Succession PlanningThrough ESOPs

James F. Higgins, Jr.PrincipalSES Advisors, Inc.

East Coast Estate Planning Council – West Palm Beach, FL

May 2006

2

Program Agenda

Introductions

Ownership Transition: Issues Facing Private Business Owners

Alternative Transition Choices

Case Studies

Section 1042 – Sale of a Business to an ESOP – Tax-Free Rollover Break

Financing Leveraged ESOPs

ESOP Mechanics

ESOPs and Employee Productivity

Valuing Closely-Held Companies

Q&A

3

An Issue Facing ManyPrivate Business Owners

4

Cash10%

Equities55% Fixed Income

35%

Net Worth: Properly Diversified?

5

Fixed Income4%

Equities6%

Cash1%

Private Company

89%

Typical Net Worth of Private Business Owners

6

The business owner wants cash for his or her company stock

However, there may be several constraints to consider….

Owner may not be ready/willing/able to “ride out of town” tomorrow

Owner wants management to buy the company; however, management does not have the cash

Owner wants to minimize personal and corporate taxes

Some of the company’s shareholders may not want to sell

Owner wants to ensure that the employees are not adversely impacted

Ownership Transition Challenges for Private

Business Owners

7

Ownership Transition Alternatives for

Private Company StockSale

Merger

Going public

Redemption

Management buyout

ESOP

8

Sale of Company

PositiveCan usually attract top dollarMay be quickest exit

NegativeTime consuming and disruptiveInformation disclosure

Issues to ConsiderAll or nothing transaction – no partial saleContingencies can cause unforeseen

problems

9

Merger

PositiveMay be tax-free transactionSynergies can enhance value

NegativeYou may no longer be in controlYou must accept acquiring company’s stock

Issues to ConsiderRequires 80% or more of stock – no partial

saleNet worth diversification has not improved

10

Initial Public Offering

PositiveGreat strategy for a hot company in a hot market“Bragging rights”Access to “OPM” for growth capital

NegativeIPO proceeds rarely cash-out ownersConsumes a significant amount of executives’

time

Issues to ConsiderCritical mass and a good “story” are a mustTiming is everything . . .

11

Redemption/Buy-Sell

PositiveOften pre-negotiated with shareholdersAccretive to remaining shareholders

NegativeFinance with after-tax dollarsBuy-Sell valuation formulas can be

arbitrary

Issue to ConsiderWill a bank finance the transaction?

12

Management Buyout

PositiveInside/friendly transactionTypically a quick turnaround

NegativeFinancing is a major issueOnly a few employees own all of company

Issue to ConsiderIs the seller willing to accept credit risk

and a loss of control of the company?

13

The ESOP Alternative

14

What is an ESOP?

“Employee Stock Ownership Plan”

Company funded only, no employee contributions

Employees do NOT own the stock

Qualified retirement plan under IRS

Only qualified retirement plan that can borrow money

No corporate financial disclosure required except in limited circumstances

15

To Business Owners the ESOP is:…a Buyer of Stock

To Employees the ESOP is:…a Company Funded Retirement

Plan

To Companies the ESOP is:…a Corporate Finance Technique

Beauty is in the Eye of the Beholder…

16

To make a market for part of the owners’ stock

To defer payment of capital gains taxes

To borrow where the interest AND principal payments are tax-deductible

To enable owners to sell shares while maintaining control of the company

To motivate, retain and reward employees

Why Use An ESOP:

17

Common ESOP Misperceptions

An ESOP is a Stock Option plan

Employees own the stock of the company

Employees are entitled to the company’s financial information

Company has to be a C corporation

ESOP must own ≥ 30% of the company

FALSE!

FALSE!

FALSE!

FALSE!

FALSE!

18

ESOP Case Studies

19

Case Study Assumptions

XYZ Corp. has two shareholders:

Jim owns 51%

Pat owns 49%

XYZ is profitable and has a payroll of approximately $2 million

The value of XYZ’s stock is $6 million

20

Case I

Jim is seeking to sell his stock over several years as he approaches retirement

XYZ Corp. would prefer to remain debt-free

21

The Pay-As-You-Go ESOP:

A retirement benefit thatprovides “double duty”

Case I Solution:

22

$24

0,0

00 C

ash

Con

t ri b

uti o

n

4% ofXYZ

Shares

Pay-as-You-Go ESOP

XYZ Corp

ESOP Jim

$240,000 Cash

RESULT:• ESOP owns 4% of XYZ• Jim now owns 47%• Post transaction, Jim is appointed

Trustee and votes the ESOP’s stock thereby maintaining 51% voting control

• Jim can continue this stock sale strategy each year at his discretion

(Taxable Transaction)

23

Case II

The company has just experienced several financially challenging years

The company’s prospects are now much brighter

Jim would prefer to postpone selling stock until the share price has improved

Company wants to immediately reduce income taxes

24

The Pre-Funded ESOP:

Creating a “Nest Egg” for a Future Stock Sale

Case II Solution

25

RESULT:• Company receives tax deduction for

contributions each year, thereby reducing tax bill

• ESOP accumulates $1,000,000 (+) of cash over three years

• Jim sells 16.7% of stock to ESOP after Year 3

$200,000Year 1

$500,000Year 2

$300,000Year 3

Pre-Funding the ESOP

Sto

ck

$1,0

00,0

00

XYZ Corp ESOP

Jim(Taxable Transaction)

$200,000$700,000$1,000,000

26

Case III

Jim wishes to sell a large block of stock

Jim does not want to pay capital gains taxes

The company has “debt capacity”

27

The Leveraged ESOP Transaction:

The most common ESOP transaction

Case III Solution

28

The Leveraged ESOP Transaction

The ESOP purchases $1.8 million (30%) of XYZ’s stock from Jim

The stock purchase is financed with a $1.8 million loan, which will be repaid over time

The shares bought by the ESOP will be “allocated” to eligible employees’ accounts as the debt is repaid

29

Bank

$1.8 Million Note Payable

$1.8 Million Cash

$1.8

Mi ll

i on

Ca

sh

$1

.8 M

illio

n N

ote

Pa

yab

le

$1.8 Million Cash

30% of the

OutstandingShares

The Leveraged ESOP

XYZ Corp

ESOP Jim

XYZ Stock

30

Results

Jim now has $1.8 million which can now be used to execute his financial and estate planning objectives

No capital gains taxes due (C corps only)

Jim retains control of the company post-transaction

Employees will receive new retirement benefit that is tied to the success of the company

Company repays transaction debt using pretax dollars

31

Paying for the Stock

The company will make annual tax deductible contributions to the ESOP

The ESOP will use the contributions it receives to make P&I payments on the debt that it borrowed from the company

The company will use the cash that it receives on the loan payments it receives from the ESOP to make P&I payments to the financial institution

32

1. Company makes tax deductible contribution and dividends to the ESOP

2. ESOP uses the contribution to repay its loan from company

3. Company repays Bank

Paying Off The Debt

An

nu

al E

SO

P C

ont r

i but

ion

Ter

m L

oan

Rep

aym

ent

Term Loan Repayment

XYZ

ESOP

$500,000

$500,000$500,000

Bank

33

Gross Interest Payments * 378,000 280,800Value of Interest Tax Deduction (151,200) (112,320)

“Regular” ESOP

Regular vs. ESOP Debt Financing

Gross Principal Payments 1,800,000 1,800,000Value of Principal Tax Deduction 0 (720,000) Net After-Tax Principal Paid 1,800,000 1,080,000

Net After-Tax Financing Cost $2,026,800 $1,248,480

Net Cash Savings Using ESOP $ 778,320

38% SavingsAssume:Principal: $1.8 million, Interest Rate: 6%, Amortization: 6 equal annual payments, Tax Rate: 40%* Cash tax savings applied to prepay principal, thereby reducing interest expense.

34

Total Tax Savings

To Seller (Savings on Fed. and State Capital Gains Tax (20%))

$ 360,000

To Company (Tax Deductible Principal) 778,320

Total Tax Savings

$1,138,32

063% of the $1.8 million transaction !

35

Case IV

Jim wants to sell a large block of stock

Company is adverse to borrowing money from a bank

Jim is interested in seller financing the stock sale to the ESOP

36

The Seller Financed Leveraged ESOP Transaction

Case IV Solution

37

Seller Debt

Selling shareholder receives note from the ESOP as consideration for all or a portion of the ESOP shares sold

Typically principal payments are postponed until senior term debt is fully retired

Seller debt typically subordinated to other debt

Higher risk inherent in seller debt security can result in higher interest rates

38

$1.8 Million Note

30% of the Outstanding

Shares

Seller Financed ESOP

XYZ Corp

ESOP Jim

XYZ Stock

Bank

CorporateGuaranty

39

Jim

1. Company makes tax deductible contribution and dividends to the ESOP

2. ESOP uses the contribution to repay Jim’s seller note

Paying Off The Seller Note

An

nu

al E

SO

P C

ont r

i but

ion

Term Loan Repayment

XYZ

ESOP

$500,000

$500,000

40

Tax Treatment on Seller Note

Interest earned will be taxed at ordinary income rates

Tax treatment of seller note principal payments: Taxed at capital gains tax rates on an

installment sale basis*Deferred using floating rate notes (C corps only)

* If note exceeds $5mm, IRS will charge deferred tax interest

41

Case V

Company is an S corporation

The company/shareholders want to maintain their S election

Selling shareholders are “at peace” with paying capital gains taxes given relatively lower capital gains tax rates

42

S Corporation ESOP

Case V Solution

43

S Corporation ESOPs

Prior to 1998, S corporations could not have ESOPs

S corporation ESOPs do not qualify for capital gains tax deferral, however…..

Some clients will convert from an S corporation to a C corporation to receive the favorable capital gains treatment, still……

Half of our clients transact as S corporations where the selling shareholders immediately pay the capital gains tax

There are unique tax benefits for S corporation ESOPs

44

S Corporation ESOP Tax Benefits

S corporation shareholders are responsible for paying their pro rata share of the company’s tax liability

An ESOP is a qualified, tax-exempt trust similar to a 401(k) trust

As an S corporation shareholder, the ESOP is not required to pay its pro rata share of the company’s taxes

ESOP can use distributions it receives to pay debt rapidly

45

Terminating theS Corporation Election

Step 1Make a tax free cash distribution of AAA balance or convert AAA balance to shareholder note

Step 2Convert company to a C corporation

Step 3Sell zero-basis equity tax free using a §1042 ESOP transaction

46

FI

S Corporation Distributions with ESOPs

S Corp

ESOP(40% Shareholder)

Assumptions•S Corp generates taxable income of $1,000,000

•S Corp makes a $500,000 distribution to its shareholders pro-rata

Jim(60% Shareholder)

$300

,000

Dis

trib

uti

on

IRS

$200

,000

Dis

trib

uti

on

$200

,000

Lo

an P

mt.

$200,000Loan Payment

Tax Payment

47

The S Corporation Home Run

An S corporation that is 100% owned by an ESOP

Company is exempt from federal and most state income taxes

Cash flow used to rapidly retire debt

Once debt is paid, company is a “cash cow”

48

The S Corporation Grand Slam

Shareholders sell 100% of C corporation stock to an ESOP

No capital gains tax due for selling shareholders

Company converts from a C corporation to an S corporation after the ESOP transaction

Company is now tax free

49

S C CorporationPrimary Considerations

Percentage of stock being sold

May force switch from cash to accrual accounting

Effect on non-employee shareholders

May limit shareholder to “Reasonable Compensation”

LIFO reserve recapture

Double taxation on earnings and bulk sale of assets

Conversion can occur at any time

50

Section 1042 – Sale of a Business to an ESOP

51

52

53

54

55

56

57

58

59

Financing the Leveraged ESOP

60

Financing the Leveraged ESOP

How much will the lenders lend? Balance sheet debt capacity

Cash flow debt capacity

Leverage debt capacity

61

Balance Sheet($000)

Cash $ 300A/R 1,000Inventory 1,590Prepaid Expenses 400 Current Assets 3,290

PP&E 4,000Less: Accum. Dep. 1,200 PP&E, Net 2,800

Total Assets $6,090

Line of Credit $ 950CMLTD 200A/P 1,300Accruals 600 Current Liabilities 3,050

Long-term Debt 1,040

Owners’ Equity 2,000

Total Liabs + Equity $6,090

62

Balance EffectiveSheet Advance “Bankable”

Amount Rate Collateral

Cash $300 0% $ -A/R 1,000 80% 800Inventory 1,590 60% 954Prepaid Expenses 400 0% -Net PP&E 2,800 50% 1,400 Gross Balance Sheet Capacity 3,154 Less: Outstanding Debt (2,190)

Marginal Balance Sheet Borrowing Capacity $964

Balance Sheet Borrowing Capacity($000)

63

Sample Income Statement($000)

Income Statement 2000 2001 2002 2003 2004

Net sales 8,145$ 8,574$ 9,025$ 9,500$ 10,000$

Cost of Goods Sold 5,702 6,002 6,318 6,650 7,000

Gross profit 2,444 2,572 2,708 2,850 3,000

Operating Exps/SG&A 1,772 1,865 1,963 2,066 2,175

Income from operations 672 707 745 784 825

Depreciation 163 171 181 190 200

EBITDA 835$ 879$ 925$ 974$ 1,025$

64

Average EBITDA 975$ Less: Interest on Existing Line of Credit (45)

Gross Cash Flow Avail. for Long Term Debt Service 930$ Divide by: Cash Flow Coverage Ratio 1.5 x

Net Cash Flow Available for Long Term Debt Service 650$

Cash Flow Debt Capacity ($650 pmt, 7%, 6 years) 3,097$ less: Existing Long Term Debt (1,240)

Marginal Cash Flow Borrowing Capacity 1,857$

Debt Service as % of EBITDA 63% Implied Coverage 1.58

Cash Flow Borrowing Capacity($000)

65

Maximum Leverage Borrowing Capacity

($000)

Most Recent 12 Month EBITDA 1,075$

Maximum Leverage Multiple 3.50x

Maximum Gross Debt Capacity 3,763

Less: Existing Debt (Short & Long Term) (2,190)

Net Leverage Borrowing Capacity 1,573$

66

Stand Alone Senior Debt Loan “Sizing”

Balance sheet borrowing capacity $964,000

Cash flow borrowing capacity $1,857,000

Leverage borrowing capacity $1,573,000

The maximum of new “Stand Alone” senior debt that the company can borrow is $964,000

Company could probably borrow up to approximately $1.5 million in new bank debt with additional external credit support

67

Limited Personal Guaranty

Selling shareholder makes a limited guaranty for the uncollateralized portion of the loan

Typically, all or a portion of sales proceeds are used as collateral to support limited guaranty

Limited guaranty typically “ratchets” down annually as company pays down principal and loan/value ratio decreases

68

How does theESOP Operate?

69

What Stock May the Plan Purchase?

The “Highest & Best” Class

Other Classes

70

What InvestmentsMay the Plan Hold?

Primarily: “Employer Securities”

But Also: Any other prudent investment

71

To store up cash for future stock purchases From shareholders From ESOP participants

To provide investment diversification

Why Hold “Other Investments”?

72

Who Participates in the ESOP?

Which employees can be plan participants?

All employees

Possible exclusions:

Union members Part-time or short term employees Employees under age 21 Employees of subsidiaries Highly compensated employees Original shareholders Leased employees

73

Highly Compensated Employees

Who is “Highly Compensated” in 2005?

Anyone employee paid over $90,000 in 2004 (increases to $95,000 in 2005)

Anyone owning at least 5% of the company during 2003 or 2004

There is a “top 20%” limit, so that if a company has a large number of high earning employees, only the top 20% highest paid are considered HCEs

74

When do Employees BecomeEligible to Participate?

Immediately

Deferred

1,000 hours of service

12 consecutive months of service

75

What is Covered Compensation?

W-2 wages

Bonuses and overtime

Commissions

“Covered Compensation” is limited to a maximum of $210,000 in 2005, so any wages in excess of $210,000 are ignored for the purposes of allocations

76

Maximizing Corporate Deductions

§404 Limitation: A company may deduct contributions* to qualified retirement plans for tax purposes to the extent that the aggregate contributions to such plans do not exceed 25% of aggregate eligible compensation.

§415 Limitation: The most any employee can accumulate in deferred compensation for retirement plans. Currently, that limit is the lesser of 100% of pay or $42,000 in 2005

*Includes ESOP, Profit Sharing and 401(k) matching contributions.

77

Over 25% of Covered Compensation:

Interest on ESOP loan (1/3 rule – C corps only)

Deductible dividends on C corporation ESOP stock

Further Maximizing Your Deductions

78

When are dividends paid on ESOP-owned stock deductible?

C corporations ONLY

Must be paid by fiscal year end

Must be “reasonable”

When applied to pay down the loan used to buy those particular shares

When paid out directly to plan participants

Preference item for AMT

Deductible Dividends?

79

Allocations of ESOP Benefits

ESOP benefits are generally allocated to the participants on a relative compensation basis

Example:

• Sam’s compensation is $20,000 in 2004• Pat’s compensation is $40,000 in 2004• Pat’s 2004 ESOP benefit will be twice as much as Pat’s

benefit*

* This is a general illustration and actual allocations may be impacted by various IRS limitations.

80

Individual Allocation Limitations

For §1042 Transactions:

Seller and family may NOT receive any stock allocation in the ESOP

Other non-selling shareholders who own at least 25% of the company and their family may not receive any stock allocation in ESOP

81

Vesting

Death, Disability or Retirement

Participant’s account must become fully vested upon retirement, but typically becomes vested for retirement and disability as well

Terminated (Quits or is Fired)

Only the vested portion of the participant’s account becomes payable

82

Years of Service for Vesting

Several choices in designing the ESOP:

Vesting commences with inception date of ESOP

100% credit for prior years of service

Partial credit for prior years of service

Revert to vesting status under prior or existing plan (e.g. 401(k) plan)

83

Vesting

Death, Disability or Retirement

Participant’s account must become fully vested

Terminated (Employee Quits or is Fired)

Only the vested portion of the participant’s account becomes payable

84

7 Year “Graduated” Vesting

0%

20%

40%

60%

80%

100%

0 1 2 3 4 5 6 7Years of Service

% o

f ESO

P B

enef

it V

este

d

85

5 Year “Cliff” Vesting

0%

20%

40%

60%

80%

100%

0 1 2 3 4 5 6 7Years of Service

% o

f ESO

P B

enef

it V

este

d

86

Distributions for Non-Terminees

Distributions commence during the year following death, disability or retirement

Distributions can be in a lump sum or in annual installments over five years

(e.g. Death, Disability or Retirement)

87

Distributions ofTerminated Participants

Plan can be designed to delay distribution payments on vested balances for up to 5 years after termination, unless participant reaches retirement, dies or becomes disabled

Distributions can be in a lump sum or in equal annual installments over five years

Exceptions: If C corporation ESOP loan is still outstanding If account balance is greater than $800,000, then

one additional year for each $160,000 increment

(e.g. Employee Quits or is Fired)

88

Taxation to Participant Upon Distribution

Taxes deferred if properly rolled over into another qualified account (e.g. I R A)

Taxed as ordinary income with a potential penalty if not properly rolled over

Cash out distributions made to employees 59 ½ and younger are subject to a 10% excise tax

89

Form of Distribution

Cash

Stock Put option Right of first refusal Mandatory cash out

• S corporation• Amend C corporation bylaws and/or create an

“employee only” class of stock

90

Diversification Requirements

Participants who . . . Have reached age 55, and

Have participated in the ESOP for 10 years or more: May direct that up to 25% of their company stock

account be distributed or transferred from company stock into other investments

Once the participant reaches age 60 with at least 10 years of service in the plan, the participant can diversify an additional 25% of the company stock account

91

Voting Rights

On ordinary issues – Trustee votes stock unless company wants to provide employees with vote

On special issues – “Pass-through” voting rights:

On merger, consolidation re-capitalization or on liquidation or sale of substantially all corporate assets

ESOP Participants only vote allocated shares Trustee votes the unallocated shares

No pass-through voting rights for sale of stock for cash

92

• Account Balance

• Vested Percentage

• Per Share Value of Stock

• Financial Statements

• Salaries of Officers

• Valuation of Company

Yes No

InformationDisclosed to Employees

93

Trustee’s Fiduciary Responsibility

ProfitSharing

ESOP

Fair Rate of Return Yes No

Diversification Yes No

Liquidity Yes No

Fair Market Value Appraisal YesYes

Do ESOPs Really

IncreaseEmployeeProductivi

ty

95

Do ESOPs IncreaseEmployee Productivity?

Northwestern University and Hewitt Associates (1999)

2.7% higher return on assets compared to non-ESOP companies

6.9% higher total shareholder return compared to non-ESOP companies

96

Power of the Multiple

Each employee increases profits by $2,000 in a year =

$200,000 increase in pretax earnings

Price/Earnings (P/E) multiple is 5x =

Company’s value increases $1,000,000

Direct shareholders own 70%=

$700,000 extra value for direct shareholders

ESOP owns 30% =ESOP value increases $300,000 or $3,000 / employee account

ASSUME: 100 EMPLOYEES

97

Valuing Privately HeldCompanies for ESOPs

98

Tiers of Value

Control

Publicly TradedMinority

Non-Public MinorityWith a Put Option

Liquidation

Non-Public MinorityWithout Put

$6.00

$10.00

$12.00

$13.50

$17.00

99

Valuation Criteria

FinancialPerformance

100

Business Valuation Approaches

Income approach

Market approach

Asset-Based approach

101

Income Methods

Capitalization of adjusted earningsNormalize earnings to determine adjusted

earningsBuild-up capitalization rate

Discounted Cash FlowNet present value of future cash flows as

prepared by management

102

Discounted Cash Flow Analysis

103

Cost of Equity Estimate

Risk Free Long-term U.S. Treasury Rate (20 Yr. Bond)14.81% r f

Common Stock Equity Risk Premium27.00% r m

Small Stock Equity Risk Premium - Decile 10b39.16% r s

Base Small Stock Equity Discount Rate 4 20.97% r b

Company Specific Risk Premium54.00% r p

Estimated Cost of Equity6 (Rounded) 25.00% r E

1 Representative Over-the-Counter quotation as of 3/2/05. Source: eSpeed/Cantor Fitzgerald2 Assumes β = 1.00 . Source: Ibbotson Associates3 Source: Ibbotson Associates

4 r b = r f + β x (r m-r f) + r s. We assumed that the company is positively correlated to the S&P 500 and we therefore assume β = 1.005 Company specific risk addresses the business or unsystemic risk premium associated with the company based on our informed judgement.

6 r E = r b + r p.

Weighted Average Cost of Debt

Amount RateLine of Credit and Overdraft less cash on hand 1,875,433$ x 3.4% = 3.27%Term Debt 75,084 x 5.0% = 0.19%

Total Value of Debt 1,950,517$ Weighted Average Cost 3.46% r D

Weighted Average Cost of Capital Estimate

Estimated Cost of Equity 25.00% r E

Weighted Average Cost of Debt 3.46% r DEstimated Marginal Tax Rate (State and Federal) 40% T c

Market Value of Debt 1,950,517 DProxy Estimate of Market Value of Equity Capital 2,750,000 E e Total Long Term Invested Capital 4,700,517 I c

Weighted Averaged Cost of Capital (WACC) - Rounded 15.50% r * r D x (1-T C ) x D/Ic + r E x E e /Ic

Weighted Average Cost of Capital ("WACC") Buildup

104

WACC* 15.50%TVGR** 3.5%

Oct-04 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8Revenue 17,445,651$ 18,317,934$ 19,233,830$ 20,195,522$ 21,205,298$ 22,265,563$ 23,378,841$ 24,547,783$ 25,775,172$ (Growth Rate) 20.4% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

COS 15,246,930 15,387,064 16,156,417 16,964,238 17,812,450 18,703,073 19,638,226 20,620,138 21,651,145

Gross Profit 2,198,721$ 2,930,869$ 3,077,413$ 3,231,283$ 3,392,848$ 3,562,490$ 3,740,615$ 3,927,645$ 4,124,028$

Operating Expenses (Pre-Depreciation) 1,753,842 1,806,457 1,860,651 1,916,471 1,973,965 2,033,184 2,094,179 2,157,004 2,221,715

EBITDA 444,879$ 1,124,412$ 1,216,762$ 1,314,813$ 1,418,883$ 1,529,306$ 1,646,435$ 1,770,641$ 1,902,313$ (EBITDAE Margin) 2.6% 6.1% 6.3% 6.5% 6.7% 6.9% 7.0% 7.2% 7.4%

Less: Depreciation Expense (41,000) (42,000) (43,000) (44,000) (45,000) (46,000) (47,000) (48,000)

EBIT 1,083,412$ 1,174,762$ 1,271,813$ 1,374,883$ 1,484,306$ 1,600,435$ 1,723,641$ 1,854,313$ Less: Taxes @ 40% of EBITE (433,365) (469,905) (508,725) (549,953) (593,723) (640,174) (689,456) (741,725) Plus: Depreciation Expense 41,000 42,000 43,000 44,000 45,000 46,000 47,000 48,000 Less: Capital Expenditures (41,000) (42,000) (43,000) (44,000) (45,000) (46,000) (47,000) (48,000) Less: Changes in W/C (109,797) (261,059) (274,243) (288,090) (302,633) (317,907) (333,950) (350,799)

Free Cash Flow 540,250$ 443,798$ 488,845$ 536,840$ 587,951$ 642,354$ 700,235$ 761,789$

Terminal value using WACC of 15.5% and TVGR of 3.5% - - - - - - - 6,570,431

Present Value of Cash Flows using WACC of 15.5% 502,694 357,530 340,970 324,196 307,413 290,786 274,448 2,488,116

Net Present Value of Future Cash Flows 4,886,153$

Add: Value of Officer Loan Receivable - Add: Cash Surrender Value of Life Insurance -

Total Adjustments - Less: Debt Capital (1,950,517) TVGR** 11.50% 13.50% 15.50% 17.50% 19.50%

Value as if Publicly Traded (marketable, minority basis) 2,935,636 1.5% 4,343,227 3,225,037 2,433,409 1,845,134 1,391,853 Add: Control Premium @ 0.0% - 2.5% 4,760,390 3,478,426 2,597,461 1,956,404 1,470,056

Equity Value (marketable, controlling basis) 2,935,636 3.5% 5,281,843 3,782,493 2,788,854 2,083,570 1,558,034 4.5% 5,952,284 4,154,130 3,015,047 2,230,299 1,657,742

Less: Marketability Discount @ 5.0% (146,782) 5.5% 6,846,204 4,618,677 3,286,477 2,401,483 1,771,695

Equity Value (non-marketable, non-controlling) 2,788,854$

* WACC is the weighted average cost of capital of the company's stock on a minority interest basis using the mid-year NPV convention** TVGR is the terminal value growth rate

Weighted Average Cost of Capital*

Discounted Cash Flow Valuation Estimate

Valuation Assumptions

Projected

Estimated Value Range

105

Market Comparable Analysis

106

Market Comparisons

Calculate valuation multiples from similar companies trading publicly

Utilize valuation multiples against recently completed transactions

Selection Issues:Lines of business, competitive environment,

size, geographic areas served, business-line diversification, financial performance, availability of financial data

107

Market Current Average Average Averageto Book Annual Annual Dividends Dividend

Company Ratio P/E Ratio P/E Ratio as % NI Yield

Amende Parts 2.5 11.4 9.5 18% 2.3%

Guideline / ComparableCompany Method

Arc Industries, Inc.1.9 11.3 9.5 0% 0%Durophil Corp. 1.5 14.8 14.3 9% 0.3%Zay Components 2.4 12.9 12.1 22% 1.6%Smith Automotive 2.3 16.6 14.2 0% 0%Armstrong Central 1.8 13.9 12.8 48% 2.9%L & M Inc. 1.7 11.0 10.0 0% 0%Auto Technologies 2.6 10.8 11.9 18% 2.1%Central Bachman 2.6 13.1 11.6 16% 1.5%

Average 2.2x 13.1x 11.9x 16% 1.2%

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Market Comparable Estimate

Prior Years Earnings $250K

Average Industry P/E Ratio 11.9x

Estimated Equity Value $2,975K

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Balance Sheet Methods

Assets and liabilities accounted for at cost

Over time, these assets and liabilities may change in value

Accounting values may not reflect current fair value

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Adjusted Book Value Approach

Book Value on 12/31/03

$2,585,000

Add: Value of Real Estate over Book Value

200,000

Adjusted Book Value

$2,785,000

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Summary of Valuation Approaches

($000)Value

Valuation Method Estimate WeightingDiscounted Cash Flow Method 2,788$ 65%Market Comparable P/E Method 2,975 25%Adjusted Book Value Method 2,785 10%

Weighted Value Estimate 2,834$

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Other Appraisal Factors

Analysis of prior transactions or offers If recently closed If at arm’s length If reliable information

Future repurchase obligation

Appraiser is hired by the trustee

Trustee is responsible for the price

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($000)Pre-

TransactionPost-

TransactionOne Year

Anniversary

Enterprise Value $6,000 $6,000 $6,000

(-) Pre-Transaction Debt (1,000) (1,000) (1,000)

(-) ESOP Debt - (2,000) (1,600) + PV of ESOP Debt Tax Shield *

- 577 486

Equity Value $5,000 $3,577 $3,886

Shares Outstanding 1,000 1,000 1,000

Stock Price/Share $5.00 $3.58 $3.89

Impact of Debt on Valuation

114

Disadvantages of ESOPs

115

Excessive Leverage?

Sufficient, consistent operating cash flow

Adequate unencumbered collateral

A leveraged ESOP is a “lite” version of an LBO

Tax deductibility of both principal and interest

The majority of leveraged ESOPs are for less than 100% of the company’s stock

116

ESOP Repurchase Liability

Federal law requires the sponsoring company redeem stock from ESOP when:

Older employees exercise their diversification option

Employees leave the company and have a vested stock benefit that must be liquidated.

Cash accumulated in ESOP, COLI or sinking fund can finance this obligation

The company should conduct a repurchase obligation study to forecast and plan for funding these obligations

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Accounting for Leveraged ESOPs

ESOP debt recorded as employer debt

Contra Equity Account: Equity is reduced by value of the transaction

Contra Equity is amortized as debt is repaid

Repurchase not presently recorded on financial statements

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Accounting for Leveraged ESOPs

Assumptions:

$3 million stock purchase by ESOP from shareholder

Company borrows $3 million from lender and proceeds to lend the $3 million to the ESOP

119

Pre-Transaction Balance Sheet

Current Assets $ 4,000,000 Current Liabilities $ 6,000,000

Net PP&E 6,000,000 Debt -

Total Liabilities 6,000,000

Common Stock 1,500,000

Retained Earnings 2,500,000

Total Equity 4,000,000

Total Assets $10,000,000Total Liab. & Equity $10,000,000

Leverage Ratio 6,000,000 = 1.5 x

4,000,000

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GAAP Accounting for the Transaction

Current Assets $ 4,000,000 Current Liabilities $ 6,000,000

Net PP&E 6,000,000 Debt 3,000,000

Total Liabilities 9,000,000

Common Stock 1,500,000

Retained Equity 2,500,000

Unearned ESOP Stock (3,000,000)

Total Equity 1,000,000

Total Assets $10,000,000 Total Liab. & Equity $10,000,000

Leverage Ratio 9,000,000 = 9.0 x

1,000,000

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. . . One Year Later

Current Assets $ 4,000,000 Current Liabilities $ 6,000,000

Net PP&E 6,000,000 Debt 2,500,000

Total Liabilities 8,500,000

Common Stock 1,500,000

Retained Equity 2,500,000

Unearned ESOP Stock (2,500,000)

Total Equity 1,500,000

Total Assets $10,000,000 Total Liab. & Equity $10,000,000

Leverage Ratio 8,500,000 = 5.6 x

1,500,000

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Other Considerations

ESOPs regulated by IRS and DOL - same as all qualified retirement plans

Trustees must act prudently and for the “exclusive benefit” of plan participants Many companies use independent

fiduciaries for transactions

ESOP participants are not directly involved in company management

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SES | ADVISORS

Fourth largest ESOP advisory firm in U.S.

Headquartered in Philadelphia, four other offices

Full service:ESOP Feasibility and Design

Transaction Structuring (Legal and Consulting)

Raising Debt Capital

Transaction Management and Execution

Ongoing Plan Recordkeeping

124

JAMES F. HIGGINS, JR.Principal

6 South Street • Suite 202Morristown, NJ 07960

973-540-9200 • 973-755-9161 fax

jhiggins@sesadvisors.com

www.sesadvisors.com