Session 4B ESOP Challenges Facing Senior Management Taking Care of Business

Session 4B ESOP Challenges Facing Senior Management Taking Care of Business The ESOP Association California/Western States Chapter Conference October 5-7, 2011 Paradise Point Resort, San Diego Larry Goldberg Sheppard Mullin (415) 774-2927 lgoldberg @sheppardmullin.com Larry Renaud President & CEO 818-735-6100 Chatsworth Products, Inc. Michael Harden Eureka Capital Partners (949) 719-2267 michael.harden@eurekacap.com 1 Today s Topics Second Stage Sales of Stock to ESOP Subsequent sales of stock to the ESOP to cash out shareholders provide liquidity and significant tax advantages to the sellers and to the company Borrow, Refinance Existing Debt or Raise Growth Capital Lenders/investors find ESOP tax advantages appealing and are likely to be more aggressive in their lending or investment standards given that their loan/investment will be repaid with pre-tax dollars Unique Share Allocation Methods Rewarding high performing business units or longer term employees Provide Synthetic Equity to Key Managers Structured to track ESOP stock value Extend ESOP Participation to Foreign Employees How to include them, principal issues to be addressed 2 1

Use your ESOP to Provide Second Stage Liquidity to Shareholders 3 Subsequent Sales of Stock to Your ESOP C-Corp ESOPs Sell more shares in a second or later stage transaction to get more tax deductions In subsequent sales, if ESOP holds more than 30% of the total outstanding stock, sellers may elect to defer their capital gains taxes, possibly permanently, on the gain from the sale (IRC 1042) C-Corp or S-Corp ESOPs can sell more stock in a subsequent transaction and transition to a 100% ESOP owned S-Corp to become a tax exempt entity Transactions can be financed with balance sheet cash, bank debt, outside subordinated debt, seller financing or some combination thereof If a loan is established between Company and ESOP as part of the transaction (called the Inside Loan ), ESOP contributions are essentially non-cash, but generate tax deductions for the Company and allocate stock to employees (example on next page) May be utilized in either an all cash transaction or a seller financed transaction May be established using a bridge loan if transaction will be seller financed 4 2

Example: Subsequent ESOP Sale Seller Financing via a Bridge Loan Company Step 1 Company receives $5MM Bridge Loan financing Step 6 Company repays $5MM Bridge Loan to Lender Lender Company lends $5MM to ESOP (Inside Loan) Shareholders lend $5MM to Company (received Seller Notes) Shareholders received $5MM in Seller Notes ESOP Step 3 ESOP pays shareholders $5MM in Cash Step 4 ESOP receives 30% of stock from Shareholders Shareholders 5 Subsequent Sales of Stock to Your ESOP Impact on existing ESOP s shares Likely a post-deal drop in value May need a floor-price agreement to protect equity value of pre-leverage ESOP accounts review examples of floor price arrangements, consider S-Corp and Rollover issues Consider role of dividends ESOP dividends on shares from deal number 1 cannot be used by ESOP to make payments on loan from deal number 2 planning for the dividend segregation Benefit distributions of shares from deal number 1 cannot be automatically deferred by loan number 2 consider repurchase liability impact, consider lender issues Consider redemption transaction for deal number 2 in which the Company, not the ESOP, buys the stock. Eliminates dividend tracking issue and fails to provide the on going leveraged ESOP benefit of cash-less contributions unless ESOP is eventually re-leveraged. 6 3

Borrow, Refinance Existing Debt or Raise Growth Capital using ESOP Financing Tools 7 Comparative Debt Financing Alternatives Underwritin g Criteria Security Interest Pricing Asset Based Loan Asset values 1st lien on all assets Floats based on LIBOR + 150 350 bps (LIBOR Floors Uncommon Again) Cash Flow Senior Loan Enterprise value (i.e. multiple of EBITDA; not asset values) 1st lien on all assets Floats based on LIBOR + 400 600 bps (possible LIBOR Floors) Second Lien Enterprise value (unless special assets are available) Secured but junior to 1 st lien holders Varies but higher than ABL and CF Loans (greater than 600+ LIBOR Mezzanine/ Sub Debt Enterprise value and earnings None Yield enhanced with PIK interest and /or warrants Maturity 1-3 years 1-3 years N/A 5 years Other Minimal amortization Appraisal based Annual amortization > $10MM EBITDA Annual amortization > $10MM EBITDA - Prepayment penalties - Equity dilution Seller Note None None Varies but typically low cash pay and PIK interest and/or warrants After all other debt No prepayment penalties 8 4

Current Market Conditions December 31, 2006 2007 2008 2009 2010 Current LIBOR Rates 1,2 5.37% 5.13% 1.43% 0.25% 0.30% 0.36% Prime Rates 1 8.25% 6.75% 3.25% 3.25% 3.25% 3.25% Second Lien 11.5-13% 12-13% N/A N/A N/A N/A Mezzanine 3 13-18% 14-20% 16-20% 20-25% 17-25% 15-25% 3 Private Equity 20-25% 25-30% 30-35% 35-40% 35-40% 30-40% 1 Excludes Spread 2 3-Month LIBOR 3 Mezzanine has cash pay interest of 12-15% with the remainder of return in PIK interest or warrants 9 Mezzanine to Fill the Senior Capital Void Mezzanine lending has increased to fill some of the void However, mezzanine is expensive and dramatically impacts the buyer s IRR Typical rates: 12-15% cash interest plus warrants to achieve a 15-25% return In 2008, mezzanine funds in the United States raised a total of approximately $32 billion, while in 2009 and 2010 they raised $3 billion and $6 billion, respectively and the upward trend appears to be continuing. Private Equity Fund Raising Mezzanine Debt Fund Raising $350 $326 $300 $250 $200 $246 $266 $150 $100 $50 $96 $86 $20 $32 $9 $3 $6 2006 2007 2008 2009 2010 10 5

Senior Debt Asset Based Loans Cash Flow Loans Second Lien Loans 11 Senior Debt Asset Based Loans (ABL) Based on liquidation value of company s assets Less risk/less reliance on operating performance ABL Collateral - A/R and Inventory - Fixed Assets (Machinery & Equipment, Real Estate) Cash Flow/Unsecured Less reporting requirements Dependent on continued cash flow improvement Strict financial covenants Second Lien Loans Second collateral position behind senior loan Amortizing loan with higher rates Generally not available in today s loan market 12 6

Junior Debt Mezzanine Debt (senior subordinated debt) Seller Financing (junior subordinated debt) 13 Structure of Subordinated Debt in ESOP Transactions Subordinated debt issued to seller or third party commonly used in ESOP transactions to help ESOP achieve 100% ownership of an S corporation Conventional subordinated debt seeks 15%-25% IRR through high coupon interest (12-15% current pay, sometimes PIK ) and warrants as kicker Tax attributes of subordinated debt are (i) interest paid deductible to issuer and ordinary income to holder and (ii) warrants not deductible to issuer and primarily capital gains to holder High coupon/low warrant structure usually achieves tax parity between issuer and holder as issuer needs tax deductibility and holder accepts offsetting income. Also matches culture/financial expectations of third party sub debt funds seeking primarily fixed returns Low coupon/high warrant structure may be better suited to S Corp. ESOP structures where issuer (the S Corp. owned by an ESOP) is not a tax-paying entity and warrant-holder benefits from more capital gains vs. ordinary income and potential additional return on equity kicker held in non-tax-paying entity 14 7

Seller Financing Selling shareholders receive a note as payment for all or part of the sale price Used in various circumstances: Alternative to bank financing when costs, covenants or availability may be a consideration In conjunction with bank financing to fill gap in capital structure May comprise 100% of financing when it is difficult to obtain traditional senior financing May allow seller to receive greater overall consideration than if transaction is financed 100% with outside financing Sellers generally view credit support (pledged collateral or personal guaranty) in a similar manner to taking back a note Sellers generally desire an appropriate return for the risk inherent in supporting senior credit 15 Seller Financing Internal Rate of Return (IRR) The IRR should take into consideration the various tranches that Seller financing is replacing in the capital structure of the transaction If senior debt is maxed-out and sellers provide balance of financing, appropriate debt to EBITDA multiples must be applied to each capital tranche If sellers are providing all financing, the IRR should assume that an appropriate level of senior debt can be raised In effect, a weighted average cost of capital approach should be used 16 8

Seller Financing IRR Example Determine appropriate IRR for seller note by maximizing all other available lower-cost capital sources for the transaction This is a theoretical exercise because the Sellers may not plan to use other forms of capital in the transaction Normalized EBITDA $3,000 (including adjustments acceptable to Bank) Senior Debt 6,000 Seller Note 9,000 Total Debt for Transaction $15,000 Debt/EBITDA Multiple for Transaction 5.0x Total Transaction Debt Junior Secured Note Cumulative Amount of % of Allocation of % of Total Estimated Weighted Capital Structure Debt/EBITDA Debt Total Jr. Sec. Note Jr. Sec. Note IRR IRR Senior 2.0x $6,000 40.0% $3,600 40.0% 6.50% 2.6% Mezzanine 3.0x 3,000 20.0% 1,800 20.0% 20.00% 4.0% Equity 5.0x 6,000 40.0% 3,600 40.0% 27.50% 11.0% Total $15,000 100.0% $9,000 100.0% 17.6% 17 Payment In Kind (PIK) Interest Typically in connection with junior financing (sub debt, seller financing or equity) Can be used when the Company lacks cash flow to pay the required junior debt cash interest Accrues to the note balance Example: 15% total IRR with 8% cash pay = 7% PIK interest would accrue to note balance Accrued interest compounds each year with the annual interest calculation made using a higher note balance All unpaid interest (PIK) is paid at note maturity 18 9

Warrants Typically, in connection with junior financing (sub debt, seller financing or equity) Right to acquire shares of the Company in the future at a pre-determined price 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 Why a call feature is important 19 PIK vs. Warrants as Components of Junior Note Return Junior Note Return Feature PIK Interest Warrants Advantages Simple Structure Less costly to implement Capital gains tax rates Possibly higher return if note giving rise to warrant is prepaid May result in higher return if forecast exceeded Disadvantages May create phantom income Ordinary income tax rates More complicated More costly to implement 20 10

Unique Share Allocation Approaches 21 Unique Share Allocation Approaches Most common approach allocate shares annually based on compensation of employees Alternative allocate based on performance of business units relative Formula can be built into plan document; Identify business units; identify method of allocation within each business unit employee group Regulated by non-discrimination testing rules of the IRC Essential compliance requirement avoid impermissible discrimination in favor of highly compensated employees - Easiest compliance structure exclude HCEs - Alternative pro forma testing of HCEs 22 11

Unique Share Allocation Approaches Service Component Allocation formula could include a factor of years of service with the company Example: shares are allocated each year based on a participant s points for the year relative to the total points for all participants - One point for each $200 of compensation - Ten points for each year of service - Must meet the general non-discrimination testing rules - Mostly likely to work when longer service employee group includes HCEs and non-hces 23 Reward Key Managers with Synthetic Equity that Tracks the ESOP Stock Value 24 12

Synthetic Equity Management Incentive Plan Common to use either Stock Appreciation Rights (SARs) or Phantom Stock Units 100% ESOP ownership structure precludes use of stock options or restricted stock Pool set aside for management Units derive value based on underlying stock SARS act like options do in a public company Phantom Stock acts like underlying stock Board distributes some units to management initially as retention units and then additional units in future based on performance Consider role of ESOP Trustee or outside directors in approval process Flexibility in plan regarding cashing out Considered deferred compensation; ordinary income treatment to participants 25 Management Incentive Plan - Example #1 - SAR Plan structure Total Pool: 10% of the equity of the company set aside in a pool of Stock Appreciation Rights (SAR) units for key management Retention SARs: Half of the pool (5% of the company s equity) issued after implementation of plan (or transaction closing) as retention SARs Performance SARs: Half of the pool (5% of company s equity) issued each year up to 1% of company s equity per year, and split between key managers based on achieving at least 105% of the company s annual EBITDA targets 5 year cliff vesting Designed to be exempt from 409A 26 13

Example #2 - CPI Executive Synthetic Equity Plan Purpose To attract and retain executive management talent and to drive management behavior that enhances long-term shareholder value. Plan Design Non-qualified deferred compensation plan Benefits become an unfunded promise of the company, subject to company s ability to pay when due and subordinated to other creditors of the company Annual grants, initial value of which is based on a fixed percentage of annual base salary of executive Initial value converted to unit grant based on previous year s per share value ($/per share value = synthetic equity unit) Synthetic equity compensation is non-taxable to the participant at the time of the grant 27 CPI Executive Synthetic Equity Plan Plan Design (continued) Individual, three-year cliff vesting period for each annual grant All outstanding grants, not otherwise vested, become fully vested upon normal retirement, death, or disability If individual plan participant leaves the company prior to RD&D, then nonvested grants are forfeited Value of outstanding grants float with per share value until time of payment 3 year installment payments begin upon termination, normal retirement, death, or disability Benefits pursuant to plan result in taxable income to participant at time of payment (reportable W-2 income, subject to withholding) 28 14

Extend ESOP Participation to Foreign Employees 29 Foreign Employees Why Include Them? May be inconsistent with Company s ownership culture to exclude; consider their role in the Company If U.S. payroll is small, it may be desirable to support amortization of larger ESOP loan 30 15

Foreign Employees Key Issues to Consider Company compliance with U.S. limits on ESOP deductions (Section 404(a) of IRC) ESOP compliance with U.S. limits on annual allocations to ESOP participants (Section 415(c) of IRC) Role of foreign subsidiary as employer of ESOP participants Taxation of foreign employee in his/her local jurisdiction Number of jurisdictions involved 31 CPI Global ESOP Purpose To create an ESOP-like benefit for non-u.s. employees consistent with the company s ownership culture and philosophy Plan Design Eligible plan participants are international employees of CPI Annual discretionary contributions mirror those of domestic ESOP Contributions allocated among eligible participants based on relative eligible compensation Allocated contributions are converted to synthetic equity units based on CPI s per share value as of the contribution date Eligibility requirements mirror those of the domestic ESOP Vesting and forfeiture rules mirror those of the domestic ESOP Participants receive an annual statement 32 16

CPI Global ESOP Plan Design (continued) Distribution of vested benefits occur following termination; no in-service distributions allowed Distributions made in accordance with Global ESOP Plan distribution policy, which may be modified from time to time Distribution timing For RD&D, lump sum cash payment in year following year of termination. For other, lump sum cash payment in year of termination Benefits distributed in cash based on the value of CPI common stock as of the valuation date (December 31) immediately preceding date of distribution CPI reserves the right to amend or terminate the plan Benefits are unfunded and subject to CPI s financial ability to pay at the time a distribution is due 33 Questions? Larry Goldberg Sheppard Mullin (415) 774-2927 lgoldberg @sheppardmullin.com Larry Renaud President & CEO 818-735-6100 Chatsworth Products, Inc. Michael Harden Eureka Capital Partners (949) 719-2267 michael.harden@eurekacap.com 34 17