Redemption Approach to Leveraged ESOP Transactions

Transcription

1 Redemption Approach to Leveraged ESOP Transactions Scott D. Levine, CPA/ABV, CFA, ASA Managing Director Stout Risius Ross, Inc. Peter H. Briggs Managing Director Shareholder Strategies, Inc.

2 CLASSIC LEVERAGED ESOP BANK Front-end Loan Principal + Interest Payments COMPANY Interior Loan Contributions Principal + Interest Payments ESOP Stock STOCK- HOLDERS Cash 2

3 SELLER-FINANCED ESOP Loan Thru Company COMPANY P+I Shareholder Distributions Contributions Loan Loan Principal and Interest Payments ESOP Stock Cash STOCK- HOLDERS 3

4 Illustration Assume FMV of Company Stock is a total of $10,000,000 1,000,000 Shares Outstanding Purchase price equals FMV and is $10.00 per share ESOP purchases 100% of the stock for $10.0 million Purchase is entirely funded with debt Assume seller note for $10.0 million to the Company This seller note is 10 years, level principal, $1.0 million per year A back-to-back loan from the Company to the ESOP for $10.0 million The Inside loan from the Company to the ESOP is 15 years, level principal The 15-year ESOP loan provides cash flow savings to the Company by virtue of the tax-deductibility of principal payments on the ESOP loan These tax savings result in a post-deal value of $1.5 million or $1.50 per share Note that the ESOP is the buyer. This would be required for the Section 1042 Tax- Free Rollover 4

5 Recovery in Value as Debt Repaid After just one year, $1.0 million of seller debt should be repaid. This alone should cause value (all else equal) to recover to $2.5 million or $2.50 per share. This represents a 67% growth in the price per share in year 1. 5

6 DOL s Dollar for Dollar Position The DOL does not like the Post-Deal drop in Value They are troubled that the asset being purchased by the ESOP is immediately less than the ESOP paid for it 6

7 Dole v. Farnum 7 DOL files lawsuit in 1990 against independent ESOP Trustee 1985 ESOP transaction at Wardwell Braiding Machine Company ESOP purchased 80% of the Company, largely funded with debt from Fleet DOL alleges that Trustee paid more than Adequate Consideration because the appraisal did not take into account the necessary future debt service to Fleet Therefore, the ESOP loan was not an Exempt Loan Therefore, it was alleged to be a Prohibited Transaction Huge outcry among the business, labor and ESOP community DOL withdraws suit later that same year Note that ESOPs were specifically intended by Congress to be not only an employee benefit but also to be used as a tool of corporate finance. They were intended to borrow money. That is the whole point behind the exempt loan rules.

8 What Is The Typical ESOP Candidate? A closely held corporation (C or S corporation) One or more owners nearing retirement Company needs tax favored capital In closely-held company, generally no (or limited) family involvement in business History of profitability Comfort with the concept of employee ownership Stable employee population Successor management in place or in the wings Available corporate credit Focus on organic growth 8

9 REDEMPTION APPROACH STOCK- HOLDERS Sell Stock to Company Note Principal + Interest Payments COMPANY Sells Treas. Stock to ESOP Contributions and Distrib's Principal + Interest Payments ESOP 9

10 Advantages of Redemption Approach Avoids the Post-deal drop in value issue Reduces contribution levels to service ESOP debt and can therefore avoid Section 404 problems (limits on Plan contributions) Safer from a Fiduciary standpoint ESOP might purchase its stock at a price that is somewhat lower than even the post-debt value 10

11 Disadvantages of Redemption Approach Cannot elect tax-free Section 1042 rollover. ESOP must be the buyer in that case 11

12 Redemption Transaction Redemption Transaction Illustration In U.S. Dollars Indicated Range of Value Low High Guideline Company Method $ 11,000 $ 14,000 Discounted Cash Flow Method 10,000 13,000 Concluded Enterprise Value $ 10,500 $ 13,500 Less: Interest-Bearing Debt (2,000) (2,000) Add: Cash and Cash Equivalents 1,000 1,000 Total Adjustments to Enterprise Value (1,000) (1,000) Fair Market Value of Equity (Rounded) $ 9,500 $ 12,500 Redemption Price ESOP Purchase $10,000 $2,500 12

13 Post-Transaction Value Post-Transaction Fair Market Value of Common Stock In U.S. Dollars Indicated Value Post-Transaction Implied Enterprise Value (Rounded) $ 10,500 $ 13,500 Add: Cash and Cash Equivalents 1,000 1,000 Less: Existing Debt (2,000) (2,000) Less: Senior Subordinated Term (7,000) (7,000) Less: Subordinated Seller Notes (3,000) (3,000) Add: Present Value of ESOP Debt Tax Benefit 1,000 1,000 Total Adjustments to Enterprise Value (10,000) (10,000) Marketable, Controlling-Interest Value of Equity $ 500 $ 3,500 Less: Discount for Limited Marketability 5.0% (25) (175) Fair Market Value of Equity (Rounded) $ 500 $ 3,300 Divided by: Common Shares Outstanding Estimated Post-Transaction Fair Market Value Per Share of Common Stock $ 5.00 $ Per Share Strike Price of Warrants $

14 What is a Warrant? A warrant is a security similar to a stock option that entitles a holder to buy the underlying stock of the issuing company at a fixed exercise price for a specified period of time. A warrant is frequently attached to bonds allowing the issuer (ESOP company) to pay a lower interest rate and can also be used to enhance the yield of the bond. 14

15 Why Are Warrants Used in ESOP Transactions? With less access to capital from more traditional financing sources seller financing is often used as an alternative form of capital to help finance an ESOP Transaction Almost always utilized in highly leveraged deals The ESOP transaction creates significant leverage and a lower interest rate combined with warrants reduces an ESOP company s cash obligations post-transaction Sellers will pay taxes at ordinary income levels for the interest earned on their seller notes but can pay the long-term capital gains tax rate on the appreciation of warrants. 15

16 Overview of Seller Debt and Warrant Position $3 million of seller debt Interest rate of 5% and warrant equal to 20% of stock post-transaction Targeted IRR 15% 16

17 IRR Calculation Calculation of IRR of Subordinated Term Notes In U.S. Dollars For the Year Ending 12/31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/2021 Initial Outlay $ (3,000) $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 Interest Payments [a] Principal Payments Payment for Warrants ,400 Total Debt Cash Flows $ (3,000) $ 150 $ 150 $ 150 $ 750 $ 720 $ 690 $ 660 $ 4,030 Internal Rate of Return 15.0% [a] Based on cash interest of 5.00% per annum. Interest calculation is based on annual payments. 17

18 Items for ESOP Team to Consider Regarding Warrant Position Cash flow considerations (interest rate v. warrant position) Strike price for warrant What is a reasonable IRR? What is reasonable ownership dilution (also consider other equity holders)? 18

19 Questions? 19

20 Contact Information Scott D. Levine, CPA/ABV, CFA, ASA Managing Director Stout Risius Ross, Inc Greensboro Drive, Suite 600 McLean, VA (703) Peter H. Briggs Managing Director Shareholder Strategies, Inc. P.O. Box 158 Charlottesville, VA (434)