Liquidity & Succession Planning Using ESOPs The State of the Market

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1 Liquidity & Succession Planning Using ESOPs The State of the Market

2 William E. O Brien Corporate Client Group Director Senior Vice President / Financial Advisor The O Brien Group at Morgan Stanley Since he started his financial-services career in 1989, Bill has been committed to providing his clients with a high level of professionalism and personal service. Through the years, Bill has assisted business owners and corporations, including several in the Fortune 100, in areas such as business succession planning, retirement plan design and implementation, and employee financial education. Bill s business succession planning capabilities have assisted many business owners of both publicly and privately held corporations. His capabilities include implementing Employee Stock Ownership Plans (ESOPs), understanding the complexities of Internal Revenue Code Section 1042(b), and leveraging equity risk-management and taxadvantaged strategies. Bill holds a Bachelor of Science degree in Finance from Northern Illinois University. Currently, Bill is a member of the National Center for Employee Ownership (NCEO) and The ESOP Association.

3 Steven B. Greenapple, Esq. Shareholder Steiker, Fischer, Edwards & Greenapple, P.C. Steve Greenapple is a shareholder of Steiker, Fischer, Edwards & Greenapple, P.C. He has represented ESOP plan sponsors, shareholders selling to an ESOP, and ESOP trustees in transactions establishing and amending ESOPs, increasing ESOPs share ownership, using ESOPs to acquire other businesses, and terminating and buying out ESOPs. He is also experienced in designing and implementing other forms of equity compensation plans such as stock appreciation rights, phantom stock plans and stock option plans. Steve is frequently brought into transactions as special ESOP counsel by clients corporate counsel. He has also served as an expert in litigation related to ESOPs in State and Federal court. Steve is a member of NCEO and The ESOP Association, where as of May 1, 2013 he will serve as the chair of the national Legislative and Regulatory Committee. Steve received his Bachelor of Science from Cornell University and his J.D. from Cornell Law School. He is admitted to practice in New Jersey, New York and Pennsylvania. He has received Martindale-Hubbell s highest AV rating.

4 Agenda Leveraged ESOPs as a Tool for Shareholder Liquidity: What they are & What they are not State of the Market for Financing Leveraged ESOPs

5 Leveraged ESOPs as a Tool for Shareholder Liquidity: What they are & What they are not

6 Why Care About ESOPs? The Problem of Liquidity and Succession Businesses need to be sold or transferred privately-held companies have no ready market Current economic conditions have slowed private M&A transactions but have not eliminated need/desire for liquidity and succession Approach should be based on shareholder goals in the context of achievable alternatives 6

7 Liquidity & Succession: Alternatives A finite range of choices: External buyers Strategic competitors or new entrants Financial private equity IPO Internal Buyers Family Management Partner (Redemptions & Buy-Sells) ESOP Liquidation 7

8 Non-ESOP/Management Leveraged Buy Out (LBO) The Company Guarantee Lender Management $10 Million Cash Stock Owner 8

9 Payment of Management LBO Financing Buyer $820K Tax Payments* $1,180K Loan Payment The Company Lender $2MM Earnings Before Taxes * assumes 35% Federal corporate tax rate plus State corporate tax rate of 6% 9

10 What is an ESOP? Employee Stock Ownership Plan Qualified retirement plan under IRC Regulated by US DOL and IRS Company funded benefit - no employee contributions Assets held in a Trust; employees do NOT own the stock directly Intended to be invested primarily in company stock Tax efficient and controlled means of selling stock Since 1974 over 20,000 companies have adopted an ESOP Today, ESOPs, stock bonus plans, and profit sharing plans primarily invested in employer stock include 10.3 million employee-participants with over $869 billion in assets (average of over $84,000 per participant)

11 The Leveraged ESOP XYZ Corp. $10 Million Promissory Note Lender ESOP Promissory Note $10 Million ESOP SUSPENSE ACCOUNT $10 Million Stock Selling Shareholder P1 P2 P3 P4 P5

12 Payment of Leveraged ESOP Financing XYZ Corp. $2 Million Earnings Before Taxes $2 Million Loan Payment Lender $2 Million Contribution ESOP SUSPENSE ACCOUNT Participant Allocations 1. XYZ makes a taxdeductible contribution to the ESOP 2. ESOP uses the contribution to repay its loan from XYZ 3. Participant allocations P1 P2 P3 P4 P5 4. XYZ repays Lender

13 Advantages of an ESOP Transaction Maximize after-tax proceeds Sell stock (capital gains) vs. sell assets (ordinary income and C corp. double taxation) Potentially pay no tax on sale of company stock (C corp. / 1042 election) Flexibility Control transaction timing & design % of stock sold diversify wealth, resolve incompatible shareholder goals, or sell 100% timing of sale subsequent transactions single or multiple transactions, you don t have to decide now Seller financing attractive IRR, equity based return Process is confidential

14 Ongoing Advantages of an ESOP Company Tax Benefits for Company Deduction of loan interest AND PRINCIPAL Pay little or NO corporate income taxes (S corp.)* Control Seller may continue as executive and Board member Legacy Preserve Company identity Preserve employees jobs Motivate and attract employees ESOP should not limit options for management incentive plans ESOP should not limit options for future M&A transactions *Subject to IRC limits/ rules

15 Common ESOP Misperceptions An ESOP is a Stock Option plan ESOP is a qualified retirement plan under ERISA. Employees are entitled to the company s financial information Employees are entitled to their own account statement. Company has to be a C corporation Since 1998, S corporations can also maintain ESOPs. ESOP must own 30% of the company ESOP can own any %, and can buy/sell shares in one or more transactions. Employees own the stock of the company Stock is owned by a Trust, for the benefit of employees/participants.. True or False True or False True or False True or False True or False

16 Total Tax Savings on Hypothetical $10,000,000 Transaction To Seller using 1042 (Savings on Fed.) $ 2,380,000 To Company (Tax-Deductible Principal at 41%** tax rate) $ 4,100,000 Total Tax Savings $6,480, % of the transaction value! * assumes base capital gains rate of 20% plus 3.8% medicare tax imposed on net investment income for high income individuals ** assumes 35% Federal corporate tax rate plus State corporate tax rate of 6%

17 C Corporation ESOP Tax Benefits IRC 1042 IF: Company is a C corporation on the day of closing; ESOP owns at least 30% of Company after closing; Seller has a 3 year holding period; Stock satisfies the definition of employer securities (best dividend rights and best voting rights); Seller invests proceeds of sale to ESOP in Qualified Replacement Property (QRP) within 12 months; THEN: Seller may elect not to recognize any gain on the sale of stock to the ESOP.

18 C Corporation ESOP Tax Benefits IRC 1042 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 * Issuer must be a U.S. Operating Corporation : 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 18

19 C Corporation ESOP Tax Benefits QRP Floating Rate Note Specially designed as Qualified Replacement Property: Highly rated issuer; Long term; Floating rate; Put option. All result in Floating Rate Note: Stable value; Highly marginable. Allows Seller to satisfy requirements of 1042, AND obtain an actively managed investment portfolio.

20 S Corporation ESOP Tax Benefits S corporation shareholders are responsible for paying for their pro rata share of the company s tax liability An ESOP is a non-tax paying shareholder and is exempt from paying federal income taxes Thus, a 100%* ESOP-owned S corporation may be able to operate completely tax-free *Doesn t have to be 100%; the percentage of ESOP ownership is tax-exempt.

21 ESOP Ownership: Beneficial vs. Direct Shares purchased by the ESOP are owned in a trust, not by employees directly Employees are beneficial owners of the trust Beneficial owners/employees are not entitled to company financial statements. The ESOP has a trustee who will represent the plan interests The ESOP Trustee will vote the stock owned by the ESOP, except in special cases (pass through voting) Special cases are merger or consolidation, sale of substantially all assets, liquidation, dissolution, recapitalization

22 ESOP Provisions Allocation Formula Most common formula allocates contribution proportional to compensation Vesting Up to a 3 year cliff or 6 year graded Benefit Distribution Timing Permissible delays following termination of service; five installments

23 ESOP Stock Appraisals ESOP Trustee hires a third-party, independent appraiser as an advisor Appraiser should be experienced in valuing stock for ESOP transaction purposes ESOP stock may need to be reappraised annually

24 Characteristics of Best ESOP Candidates Profitable and growing Not overleveraged Strong financial reporting Deep and broad management team Employees are an important part of the value of business Owner(s) concerned about Legacy Owner(s) wants to retain control Owner(s) strongly dislikes paying taxes

25 State of the Market for Financing Leveraged ESOPs

26 State of the Market for Financing Leveraged ESOPs Availability of Financing Who is lending for ESOP transactions? Leverage Ratios How much can we borrow? Interest rates What s it going to cost? Collateral Requirements personal guarantees, pledges, airballs?

27 Important Disclosures Neither Morgan Stanley nor its affiliates or employees provide tax, accounting or legal advice. You should consult your tax and accounting advisors on matters involving taxation, accounting and/or tax planning, and your attorneys with respect to legal matters. More specifically, neither Morgan Stanley nor its affiliates or employees provide any tax advice, tax guidance, or legal or tax opinions regarding the qualification of a particular security under Section 1042 of the Internal Revenue Code, and nor do they prepare any of the forms necessary to successfully elect Section 1042 treatment. In every case, the client must consult and confirm with their tax and legal advisors whether a particular course of action meets the requirements of Section 1042, including whether a particular security is qualified replacement property and a particular purchase strategy meets the applicable time limits. Although Morgan offers both passive and active reinvestment strategies, its role is much more limited in the passive strategy. This is not a commitment to lend money. All loans are subject to required credit approvals. Circular 230 Notice: This material was written to support the potential promotion or marketing of the transaction or matters addressed herein, to the extent permitted by applicable law. It was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Each taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor.

28 Contact Information William E. O Brien Senior Vice President Financial Advisor The O Brien Group at Morgan Stanley Oak Brook, IL william.obrien@morganstanley.com Morgan Stanley Smith barney LLC, member SIPC Steven B. Greenapple, Esq. Shareholder Steiker, Fischer, Edwards & Greenapple, P.C. Cedar Knolls, NJ sgreenapple@sfeglaw.com