ESOPs: Basics and Beyond Twin Cities FSPsfsptwincities.org/.../Handout_ESOPs...15_Three-Up.pdfESOP Tax Benefits $10M Sale of Stock MBO or Redemption ESOP ESOP Tax Savings Proceeds

9/1/2015

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Kelly O. Finnell, J.D., CLU, AIF®Executive Financial Services, Inc.

(901) [email protected]

ESOPs: Basics and BeyondTwin Cities FSP

The $10 Trillion Opportunity

Baby Boomer Business Owners

72% Planning for Monetization Event

62% Planningin the next 5-6 Years

Source: PricewaterhouseCoopers, Trendsetter Barometer™

The $10 Trillion Opportunity

Baby Boomer Business Owners

Source: White Horse Advisors, Survey of Closely-Held Business Owners

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Monetization Planning Strategies

Traditional Exit Paths:

Sale to Third Party Strategic Buyer

Private Equity Group

Lifetime Gift to Family Member

Management Buy-Out

Leveraged Re-cap

Monetization Planning Strategies

Traditional Exit Paths:

Sale to Third Party Strategic Buyer

Private Equity Group

Lifetime Gift to Family Member

Management Buy-Out

Leveraged Re-cap

Sale to Employee Stock Ownership Plan (ESOP)

Presentation Overview

Technical

Practical

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What is an ESOP?

Qualified Retirement Plan

2½ times Greater Contribution

What is an ESOP?

Tax-Efficient Liquidity

Keep Control

Retain Legacy

What is an ESOP?

Pre-Tax LBO

Tax-Exempt

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What is an ESOP?

Qualified Retirement Plan, but

An ESOP can borrow money

An ESOP can transact with “parties in interest”

An ESOP invests in the stock of sponsoring company

Creates

How Does an ESOP Work?

Company

ESOP & ESOP Trust

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Outside Loan


Company

InsideLoan


Outside LoanCompany

ESOP

InsideLoan


Outside LoanCompany

ESOPSelling

Shareholder

Stock

Cash + Seller Note

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Company

ESOP

Contribution/Dividend


Company

ESOP


Inside Loan Payment


Company

ESOP


Inside Loan Payment

EmployeesStock

Allocations

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Company

ESOP


Inside Loan Payment

EmployeesStock

Allocations

Outside Loan Payments

Seller Note Payments

Selling Shareholder

ESOP Tax Advantages

Corey Rosen, Ph.D.Former Executive Director, NCEO

“ESOPs were designed by Congress to provide unique tax advantages to owners, companies and employees,

advantages no other approach can replicate.”

ESOP Tax Advantages

Corporate Pre-Tax Debt Payment

Tax-Deductible Dividends

Tax-Free Stock Sale

Tax-Exempt Corporation

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ESOP Tax Advantages

CompanyContributions

CompanyDividends

ESOP Company

Tax-Deductible Corporate Expense

Loan Interest AND

Principal

ESOP Tax Benefits: Tax-Free Stock Sale

Only Available to C Corporation Shareholders

Like-Kind Exchange Requirements:

30% Rule

Qualified Replacement Property (QRP)

15-Month Rule

ESOP Tax Benefits: QRP

Eligible Not Eligible

Common Stock

Corporate FixedRate Bonds

Preferred Stock

Corporate Floating Rate

Notes

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ESOP Tax Benefits: QRP

Eligible Not Eligible

Common Stock

Corporate FixedRate Bonds

Preferred Stock

Corporate Floating Rate

Notes

U.S. Gov’t Bonds

Municipal Bonds

Foreign Securities

REITsCDs

Mutual Funds

ESOP Tax Benefits

$10M Sale of Stock

MBO orRedemption

ESOPESOP

Tax Savings

Proceeds to Shareholders

$7.62M1 $10.0M $2.38M

Cost to Company $10.0M $6.6M2 $3.4M

$5.78M (57.8%)

1 Assumes 23.8% federal tax on sales proceeds

2 Assumes 34% federal corporate tax rate

1 Assumes 23.8% federal tax on sales proceeds

2 Assumes 34% federal corporate tax rate

ESOP Tax Benefits: Tax-Free SaleCapital Gain (Taxed at 23.8%)

ESOP Sale$10,000,000

Taxable Sale$13,123,359

Net to Seller$10,000,000

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ESOP Tax Benefits: Tax-Free SaleC Corporation Asset Sale

(Taxed at 35%)




Capital Gain (Taxed at 23.8%)




ESOP Tax Benefits: Tax-Free Sale

Tax-Affected AEBITDA Multiples

Tax Rate0.0% 23.8% 35.0%

Multiple

4.0 4.0 5.25 6.154.5 4.5 5.91 6.925.0 5.0 6.56 7.695.5 5.5 7.22 8.466.0 6.0 7.87 9.236.5 6.5 8.53 10.007.0 7.0 9.19 10.77

ESOP Tax Benefits: Tax-Exempt Corporation

Only Available to S Corporations

No tax at corporate level

ESOP Trust is tax-exempt

To extent of ESOP’s ownership, S Corporation will not pay income tax

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ESOP Tax Benefits: 100% ESOP-Owned S Corporation

NO TAX ON CORPORATE INCOME!


$10M Sale of Stock

MBO/Redemption

ESOPESOP

Tax Savings

Tax on Company’s Income1

$792,0002 $0M3 $7.92MM4

1 Annual corporate earnings of $2MM

2 39.6% tax rate

3 Company operates as 100% ESOP-owned S Corporation

4 $792,000 per year for 10 years


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ESOP Transaction Major Issues

Valuation

Financing

Control

ESOP Valuation

Independent Trustee Responsibility

Qualified Independent Appraiser

Range of Value Report

Negotiate Transaction Terms

Fairness Opinion

Annual Valuation

Sample Multiples

Defense Contractor

ManufacturingCollection Agency

Revenue $266MM $10MM $25MM

AEBITDA $25.18MM $923k $2.42MM

100% Valuation

$180MM $6MM $18.5MM

AEBITDA Multiple

7.15 6.56 + $4MM Excess Cash

Tax Status C Corporation C Corporation C Corporation

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Sample Multiples

Environmental Consulting

Third-PartyLogistics

Mortgage Company

Revenue $50MM $213MM $50MM

AEBITDA $7.01MM $5MM $10.38MM

100% Valuation

$50.17MM $45.34MM $61.76MM

AEBITDA Multiple

6.5 + $4.6MM Excess Cash

9.61 –$4MM Debt

5.56 + $4MM Excess Cash

Tax Status C Corporation C Corporation C Corporation

ESOP Financing: Basic Structure

Excess Company Cash

Seller Note

Bank Loan

+ +Total

Transaction=


Excess Company Cash

Seller Note

Bank Loan

+ +Total

Transaction=

$2MM $4MM $4MM $10MM+ + =

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Excess Company Cash

Seller Note

Bank Loan

+ +Total

Transaction=

$2MM $4MM $4MM $10MM+ + =

$6MMCash atClosing

$320,000 per year(8% Interest + Warrants)

ESOP Financing: Advanced Structure

Excess Company Cash

Seller Note

Bank Loan

+ +

TotalTransaction

Mezzanine Debt

Cash Flow Lender

401(k) Lateral Transfer

++

ESOP Financing

Sources of Cash for Debt Service

Tax Savings

401(k) Match

Owner’s Adjusted Salary, Bonuses, and Perks

Corporate Earnings

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ESOP Financing

Control in ESOP Companies

Stock Ownership

Directed Trustee has legal title

Employees have beneficial interest

Trustee directed by Board

Seller Note Provisions

Limited Pass-Through Voting

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Characteristics of Good Candidates

For a Transaction

Owners accustomed to dealing with complexity

Previous transaction experience

Sophisticated advisor team

Strong successor management team


ESOP Specific Transaction

Tax Motivated

Legacy Motivated

AEBITDA of $1M +

Payroll (excluding Owner) of $1M+


ESOP Specific Transaction

Low level of debt

Commitment to employees/community

Mother Theresa/Gordon Gekko

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Recent EFS ESOP Transactions

Gov’t Contractor & Logistics Services

Tax Status S Corporation

Revenue $10.8M

AEBITDA $2.1M

Payroll $6.1M

Number of Employees

70

Transaction Price

$3M (49%)

Uniquely unsophisticated company

Credit union

Owner’s HELOC was company’s LOC

Outsourced CFO

Didn’t know what an “audit” was

No outside CPA firm

No corporate counsel

We recommended that the company hire IBG

Recent EFS ESOP TransactionsESOP Financing (New Bank)

$2M Bank Debt

No personal guaranty

$1M Seller Note

Company brought CFO in house

Seller took less value in order to reward employees

Retained flexibility for future transaction

Gov’t Contractor & Logistics Services


Revenue $10.8M

AEBITDA $2.1M

Payroll $6.1M

Number of Employees

70

Transaction Price

$3M (49%)

Reflections

Just met minimum transaction size ($3M)

Very smart Owner, but very low level of business knowledge and experience

Outsourced CFO

Credit Union

HELOC as Company LOC

“Audit”

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Reflections

Owner felt like transaction was difficult

Wanted everything to move in straight line (i.e., “cookie-cutter” process)

We referred Company to local CPA firm and banker


Manufacturing Company

Tax Status C Corporation

Revenue $10M

AEBITDA $1M

Payroll $3.2M

Number of Employees

75

Transaction Price

$6M (100%)

Owner (age 70) came in late, took a long lunch, left early

Company received LOI from strategic buyer, but plant would close

2 children employed, but not capable of leading the Company

2 long-term employees tapped as successor management team

Attractive collateral base

Property, Plant, and Equipment

Recent EFS ESOP TransactionsESOP Financing (New Bank)

$5M Bank Debt


$1M Seller Note

Incentives for successor management

Increased salary

ESOP Accounts

SAR Plan (20%)



Revenue $10M

AEBITDA $1M

Payroll $3.2M

Number of Employees

75

Transaction Price

$6M (100%)

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Recent EFS ESOP TransactionsChildren kept their jobs

Plant remained open

Seller made §1042 election

S election



Revenue $10M

AEBITDA $1M

Payroll $3.2M

Number of Employees

75

Transaction Price

$6M (100%)

Reflections

Successor management team negotiated very hard for increased pay and benefits

Recognized they were in strong position

Owner had transaction experience (LOI)

“Ruled out” sale to third party

Many great financing offers resulted from competitive process


Logistics Services


Revenue $213M

AEBITDA $5M

Payroll $10M

Number of Employees

145

Transaction Price

$22.5M (49%)

Owner (age 68) diagnosed with multiple myloma

Company hired IBG to sell Company

IBG brought stalking horse with LOI

Owner walked out of meeting

Strong successor management team

President and CFO ran ESOP process

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Recent EFS ESOP Transactions9.61 Multiple

49% sale of CPS

ESOP Financing (Existing Bank)

$6M Bank Debt


$16.5M Seller Notes + Warrants

Logistics Services


Revenue $213M

AEBITDA $5M

Payroll $10M

Number of Employees

145

Transaction Price

$22.5M (49%)

Recent EFS ESOP TransactionsIncentives for successor management

Increased salary and bonus pool

SAR Plan (15%)

Owner did NOT make §1042 election

Age and health

15% rate on Capital Gains

Logistics Services


Revenue $213M

AEBITDA $5M

Payroll $10M

Number of Employees

145

Transaction Price

$22.5M (49%)

Reflections

ESOP can pay as much as any financial buyer

Used convertible preferred stock to mitigate impact of minority interest discount

Owner entrusted transaction process to successor management team

Issues with lender counsel

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Recent EFS ESOP TransactionsPlant Automation & Information

Systems


Revenue $25M

AEBITDA $3.8M

Payroll $17.6M

Number of Employees

150

Transaction Price

$23.7M (100%)

55 Shareholders (all employees)

Sophisticated company and employees

Great CFO

Very involved President and Benefits Manager

“Won’t take a penny less than $25 per share”

Recent EFS ESOP TransactionsESOP Purchase Price: $27.50 per share

ESOP Financing (Existing Bank)

$5M Bank Debt


$18.7M Seller Notes

Incentives for executive team

Increased salary and bonus pool

SAR Plan (40%): Sellers accepted less than FMV for stock in exchange for richer SAR package

Plant Automation & Information

Systems


Revenue $25M

AEBITDA $3.8M

Payroll $17.6M

Number of Employees

150

Transaction Price

$23.7M (100%)

Reflections

Company was very well prepared for ESOP

Fired first ESOP consultant and hired us

Purchased 22 copies of my book

Had internal ESOP education session led by CFO

Great attitudes

CFO viewed financial due diligence process as a “learning opportunity”

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Missile Defense Contractor


Revenue $266M

AEBITDA $25.2M

Payroll $105M

Number of Employees

1,200

Transaction Price

$84M (51%)

200 Shareholders

Extremely well-educated workforce

200 employees hold Ph.D. in engineering or physics

Virtually unlimited opportunities to sell to strategic buyer

Board committed to maintaining company’s independence

$120M in 401(k) Plan Assets

Recent EFS ESOP TransactionsESOP Financing

$10M Bank Debt ($25MM committed)

$47M Seller Notes (7% interest)

$27M Lateral Transfer

Virtually no incremental cost



Revenue $266M

AEBITDA $25.2M

Payroll $105M

Number of Employees

1,200

Transaction Price

$84M (51%)

Recent EFS ESOP TransactionsS election

$10M annual tax savings

Government contractor, redirected PSP contribution

Gifts to local community foundation of $5M

ESOP purchased shares from foundation



Revenue $266M

AEBITDA $25.2M

Payroll $105M

Number of Employees

1,200

Transaction Price

$84M (51%)

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Reflections

Many shareholders preferred a Seller Note to cash at Closing

Despite transaction complexity, process completed in 6 months

$2M+ in Company fees

ESOP Committee/Successor Management Team

Co-op most challenging employee

Consider an ESOP…

Minority Interest Transaction

Buyout minority shareholder

“Take Chips off the Table”

Owner Insists on Control

Post-Transaction

Over the Transaction Process

Consider an ESOP…

Liquidity Event Plus Family Succession

Committed to Independence

No Market for the Company

ESOP as Stalking Horse

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Consider an ESOP…

“Don’t Repay Employee Loyalty with Betrayal”

“Mergers and Executions”

“Maintain Company Culture”

“My Company is an Integral Part of my Identity”

Consider an ESOP…

“Government Contractors”

Private Utilities

ESOP Contra-Indicated…

Hot Target for Strategic Buyer

Niche Industry Segment

IP

Exceptional Financial Performance

Gordon Gekko Type Owner

Highly Leveraged Company

Want to “Take the Money and Run”

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Cost-Benefit AnalysisProjected ESOP

Implementation Fees

of $20,000,000 ESOP Transaction

ESOP Consultant

Valuation

Trustee

Trustee Counsel

Other

Total Cost

1.65%

Total

$200,000

$35,000

$35,000

$50,000

$10,000

$330,000*

2.59%

* Does not include fees for corporate counsel or accountant

Projected ESOP Tax Benefit2

over the next 10 yearsSelling

ShareholdersCompany

$4,760,000(23.8% Capital Gains Rate)

$8,000,000(40% Corporate Tax Rate)

$12,760,000

% of Fees

$4,760,000(23.8% Capital Gains Rate)

$12,760,000

$8,000,000(40% Corporate Tax Rate)

Documents

ESOPs: Basics and Beyond Twin Cities FSPsfsptwincities.org/.../Handout_ESOPs...15_Three-Up.pdfESOP Tax Benefits $10M Sale of Stock MBO or Redemption ESOP ESOP Tax Savings Proceeds