Embed Size (px)
Citation preview
Employee Stock Ownership Plans2021
2
Last 17 years – senior East Coast partner of Menke &
Associates, focusing on ownership transitions through
ESOPs. Assisted over 250 companies in designing, adopting
and selling shares to new ESOPs.
Previously 14 years as director of mergers & acquisitions
investment banking for Morgan Stanley and Salomon Smith
Barney.
Previously two year as a research process engineer focusing
on chemical plant scale ups at the Rohm & Haas.
Chemical Engineering from the University of Delaware.
MBA in Finance from UCLA.
Board member - Boy Scouts of America, Del-Mar-Va Council.
Board member - Delaware American Heart Association.
Board member - Delaware Safety Council
Board member - Global Algae Innovations, Inc.
Board member - NY/NJ Employee Ownership Center.
Board member - St Hubert High School for Girls, Philadelphia.
ESOP speaker - ESOP Association, NCEO & CPA Academy.
Managing Director, Investment Banking, Menke & Associates, Inc.
Presenter - Phillip DeDominicis
Chesapeake City, MD(410) [email protected]
3
The largest ESOP advisor in the United States
Menke & Associates, Inc.
Chicago
Atlanta
Oakland
Wilmington, DE
Los Angeles
Chesapeake City, MD
Las Vegas
Naples
BurlingameCharlottesville, VA
Aiken, SC
Green Bay
4
Menke & Associates, Inc.
Oldest & largest ESOP Advisor
47 years in the business,
50 dedicated ESOP specialists; including
7 lawyers, 7 investment bankers; 20 recordkeepers
Most ESOPs Created
Over 3,500
We create 1 out of every 4 new ESOPs
Largest Current Number of ESOP
Clients 1,000+ clients
Most Sophisticated Online ESOP
Administration $4 mm investment
ESOP Owned
Menke is 70% ESOP owned
Introduction
6
Similar benefits of other qualified company funded retirement plans (e.g., 401k, PSP)
– Tax deductible contributions for employer
– Tax deferred growth investments for employees
But, it is also a company shareholder liquidity event
– ESOP invests primarily in your company’s stock
– Investments are directed by the board of directors
– Employees then participate in company earnings and growth
What is an ESOP?
7
Employee Benefit – The Four Steps
Distributions4
Eligibility/Participation1
Vesting3
Company contributions & dividends2
8
ESOP stock ownership of private companies -No requirement to sell a certain percent
Percent of each private company owned by its ESOP
0-10% 11-30% 31-50% 51-100%
Percent of 11,000 private ESOP
companies
20% 20% 25% 35%
Over 2,500 U.S. businesses are owned 100% by their ESOP!
9
ESOP benefits to business owners
Enhance employee productivity 5
Diversify owner’s asset allocation2
Real business succession strategy3
Increase company cash flow4
Liquidity for shareholders1
10
They are flexible and satisfy many different situations!
Sell all shares or just sell some
Sell shares now or sell shares later, or both
One partner sells, some partners sell, all partners sell
Stay, go, change position
Keep control, sell control
Never sell the business, sell the business later
Why are ESOPs popular?
11
ESOPs have been around since 1974.
Over 22,000 U.S. corporations have adopted ESOPs (DOL).
Average age of ESOP companies is 16 years (years the ESOP has been in existence). (ESOP Association 2014).
There are currently 11,000 privately held ESOPs (NCEO 2015).
ESOP owned businesses, on average, consistently outperform their peer group.
Some basic ESOP statistics
Polling Question #1
13
40% of working Americans have less than $10,000 of retirement savings (Bankrate 2018). 51% of adult Americans have more credit card debt than savings (New York Federal Reserve
2015).
Today, there are over 14.1 million participants (11% of non-governmental U.S. workforce) with $1.4 trillion in assets (28% of 401k assets). (NCEO 2017).
Average ESOP account size is $99,300. This is 4.5x the national average! (Rutgers & DOL)
New study shows ESOP participants in the 60-64 year age range have 10 times the retirement accounts than everyone else (approximately $400,000). (NCEO 2019)
Economic significance of ESOPs
14
ESOPs by Industry
ESOPs span all non-governmental industries
Technology
15
16.9%
22.4%
29.2%
14.3%
10.2%
6.9%
Number of employees in privately held businesses with an ESOP
Source: ESOP Association 2015 Survey
Employee count within private ESOP companies
50-99
10-49
Over 1,000
500-999
240-499
100-249
16
ESOPs create better companies!
Basic ESOP Structures
18
ESOP structures
ESOP + family owned business5
ESOP + partnership (“partners” in control)2
ESOP + numerous outside private S/H’s3
ESOP + public company shareholders4
ESOP + one owner/operator in control1
ESOP + special/minority status business6
100% ESOP7
ESOP followed by 100% sale to 3rd party8
19
Must borrow money
Must sell 30% or more
Must sell stock immediately
Will be at lower price than selling to 3rd party
Employees become shareholders/get a vote
Current owners lose control
More difficult to sell the business in future
Expensive
Existing ESOP misconceptions
All… NOT True!
20
The assets are held in trust for the benefit of plan participants
Trust is tax exempt
Trust shares are voted by ESOP trustee, NOT the employees
How is an ESOP structured?
ESOP Trust(controlled by
trustee)
Eligible Employees(“Participants”)
Loyalty &
hard
work
Retirement
benefits
21
Four basic ESOP transactions
Borrow cash – buy stock from shareholder2
Contribute stock directly to ESOP3
Use cash in ESOP to buy treasury shares4
Contribute cash – buy stock from shareholder1
Polling Question #2
23
ESOP Structure #1Cash contribution, buy stock from S/H
Company
ESOP Trust
Retirement plan & tax deduction
Cash (max 25%
payroll)
Diversificationor
Spending
SellingShareholders
Steps 1 and 2 do not need to occur simultaneously!
Cash
Cash Financial security,
better lifestyle
11
2
33
Company stock
2
1 Employee benefit
24
Company
Company stock
Cash or seller note
Lender
SellingShareholders
2
Financing loan proceeds
Note & collateral
1
1
2
A typical stock redemption (typical shareholder agreement)
Pro: Anti-dilutiveCon: Not Tax Deductible
25
ESOP Structure #2a Leveraged (borrow cash from bank)
Company
ESOP Trust
ESOP loan obligation
Cash
Lender
SellingShareholders
Company stock
Cash
2
3
3
Cash
Bank loan obligation
1
1
2
26
ESOP Structure #2b Leveraged (with seller financing)
Company
ESOP Trust
Employee benefit
Pledge agreement
SellingShareholders
Company stock
Seller note
27
ESOP Structure #3Stock Contribution
Company
ESOP
Retirement plan &
tax deduction
Newly issued stock
OutsideShareholders
1
Increase company cash & productivity
Dilution
2
2
1
1 Employee benefit
Typical ESOP Scenarios
29
Owners need an exit or desire some liquidity
Succession management team is or will be in place
Profitable – strong cash flow
ESOP valuation acceptable to owners
Company is large enough to warrant installation and maintenance expense (approximately 15 employees & $200,000 of pretax income)
Owners seek to increase employee productivity
Good ESOP candidates
30
Doctor & dental practices, CPA firms – depending on state licensing requirements, non-licensed professionals may not be able to own shares
Certain franchised businesses
Real estate or insurance agencies – if agents are “independent” and not W-2 employees
Minority-status businesses – ESOP is counted as a non-minority shareholder; limits ESOP to 49%
Unprofitable businesses
Scenarios where ESOPs may not work well
31
Owners
Company assumptions
Sales $20,000,000
Eligible Payroll $2,000,000
(max contribution 25% is $500,000 in this example)
Pre–tax Profit $2,000,000
Fair Market Value $10,000,000
Majority 75%
Minority 25%
32
Shareholder not ready to sell any stock but wants to create a tax deduction for this year and next year
Reasons for doing this include:
– (1) not ready to diversify
– (2) believe upside in stock price is great
– (3) want to accumulate enough funds to reach 30% threshold for §1042 rollover election
Objective #1
33
Company may prefund up to 25% of payroll, or $500,000 per year
ESOP accumulates $400,000 for future purchases of stock
Company receives tax deductions totaling $250,000 and $150,000 in years 1 and 2, respectively
Year 3 BOD can decide no contribution for various reasons
$250,000
$150,000
$0
Solution #1 The Prefunded ESOP
ESOP
ESOP
ESOP
Company
Company
Company
Year 1
Year 2
Year 3
34
0102030405060708090
100
1 2 3 4 5 6 7 8 9 10 11
ES
OP
Ow
ne
rsh
ip %
Year
Majority wants to cash out on a gradual basis (e.g. start with 5% sale)
Objective #2
35
Majority
Company
$500,000
$500,000ESOP
Solution #2Gradual or “pay-as-you-go” ESOP
Majority VOTES 75%4
Majority now owns 70%3
ESOP buys 5% of shares at FMV2
Next year BOD can elect to do a similar transaction5
Company makes a cash contribution1
Polling Question #3
37
Shareholders want to cash out pro rata(state law default)
Objective #3
7.5% of Company22.5% of CompanyESOP
(Post = 30%)
Minority
(Post = 17.5%)
Majority
(Post = 52.5%)
$2,250,000 $750,000
38
Company
ESOP
ESOP loan
obligation
$3,000,000
Shareholders
30% of Stock
$3,000,000
$3,000,000
Bank loan obligation
Solution #3Bank lends the money
39
Company
ESOP
ESOP loan
guarantee
$3,000,000 future
contributions and
distributions
Shareholders
30% of Stock
$3,000,000 seller note
Solution #3100% seller note
40
Solution #3 A Combination of Alternatives
ESOP
Shareholders
Prefunding -replaced profit
sharingor 401(k) match
$2,400,000 cash
$600,000 seller note
30% of
Company
$400,000$2,000,000
Company
41
Objective #4
Minority wants to cash out and retire
42
$2,500,000
$2,500,000
25% of Company
$625,000 cap gains tax
assuming $0 basis
Solution #4
Majority owns 75%and votes 100%
3
ESOP owns 25%2
Minority keeps 80% of …$ 750,000 (after tax)
1
ESOP
Bank(or seller note)
Minority keeps$1,875,000
Company
43
ESOP vs. Conventional Approach
Amount After–Tax Cost
Conventional Approach
Profit sharing and/or401(k) contributions
$2,500,000 $1,650,000
Treasury repurchase $2,500,000 $2,500,000
Total $5,000,000 $4,150,000
ESOP Approach
ESOP contribution $2,500,000 $1,650,000
44
Objective #5
Shareholders want to sell 100% of the company
45
Solution #5A The 1 Stage ESOP Buyout
YearEquityValue
SaleProceeds
P&I paymentEnding loan
balance
1 $10,000 $10,000 (100%) $1,359 $9,241
2 seller note 1,359 8,437
3 plus 1,359 7,585
4 bank 1,359 6,681
5 financing 1,359 5,723
6 1,359 4,708
7 1,359 3,361
8 1,359 2,491
9 1,359 1,282
10 1,359 0
($ thousands, 6% interest)
46
Solution #5B The 3 Stage ESOP Buyout
YearEquityValue
SaleProceeds
P&I paymentEnding loan
balance
1 $10,000 $3,000 (30%) $1,102 $2,048
2 (3 years, 5%) 1,102 1,049
3 1,102 0
4 $12,000 $3,600 (30%) 1,322 2,648
5 (3 years, 5) 1,322 1,649
6 1,322 0
7 $15,000 $6,000 (40%) 1,182 5,118
8 (6 years, 5%) 1,182 4,192
9 1,182 3,219
10 1,182 2,198
($ thousands)
Polling Question #4
48
Create a better incentive plan than the retirement plan or equity plans
the company is already funding
Objective #6
49
Productivity
Cash Compensation High
Low
Low
High
Solution #6 Cash only goes so far
50
Why replace 401(k) match or profit sharing with an ESOP?
– ESOP is a broader based retirement program –matching plans skewed to savers
– Replaces short-term, cash benefit with long-term, stock benefit
– Studies say productivity increases
– By definition, more stable company for employees
Solution #6 “Two Bangs for the Same Buck”
51
You can start your ESOP this year!
Solution #6 SolutionCombination of programs
ProgramCompatible with ESOP?
Typical Recommendation
PSP or SEP Yes But, typically replaced by ESOP
401k Match Yes Company match stops or lessened
401k Safe Harbor YesBut, ESOPs qualify for safe harbors too!
But, safe harbor $ to ESOP starts next year (30 day notice)
Pension Plan Yes Exclude union in ESOP
52
Solution #6 SolutionCombination of programs
Other plans
ProgramCompatible with ESOP?
Typical Recommendation
Model SEP NoTerminate & replace with
ESOP & 401(k) THIS year
Simple IRASimple 401(k)
NoTerminate (30 days) & replace with
ESOP & 401(k) NEXT year
53
MBO – buy shares directly
Sweat equity plans
– Management stock bonus plans
– Phantom stock plans
– Stock options
– Warrants
Solution #6 Other equity plans allowed
54
Objective #7
Raise Capital or Conserve Cash
55
Issue new shares to ESOP
Take tax deduction for fair market value of shares
Company conserves cash by:
– Paying less taxes
– Replacing cash compensation program, like 401k match or profit sharing, with non-cash ESOP
Solution #7The “Cash Flow ESOP”
56
Smaller Piece of a Bigger Pie?
Mr. Majority
Owns 100%
Without ESOP
“Percentage” Dilution May Not Be “Economic” (Per-Share) Dilution
Solution #7
With ESOP
Mr. Majority
Owns 85%
ESOP
Owns
15%
57
In a Single Action, Company Increases Cash Flow and Creates Employee Benefit
Solution #7 Example
No Plan ESOP
Earnings Before Taxes $500,000 $500,000
Retirement Plan Contribution 0 (300,000)
Adjusted Pre-Tax Earnings 500,000 200,000
Federal & State Taxes (44%) (220,000) (88,000)
After-Tax Income 280,000 112,000
Plus Non-Cash Contribution 0 300,000
Operating Cash Flow $280,000 $412,000
Increased Company Cash Flow $132,000
58
Replacing an Existing Cash Retirement Plan with a Stock Contribution Enhances the Cash Flow
Profit Sharingor 401k Match
ESOP
Earnings Before Taxes $500,000 $500,000
Plan Contribution (300,000) (300,000)
Adjusted Pre-Tax Earnings 200,000 200,000
Federal & State Taxes (44%) (88,000) (88,000)
After-Tax Income 112,000 112,000
Plus Non-Cash Contribution 0 300,000
Operating Cash Flow $112,000 $412,000
Increased Company Cash Flow $300,000
Solution #7 Example
Polling Question #5
S Corporation ESOPs
(Since 1996)
61
Company
ESOP (does notpay taxes)
Shareholders
30% distribution
Taxes
70% distribution
S Corporation –30% owned by ESOP
100% of ESOP distribution can be
used to repay ESOP loan quicker, buy
more shares, satifyrepurchase
obligation or build up cash in ESOP
62
Company
S Corporation –100% owned by ESOP
A 100% ESOP-owned S corporation pays no more income taxes!
ESOP
Distribution –optional
No longer a shareholder need
for company distributions for taxes (except for
repurchase obligations), so all pre-tax cash can
remain in the company’s balance
sheet.
C Corporation ESOPs
(Since 1974)
64
Private C corporations only
Shareholder must have owned shares >3 years
ESOP must now own 30% or more of the stock
Seller must reinvest proceeds within 12 months
Must invest in Qualified Replacement Property
Tax deferral continues as long as seller holds QRP
§1042 tax–deferred rollover requirements
65
Any “U.S.” corporation, public or private
Equity or debt securities
Can be a brother/sister, but not a subsidiary of the ESOP company
§1042 Qualified Replacement Property
Corporate Status
67
At time of ESOP
– 68% C corp
– 32% S corp
After ESOP
– 82% S corp
– 18% C corp
• 2015 ESOP Association study
Private ESOP owned businesses
68
Which way to go?
C remains C Keep §1042 option
Will not receive S corp distribution savings
C coverts to S(convert day after sale)
Receive §1042 initially
Receive S corp distribution savings
S remains S Receive S corp distribution savings
Forego§1042 option
S to C to S Get all ESOP tax benefits
Double taxed for 5 years
LLC to C then S Can only prefund ESOP this year
Can convert to C corp then immediately S corp
LLC to S Can only prefund ESOP this year
Selling shareholders can participate in ESOP
Polling Question #6
ESOP Valuation
71
ESOP can not pay more than FMV
Revenue Ruling 59–60
Fair Market Value (FMV) is the price at which the property would change hands
between a willing buyer and a willing seller when the former is not under any compulsion
to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
72
Why? Required by DOL and IRS
Independent appraiser required (unless publicly traded)
Responsibility of ESOP trustee
Frequency:
– As of transaction date
– At least annually AFTER ESOP owns shares
Consistency from year to year
Information & access to management required
ESOP valuation requirements
73
Value
How does ESOP value compare to other options?
Control Value
$1.15+ strategic value, if available
$1.15 control block ESOP sale
Minority Value (Liquidity Factor)
$1.05 public market
$1.00 minority sale to ESOP
$0.60-$0.80 private market – i.e., current buy-in method
$0.20-$0.50 orderly liquidation
74
External
– General economic outlook
– Nature and history of the industry
Internal
– Nature and history of the company
– Normalized historic and current earnings:– Non recurring income & expenses
– Non operating income & expenses
– Discretionary expenses
– Projected growth & earnings
Valuation criteria
75
Answer: Yes, no, maybe
– Lots of failed sales end up doing ESOPs
– Can always get ESOP price BEFORE trying to sell the business
– Most initial ESOP sales are only partial sales
– Company can ALWAYS be sold after ESOP is established
– ESOP allows founder(s) to remain, get paid, participate in ESOP and participate in company stock price upside by retaining outside shares
– Some ESOP structures allow for selling shareholders to receive additional equity upside through warrants or management equity compensation programs
– ESOP seller notes many times exceed the returns of company stock
Is ESOP price lower than 3rd party sale?
Control
77
No formal change in governance
–Shareholders elect the Board of Directors
•Also vote on major corporate transactions
–Directors responsible for running the company
•Can delegate authority to managers
–Officers/Managers appointed by Board
•Have responsibility for day-to-day operations
typically becomes the ESOP trustee retaining
control of day-to-day operations
Who runs an ESOP-owned corporation?
78
The ESOP Trust is the DIRECT owner of company stock, NOT the employees
Employees are BENEFICIAL owners, and thus, do not have the same rights as direct owners of stock
But who is the shareholder?
79
ESOPFiduciaries
ESOP Trust
ESOP Participants
Board of Directors
OutsideShareholder(s)
Management
Employees
For sales of <50% to ESOP,
or >50% at BOD option
Shareholders Retain Control –No Control Premium Received
80
Bill initially owns 100%
Bill sells 40% to ESOP with no control premium
Bill appoints himself as the ESOP fiduciary and then BOD
Bill votes his own remaining 60%
As the plan committee and trustee, Bill also votes the 40%
Hence, Bill still votes 100%
Board ofDirectors
ESOP PlanCommittee and
Trustee
Shareholders Retain Control
Appoints
Votes ESOP Shares
81
At times it may be advisable for the board of directors to hire an Independent Fiduciary to oversee a particular transaction involving the ESOP
Events to consider an Independent Fiduciary include
– 100% sale to an ESOP
– A sale to a third party for stock sales with proceeds greater than $2 million
– Transactions that include other aspects beside a sale of stock, e.g., a new MSBP, seller note with high interest rate or long maturity
Independent Fiduciaries
82
ESOPFiduciaries
ESOP Trust
ESOP Participants
Board of Directors
OutsideShareholder(s)
Management
Employees
Option for sales where
ESOP now owns >50%
at BOD option
Shareholders Give Up Control –Pricing Premium Received
If the seller wishes to receive a control premium price for the shares sold to
the ESOP, the seller must relinquish control of the company (not
control the Board or trust, but can still be CEO and
Chairman)
83
Mary initially owns 100%
Mary sells 60% to ESOP with control premium
Mary adds others as BOD and is not ESOP fiduciary
Mary votes her remaining 40%
Plan committee votes the 60%
Shareholders Give Up Control
Board ofDirectors
ESOP PlanCommittee and
Trustee
Appoints
Votes ESOP Shares
Polling Question #7
Financing Leveraged ESOPs
86
ESOP lending is a mature market and has been around for 40+ years
Most major financial institutions welcome the idea lending to ESOP owned companies
Why?
– ESOP companies tend to more stable
– Cash flow is better – tax deduction for interest AND PRINCIPAL on the loan value, and S Corp ESOPs can use pro rata distributions for loan repayments
ESOP Lenders
87
ESOP loans are normal corporate loans
– Bank debt recorded as employer debt
How is ESOP loan handled?
– Equity is reduced (contra-equity account) for “inside” or “ESOP” loan
– Equity is restored as inside loan is repaid
Bonding issues due to temporary negative impact to shareholders equity?
ESOP Loan Balance Sheet Effects
88
S corporation cash flow savings are even greater due to tax exempt status of the ESOP trust!
($ Thousands)
ESOP vs. Redemption Debt Financing
Redemption C Corp ESOP
Gross principal payments ($5,000 total) $1,000 $1,000
Principal tax deduction (40% tax rate) (0) (400)
Gross interest payments (5.0% vs. 4.5%) 250 225
Interest tax deduction (40% tax rate) (100) (90)
$1,150 $735
SAVINGS 36%
How the ESOP Plan Operates
90
Employee Benefit – The Four Steps
Distributions – very different than 401k4
Eligibility/Participation – typically similar to 401k1
Vesting – typically similar to 401k3
Company contributions – similar to 401k, maybe moreCompany dividends – different than 401k
2
91
A Participant who:
– Is over the age of 55, and
–Has 10 Years in ESOP
May direct a portion of his/her account to be transferred from Company Stock into Other Investments
–Up to 25% first five years
–Up to 50% after six years
Participant ESOPDiversification Option
92
Required Disclosure to Participants
YES NO
Individual’s Balance/Vested Amount
Per Share Value of Stock
ESOP Summary Plan Description
Company Financial StatementsNot required,
but beneficial
Officer Salaries
Company Valuation
93
Information, Good or Bad, Can Help!
Productivity
Stress
Low
Low High
High
94
Take care of your company
–Accountability to the company
–Accountability to the client
–Accountability to each other
–Accountability to yourself
Loyalty
Employee Investment
95
In the past 37 years, dozens of independent studies have measured employee productivity ESOP owned vs. non-ESOP owned companies. The results are indisputable.
– Higher sales growth vs. competition and vs. pre-ESOP
– Higher sales growth per employee
– Less likely to fail vs. competition
– Lower turnover
– Higher employee morale
– Employees, on average, have 4.5x retirement savings
– Ages 60-64, on average, have 10x retirement savings
– 81% of ages 22-40 feel a stake in the company (2x non-ESOP participants)
– Community wealth goes up!
Do ESOPs really increaseemployee productivity?
Next Steps
97
Step 1: Preliminary appraisal/feasibility study
Step 2: Design & adopt ESOP by fiscal year end
Step 3: Make annual contribution before filing taxes (including extensions)
Step 4: Sell shares to your ESOP at any time
Typical ESOP Steps
Polling Question #8
