The ESOP Solution for Private Companies

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1 The ESOP Solution for Private Companies An e-seminar presented by the Beyster Institute at the Rady School of Management University of California, San Diego Copyright 2006 Regents of the University of California

2 Your Instructor Martin Staubus, Institute s Director of Consulting More than 20 years in employee ownership, law and human resources. Past service as employee ownership attorney, corporate VP of HR, policy analyst for Labor Secretary Robert Reich, legal advisor to California State labor relations board, and deputy director of the ESOP Association in Washington DC. The Beyster Institute Founded as a non-profit organization in 1986 by Bob Beyster, founder and Chairman of SAIC. Beyster started SAIC in 1969 and, using employee stock ownership as the key competitive edge, built the company into a Fortune 500 business. Today the Institute is a part of the new Rady School of Management at the University of California, San Diego.

3 Procedural Orientation Phones will be muted to eliminate background noise Want to ask a question? Type it into the chat box at bottom left (and hit send ); or Raise your hand by clicking the hand symbol at upper left. A PowerPoint version of this entire presentation will be ed to you at the close of this session.

4 Seminar Objective To provide an overview of Employee Stock Ownership Plans (ESOPs) and the strategies for implementing them in private companies

5 Agenda Time Topic 5 Why Consider An ESOP? 10 ESOP Basics 10 Leveraged ESOPs 10 Section 1042 Rollover 10 Operating An ESOP 5 Next Steps 10 Q&A

6 Why Consider An ESOP?

7 Why Are You Here? In the chat box, please share briefly why you are considering an ESOP It is important to refine your objectives in this process as this will enable you to design an ESOP best suited to your desired goals

8 Why Do Business Owners Adopt ESOPs? To incentivize performance, productivity and growth (enlightened self interest) As a way to gain liquidity (attractive way to sell) As part of strategic planning (divestitures, business succession, benefits redesign)

9 ESOP Basics

10 What If You could sell part or all of your company to your employees and Receive full price (fair market value) Pay no taxes on your gain Provide employees with an ownership stake, significant retirement benefits, and a reason to want to make the company more successful Provide the company with a significant tax deduction Continue to run the company should you wish

11

12 What is an ESOP? A defined contribution retirement plan qualified under federal tax law Similar in structure to a 401(k) or profit sharing plan Designed to be primarily invested in company stock Can borrow money to buy stock in the sponsoring company A mechanism for transferring stock from owners to employees at no cost to employees and tax benefits for all involved A means for a company to borrow money and deduct the entire cost of repaying the loan (both principal and interest)

13 How Do ESOPs Work? Example 1: Non-Leveraged ESOP Assume XYZ Corp. is worth $5 million 1. XYZ Corp. sets up an ESOP and contributes new shares worth $500,000 to it 2. The shares are allocated to the accounts of employees based on salary The company receives a tax deduction for the value of the shares contributed ESOP 2 1 XZY Corp. $1,800 $2,300 $2,000

14 How Do ESOPs Work? Example 2: Non-Leveraged ESOP Assume XYZ Corp. is worth $5 million 1. XYZ Corp. sets up an ESOP and makes a $500,000 tax-deductible cash contribution to it 2. The ESOP uses the cash to buy 10% of the company from the owners 3. The shares are allocated to the accounts of employees based on salary XZY Corp. 1 ESOP 3 2 The Owners $1,800 $2,300 $2,000

15 ESOP Tax Incentives Corporate contributions to an ESOP are tax-deductible Contributions to an employee s ESOP account are tax deferred until distribution Selling shareholder(s) may defer capital gains taxes on sales of stock to an ESOP ( Section 1042 Rollover ) Benefit plans can transfer assets to an ESOP with no tax consequences

16 Questions So Far? Type your question in the chat window

17 Leveraged ESOPs

18 How Do Leveraged ESOPs Work? Assume XYZ Corp. is worth $5 million 1. XYZ Corp. sets up an ESOP, to which a bank loans $2 million (with company guarantee) 2. The ESOP uses the loan proceeds to purchase 40% of the company from the owners Alternatively, the bank may loan to the company and a mirror loan is set up from the company to the ESOP 1 ESOP 2 The Owners

19 How Do Leveraged ESOPs Work? (cont.) 3. In the ESOP s first year, the company makes a contribution to the ESOP 4. The ESOP uses the money to pay off 20% of the loan (plus interest) 5. 20% of the shares bought by the ESOP are released from the suspense account and allocated to the accounts of employees based on salary XZY Corp. 3 4 $1,800 Suspense: 32% of XYZ Corp. ESOP 8% of XYZ Corp. 5 $2,300 $2,000

20 Key Issues in Leveraged ESOP Transactions Corporate guarantee essential Often mirror loan structure where bank loans to company and company then loans to ESOP on same terms Loan subject to normal risk analysis ESOP fiduciary exercises independent judgment Must act exclusively in interest of employees Held to strict standards of fairness Independent appraisal required annually Payroll must be large enough to service ESOP debt

21 Section 1042 Rollover

22 Section 1042 Rollover Seller(s) may defer/eliminate capital gains taxes of the sale of stock to an ESOP when certain conditions are met. " Company must be non-public C corporation " Seller(s) must have owned the stock for 3 years " ESOP must own 30% of company at close of sale " Seller(s) must reinvest funds within 12 months of the sale date in qualified replacement property

23 Qualified Replacement Property Stocks and bonds of domestic operating companies No government securities Not more than 25% foreign owned No mutual funds or REITs Can be another private company Some public companies offer investment-grade, floating rate corporate bonds designed specifically for 1042 sellers Can be margined while preserving tax deferral

24 Potential Tax Savings No ESOP With ESOP Debt Transaction $30m $30m Net Savings Principal Deduction* 0% 34% Corporate Tax Savings $0 $10.2m $10.2m Capital Gains Rate 15% 0% Selling Shareholder s Capital Gains Tax Combined $4.5m $0 $4.5m $14.7m * Plus applicable state tax deductions

25 So Far So Good? Type in the chat window whether an ESOP looks like a good solution for your company

26 Operating An ESOP

27 Employee Accounts Employees accounts credited each year with company contributions Typically allocated as a percentage of salary Maximum employer contribution is 25% of covered payroll plus loan interest Accounts may be subject to vesting requirements Stock forfeited by unvested departing employees reallocated to remaining employees

28 Role Of The Trustee May be an outside entity (e.g., bank or trust company) or individual(s) in the company May be independent (exercise its own judgment) or directed (by a governing group in the company) Trustee votes the shares owned by the ESOP Pass-through voting to participants required on issues involving merger, liquidation or sale of the company Responsible for ensuring that the ESOP is operated according to law, solely on behalf of the ESOP participants Oversees management of the assets held by the ESOP

29 Distributions Contents of employee s ESOP accounts are paid out to them ( distributed ) only after they leave the company. Small account balances (<$5,000) typically paid out within 1 year of termination Distribution of larger accounts may be deferred up to 5 years after a pre-retirement termination up to 1 year after retirement/disability For leveraged ESOPs, until loan is paid off Participant may delay distribution until age 65 Distributions taxed as ordinary income unless rolled over into an IRA

30 Repurchase Liability How does a separated employee liquidate company shares received on distribution of his ESOP account? Company or ESOP has legal duty to repurchase shares from departing employees Repurchased at Fair Market Value (FMV) Payments may be deferred and paid in installments of up to 5 years Company should plan ahead, preparing a strategy to meet these cash demands This repurchase liability is manageable. Software and repurchase liability experts can help with forecasting

31 Next Steps

32 For Further Help For guidance, feasibility and plan design: Beyster Institute Benefits Consulting Firms For Plan Implementation: Attorneys Independent Appraiser

33 Cost Factors Legal costs for drafting plan Independent appraisal Third party administrator ESOP Trustee Bank fees Costs can vary from $20k to six figures depending on complexity of deal

34 Beyster Institute Contacts Washington, D.C. David Binns 1608 Rhode Island Ave. NW Washington DC (202) San Diego, CA Martin A. Staubus 1241 Cave Street La Jolla, CA (858)

35 Q&A

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