gap” financing provided by seller (which offers opportunity to

participate in future upside via warrants) at mezzanine-like returns

Private Equity as a Seller – How?

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An ESOP transaction can provide competitive price, terms and conditions; ESOPs offer greater confidentiality and a higher certainty of close relative to non-ESOP sale alternatives

Cash from the ESOP “buyer” comes at close and/or over time Selling shareholders’ consideration can range from all cash at close to virtually

no cash at close; overall consideration is generally captured through the following: Cash at close: Dependent on company’s debt capacity and other factors Seller notes: Annual interest payment (taxed as ordinary income) plus return of

principal (capital gains); rollover of management equity provides unique economic opportunity for key leaders

Warrants: Participation in future equity upside with an all-in yield comparable to prevailing market terms; capital gains treatment is often claimed for warrants Warrants often appreciate over post-close (debt-reduced) value and therefore appreciate as debt is

repaid and returns from tax exempt status are realized

Why an ESOP Exit Strategy Makes Sense

An ESOP transaction provides selling shareholders liquidity at full, fair market value, and also allows for participation in future equity upside. At close and over

time, an ESOP can enhance overall value derived from a portfolio company.

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Previous attempt to sell via conventional M&A process was unsuccessful History of non-recurring/extraordinary events Partial leveraged ESOP buyout as an alternative to traditional dividend

recapitalization Portfolio company is held by a fund with 4-5 years remaining on its term Modest growth prospects in mature industry with highly compensated

employees Existing portfolio company culture consistent with employee ownership Strong management team in place poised to generate growth, but the

growth has not yet been realized

Sale to an ESOP – Relevant Portfolio Company Characteristics

Portfolio Company Liquidity Alternatives:

IPO

Financial Buyer

Strategic Buyer

Dividend Recap

ESOP

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Professional Advisors to the “Seller”

Private Equity Fund

Investment Banker ESOP

Administration and Communication

Legal Counsel

Negotiate price, terms, and conditions on behalf of seller

Overall transaction support and structuring

Provide capital placement, if applicable

Provide detail on plan design

Provide guidance on communications

Provide detail on plan requirements and compliance

Provide repurchase liability and 409(p) analysis

Assist with transaction structure

Draft ESOP Plan and related ESOP transaction documents

Can be the same law firm as company counsel; often a special ESOP firm assists company counsel for the transaction

Advisor:

Scope:

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Professional Advisors to the “Buyer”

ESOP Trustee

Legal Counsel Financial Advisor

Review ESOP Plan and related transaction documents for the Trustee

Provide independent valuation to the Trustee Ongoing annual

valuation update

Advisor:

Scope:

PRIVATE EQUITY AS AN INVESTOR

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Mature ESOP company requires capital to pursue growth opportunities

100% ESOP transaction requires incremental financing between senior debt and seller notes

Large non-ESOP owner desires an exit but does not want to sell the entire business

Successful ESOP companies may have significant claims on cash flow for repurchase obligation, which may reduce overall debt capacity to achieve strategic opportunities

Private Equity as an Investor – Why?

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Invest as minority equity shareholder, sometimes with partial or full control

Invest as a source of subordinated debt (with warrants) Flexibility with ownership structure (S-Corp, C-Corp, and LLC)

Private Equity as an Investor – How?

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A drop-down LLC structure can be utilized to achieve the benefits of a pass-through structure while avoiding complexities of seller note and warrant/derivative structures.

Private Equity as Owner of an S-Corporation

Private Equity Firm

ESOP

Common equity

ownership

Portco S-Corporation

Minority or majority common or preferred

equity*

Lenders

Portco LLC (or Partnership)

* This could take the form of member units or partnership interests

Typically, operating assets and liabilities of Portco S-Corp are contributed to Portco LLC in exchange for common equity ownership.

Employees remain at Portco S-Corp level and provide all or virtually all services required for Portco LLC to operate, in exchange for which Portco S-Corp is paid a fee.

KEY ESOP CONSIDERATIONS FOR PRIVATE EQUITY

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Valuation: An ESOP sponsored by a privately held company cannot

pay more than adequate consideration for employer securities purchased by the ESOP,

The ESOP trustee is required by law to have an independent appraisal performed to determine the fair market value of any non-public company stock acquired by the plan.

Perceived Challenges Regarding ESOPs

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Financing: Many large commercial lenders and non-bank financial institutions are active in the

leveraged ESOP marketplace Certain subordinated debt/mezzanine funds find ESOPs especially attractive credit

candidates There are numerous other sources of financing for ESOP transactions, including

management rollovers, 401(k) raises, sale of warrants, “friend and family” raises, and others

ESOP companies frequently secure incremental debt financing due to tax advantages Underwriters view fixed-charge coverage ratio as key credit metric, which is an advantage for

ESOP borrowers

Competitive debt capital market conditions will further drive 2013 transaction activity “Borrower-friendly” terms and market conditions Larger lender hold levels Strong access to capital for middle-market companies and sponsors

Perceived Challenges Regarding ESOPs

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Seller Financing: Seller financing includes warrants that can offer the selling private equity

firm up to 49% of fully diluted future value Expected all-in returns on seller financing are benchmarked against

prevailing mezzanine market IRRs Seller note can be structured to accommodate a subsequent sale to a third-

party investor; such sales generally require a layer of equity, which can be achieved through: Management rollover 401(k) raise Time, as the post-closing company deleverages and compounds its earnings growth

via tax shield

Warrant strike prices can be set at pre-transaction or post-transaction value and vary with transaction design Warrants benefit from company not paying income tax

Perceived Challenges Regarding ESOPs

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Tax Issues: Tax treatment on retained seller note

Transaction proceeds are capital gains – interest income is ordinary income Warrants are usually claimed as capital gains

Installment sale is common, but prepayment of tax is an option

Ownership of warrants on stock in an S-Corporation S-Corporation shareholder laws do not apply to synthetic equity holders

409(p) disqualified person issues Disqualified persons cannot hold synthetic equity in excess of 49% of fully diluted

equity

Distribution of pro rata pieces of notes and warrants to LPs Note and warrant holders are not subject to S-Corporation limitations

Perceived Challenges Regarding ESOPs

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Management Conflict of Interest: Management less able to influence buyer (i.e., the ESOP) than in

traditional M&A exit Management more incentivized to consummate a transaction than in other

exits

Perceived Challenges Regarding ESOPs

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Dividend Recap: The dividend recap does not effect a sale of the company’s equity, whereas

an ESOP can partially or completely monetize the private equity firm’s investment

An ESOP provides tax savings not available for a straight dividend recap – allows for faster deleveraging in an ESOP-owned company

Perceived Challenges Regarding ESOPs

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Trustee Fiduciary Objectives: Trustee does not have an affirmative obligation to shop the company The trustee does, however, have an obligation to consider bona fide offers

from prospective buyers

Perceived Challenges Regarding ESOPs

Each private equity fund has its own unique characteristics and rules – ESOP transactions can be structured to accommodate

such constraints.

CASE STUDIES

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Case Study – Project “Shared Values” Quasi-private equity investors controlled a leading manufacturer and distributor of pressure-sensitive labels and other materials with revenues in excess of $100 million Situation

The company, already moderately leveraged and in need of continued access to capital to support growth, had a track record of non-recurring events and exposure to certain environmental liability issues

Challenge

Evaluate liquidity alternatives by benchmarking traditional M&A valuation and ESOP alternatives

Project

Execution of a 100% ESOP-owned S-Corporation at a 45% premium to the established M&A valuation

Solution

Observations:

Superior returns relative to M&A alternative if warrants provide the projected value Continued equity participation in future earnings growth via warrants or SARS Excellent legacy for company and its leadership team Employees participate in generous retirement tied to company performance and

stock appreciation

(a) 6% coupon for years 1-3 and 8% for years 4-7 with warrants for 30% of the company’s fully diluted equity

ESOP Sale Economics Projected Year-7 Economics

▪ Cash at close 3,250$ ▪ Cash at close 3,250$

▪ 7-year seller note (a) 24,250 ▪ Seller note principal 24,250

Total 27,500$ ▪ Seller note interest 12,125

▪ Warrants 29,866

Total 69,491$

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Case Study – Project “Maple Leaf” A private equity firm was the majority shareholder of a service provider and manufacturer of equipment for niche projects in the timber, construction, and oil and gas industries with revenues in excess of $150 million and EBITDA of $25 million

Situation

The company suffered two significant quality-of-earnings events (loss of a contract that contributed 30% of gross profit and a significant asset impairment) while the private equity owner was assessing its transaction options

Challenge

Explore the sale of the company to management and an S-Corp ESOP as an alternative to the traditional M&A process that had been initiated by the fund Project

Develop an ESOP "stalking horse" bid to compete with the traditional M&A process Solution

Observations:

ESOP provided a stalking horse to optimize price, terms, and conditions from M&A process

Greater certainty of close relative to M&A buyer ESOP was able to deliver a firm and fully financed and negotiated stock purchase

agreement within 60 days ESOP team expenses paid by private equity firm

M&A Buyer / M&A Buyer / Benefit ofInitial Offer ESOP Offer Final Offer Dual Track

▪ Valuation 166,000$ 208,000$ 190,000$ 14.5%

▪ Tax escrow 15,000 5,000 5,000 66.7%

▪ Indemnification baskets 25,000 15,000 15,000 40.0%

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Case Study – Project “Beat the 2013 Tax Increase” Owners of company were motivated to sell. Several traditional M&A attempts had failed. By the Spring of 2012, they want to be assured of a 2012 closing Situation

Sellers want all cash. Challenge

Structure a realistic ESOP transaction that could be closed during 2012. Project

Sales price of $170 million; closed December 2012; financing as follows: (1) first and second senior secured loans: $130 million, (2) first subordinated loan from an investor: $15 million (3) second subordinated loan (seller note): $25 million No warrants were issued. First subordinated interest: 17.5% cash. Second subordinated interest: 13% cash/4% PIK, with ratio changing to more cash and less PIK through year 6, and rate increasing to 18% starting in year 7.

Solution

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Case Study – Project “Breeze” A private equity firm was 70-percent shareholder of a national leading niche business-to-business service company with EBITDA of less than $10 million – which had been acquired from another private equity fund

Situation

The company had a colorful history, including numerous "non-recurring" events, contributing to inconsistent sales and earnings results Challenge

Advise the company and management on the formation, valuation, structure, and financing of an ESOP transaction Project

Execution of a management-led ESOP MBO at a purchase price equal to 8.0x EBITDA with 100% cash at closing for the private equity firm Solution

Observations:

Transaction was completed in less than 90 days Private equity firm was looking for full and fair price and all cash at close…and got it

EBITDAType of Capital Multiple

Senior debt 4.00x

Mezzanine 1.50x

Seller debt -

"Friends and family" 1.25x

Equity raise from 401(k) 1.25x

Purchase price 8.00x

Management rolled most of its equity; in addition, former corporateexecutives invested on a pari passu basis

All in, 401(k) investments in employer securities represented less than 35%of total plan assets

Sources / Comments

Cash flow loan, raised at one turn above market at the time; ESOP tax shield,strong relationships, and management investment / strength contributed tothis above-market commitment

Mezzanine provider had a prior relationship with management, familiaritywith the ESOP tax shield, and an understanding of the improved debt serviceprovided by the structure

While common in many ESOP transactions, there was no seller financing inthis transaction

SUMMARY

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Summary: Review of Each of the Three Categories

Seller

Buyer

Investor

In select niche situations an ESOP can be a superior corporate finance alternative for private equity investors.

Large minority shareholder wants to stay Private equity majority owner wants to sell Private equity firm wants to divest a subsidiary

of a newly acquired company

Carve out of subsidiary/division using an ESOP Terminate existing ESOP

Maintain partial ESOP Acquisition financing potential Growth capital potential Take-out of minority, non-ESOP shareholder

potential Investor able to negotiate typical covenants,

including covenants related to activities of the company

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Questions?

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Join us for these related EES courses: Nov. 14 and 19: Employee Benefit Plan Accounting Issues

Update Accounting & Management Issues of Employee Stock

Ownership Plans (recorded on 5/23/13)

ESOPs for the Construction Industry (recorded on 6/18/13)

Read these related publications: MHM Messenger 11-13: FASB Proposal Affects Employee

Benefit Plans Employee Stock Ownership Plan Primer

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