ESOP An Alternative Exit Strategy (while Maximizing Business Cash Efficiency)

Transcription

1 ESOP An Alternative Exit Strategy (while Maximizing Business Cash Efficiency) Presented to : Givner & Kaye Copyright 2009 Corporate Solutions Group, LLC No part of this presentation may be reproduced, adapted, translated, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. The subject matter discussed herein has been simplified for discussion purposes. March 15,

2 Agenda Introduction ESOP Theory / Structure Post Transaction Our Approach Case Study CONFIDENTIAL 2 2

3 About CSG Partners Boutique middle-market investment bank, specializing in ESOPs, M&A, and capital advisory services FIRM OVERVIEW Nation s largest investment banking practice for ESOPs Headquartered in New York, with offices in Miami and San Francisco Founded in 2001 as affiliate of American Express, now privately owned Implemented 100 ESOP transactions for companies with total market value exceeding $6 Billion 50 ESOP transactions in last 3 years alone DEPTH OF EXPERIENCE CSG professionals previously worked for Barclays Capital, GE Capital, KMPG, Oliver Wyman, Prudential, PwC, and as CEOs of public and private companies Clients have ranged full middle-market spectrum, with values from $10MM to $500MM

4 Recent notoriety for our ESOP practice 2011 Awards Acquisition Financing Deal of the Year (Winner) Boutique Investment Bank of the Year (Finalist) Debt Financing Firm of the Year (Finalist) Professional Services Deal of the Year (Finalist) 2011 Rankings CSG Partners ranked among nation s top 25 investment banks for US transactions up to $50MM, $100MM, and $250MM Largest investment banking practice for ESOPs 2010 Awards Acquisition Financing Deal of the Year (Winner) Boutique Investment Bank of the Year (Finalist) Debt Financing Firm of the Year (Finalist) Professional Services Deal of the Year (Finalist) Consumer and Retail Deal of the Year above $50MM (Finalist) Debt Financing Deal of the Year above $75MM (Finalist) Debt Financing Deal of the Year below $75MM (Finalist) Professional Services Deal of the Year (Finalist) Middle-Market Financing Deal of the Year below $100MM (Finalist) 2010 Rankings CSG Partners ranked among nation s top 25 investment banks for US transactions up to $50MM and $100MM Largest investment banking practice for ESOPs 4

5 Liquidity Alternatives Traditional alternatives available to business owners wishing to achieve personal liquidity and asset diversification? Sale to a financial buyer Usually requires giving up control of company Sale to a strategic buyer Requires giving up control of company IPO Option is available to only select group of businesses Leveraged Re-CAP Significant tax implications, if available at all Not An Easy Task In Today s Environment!

6 Economic Environment Overview Good News Some industries/companies performing well during recession: Government contractors, healthcare, business process outsourcing, etc. Bad News CASH IS SCARCE Internally: due to depressed performance, higher taxes Externally: due to tight credit markets, lack of liquidity/exit alternatives, depressed valuations CONFIDENTIAL 6

7 Where Does the Cash Flow Go? Available Cash For Distribution, $1,550,000 Taxes, $4,250,000 Interest, $1,500,000 Typical company with $10MM EBIT Working Capital, $1,000,000 Capex, $750,000 Existing Debt Amortization, $1,000,000 CONFIDENTIAL 7

8 ESOP Solution ESOP = Tax advantaged leveraged buyout of one s own Company CONFIDENTIAL 8

9 Myths About ESOPs Employees will run the company Employees will have access to confidential financial information Owner will not receive fair market value Owner must guarantee the ESOP loan Repurchase liability will cripple the business ESOP will prohibit my children from inheriting the company ALL are NOT true CONFIDENTIAL 9

10 Introduction ESOP Theory / Structure Post Transaction Our Approach Case Study CONFIDENTIAL 10

11 What Is An Employee Stock Ownership Plan (ESOP)? Type of defined contribution employee benefit plan Designed to invest primarily in employer securities Advantages not found in traditional tax-qualified employee benefit plans: Can buy stock from owners Can borrow money to finance purchase Substantial tax benefits Over 11,000 private businesses have used ESOPs Must comply with numerous DOL and Internal Revenue Code rules / regulations CONFIDENTIAL 11

12 Benefits of Selling to an ESOP Company becomes a tax-free entity Increases cash flow significantly Liquidity for shareholders Shareholder can sell minority or controlling interest Shareholder can utilize 1042 to (indefinitely) defer Cap-Gain Tax ESOP valuations still strong- despite recession Paid fair market value Valuation heavily weighted towards DCF vs. public comps Selling shareholders can maintain control Provides incentive for employees and key managers CONFIDENTIAL 12

13 ESOP Mechanics Lender Cash Note Company Note Internal Loan Selling Shareholder Cash Stock ESOP Trust CONFIDENTIAL 13

14 Repaying the Loan Bank Loan is repaid with tax-deductible dollars o Company contributions to ESOP 25% of eligible payroll plus unlimited interest payments if a C Corporation ESOP TRUST Tax Deductible Cash Contribution Internal Loan Repayment Company o Dividends on ESOP stock Limits based on compatible transactions and reasonability (for C Corporations) Employee ESOP Account Bank CONFIDENTIAL 14

15 Tax Advantaged Leveraged Buyout (Real World Definition) Savings 1 Owner receives cash tax free $10mm x Capital Gains Rate Est. Fed 15% State 10% = $2.5mm 2 Company receives income tax deductions (over time) = to sale price $10mm x Corporate Tax Rate Est 40% = $4.0mm Total Savings $6.5mm

16 Free Cash Flow Primer ( C Corp, w/esop) ESOP TRUST Debt to Company - Beginning of Period $ 10,000 Repayment (3,250) Debt to Company - End of Period $ 6,750 ESOP Contributions $3.25MM SIMPLIFIED INCOME STATEMENT ($ in thousands) Net Revenue $ 32,000 Cost of Goods Sold 23,000 Gross Profit 9,000 Overhead (4,000) Depreciation (750) Net Interest (1,000) Pre-tax Income 3,250 ESOP Contributions (3,250) Taxable Net Income $ - Repayment of ESOP Debt to Company CASH FLOW STATEMENT w/esop Net Income $ - Repayment of Debt from ESOP Trust 3,250 Working Capital (500) Depreciation 750 Capex (750) Free Cash Flow $ 2,750 CONFIDENTIAL 16

17 Comparative Free Cash Flow Primer ( C Corp) CASH FLOW STATEMENT w/esop Net Income $ - Repayment of Debt from ESOP Trust 3,250 Working Capital (500) Depreciation 750 Capex (750) Free Cash Flow $ 2,750 CASH FLOW STATEMENT (w/o ESOP) Net Income $ 1,625 Depreciation 750 Working Capital (500) Capex (750) Free Cash Flow $ 1,125 COMPARATIVE Free Cash Flow w/esop $ 2,750 Free Cash Flow w/o ESOP 1,125 ESOP Incremental Benefit 144% CONFIDENTIAL 17

18 ESOP Structures C Corps / S Corps / LLC C CORPORATION Preferred stock is often sold to the ESOP; payroll contributions, preferred dividends are tax-deductible; This structure is used best for minority ESOP sales; Tax liability is minimized; Selling shareholders have an option of deferring capital gains taxes through a 1042 rollover or electing an installment payment treatment and paying capital gains taxes; If no 1042, selling shareholders participate in the ESOP accumulate a substantial amount of the Company s equity in their ESOP account; Selling shareholders maintain a majority ownership. 18

19 ESOP Structures C Corps / S Corps / LLC S CORPORATION S Corporations 100% owned by the ESOP are free from federal income tax liability; This structure is used best for majority ESOP sales; Company s cash flow can be used to amortize bank debt / seller notes tax free; Company can issue a warrant for the benefit of the selling shareholders or their family members; Selling shareholders pay capital gains taxes; elect an installment payment treatment; Selling shareholders can participate in the ESOP accumulate a substantial amount of the Company s equity in their ESOP account; Selling shareholders continue to control the Company exercising control through the Board of Directors and other corporate governance tools. 19

20 S Corp ESOP Structure (Cont.) Company maintains (or becomes) S corp. Shareholders sell 100% equity to ESOP Financing to purchase stock: Outside financing- seller paid cash immediately Seller note- sellers receive promissory note, paid over time Company is tax free. Substantially increases free cash flow Additional cash flow can be used to amortize bank debt / seller note Selling shareholders retain equity upside Synthetic equity - warrants for up to ~50% off business Allows company to be tax free, but maintains equity-like interests for sellers Can participate in ESOP- get back stock sold Elect installment sale treatment- pay cap gains only as seller note amortized Converts ordinary income stream (business operations) into cap gains Selling shareholders continue to control the Company exercising control through the Board of Directors and other corporate governance tools CONFIDENTIAL 20

21 ESOP Structures C Corps / S Corps / LLC LLC ESOPs Allow substantial structuring flexibility; New corporation has to be formed; Membership interests in the LLC contributed to a new corporation in a tax-free Section 351 exchange for all the shares of the Company; Establish a holding period and avoid tax liability; Can elect to do an S Corp ESOP transaction (tax free structure) or a C Corp ESOP (1042 rollover, preferred dividend value enhancement); Unique option: LLC C S A Company first forms a C Corp, so its owners can qualify for the 1042 rollover, then makes an S election on a subsequent January 1, to become a tax-free entity LLC C S 21

22 Benefits of ESOP-Owned S Corp Tax Free No Federal or State taxes Substantially increases Company s cash flow Selling shareholders convert ordinary income into capital gains Get cost basis out of business Creates diversification / liquidity outside of business Selling shareholders retain control Selling shareholders retain significant upside Receive warrants for up to ~50% of business Can participate in ESOP (receive portion of equity back) CONFIDENTIAL 22

23 ESOP Benefits S CORP No State or Federal taxes on 100% Employee-owned Companies Company $4MM to Repay ESOP Debt T A X E S $4MM 23

24 Building a Better Company Under ESOP According to a recent University of Pennsylvania study, ESOPs represent a tangible effect on the employee morale and productivity (University of Pennsylvania Center for Organizational Dynamics, Work Paper #08-07, July 29, 2008). Financial success for all shareholders, i.e. ESOP & others Better results for other stakeholders customers, communities A better place to work - better employee attraction & retention, lower turnover Higher productivity, cost efficiency 24

25 Valuation Sellers paid Fair Market Value for stock Determined by independent valuation firm But a negotiated process Discounted cash flow analysis prevalent methodology ESOP valuations less affected by public market comparables, less volatile Good companies still command strong multiples: Public markets declined by 40%-50% in 2008, but CSG ESOP clients only lost 10%-20% in valuations Valuation of stock sold reduced by warrants sellers receive Structuring depends on owners objectives CONFIDENTIAL 25

26 Maintaining Upside in 100% Transactions Even in 100% Sale Transactions, CSG clients often retain significant ownership: o Synthetic equity (warrants) o ESOP participation Warrants: o selling shareholders often receive up to ~50% warrants that allow them to acquire shares of the Company at a pre-determined low price o provides upside ESOP Participation: o selling shareholders can participate in the ESOP o each shareholder s allocation based on his share of total company payroll (subject to limitations) o for companies with high employee turnover, shareholder share allocations often exceed their direct share of payroll; o Once ESOP loan is repaid, net profits of business can be distributed to taxdeferred ESOP accounts. Builds up cash. CONFIDENTIAL 26

27 Maintaining Control Corporate Governance In 100% ESOPs, Company is run by Board of Directors Selling shareholders nominate Board of Directors and control it ESOP Trustee is a directed Trustee votes on most corporate matters as directed by the Board Selling shareholders also control the Company as its largest creditors (through seller note in seller-financed transactions) Company s restated Certificate of Incorporation and other transaction documents drafted to ensure shareholders control over business even after seller note is repaid CONFIDENTIAL 27

28 Comparisons to M&A Transaction Criteria ESOP M&A Satisfactory Value - ESOP pays fair market value less affected by volatility? Control Seller retains control Seller looses control Taxation on deal proceeds Option for long term deferral of capital gains (1042 election) Capital Gains Company s ability to repay debt Excellent (pre-tax dollars) Moderate (post-tax dollars) Retain Family Control Future alternatives -Sale of another portion to ESOP -Sale to Strategic Buyer -Sale to Financial Buyer -Retain control Limited Probability of success High Average CONFIDENTIAL 28

29 Comparisons to M&A Transaction (cont d) Criteria ESOP M&A Time to Completion 4-8 months 8-18 months Fees and expenses Relatively low High Second bite at the apple (sellers benefit from future growth) Can sell incremental % at any time Limited Confidentiality of the process Disruption to operations during process Employee impact Very low Valuable benefit and motivational tool High (multiple parties involved in due-diligence) Uncertainty detrimental to morale ESOPs are also often compared to leveraged recaps o ESOP debt is repaid with pre-tax $$$ versus after tax $$$ in recaps o ESOPs significantly improve companies credit profiles lenders are more likely to lend / lend more CONFIDENTIAL 29

30 Benefits of Selling to an ESOP Company becomes substantially a tax-free entity Increases cash flow significantly Liquidity for shareholders Shareholder can sell minority or controlling interest Shareholder can utilize 1042 to (indefinitely) defer Cap-Gain Tax ESOP valuations still strong- despite recession Paid fair market value Valuation heavily weighted towards DCF vs. public comps Selling shareholders can maintain control Provides incentive for employees and key managers CONFIDENTIAL 30

31 Economic Environment ESOP Implications Approach change from a liquidity event focus to more of a cash-preservation/tax strategy Installment Sale tax treatment gaining popularity vs rollovers 100% S Corp ESOP transactions with warrants gaining preference vis a vis 30%-49% C Corp deals (100% ESOP-owned S corps are tax free by definition) Selling shareholders often elect to participate in the ESOP receive substantial equity/cash allocations in their tax-deferred accounts Warrants to selling shareholders are actively utilized in 100% S Corp ESOPs (subject to 409(p) limitations) According to section 409(P) individuals with 10%+ ownership in a 100% S Corp ESOP cannot collectively own in excess of 50% of the equity on a fully diluted basis Shareholders are more willing to accept seller-financed transactions Can refinance at a later point of time Have options open to sell to a third party later CONFIDENTIAL 31

32 ESOP Financing Structure under Current Market Conditions i. Senior debt traditionally, the least expensive source of outside capital ii. Subordinated debt pricier than senior debt, but more readily available in the current environment iii. Seller Financing an increasingly popular source of ESOP Transaction financing Traditional ESOP Financing Structure Seller Financing Current ESOP Financing Structure Seller Financing Subordinated Debt Senior Debt Subordinated Debt Senior Debt 32

33 Senior Debt Lenders rely on companies assets and cash flows in making their lending decisions; Capital is cheap (3 Month LIBOR 0.25%, Prime 3.25%); Require monthly (sometimes weekly) borrowing base reports from their clients, advance 80%-90% against eligible accounts receivable and 45%-60% against eligible inventory and letters of credit Fixed assets (e.g. equipment or real estate) and intellectual properties (e.g. trademarks and patents) sometimes would be included as a part of the collateral. In the current environment lenders increasingly prefer to lend against liquid assets; 33

34 Senior Debt (continued) Asset-based or hybrid senior lenders also occasionally stretch their loans, advancing funds in excess of their clients collateral support. Historically, CSG was able to secure month cash flow over-advances for its clients. Presently, this financing window has been shortened to 0-6 months; Typical covenants include (i) minimum availability, (ii) maximum fixed charge coverage, (iii) maximum leverage, etc; Senior lenders price their loans as a function of Prime or Libor. Typical ranges are L+4% to L+6% or P+0.5% to P+3%; Cash flow-based lenders typically advance loans based on multiples of their clients EBITDA. Largely unavailable for middle-market companies at this time. 34

35 Subordinated Debt A more expensive form of financing; Mezzanine debt is still available in the current environment; it is typically priced at 16%-23% total target rate of return; Typically requires a Subordination Agreement, determining each lenders rights and claims; Subordinated lenders typically take precedence over seller debt and may add financial covenants (e.g. total debt to EBITDA) to monitor the company s performance; Subordinated debt providers include private equity / mezzanine funds, designated groups within traditional banks, insurance companies, etc. 35

36 Seller Financing Most inexpensive and most readily available form of financing Selling shareholders accept notes from company for stock sold to ESOP Sellers earn current interest (typically, 5%-6%), taxable as ordinary income Companies utilize ESOP-related tax benefits to enhance their cash-flow and thus accelerate the amortization of the seller notes The involvement of senior and subordinated third-party lenders may subject the seller notes to various covenants and affect (defer) the timing of their repayment In the current environment, seller financed transactions are becoming increasingly popular, as clients desire the tax benefits associated with the ESOP without having to go through the arduous bank due diligence and approval process. Furthermore, market uncertainty makes financial covenants and other limitations typically imposed by the third-party financing sources increasingly less appealing. 36

37 Ideal ESOP Candidate Company Characteristics Stable or growing revenues Generating taxable earnings Relatively large payroll base desirable but not critical Owner interested in liquidity Industries that have recently implemented ESOPs include: Restaurant chains Engineering and Architectural firms Healthcare staffing Companies General and Specialty Contractors Call center operators Grocery/supermarket chains Federal Government Contractors Insurance brokerages Apparel and Textile Manufactures Transportation CONFIDENTIAL 37

38 Myths About ESOPs Employees will run the company Employees will have access to confidential financial information Owner will not receive fair market value Owner must guarantee the ESOP loan Repurchase liability will cripple the business ESOP will prohibit my children from inheriting the company ALL are NOT true CONFIDENTIAL 38

39 Introduction ESOP Theory / Structure Post Transaction Our Approach Case Study CONFIDENTIAL 39

40 Post Transaction Alternatives Both minority (30-49%) and majority (100% with warrants) ESOP transactions allow a broad range of post-transaction alternatives, including Follow-on sale to the ESOP of the residual equity Sale to a third party acquirer Estate Planning (e.g. GRATs, Intentionally Defective Grantor Trusts, etc.) CSG encourages all of its clients to utilize the ESOP structure and consider estate planning post-transaction CONFIDENTIAL 40

41 Introduction ESOP Theory / Structure Post Transaction Our Approach Case Study CONFIDENTIAL 41

42 CSG An ESOP Quarterback CSG has developed a unique ESOP focus and expertise. ESOP is a highly multidisciplinary product we partner with other professional advisors (accounting and law firms, valuation experts, Trustees, investment advisors, etc.) to conduct the process in the most efficient way possible and provide maximum value to the client. Accountants Attorneys CSG Lenders ESOP represents a tremendous win-win proposition for clients and their advisors Valuation Experts Independent Trustees Investment Advisors CONFIDENTIAL 42

43 CSG s Role Advise the Company regarding transaction structure CSG conducts extensive analytics on optimal structures Prepare transaction/financing memorandum Engage parties and coordinate transaction Engage independent valuation firm to determine fair market value Select fiduciary to represent employees Retain legal counsel Negotiate transaction with parties Solicit and negotiate financing proposals Coordinate with the client s accountant re: optimal tax / estate planning structure Close transaction CONFIDENTIAL 43

44 ESOP Benefits Trusted Advisors Assist the client in achieving liquidity and reducing business taxable income Retain the client (alternative liquidity events, such as M&A, often lead to an account loss) Earn clients appreciation for creativity and objectivity Create an opportunity to provide clients with additional services (e.g. tax / estate planning, more frequent reviews) Meet and establish relationships and referrals with other deal participants (CPAs, bankers, lenders, etc.) For firms with trust/estate practice substantial amount of released value to be managed Transaction related work either on ESOP side, on trustee side or on general corporate matters Newly found liquidity requires wealth management CONFIDENTIAL 44

45 Overview of an ESOP Transaction: Liquidity & Diversification Valuation Company Tax Incentives Seller Tax Incentives Upside & Control Incentivize Employees Creating a buyer for your company Can do partial or complete sale (e.g. 30% - 100%) Typically some cash at closing; balance paid over time Paid fair market value With planning, valuations can be attractive Partial sale- company can deduct purchase price 100% sale- company becomes permanently tax-free business Substantially increases cash flow Shareholders can avoid capital gains taxes when selling to ESOP- called a 1042 Rollover Selling owner can retain control over business- even when selling 100% Can have upside potential Excellent benefit for employees 45

46 CASE STUDY:

47 Minority Sale- Estate Planning Post transaction, owner ( Charles ) can consider gifting unsold stock Unsold common stock is temporarily depressed because: (1) new debt, and (2) the ESOP stock receives preferred dividends until converting back into common (diverts cash flow) Value of Gift Post Transaction (49% sale) Pre-ESOP ($ in '000) Charles' Equity Value $71,080 Value of Charles' 51% Pre-ESOP 36,251 Value of Sale to ESOP (49% Preferred Stock) 39,846 Post-ESOP ($ in '000) Pre-Transaction Equity Value $71,080 Less: Bank Debt ($10,000) Less: PV of ESOP Debt (23,877) Less: PV of Preferred Dividends (13,949) Plus: PV of Tax Shield 3,885 Post-Transaction Equity Value 27,139 51% Remaining Equity 13,841 Less: Lack of Marketability Discount (30%) (4,152) Value of Gift (remaining 51%) $9,689 Comment: Charles and his wife will use their combined $10MM gift tax exemption to gift the stock to a trust for their children. Will be removed from their estates permanently 47

48 Contact Eitan Milstein, Managing Director CSG Partners, LLC 238 S. Ridgewood Rd. Suite 450 Kentfield, CA Fulton St, Suite 600 New York, NY (415) (direct) (415) (cell) (212) (fax) Copyright 2009 Corporate Solutions Group, LLC ( CSG ). This presentation may contain general, summary discussions of certain tax, investment regulatory, accounting and/or legal issues relevant to the contemplated transactions. Any such discussion is necessarily generic and may not be applicable to, or complete for, any particular recipient's specific facts and circumstances. CSG does not offer and does not purport to offer, tax, investment, regulatory, accounting or legal advice, and this information should not and cannot be relied upon as such. CSG makes no warranties or representations of any kind with respect to the attached information. In no event shall CSG be liable for any use of or reliance on such information, or for any inaccuracies or errors in such information. All analytics, examples, rates, and returns in this presentation are for preliminary discussion purposes only and are not guarantees of future results. IRS Circular 230 Disclosure: To comply with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained herein (including any attachments), unless specifically stated otherwise, is not intended or written to be used, and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter herein. 48

49 Questions & Answers