ADVANCED ESOP STRATEGIES: OPTIONS AND ALTERNATIVES

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1 Welcome to ADVANCED ESOP STRATEGIES: OPTIONS AND ALTERNATIVES Presented by 1

2 Today s Agenda Introduction Basic ESOP Transactions Advanced ESOP Transactions Tax Considerations Financing Considerations Incentive Plans for Key Employees Q&A 2

3 Introduction 3

4 What is an ESOP? Similar to a Profit Sharing Plan: Tax deductible contributions for employer Retirement savings for employees Also an M&A opportunity ESOP invests in sponsor s stock ESOP participates in earnings and growth of the sponsor 4

5 Some Familiar ESOP Companies 196 of S&P 900 have ESOPs 5

6 Why Use an ESOP? Liquidity for shareholders Diversify owner s asset allocation Real business succession strategy Increase company cash flow Enhance employee productivity 6

7 Basic ESOP Transactions 7

8 The Company Incorporated (TCI) Sales $ 10,000,000 Payroll $ 1,000,000 Pre tax Profit $ 600,000 Net Worth (Book Value) $ 2,000,000 Fair Market Value $ 3,000,000 Owners: John 75% Pat 25% 8

9 Case I Gradual ESOP John wants to cash out on a gradual basis, starting with a 5% sale ESOP Ownership % Year 9

10 Case I Gradual ESOP TCI $ 0 $ 250,000 ESOP $ 0 $ 250,000 TCI Stock JOHN 10

11 Case II Prefund Annual contributions to build up cash for a future sale 11

12 Case II Prefund Year 1 TCI $ 250,000 ESOP Year 2 TCI $ 150,000 ESOP ESOP accumulates $400,000 for future purchase of stock. TCI takes annual deductions for contributions 12

13 Case III Leveraged C Corp ESOP John wants to cash out more quickly TCI s bank is willing to extend financing Potential for tax deferral on John s sale 13

14 Case III Leveraged C Corp ESOP $ 900,000 Bank TCI $ 900,000 ESOP 14

15 Case III Leveraged C Corp ESOP ESOP $ 900,000 30% of TCI Stock JOHN 15

16 Case III Leveraged C Corp ESOP TCI makes a deductible cash contribution to the ESOP. Up to $250,000 (1/4 of payroll) plus interest. The ESOP uses that contribution to repay interest and principal on the company loan. TCI repays the bank loan. Bank TCI ESOP 16

17 Case IV Combine Cases II &III Year Company s Fair Market Value 30% of FMV Tax deferred sales proceeds To seller Prefunding annual Prefunding cumulative Required bank loan Annual Debt Service 1 $ 3,000,000 $ 900,000 $ 250,000 $ 250,000 $ 900,000 $ 243,000 2 N/A N/A 150, ,000 N/A N/A 3 $ 3,333,333 $ 1,000,000 N/A $ 400,000 $ 600,000 $ 162,000 Results: 1. John receives additional $ 100,000 in tax deferred rollover funds. 2. The required loan is reduced by 33% ($600,000 rather than $900,000) and the Company s first-year principal + interest debt service is reduced by $81,000 pretax. 17

18 Case V Combine Cases I and III Capital-gains sales followed by a tax-free rollover sale % Sale -- % Sale -- Taxable or Year Annual Cumulative Tax Deferred S or C 1 3 % 3 % Capital-gains S or C 2 4 % 7 % Capital-gains S or C 3 5 % 12 % Capital-gains S or C 4 18 % 30 % Tax Deferred C 18

19 Case VI Two Stage ESOP Buyout Year Market Value Sale Proceeds Loan Balance Debt Service 1 $3,000 $1,500 (50%) $1,500 $ ,200 1, , ,800 $1,900 (50%) 2, ,100 2, ,400 1, ,800 1, ,200 1, ,600 1, , ($ thousands) 19

20 Tax-free Rollovers Gross Purchase Price Less Tax Net to Seller Tax Free ESOP $ 900,000 0 $ 900,000 Taxable Sale at 25%* $ 900,000 ($ 225,000) $ 675,000 Seller s Extra Cash $ 225,000 = 33% More Capital * 20% Federal Tax, plus 5% State tax 20

21 Tax-Free Rollover ESOP must acquire 30% or more of the stock of a privately held C corporation Seller must have a holding period of at least 3 years Seller must reinvest the proceeds within 12 months Funds must be reinvested in Qualified Replacement Property Tax deferral continues as long as seller holds QRP Basis in QRP carries over from basis in stock sold Seller may not receive ESOP allocation of sold shares 21

22 Qualified Replacement Property Stocks, Bonds or Notes issued by U.S. Corporations, Public or Private Can invest in Brother/Sister of the ESOP Company, but not a Subsidiary Option to create diversified portfolio 22

23 Unlocking the QRP Lockup $ 900,000 From Sale of Stock To ESOP $ 900,000 QRP Bond $ 720,000 Margin Loan Proceeds Net Unrestricted Proceeds To Seller 23

24 The S CORPORATION ESOP 24

25 Benefits of S Corp ESOPs ESOP s share of S corp. earnings is exempt from unrelated business income tax (UBIT). Taxation is delayed until distributions are made to ESOP beneficiaries. Thus, a 100% ESOP-owned S corp. does not pay Federal income taxes. However, an S corp. ESOP must meet broadly based test. Selling Shareholders participate in ESOP allocation 25

26 S Corp. ESOPs Tom, age 50, owns 100% of S, Inc., an S corp. Tom s compensation is $210,000/year S, Inc. employs 20 other employees with total compensation of $840,000/year Annual pretax earnings are $800,000 The fair market value of S, Inc. is $4MM 26

27 Leveraged S Corp. ESOP (Seller Financed) S, INC. STEP 1 TOM NOTE FOR $4 MM STOCK 100% ESOP 27

28 Leveraged S Corp. ESOP (Seller Financed) S, INC. CONTRIBUTIONS DISTRIBUTIONS STEP 2 TOM TOM NOTE PAYMENTS ESOP* ESOP * Stock is allocated to participants as a note payments are made 28

29 Leveraged S Corp. ESOP (Seller Financed) Seller Note Options Conventional Seller Note 10 to 15 year term with prepayment provisions 6% to 8% interest rate Fully Priced Seller Note 10 to 15 year term with prepayment provisions IRR of 13%, based on comparable mezzanine loan rates 6% to 8% current-pay interest Warrants for 10% - 20% ownership to make up the difference 29

30 Leveraged S Corp. ESOP END RESULTS: S, Inc. no longer pays income tax, as its sole shareholder is tax-exempt Tom receives $ 4MM and, on the gain, pays only capital gains tax (not ordinary income tax) Tom is allocated 20% of ESOP stock (which he will be able to cash out when he leaves Company) Since Company avoids making distributions to fund S corp. shareholders income tax, additional Company funds are available to repay debt and increase Company value 30

31 Advanced ESOP Transactions 31

32 Advanced ESOP Transaction Overview Section 1042 Transaction and Floating Rate Notes Combination Redemption / ESOP buyout Stock warrants Case Study: 100% Leveraged 1042 ESOP Transaction Asset Purchase by ESOP-Owned Company 32

33 Section 1042 Transaction and Floating Rate Notes 1 Company $ ESOP 2 $ Seller 3 10%$ 90%$ 4 QRP= FRN 33

34 Seller Financing and Floating Rate Notes ESOP 1 Seller Note Stock 2 Seller 10%$ 90%$ FRN 34

35 Redemption and ESOP Purchase Combo Company Cash $ ESOP Note 95% 5% Cash Seller More flexibility with purchase price More flexibility on seller note terms of collateral Helps manage company s repurchase obligation Seller note has higher interest rate (mezzanine debt) Disadvantage: 1042 probably not available Disadvantage: state solvency laws 35

36 Redemption and ESOP Purchase Shares Company ESOP Note Note Shares Seller 36

37 Stock Warrants Company Stock Promissary Note w/ warrants or deferred interest Seller 37

38 Stock Warrants Gives the holder a right to purchase company stock at a specified price at a future date Almost identical to an option Used in Seller-financed transactions Issued in lieu of a higher interest rate on the seller note 38

39 Stock Warrants Example: 15% total IRR with 8% cash pay = 7% of note balance (per year compounded) would represent a predetermined number of warrants (a certain ownership %) in the Company to enable sellers to acquire shares in the future at a pre-determined price Sellers often have right to put warrants to Company for cash once all transaction debt has been repaid Company may request a call feature 39

40 Case Study: 100% ESOP Transaction ABC Corp Step 1 Outside Financing: (1) $12MM bank term loan, (2) $13MM bridge loan from bank, (3) $10MM Mezzanine Debt Step 5 Repay Bridge Loan ($13MM) Lenders (Bank & Mezz Firm) Step 2 $35MM Loan to ESOP ( Inside Loan ) Net Cash before 1042 Deferral: $22MM and Approx. $18.5MM after 1042 deferral ESOP Step 3 ESOP pays $35MM) cash for 100% of ABC Stock Shareholders 1042 Deferral Step 6 Invest in Qualified Replacement Securities (approx. $3.5MM) 40

41 Case Study: 100% ESOP Transaction SELLERS Receive a total of $35MM for the sale of ABC Corp stock: $22MM cash (from $12MM senior debt loans and $10MM mezzanine financing) $13MM subordinated seller notes Sellers may elect to defer (possibly permanently) capital gains taxes on entire sale by investing in qualified replacement securities (e.g. Floating Rate Notes or FRNs ) If 1042 Deferral is elected, Capital gains tax savings up to $7MM (assumes $35.0MM price, stock basis of $0 and 20% federal long-term capital gains tax rates) 41

42 Asset purchase by ESOP-owned Company Objective Due to pending liabilities, Company wants to purchase assets rather than stock, or Seller wants to sell assets in exchange for cash, a seller note, and an earn-out provision Application Can be used either by an S or C corp Cannot be used in a 1042 transaction 42

43 Asset purchase by ESOP-owned Company Steps in the transaction 1. Management forms a Newco with paid-in capital of $10, Newco establishes an ESOP 3. ESOP purchases all of the outstanding stock of Newco in exchange for a promissory note in the amount of $10,000 payable over a term of 10 or 15 years. 43

44 Asset purchase by ESOP-owned Firm Steps in the transaction (ctd.) 4. Newco borrows say, $10 million from a bank, secured by the assets to be purchased 5. Newco purchases the assets from company X in exchange for $10 million of cash, a promissory note of, say, $5 million, and an earn-out of up to $5 million if earnings over the next 5 years exceeds projections 44

45 C corporation tax strategies C corp remains as C corp Taxable sale Pay current federal capital gains tax Seller participates in ESOP Tax-free rollover sale No current tax on sale of stock If QRP sold later, capital gains tax may be higher If QRP never sold, estate gets a step-up in basis Seller, seller s family, and 25% shareholders (and their families) are excluded from ESOP participation 45

46 C corporation tax strategies C corp makes an S election Advantages ESOP tax shield S corp distributions can be used to pay debt Disadvantages Must adopt calendar year Built-in-gains tax One class of stock Switch from LIFO to FIFO & LIFO recapture Loss of NOL carryovers Anti-abuse provisions- 409(p) 46

47 C Corp Second Stage Transactions If ESOP acquires less than 100% Advantage of remaining a C corp Continued availability of 1042 Advantage of switching to S status ESOP tax shield S corp distributions can be used to pay bank debt and/or seller note If ESOP acquires 100% No advantage in remaining a C corp 47

48 S corporation tax strategies S corp remains an S corp Advantages Seller taxes are low if stock basis was high Sellers and their family members participate in allocations S corp distributions can be used to repay ESOP loan ESOP tax shield on S corp distributions enables faster pay down of ESOP loan Disadvantages 1042 election not available to sellers 48

49 S corporation tax strategies S corp election ended before year end Advantages Sellers can elect 1042 Disadvantages Short period accounting & tax returns Sellers and family members cannot participate in ESOP Corporation will be subject to income taxation & liable for income tax on AR 5 year wait to switch back to S corp ESOP will not have access to S corp distributions to help repay loan amount Corporation must use accrual method of accounting 49

50 Financing Considerations Borrow if: Want to lock in capital gains rate Want to lock in current value Seller plans to elect 1042 and need to purchase QRP Do not borrow if: Company is in a cyclical industry Borrowing will use up company s line of credit Borrowing will otherwise jeopardize company s financial security Personal guarantees are a concern 50

51 Financing Considerations Alternatives to borrowing Seller Notes Seller can lock in current valuation Seller can be more flexible than a bank Seller can still lock in capital gains rate, provided that seller elects out of installment sale treatment Seller can still qualify for 1042 treatment by buying Floating Rate Notes ( FRNs ) 51

52 Financing Considerations To lend or not to lend? Advantages: Seller can earn interest at the same rate that a bank would charge Seller may charge a mezzanine rate of interest in certain cases Seller may receive warrants in certain cases May or may not be worth more than deferred interest But warrants may qualify for capital gains treatment 52

53 Financing Considerations Second Stage Transactions If there is a prior bank loan, seller note will be subordinate to bank loan C corp dividends and S corp distributions on both allocated shares and unallocated shares can be used to repay an ESOP loan But dividends and distributions paid on a prior block of stock cannot be used to make loan payments on a loan used to acquire a second block of stock 53

54 Incentive Plans for Key Employees Key employees receive a relatively small percentage of the ESOP shares Banks and some large suppliers may require that key employees have skin in the game Available tools Deferred Compensation Phantom Stock Plans Stock Appreciation Rights (SARs) Stock Options Stock Purchase Plans Management Stock Bonus Plans 54

55 Menke s Total ESOP Servicing RECORD KEEPING SERVICES VALUATION SERVICES DESIGN & INSTALLATION EMPLOYEE COMMUNICATIONS FINANCING SERVICES 55

56 Menke s ESOP Process Complete Feasibility Questionnaire Analyze ESOP Feasibility Propose Alternative ESOP Structures Engage Menke & Associates, Inc. Close Transaction Confidential ESOP Questionnaire For a free ESOP analysis, mail or fax this information to: 255 California Street, 10 th Floor San Francisco, CA Phone: Fax: Over 2,500 ESOPs ESTABLISHED SINCE

57 To determine if ESOP is feasible call or Michael Pasahow or Chuck Bachman (415) For additional information and articles go to: 57

58 Questions and Answers 58

59 THE END Thank You For Attending 59