OWNERSHIP TRANSITION: IS AN ESOP THE RIGHT TOOL FOR YOUR COMPANY?

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1 OWNERSHIP TRANSITION: IS AN ESOP THE RIGHT TOOL FOR YOUR COMPANY? Chuck Coyne Managing Director Empire Valuation Consultants Joseph D. Verri Vice President Wealth Management Morgan Stanley Tabitha M. Croscut Managing Shareholder Steiker, Greenapple & Croscut, P.C.

2 TODAY S AGENDA I. The Ownership Transition II. III. Why Choose an ESOP as a Transition Strategy? How Do ESOPs Work?

3 THE OWNERSHIP TRANSITION

4 WHY CARE ABOUT ESOPS? PROBLEM OF LIQUIDITY AND SUCCESSION All businesses must be sold or transferred Privately held companies have no ready market Approach should be based on shareholder goals in the context of achievable alternatives

5 LIQUIDITY AND SUCCESSION: ALTERNATIVES External Buyers Strategic Financial IPO Internal Buyers Family Management Partner (Redemptions & Buy-Sells) ESOP Liquidation

6 COMMON LIQUIDITY AND SUCCESSION: SHAREHOLDER GOALS Maximize after-tax proceeds Control timing of succession and transfer Post-transfer ongoing role Diversify personal wealth

7 COMMON LIQUIDITY AND SUCCESSION: SHAREHOLDER CONCERNS Determine/secure role or opportunities for family members in business Continuity of business identity and operations - Legacy Getting free & staying on ongoing responsibilities as executive officer Reward key management/employees Sale of enterprise without continued financial liability/responsibility

8 WHY CHOOSE AN ESOP AS THE OWNERSHIP TRANSITION STRATEGY?

9 WHY CHOOSE ESOP: WHAT IS IT? Employee Stock Ownership Plan Qualified retirement plan under Internal Revenue Code Regulated by US DOL and IRS Company-funded benefit no employee contributions Intended to be invested primarily in company stock Only qualified retirement plan that can borrow money Tax-efficient and controlled means of selling stock ESOP as a shareholder employees do not have title to shares

10 WHAT IS AN ESOP? To Business Owners: a Buyer of Stock To Employees: a Company-Funded Retirement Plan To Companies: a Corporate Finance Technique

11 ESOP EXISTENCE Applicable in almost all industries service, manufacturing, professional (engineering and architects)

12 WHY DO BUSINESS OWNERS USE ESOPS? Legacy Employee concern (family) Control / maintain day-to-day Diversification / Liquidity Avoid / Reduce Income Tax (Seller & Company) Additional retirement plan for employees Increase employee productivity / employee incentive Not ready to golf / leave company Value / purchase price certainty No ownership transition alternatives close the doors

13 CORPORATE STRUCTURE PRE-ESOP Shareholders Non-ESOP Shareholders elect Board of Directors President and CEO Management Team appoints and oversees hires and oversees Employees hires and oversees

14 CORPORATE STRUCTURE AFTER ESOP ESOP Trustee Shareholders Non-ESOP Shareholders are represented by selects elect Board of Directors ESOP Participants President and CEO appoints and oversees ESOP eligibility requirements are met Management Team Employees hires and oversees hires and oversees

15 A FEW CORE ESOP ADVANTAGES AND DISADVANTAGES Advantages Tax efficient Shareholder &/or Company directed process Control over timing Legacy Disadvantages Complex Regulated Often involve Seller notes (e.g. 100% transfer)

16 BASICS OF ESOP VALUATION

17 REGULATORY FRAMEWORK - DOL ERISA Section 402(18) Adequate Consideration In the case of an asset other than a security for which there is a generally recognized market, the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary.

18 REGULATORY FRAMEWORK - IRS Fair Market Value The price at which an asset 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, and both parties are able, as well as willing, to trade and are well informed about the asset and the market for such asset.

19 LEVELS OF RELATIVE VALUE Synergistic (Strategic) Value Acquisition Premium Controlling Interest Value Premium For Control Minority Interest Discount Marketable Minority Interest Value As-IF-Freely-Traded Value Lack of Marketability Discount Nonmarketable Minority Interest Value

20 PROPOSED DOL REGULATIONS Adequate Consideration = Fair Market Value Determined in Good Faith As of the Date of the Transaction Reflected in Written Documentation of Value

21 ESOP VALUATION DISCOUNTS Discount for Lack of Marketability Minority Interest Discount

22 VALUATION APPROACHES Market Approach Guideline Publicly Traded Company Method Guideline Merged and Acquired Company Method Income Approach Discounted Future Net Cash Flows Historical Based Cash Flows Asset-Based Approach

23 HOW DO ESOP TRANSACTIONS WORK?

24 Note & Pledge of Stock Initial C Corporation - Leveraged ESOP Transaction Bank Company $$ Cash Note & Collateral ESOP $$ Cash Shareholder 100% Company Stock

25 INITIAL S CORPORATION LEVERAGED ESOP TRANSACTION Bank $$ Cash Cash Note & Collateral Company Shareholder ~100% Stock Cash & Sub. Note w/warrants Cash & Sub. Note Company Stock Stock ESOP Note & Pledge of Stock

26 ESOP LOAN REPAYMENT Company Contributions or Contributions or or Dividends ($$$) ($$$) Loan Payments ($$$) Loan Payments ($$$) ESOP Loan Payments ($$$) Loan Payments ($$$) Bank and/or Shareholder Release of Shares Pledged as Collateral and Share Allocations to Individual ESOP Accounts

27 WHERE DOES THE MONEY COME FROM? Sources: External Bank Internal Cash on the Company s Balance Sheet Seller Note Profit Sharing Transfers *Can use a single source or a combination Types: Senior least expensive Subordinated or Mezzanine Seller debt

28 SIGNIFICANT ESOP TAX PREFERENCES - COMPANY S Corporation & C Corporation: Deduction of principal on ESOP loan repayment Limitations differ for S Corp versus C Corp Deduction of dividends paid on ESOP shares S Corporation: ESOP non-recognition of corporate income S Corporation income attributed to shareholders (pass through entity) ESOP as a tax exempt S Corp shareholder pays no taxes on its share of corporate income

29 SIGNIFICATION TAX IMPLICATION SELLER Tax Treatment of Sale Proceeds: Cash Proceeds: Capital Gains Tax Seller Promissory Note: Interest earned will be taxed at Ordinary Income rates Principal will be either: 1. Taxed at capital gains tax rates on an installment basis (Note: If note exceeds $5mm, taxes are due at closing!) -or- 2. Deferred using QRP investment (C corp) 1042 Tax Preference on Sale Proceeds: C Corporation Section 1042 Capital Gains Tax Deferral

30 TAX-DEFERRED LIQUIDITY TO SELLERS IN ESOP TRANSACTIONS

31 IRC 1042 ROLLOVER REQUIREMENTS FOR CAPITAL GAINS TAX DEFERRAL Must be a C corporation Reinvest in Qualified Replacement Property (QRP) ESOP must own 30% of company Minimum of 3-year holding period Best stock (voting) 15-month reinvestment window of proceeds

32 QUALIFIED REPLACEMENT PROPERTY Eligible* Common Stock Convertible Bonds Corporate Fixed Rate Bonds Corporate Floating Rate Notes (FRN) Not Eligible Municipal Bonds U.S. Government Bonds Mutual Funds Foreign Securities REITs Bank CDs *Eligible issuer must have: Securities of a corporation that is incorporated in the U.S. More than 50% of its assets used in the active conduct of a trade or business No more than 25% of its gross income from passive sources

33 UNLOCKING THE QRP LOCKUP USING THE FRN $12 Million From ESOP Stock Sale $12,000,000 ESOP Bond $10,800,000* Margin Loan Proceeds Net Unrestricted Proceeds To Seller *Based on 90% margin rate, which is subject to change.

34 IRC 1042 ROLLOVER DISADVANTAGES Exclusion from allocations of 1042 stock in the ESOP Who? Taxpayer electing 1042 Family members (brothers and sisters, spouses, ancestors and lineal descendants (children and grandchildren) 25-percent shareholder(s) [within 1-year prior to sale] Includes (i) shares allocated to ESOP account and (ii) shares owned by spouses, parents, children and grandchildren (but not brothers and sisters) How Long? Ten years after the later of (i) the date of the 1042 transaction, or (ii) the date of the final allocation of the 1042 stock.

35 THE ESOP AS A RETIREMENT PLAN

36 ESOP OPERATIONS: PARTICIPATION & ALLOCATIONS Who can Participate in the ESOP? 1,000 hours and age 21 (outside limit) Who can receive an allocation in the ESOP? Employed on last day of PY/FY AND 1,000 hours Allocation Formula In proportion to annual compensation [see next slide] Also points formula optional (not safe harbor)

37 ESOP OPERATIONS: ALLOCATION EXAMPLE Shares purchased by ESOP Allocation period 6,000 shares 20 years W-2 Pay Allocation Percentage Shares Allocated in 1st Year Employee #1 $25,000 23% Employee #2 $35,000 32% Employee #3 $50,000 45% $110, %

38 ESOP OPERATIONS POST-TRANSACTION: VESTING & DISTRIBUTIONS What does an employee get if they terminate? 1. Vesting 3 year cliff or 6 year graded (0%, 0%, 20%, 20%, etc.) Non-vested shares are forfeited 2. Timing of Distributions i- Year after death, disability or Normal Retirement Age ii- Sixth year after other termination 3. Form of Distribution Cash or Company Stock (immediately redeemed) Lump Sum or 5-year annual installments

39 FIRST STEP TO AN ESOP TRANSACTION

40 TRANSACTION ANALYSIS OR FEASIBILITY STUDY Create a road map Transaction Valuation Financing Test financial feasibility Sufficient cash flows Financial covenants Loan/financing terms Understand tax implications to all parties (negative, positive) Minority versus majority transaction After tax proceeds Preliminary valuation

41 ONGOING ESOP ITEMS POST-TRANSACTION

42 ONGOING ESOP ITEMS POST-TRANSACTION Annual appraisal update Annual recordkeeping and administration Repurchase obligations Communications training and education Legal compliance Audit for larger plans

43 WHY CHOOSE ESOP: WHAT MAKES A GOOD ESOP COMPANY? If the company is profitable and growing If the company has debt capacity it can dedicate to funding an ESOP over and above other reinvestment (not overleveraged) If the company can finance its own growth If there are enough employees and thus payroll over which the ESOP costs can be spread If the blend of share allocations and value trajectory results in an acceptable/appropriate stream of benefits If the company could benefit from a broad-based ownership plan If the company has a strong management team

44 QUESTIONS? Chuck Coyne Managing Director Empire Valuation Consultants Joseph D. Verri Vice President Wealth Management Morgan Stanley Tabitha M. Croscut Managing Shareholder Steiker, Greenapple & Croscut, P.C.

45 JOSEPH VERRI, CRPS, MORGAN STANLEY Joe has more than 20 years of experience working with privately held business owners and their families. Prior to Morgan Stanley, he was associated with Smith Barney and A.G. Edwards & Sons. He is a member of Morgan Stanley's Business Owner Executive Council joseph.verri@morganstanley.com 950 Winter St Suite 3400 Waltham, MA While Joe provides specific guidance in areas such as company sponsored retirement plans and executive compensation, he also works with business owners to help create an organized process around the eventual transition of their business. This process includes working collaboratively to develop clarity in the form of a plan; the plan serves as a roadmap that helps business owners better understand when and how to best transition their business and the impact it will have on their business, their family members and their employees. Joe s practice is focused on educating business owners on a number of different transition and succession strategies; a specific emphasis is on the education, utilization and maintenance of Employee Stock Ownership Plans (ESOPs). Joe is an active member of The ESOP Association located in Washington, D.C. and serves on the New England Chapter board. He is also a member of the National Center for Employee Ownership (NCEO).

46 CHUCK COYNE, EMPIRE VALUATION CONSULTANTS For over 25 years Chuck has provided business valuations of privately held companies in various industries. He has prepared valuations for estate and gift tax, employee stock ownership plans (ESOPs), family business succession, bankruptcy and reorganizations, fairness opinions, marital dissolution, shareholder and partnership disputes, allocation of purchase price among acquired assets and goodwill impairment testing, and mergers, acquisitions, and divestitures South Main Street Suite 201 West Hartford, CT Chuck specializes in transactional consulting services including; assistance in business succession planning, mergers and acquisitions, ESOP feasibility and transaction structuring, ESOP transaction quarterbacking, assistance in obtaining financing, and other valuation related consulting services. Chuck has assisted companies with revenues of less than a million dollars to over half a billion dollars. Chuck received his MBA with a concentration in Finance and Accounting from University of Hartford. He holds a Senior Accredited Appraiser ( ASA ) designation from the American Society of Appraisers. He serves as a member of the Valuation Advisory Committee of The ESOP Association and is a member of the National Center for Employee Ownership (NCEO).

47 TABITHA CROSCUT, STEIKER, GREENAPPLE & CROSCUT New Hampshire office: 360 Route 101 Suite 1 Bedford, NH Vermont office: 77 College Street 1st Floor, Suite 2D Burlington, VT Tabitha is the managing shareholder of Steiker, Greenapple & Croscut, P.C., a national law firm with a focus on Employee Stock Ownership Plans (ESOPs) as succession and employee compensation strategies. In addition to counseling clients regarding transactional, compliance and fiduciary issues with respect to their ESOPs, she has represented companies, sellers and internal and external trustees in ESOP transactions ranging from under a million dollars to over four hundred million dollars. She is a frequent speaker at ESOP conferences nationwide and presents regularly on how ESOPs can be an effective exit or transition planning tool for owners of closely held businesses. Tabitha serves as a director and is the President of the Vermont Employee Ownership Center (VEOC), is an active member of The ESOP Association and the National Center for Employee Ownership (NCEO), and serves on the Board of Trustees for the Employee Ownership Foundation. Since 1987, SG&C attorneys have been involved in hundreds of ESOP transactions nationwide, providing legal advice on employee ownership matters for corporations, business owners, lenders and ESOP fiduciaries. Visit our website at:

48 THANK YOU!

49 Circular 230 Disclosure Pursuant to Treasury Regulations, any tax advice contained in this presentation (including any attachments) is not intended or written to be used, and cannot be used or relied upon by you or any other person, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax advice addressed herein. Please contact a qualified professional if you require a formal, written tax opinion that satisfies applicable IRS requirements.

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