3/22/2011. Financing an ESOP Transaction. Table of Contents. I. The Leveraged ESOP Transaction. John L. Miscione Managing Director

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1 Presented by John L. Miscione Managing Director Table of Contents I. The Leveraged ESOP Transaction II. ESOP Tax Benefits III. Debt Capacity IV. Financing Markets and Terms V. The Lender s Perspective VI. The Company Perspective I. The Leveraged ESOP Transaction 1

2 The Leveraged ESOP Transaction An ESOP (like a 401K) is a qualified defined contribution benefit plan which is allowed to purchase equity securities of the plan sponsor To allow for a continuation of a private business in lieu of a sale and to provide a vehicle for employees to participate in equity appreciation, Congress passed legislation which provides tax benefits to the seller(s) and sponsoring corporation The Leveraged ESOP Transaction The ESOP is a special trust permitted to purchase employer stock. The stock purchase agreement is similar to other third party agreements. Cash ESOP Stock Shareholders The Leveraged ESOP Transaction An ESOP transaction is an alternative to a stock redemption or third party sale Cash Company Stock Shareholders 2

3 Purchase of Existing Shares Financing ESOPs The Leveraged ESOP Transaction Company External Loan Lender Internal Loan ESOP Stock Cash Shareholders The Leveraged ESOP Transaction Purchase of Existing Shares Company Annual Amortization Lender Contributions Annual Amortization ESOP Allocated Shares Employers The Leveraged ESOP Transaction Financing comes from the external loan The internal loan determines the size of the annual compensation charge and tax benefit The repayment schedule on the internal and external loan need not be the same The employees get allocated shares annually as the internal loan is repaid 3

4 II. ESOP Tax Benefits ESOP Tax Benefits The annual contribution to the ESOP that is used to repay the internal loan is a unique tax deduction Since the contribution is immediately repaid to the Company it is, in effect, a cashless transaction unlike other benefit contributions The annual contribution creates a tax benefit that significantly enhances cash flow A S Corp transaction offers additional tax benefits ESOP Tax Benefits Financial Comparison of ESOP Loan Debt Service to non ESOP Loan Debt Service Firm Value $25,000,000 Value of ESOP Purchase $12,000,000 Internal ESOP Loan $12,000,000 External Bank Loan $12,000,000 Internal Loan Amortization $1,000,000 (12 years) Bank Loan Amortization $2,000,000 ( 6 years) Bank Interest (5%) $600,000 Tax Rate 40% 4

5 ESOP Tax Benefits Financial Comparison of ESOP Loan Debt Service to non ESOP Loan Debt Service ESOP Non ESOP EBIT 5,000,000 5,000,000 Interest 600, ,000 Pre Benefit Income 4,400,000 4,400,000 ESOP Contribution i 1,000,000 0 Pretax Income 3,400,000 4,400,000 Taxes 1,360,000 1,760, ,000 Net Income 2,040,000 2,640,000 ESOP Contribution 1,000,000 0 Total Cash Flow 3,040,000 2,640,000 Debt Service 2,000,000 2,000,000 Free Cash 1,040, , ,000 Debt Service Ratios Interest Coverage Ratio 8.33x 8.33x Principal Coverage Ratio 1.52x 1.32x Loan/EBIT 2.40x 2.40x ESOP Tax Benefits If a S Corp is owned by an ESOP, the S Corp does not have to pay taxes or distributions on the portion of earnings attributable to the shares owned by the ESOP If a S Corp is owned 100% by an ESOP, the S Corp under current law doesn t have to pay federal income taxes on its earnings in perpetuity 100% owned S Corp ESOPS have 40 percent more cash flow due to tax savings than other corporations III. Debt Capacity Analysis 5

6 Debt Capacity Analysis In order to determine how much can be borrowed to finance an ESOP, you must assess the excess debt capacity of the company Debt capacity is generally determined by a company s EBITDA and market debt multiples Excess debt capacity equals total debt capacity minus total debt Excess debt capacity must be compared to the proposed purchase price to determine what can be financed Debt Capacity Analysis EBITDA $5,000,000 Debt Multiple 3x Debt Capacity $15,000,000 Existing Debt ($3,000,000) Incremental Debt Capacity $12,000,000 Debt Capacity Analysis The financing analysis must always provide a cushion of extra financing to provide for contingencies The quality of EBITDA must be considered 6

7 IV. Financing Markets and Terms The Financing Markets Lending Sources Local Banks Regional Banks National Banks Finance Companies Business Development Companies Insurance Companies Mezzanine Debt Funds Sellers Customary Terms Most ESOP Loans are collateralized by liens on all assets. Collateral coverage (excess/shortfall) is determined by traditional asset based methods. Some modest collateral shortfalls (air-balls) are permitted. In general, major collateral shortfalls have to be supported in some way. In an ESOP, when there is a collateral short fall, all or part of the proceeds of the transaction can be pledged back by the selling shareholders. Junior capital is also available. Rates and fees are situation specific.. 7

8 Current Market Conditions As illustrated in the table below, the credit stats of recent deals are more akin to the recovering market of 2003/2005 than the peak of 2006/2007 Additionally, loan spreads remain high by historical standards, both for LBO s and dividend recapitalizations Outer-edge leverage representing the most aggressive 20% of all deals during the period below are still meaningfully lower than in the 2006/2007 hot leverage period Cold Recovering Hot Lukewarm Ice cold Recovering Really Recovering Market tone FLD/EBITDA Debt/EBITDA Outer-edge leverage % > 7x leveraged 0.00% 1.90% 17.72% 14.29% 0.00% 0.00% 0.00% PPM LBO loan all-in spread* OID 99.30% 99.80% 98.90% 96.98% 97.93% 98.35% 98.68% Equity 37.00% 32.60% 32.60% 40.80% 51.06% 44.23% 41.08% Average LIBOR floor 267 NA NA % w/floor 7% NA NA 31% 100% 100% 100% *includes OID amortized over three year and excess current rate of LIBOR floors Source: Standard & Poor s LCD Junior Capital As the market for senior debt has contracted from 4.0x EBITDA during 2006/2007 to 3.0x today for middle market companies, borrowers are utilizing more junior debt and structured equity in their capital structures The mezzanine and structured equity community has been somewhat less impacted by the current credit crisis Long-term committed financing Fixed cash interest / dividend rate that never really declined below 9% to 12% during the cycle provides consistent income A more disciplined credit orientation historically helped many avoid the excesses of the last several years As a result, while leverage levels are conservative through junior debt (topping out around 3.0x total debt / EBITDA), pricing has remained fairly consistent in the 15% to 19% range More funds now require warrants and call protection vs. a straight contractual return 11% to 13% cash coupon with a small PIK component plus an equity kicker Deb/Equity Mix The tight credit markets and stricter terms (e.g., high interest rates, strict covenants, large upfront fees) of the debt capital that is available have forced private equity firms to invest more equity to fund transactions Equity contributed to fund LBOs has risen over the past 12 months to ~41% as of the end of 2010 Prior to the credit crisis, bank debt was the primary funding source for LBOs (averaging ~50% of total proceeds). In 2009, bank debt has constituted under 25% of total proceeds, with other forms of secured debt (primarily from specialty lenders and hedge funds) accounting for nearly 20% of proceeds 8

9 Junior Capital Mezzanine placements have become very popular due to the permanent and passive characteristics of subordinated debt: Longer term maturity of five to six years Less restrictive covenants with as much as a 15% to 20% cushion beyond bank covenants Bullet maturity with no amortization Many companies are utilizing minority equity as an alternative to mezzanine No cash coupon A dividend is only due if cash flow is sufficient to service the payment Convertibility features can eliminate refinancing risk Equity treatment by lenders Yield requirements in the structured equity community are in the low-tomid 20% range Dividend Warrants / conversion price V. The Lender s Perspective The Lender s Perspective A loan used to fund an ESOP purchase of stock is a Tax Advantaged Financing A loan to finance the purchase of stock by an ESOP from an existing shareholder is a capital or business value loan since the proceeds of the loan leave the business. Capital loans substitute debt for equity. A Capital Loan is Risky! 9

10 The Lender s Perspective Non Leveraged Transactions Net Assets Liabilities $4 20% Bank Interest Debt $16 Market Value 80% $20 $20 100% The Lender s Perspective Leveraged Transactions Leverage increases the percentage claim on asset value. Net Assets Liabilities $12 60% Interest Bearing Debt $8 40% Market Value $20 $20 100% The Lender s Perspective Leveraged Transactions A change in cash flow or market multiples increases the risk. Assets Liabilities $12 75% Interest Bearing Debt (4) 25% Equity Value (4) (4) $16 $16 100% 10

11 The Lender s Perspective The focus of the analysis is on: The long term ability of the business to generate cash flow and the existing and future claims on that cash flow. This includes an analysis of the following: The stability of the income stream; The existing debt and required debt service; The future needs to fund capital investment t and working capital; The secondary protection afforded by the assets of the corporation. Solvency issues. Does the company have sufficient capital to meet its obligations and run its business? The Lender s Perspective Important Lender Questions Identify total Company financing needs (including excess availability) Examine the impact on customers and current trade credit Examine the level of collateral coverage Determine the market for the Company s debt Determine the need for side collateral/mezzanine debt, seller paper or guarantees V. Company Perspective 11

12 The Company s Perspective Understand the lender s perspective on the type of financing you require Provide for your future investment needs including a reserve Prepare a five-year business plan Review the state of your accounting records and financial control systems Be prepared to address special financial arrangements with shareholders The Company s Perspective Plan for the financing process and allow time to explore financing alternatives with different financing sources Be prepared to market your company as you would your products and services Seek financial institutions with industry and transaction experience Identify and hire advisors with transaction and market experience The Company s Perspective Anticipate the Lender s Questions Identify total Company financing needs (including excess availability) Examine the impact on customers and current trade credit Examine the level of collateral coverage Determine the market for the Company s debt Determine the need for side collateral/mezzanine debt, seller paper or guarantees 12

13 Questions? John L. Miscione LLC 55 East 52 nd Street New York, NY John Miscione John Miscione Managing Director, LLC Contact Information: Phone: Fax: Mobile: Office Address: 909 Third Avenue 12 th Floor New York, NY John Miscione joined LLC in New York in 2005 as part of Valuemetrics merger with Duff & Phelps. John manages New York financial advisory business unit. Professional Experience: John specializes in structuring and negotiating leveraged ESOPs, management buyouts and recapitalization transactions and arranging debt and mezzanine capital to finance the transactions for selling shareholders and management teams. John has substantial experience in using the sub-chapter S ESOP structure to complete acquisitions. In the advisory area, John has issued fairness opinions to public and private boards and ESOP fiduciaries in change of control transactions, going private transactions, conflicted transactions with insiders and in recapitalization transactions involving the exchange of securities. John has also provided solvency opinions in leveraged transactions, recapitalizations and distressed situations. In the valuation area, John has provided valuation opinions for gift, estate, corporate compliance, executive compensation, dispute resolution purposes and to assist financial institutions with risk assessment and management. John is nationally recognized as an expert in ownership transition and private company finance and speaks regularly on a wide range of topics including: Leveraged ESOPs, The Debt Capital Markets for Private Companies, Valuing Closely Held Businesses and Exit Alternatives For Private Business Owners. John has also served as a consultant to financial institutions on client development and risk management. Education: M.B.A. - Finance, New York University M.A. - Psychology, University of Virginia B.A. - Psychology, John Hopkins University Professional Associations & Affiliations: Association for Corporate Growth; the Turnaround Management Association and the ESOP Association, Member The Board of Directors of the National Center for Employee Ownership and the New York Institute of Credit, Member John is a registered representative and holds the Series 7 and 63 licenses 13