AC 23 Concurrent Session 2

10 Tips to Improve Employee Retention

John Williams

10 Tips to Improve Employee Retention

John Williams

President/Founder

Elucidate Resources

479-644-7733

johnwilliams@elucidateresources.com

• Founder/President of Elucidate Resources LLC. A consulting firm that specializes in helping people and organizations be successful.

• 35+ years experience in Manufacturing and Distribution

• GGOB experience as practitioner and coach since 2006

• Retired from Central States Manufacturing, a 100% employeeowned company and Great Game of Business practitioner, as VP Sales & Marketing.

• Great Game of Business Certified Coach

• Provides Sales Coaching and ESOP communication training.

• Professional member of The ESOP Association and National Center for Employee Ownership

• Chair of the Ownership Culture Committee for the ESOP Association

• Frequent speaker at ESOP, NCEO, and other conferences on employee ownership and engagement

• Co-author of Building a Resilient ESOP Company

CE Requirements - Onsite

1. Scan the session QR code upon entering the breakout room, using the Annual Conference Event app

2. Participate in the instructor-led question / discussion

3. Input the secret word in the CE Session Survey. The secret word will be revealed in the end of the is presentation

4. Complete the CE survey via the session page in the mobile app

10 Tips to Improve Employee Retention

Learning Objectives:

• Learn 10 reasons why employees leave their company

• Learn 10 tips to improve employee retention

•Learn why it is important to focus on the behaviors that are causing employees to leave

10 Tips to Improve Employee Retention

Why Employees Leave

10 Tips to Improve Employee Retention

Why Employees Leave

10 Tips to Improve Employee Retention

Why Employees Leave

No purpose

10 Tips to Improve Employee Retention

Why Employees Leave

Don’t know how they affect the company

10 Tips to Improve Employee Retention

Why Employees Leave

10 Tips to Improve Employee Retention

Why Employees Leave

Don’t know how they are doing

10 Tips to Improve Employee Retention

Why Employees Leave

They are lost

10 Tips to Improve Employee Retention

Why Employees Leave

Don’t know how the company is doing

10 Tips to Improve Employee Retention

Why Employees Leave

Bad employees cause good employees to leave

10 Tips to Improve Employee Retention

Why Employees Leave

Culture and values don’t match

10 Tips to Improve Employee Retention

Why Employees Leave

Pay/Benefits

10 Tips to Improve Employee Retention

How

10 Tips to Improve Employee Retention

How to Improve Employee Retention

Deal with poor leadership first

10 Tips to Improve Employee Retention

How to Improve Employee Retention

Packard’s Law: “No company can grow revenues consistently faster than its ability to get enough of the right people to implement that growth and still become a great company. If your growth rate in revenues consistently outpaces your growth rate in people, you simply will not – indeed cannot – build a great company” David Packard.

Stop hiring people that don’t fit

10 Tips to Improve Employee Retention

How to Improve Employee Retention

Have everything a new hire needs before they start

10 Tips to Improve Employee Retention

How to Improve Employee Retention

Explain to them how many lives they affect by the job they do.

Teach them purpose

How

10 Tips to Improve Employee Retention

How to Improve Employee Retention

the outcomes of the company.

Line of Sight

10 Tips to Improve Employee Retention

How to Improve Employee Retention

Pay and benefits must be “enough”. Explain, explain, explain

10 Tips to Improve Employee Retention

How to Improve Employee Retention

Do them, don’t be late, be candid, and give specific examples

Secret Word

Rock Chalk

10 Tips to Improve Employee Retention

Questions?

10 Tips to Improve Employee Retention

John Williams

President/Founder

Elucidate Resources

479-644-7733

johnwilliams@elucidateresources.com

• Founder/President of Elucidate Resources LLC. A consulting firm that specializes in helping people and organizations be successful.

• 35+ years experience in Manufacturing and Distribution

• GGOB experience as practitioner and coach since 2006

• Retired from Central States Manufacturing, a 100% employeeowned company and Great Game of Business practitioner, as VP Sales & Marketing.

• Great Game of Business Certified Coach

• Provides Sales Coaching and ESOP communication training.

• Professional member of The ESOP Association and National Center for Employee Ownership

• Chair of the Ownership Culture Committee for the ESOP Association

• Frequent speaker at ESOP, NCEO, and other conferences on employee ownership and engagement

• Co-author of Building a Resilient ESOP Company

360 Degree Review of Cybersecurity Insurance for an ESOP

Blake Brown

Director of IT

Baker Group

Evan Rice

Senior Vice President

Guide Star

Miles Weis

AVP – Executive Risk & Cyber Practice Leader

Holmes Murphy

Ross Ingersoll

Executive Risk & Cyber Account Executive

Holmes Murphy

CE Requirements - Onsite

1. Scan the session QR code upon entering the breakout room, using the Annual Conference Event app

2. Participate in the instructor-led question / discussion

3. Complete the CE survey via the session page in the mobile app

CYBER

LANDSCAPE

EXPOSURES & INSURANCE

Threat Landscape is Evolving

• Transition to the Cloud •

Growth of Remote Workforce

• 3RD Party Vulnerabilities

• Interconnectivity

Making Headlines

Ransomware Impact

Cyber Event Impact

Cyber Insurance Market

What our Carriers are Saying:

1) Carrier A average ransom payment made $537,036 (9x vs. 2018)

2) Carrier B Cyber loss ratio 150%

3) Carrier C Breach Response Costs have increased 220% since 2016

Top Underwriting Concerns:

1) Multi Factor Authentication

2) Endpoint Detection & Response

3) Employee training, policies, and procedures

4) Robust Backup & Recovery Procedures

Insurance Considerations

Insurance Considerations

1) Selecting the appropriate limit

2) Full Ransomware / Cyber Extortion / Business Interruption Limits. No Coinsurance Clauses

3) Social Engineering Fraud Sublimits

4) Failure to update or maintain systems exclusions

5) Catastrophic or Widespread Event (Including Cyber War) Exclusions

6) Insurance Carrier Resources

Ransomware Timeline with Insurance Response

LANDSCAPE OBTAINING INSURANCE

Mission Critical Controls

Checklist for Cybersecurity Success:

 Training

 Having a managed firewall

 Multi-factor Authentication (MFA)

 Email management and filtering

 Backup and recovery

 Managed Detection & Response (MDR)

 Have cybersecurity insurance

• Have it written down

Having a cybersecurity program

• Should be based on a 3rd party framework

• NIST, SOC, CSF, CIS, etc.

• Auditing, tabletop exercises, actively managing risk, vendor review- look at supply chain

• Make sure you have playbooks

How to operationalize the use of your insurance to generate the most value out of

Ensure playbooks have components that require interaction with insurance:

• When/how to get a hold of insurance

• Document number to call

• Make sure you’re doing a business impact analysis to understand value of the systems you’re protecting

• Know what benefits you get (response team, access to lawyers, etc.)

it

• Understand your coverages and its limitations

• Use it as a litmus for whether you’re doing enough

• Invite your insurance company or representative to your tabletop exercises- work with them/make it a partnership

Belt and Suspenders

I have insurance-why do I need controls?

• You can still get hacked with insurance. Having controls can further prevent a hack, while insurance can help you recover losses if you do get hacked.

• Insurance can’t restore your brand

• Insurance can’t restore customer faith

I have controls- why do I need insurance?

• No system is bullet proof

• Defers liability when the worst happens

• Gets you real time access to experts during and after an incident

• Helps with supply chain and government compliance

Cybersecurity in the court room

• Wyndham case – FTC Consent order

• Establish and implement a written information security program that is designed to protect security, confidentiality, and integrity of customer’s credit card data

• Must annually obtain written assessments of its compliance with certain agreed upon data security standards

• Must maintain records of its efforts, including audits, policies, and assessments which may be accessed by the FTC upon request

• Compliance and privacy- legal requirements-state to state

• Facebook biometrics lawsuit in Illinois

• California (CPRA), Virginia, Colorado, Utah, Connecticut have signed privacy bills in place

• DOL Guidance for ESOPS as ERISA

Proactive Controls Summarization

• Protects things that insurance can’t keep safe

• Insurance is reactive

• Without proactive controls, risk is going to continue to build and insurance is going to get more expensive

• Must have both!!!

LANDSCAPE

Business Impact Analysis

All businesses that use technology should plan for the inevitable: to experience an event/incident that results in a breach or compromise.

• Identify critical business functions and processes

• Assess the impact of disruptions

• Establish recovery time objectives

• Develop recovery strategies

A very viable recovery strategy for cybersecurity related disruptions is an insurance policy.

"You can train a driver to follow the laws and to be careful, but they will get in a wreck. You more importantly need to focus on providing a safe vehicle to soften the blow for when it does happen.

Cybersecurity insurance helps create a safer technology environment and softens the blow of a cyber event."

Cybersecurity Cost Breakdown

Cybersecurity costs will be directly related to the value of your resources, the amount of unique records and the amount of risk you exhibit.

How to lower your risk:

• Adopt a cybersecurity compliance standard

o SOC2

o NIST

o ISO2700x

o PCI DSS

o HIPAA

• Invest in tools that detect or detect and prevent incidents

• Become familiar with other organization's breach/incident details and trends that are publicly available; join organizations that focus on cybersecurity awareness

o ISACA

o ISSA

o ISC2

• Encourage your IT and security staff to acquire cybersecurity related certifications

• Invest in a MSSP or virtual CISO (vCISO)

Incident costs (Qualitative & Quantitative)

• Is your business able to function without technology? Most incidents will render some or all of your business inoperable.

• Your ransomware playbooks must include an option to pay the ransom. Threat actors will do research on your organization and will typically request a ransom that is hard to accept, but not out of reach.

• Determining how the breach/incident occurred is vitally important! Forensics can take a long period of time and during that time, what is being evaluated cannot be used for business functions. You may need to quickly acquire additional resources to take the place of those that can't be used. Forensics costs can add up quickly.

• A tarnished reputation can equal lost opportunity and lost revenue

• Lawsuits from affected clients, employees, vendors, etc. whose data has been breached

• Credit monitoring for those whose PII has been breached

• Losing access to manufacturers and products due to lost trust

*The average cost of a breach is usually related to how many confidential records you possess, the value of intellectual property or how costly of an impact can threat actors create.

Cybersecurity Insurance Benefits

• Financial Protection: Provide funding for costs related to a breach and efforts to return a business to an operational status

• Risk Management: Many insurance providers offer many tools to help create and maintain mature cybersecurity policies

• Risk Assessments

• Vulnerability Scans

• Security Audits

• Reputation Management: Provide support for reputation management and public relations efforts

• Compliance: Assist with regulation and standards compliance

• Incident Response: Provide access to a team of experts to assist with:

• Incident response

• Forensics

• Crisis management

• Legal needs

• Education and Training: Provide education and training programs to help businesses better understand as well as how to mitigate and respond to risks

Jazz Secret Word

Questions?

Blake Brown

Director of IT

Baker Group

Evan Rice

Senior Vice President

Guide Star

Miles Weis

AVP – Executive Risk & Cyber Practice Leader

Holmes Murphy

Ross Ingersoll

Executive Risk & Cyber

Account Executive

Holmes Murphy

Aspects of ESOP Valuations and Leveraged Transactions Frequently Scrutinized by the DOL

Michael J. Voves Partner

Dorsey & Whitney

Steve Nelson Managing Director Chartwell

CE Requirements - Onsite

1. Scan the session QR Code on the door or directional signage nearby

2. Engage in the session content for all 60 minutes.

3. Input the secret word in the CE Session Survey. The secret word will be revealed in the speaker's presentation.

4. Complete the CE Survey.

Transaction Financing

• Sources of financing and relative cost of funds

o Senior debt

o Mezzanine debt

o Subordinated debt

Subordinated Debt - Warrants

• Warrant = right to purchase shares at a specified price (stock option)

• A warrant is often used as an instrument of financing in ESOP transactions

• The expected return combining both the cash interest on the note and value of the warrant should not exceed the expected return on the note absent a warrant.

Subordinated Debt - Warrants

• Why use a warrant and not just cash interest rate?

o Warrants issued in exchange for acceptance of a below market cash interest rate

o Lower cash interest rate = more cash flow available to service loans

o Downside protection in the event of company underperformance

o Align interests

Warrants - DOL

• The DOL has frequently argued that warrants are economically dilutive, and therefore, the value of such warrants should be taken into account in the transaction price

• Warrants are consideration for the financing

o Warrants are a substitute for cash interest, the ultimate value of which is contingent on company performance

Stock Appreciation Rights

BASE BONUS

LTIP / SARs

CASH

FIXED

CURRENT

STOCK VARIABLE DEFERRED

LTIP: Any compensation that is earned, vested or paid over a period of more than one year

Stock Appreciation Rights

• Stock Appreciation Rights (SARs) are typically offered as an incentive to attract and / or retain key employees

o Aligns executives and shareholder outcomes

• Unlike warrants, SARs are not part of the transaction financing. Rather, they are compensation.

• One-time non-recurring grants vs. expected recurring grants.

• Retention vs. Performance

• Dilution?

What is the Value of Control?

• Sample control prerogatives

• How is control quantified in valuation

• Control premium vs. cash flow

• If the impact of control (or lack thereof) does not impact expected cash flows in one way or other, how does one place a value on control?

• DOL and plaintiff attorney challenges

Control

• If an ESOP buys a controlling interest / 100% interest in a company, but surrenders a majority of 5 board seats to the seller while the seller remains a creditor, should the valuation be reduced?

• Same fact set as above, but consider that 5 member board, while nominated by the seller, include 2 recognized industry/business experts. Does this change your answer?

• What is the benefit of changing a board of directors (whether external or not) that help drive the company’s industry leading growth and profitability during the past decade?

• Realized and expected cash flow drives valuation

Terminal Value

• Scrutiny of terminal value calculation within discounted cash flow method

• Gordon Growth Model • Market Multiple

Projections

• Historical budgets vs. actual performance

• Historical company performance vs. industry & public companies

• Are the projections consistent with the expectations for the economy and subject industry

• Sensitivity analysis / risk adjusted discount rate

• Scrutiny

Initial vs. Second Stage Transactions

The Board

Selling Shareholders

NEGOTIATING TABLE

Board Financial Advisor

ESOP (Purchaser)

Trustee

Trustee Financial Advisor

The Board may owe fiduciary duties to both the seller and purchaser

The Board’s Predicament

• Initial Stage ESOP Transaction

o Generally, a board of directors has a corporate fiduciary duty to maximize sale value to selling shareholders

o BUT, the board also has an ERISA fiduciary responsibility to monitor the ESOP purchaser’s advisors (trustee and FA) that it appointed

o Exact scope of this responsibility is the subject of on-going litigation

• Second Stage Transaction

o Board owes fiduciary duties to all existing shareholders – one is the seller and the other is the buyer (the ESOP)

The Officer’s Predicament

• Consider Who Signs Engagement Letters

o Engaging a trustee on behalf of an ESOP is a fiduciary act.

o The board may approve engagement of a trustee for an ESOP, but an officer may sign the engagement letter on behalf of the company.

o Even if acting at the direction of the board, the officer has become a fiduciary (according to many courts).

o Consider having board chair sign engagement letters for both trustee and financial advisor

Secret Word for CE

Wilbert Harrison

Questions?

The Announcement

 The formation of a new ESOP at the company is typically kept “under wraps” until shortly after closing

 When closed, the announcement to all employees should be BIG

 Generate excitement

 Explain the new benefit to employees

 Anticipate and answer immediate questions and concerns

 Follow-up with deeper educational session(s)

 Don’t forget to include spouses in the excitement

New Participants Want to Know

 What is an ESOP?

 How did the owner establish the ESOP?

 How do I get shares?

 What do I have to contribute?

 What’s in it for Me?

 When do I get my Money?

 What if I die?

 How is the value of my stock determined?

 Why do I only get statements once a year?

 Can I move out of stock into cash?

What is an ESOP

ESOP … Employee Stock Ownership Plan

 The ESOP is retirement plan, much like a 401(k) and often incremental to the 401(k), that is put in place by the company for the benefit of the employees.

 Through the ESOP, incremental “shares” of the company are granted to your ESOP (retirement) account on an annual basis.

 You, the employees, have become the owners of the business.

What is an ESOP

What about Joe, the owner? Doesn’t he own the company?

 As in any privately owned business, Joe needed to put a plan in place to sell the business and allow himself to retire.

• He could have sold to MegaCompany or Private Equity, walked away and allowed them to change the business, potentially without regard to the culture, the community or the employees who have built the company.

• Instead, he sold the company to an ESOP Trust of which you the employees are the sole beneficiaries.

• Management stays in place (likely including Joe). The business continues to operate as you know it, but you now replace Joe as its “owners.”

What is an ESOP

Woah, what’s this going to cost me? I’ve got a daughter going to college soon. I can’t afford to buy my company.

 Your ESOP ownership costs you nothing, nada, zero.

What is an ESOP

OK, something’s fishy; nobody gets something for nothing …

 Recognizing that we suffer from a wide disparity of wealth, and pressure on individual retirement savings (often not enough in the bank), there has been long-time governmentwide support of the ESOP as a solution. Here’s the deal…

 Joe is able to sell the business – for no more than fair market value – to the ESOP trust. There are often personal tax benefits in the process to encourage Joe to go this route.

What is an ESOP

 As this costs you nothing, the company will need to borrow the money to pay Joe for his shares. Some will come from the bank; some from Joe himself. That will all need to be paid back (often over 7-10 years).

• Rather than leaving the employees a company that struggles with too much debt, the ESOP-owned company gains very significant tax benefits to make that debt repayment easier.

• In many situations, the company pays no more income taxesever. This encourages the company to go the ESOP route.

– Studies show that default rates in P/E lead leveraged buyouts range from 5 -15% per year. In ESOP companies default rates approximate 0.2% per year.

What is an ESOP

 Finally, the Employees benefit from the ESOP with typically Much higher retirement account balances.

• The retirement savings problem is reduced and sometimes eliminated.

 The Employees and the community also benefit as transition upheaval is eliminated and the culture remains intact.

• Joe benefits by seeing the company, the legacy that he and his employes created, continue through the long term.

– Studies have shown that ESOP-owned companies have out-performed non-ESOP companies in difficult economic times; financially and with fewer (if any) staff reductions.

Share Allocation

 The ESOP has purchased a large number of shares from Joe. It will now allocate these shares to employee accounts over an extended period of time.

• As this is a non-discretionary plan, shares will typically be allocated in proportion to your salary.

 The plan was likely designed with a particular annual benefit level in mind. It’s not unusual to see the annual ESOP benefit targeted at 410% of salary with that being incremental to your 401(k).

For illustration.

Core allocation = 50 shares per year

Eligibility & Vesting

 The ESOP is intended to benefit long-term employees.

• While shares are allocated to your account on an annual basis you are “vested” in the account (they become yours) over a period of years. You’ve got to stick around to receive full value.

• Typically vesting occurs 20% per year over years 2 – 6 of your participation in the ESOP (other options exist).

–

At the end of the 2nd year, 20% of your account balance is vested. You are entitled to 20% of your account value should employment be severed

– At the end of year 3, 40% of your account balance is vested. You are entitled to 40%;

– Etc.

Note: Eligibility to participate in the ESOP typically requires an employee to be 18-years old, have worked 1,000 hours during the last year, and be employed by the company on December 31.

On your early departure, allocated but un-vested shares are re-allocated to the remaining employees

When Do I Get My Money?

 The ESOP is a retirement benefit. Like your 401(k) it is not intended to be accessed before that time.

 While there is some flexibility in writing the plan document, we see many companies and their ESOPs adopting a 5-year payout of account balances beginning the plan year after reaching retirement age.

• Low balance accounts may payout on a lump-sum basis

• On an employee’s death, disability or similar triggering event the majority of ESOPs pay immediately to the surviving spouse.

 Per the plan document, should an employee terminate before retirement, payout may be withheld until no later than the 6th plan year after the plan year in which termination occurred. A 5-year payout may ensue.

What are Your Shares Worth?

 The ESOP is managed, for the benefit of the employees by a Trustee.

 One of the Trustee’s duties is to set the share price on an annual basis.

 In setting that price, the Trustee will hire a professional valuation firm to “appraise” the business using multiple market-accepted methodologies.

• These same methodologies were used to establish the value of the company in the original sale to the ESOP.

What are Your Shares Worth?

 Key factors in determining share value include:

• Sales Growth

• Profitability

• Re-investment Needs

– Accounts Receivable,

– Inventories,

– Capital Expenditures,

– Lower is better

• Taxes

• Debt Levels

The Drivers of the Businesses Enterprise Value

If this were your house, your Value Drivers might be its square feet, number of bedrooms, number of bathrooms, finished basement, pool, recent remodeling, etc.

 You’re now an owner with a vested interest.

What can YOU do to impact these?

What are Your Shares Worth?

 Share Value is impacted by both: – Increases in “Enterprise Value” (largely via your Value Drivers) and – The repayment of debt

What are Your Shares Worth?

For illustration. Core allocation = 50 shares per year

Reading Your Statement

ABC Company - Employee Stock Ownership Plan Statement of Participation

Adam West

YOUR TOTAL ACCOUNT BALANCE as of December 31, 2022 is $ 29,622.61.21

Keen Wealth Advisors

• Keen Wealth Advisors (KWA) CEO and Founder, Bill Keen, and President, Matt Wilson, CFP® offer 50+ years of combined experience advising ESOP participants and providing customized solutions for achieving their financial goals.

• KWA's leadership team understands the unique challenges and opportunities presented by ESOPs and can offer tailored advice to help participants make informed decisions.

• Our expertise includes investment advice, tax planning, diversification, retirement income planning, and estate planning.

• KWA is committed to financial education and provides resources such as our bestselling book "Keen On Retirement, Engineering The Second Half Of Life," our long-running podcast, blogs, and webinars at www.KeenWealthAdvisors.com/insights, all designed to help ESOP participants build a solid foundation for their retirement and achieve long-term financial security.

KWMG, LLC dba Keen Wealth Advisors (“company”) is an SEC registered investment advisor located in Overland Park, KS. Keen Wealth Advisors is not affiliated with NCEO nor Prairie Capital. The company and its representatives may only conduct business in those states where registered or where excluded/exempt or from licensure. Advisory services are only offered to clients or prospective clients where the company and its representatives are properly licensed or exempt from licensure. No advice may be rendered by the company unless a client service agreement is in place. This information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy and is for illustrative purposes only. Third-party content is provided for convenience and is intended to provide additional perspective or points of view. The company does not guarantee the timeliness or accuracy of the information incorporated within this presentation. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete the CFP board’s initial and ongoing certification requirements. Submission 2786420.

ESOP Facts

• ESOPs receive significantly higher contributions, ranging from 50% to 100% more, from companies than non- ESOP companies provide to 401(k) plans, according to Department of Labor filings.

• Most funds in a 401(k) plan are from the employee's contribution, whereas all assets in an ESOP, with few exceptions, are from the company.

• Department of Labor research indicates that ESOPs have less volatility and higher returns than 401(k) plans.

• Compared to non-ESOP companies, ESOPs have a lower rate of layoffs.

• ESOPs have broader coverage among employees, particularly younger and lower-income employees, than 401(k) plans.

• ESOP companies are slightly more likely than traditional companies to provide secondary retirement plans.

ESOP Contributions Are Larger

• ESOP accounts typically surpass 401(k) accounts in size because of the generous company contributions, averaging around 6% to 8% of pay annually.

• In contrast, non-ESOP companies only contribute about 4% of pay to their 401(k) plans, which is solely for those who opt-in, representing roughly twothirds to three-quarters of eligible employees, according to the 401(k) Plan Help Center.

ESOP Funding Sources

• Most ESOPs are entirely funded by the company.

• ESOP participants accumulate large account balances, often exceeding six figures after 10-15 years.

• If the value of ESOPs suddenly drops, employees experience a significant loss, albeit distinct from 401(k) plans.

• Unlike 401(k)s, where most of the money originates from employees, ESOP losses primarily impact the company's contribution.

ESOP Diversification Options

• Mature ESOPs accumulate over 20% in cash.

• Companies invest cash once ESOPs have purchased all shares.

• Law permits employees with 10+ years in the plan and aged 55+ to diversify up to 25% of company stock.

• After five years, employees can diversify up to 50% of their company stock.

ESOP Return and Volatility Comparison

• ESOPs outperformed 401(k) plans in 15 out of 20 years between 1991 and 2010

• ESOPs exhibited less volatility compared to 401(k) plans for the periods 1991-2000, 2001-2010, 2006-2010, and 2008-2010

• Mean rate of return for ESOPs was 9.1%, while for 401(k) plans, it was 7.8%

• Standard deviation for ESOPs was lower than that of 401(k) plans in all analyzed periods, as shown in the table below

• Return Rates and Volatility in ESOPs versus 401(k) Plans

Most Requested Employee Benefits

Here is a ranking of the most requested employee benefits, based on various surveys:

1. Health insurance

2. Retirement benefits

3. Paid time off

4. Flexible work arrangements

5. Professional development opportunities

6. Employee wellness programs

7. Financial wellness programs

It's important to note that these rankings may vary depending on the specific demographics and needs of the employees surveyed.

What is Financial Wellness?

• Financial wellness refers to being financially secure and having the knowledge, skills, and resources to manage money effectively.

• It covers aspects such as budgeting, saving, investing, debt management, and retirement planning.

• Achieving financial wellness involves understanding one's financial situation and making informed decisions about how to allocate and invest money.

• It can help individuals reduce financial stress, increase their financial security, and improve their overall well-being.

• Financial wellness can also help individuals plan and work towards their financial goals.

Financial Wellness

Studies show financial wellness programs have a positive impact on employees.

• PwC survey found 60% reported increased productivity, 50% reported less stress and anxiety, and 31% reported higher job satisfaction.

• The International Foundation of Employee Benefit Plans study showed employees with access to financial education or counseling had higher job satisfaction and lower stress levels.

• Financial Finesse study found program participation increased positive financial actions like retirement contributions or debt reduction.

Overall, financial wellness programs can enhance employee performance, job satisfaction, and overall well-being, resulting in a more engaged and productive workforce.

Common Retirement Plan Questions

Some of the most common questions that employees have regarding their retirement benefits include:

1. How much should I be saving for retirement?

2. What is the best retirement savings plan for me?

3. When can I retire and how much income will I have in retirement?

4. How do I make changes to my retirement plan?

5. What investment options are available in my retirement plan and how do I choose the right investments?

6. How do I rollover my retirement savings if I change jobs?

7. How do I ensure that my retirement savings are secure?

8. What happens to my retirement savings if I pass away before or after retirement?

9. How do I calculate my Social Security benefits and when can I start receiving them?

10. What are the tax implications of my retirement savings plan?

These questions can vary depending on the specific retirement benefits offered by the employer and the individual circumstances of the employee. Employers can provide resources and education to help employees better understand their retirement benefits and make informed decisions.

How Employers Can Help

Employers can help employees plan for retirement by providing:

• Educational materials, such as brochures, videos, and online resources, explain benefit options and investment strategies.

• One-on-one consultations with financial advisors or retirement plan specialists.

• Retirement planning workshops or seminars on benefit options, Social Security benefits, and healthcare choices in retirement.

• Online tools, such as retirement calculators and investment analysis tools.

• Regular communications about benefit changes, investment performance, and other relevant updates. These resources can boost employees' confidence and preparedness, leading to increased job satisfaction and retention.

What Happens at Retirement?

• Typically, the funds from the ESOP are rolled over to a traditional IRA.

• The ESOP is tax-deferred until the participant receives distributions, the Traditional IRA is also tax-deferred and a proper rollover maintains the tax-deferred status of the funds.

Can I Diversify Shares Before Retirement?

• Section 401(a)(28)(B) of the Internal Revenue Code requires ESOPs holding employer securities to allow for participant diversification once they become a Qualified Participant.

• A Qualified Participant is someone who has reached age 55 and completed 10 years of plan participation.

• This triggers the 6-year Qualified Election Period, during which a participant can diversify up to 25% of their stock account in years 1 through 5 and up to 50% in year 6.

What are the Risks Associated with an ESOP?

Top 5 Retirement Concerns

1. Having an unplanned emergency

2. Insufficient savings for retirement

3. Outliving my retirement savings

4. Becoming a financial burden

5. Inability to afford health care

What a Retirement Plan does

1. Focus: on your goals in retirement and how you will pay for them.

2. Address: your concerns and expectations for retirement.

3. Identify: things that could pose a threat to your retirement and manage them.

4. Feel: more educated, confident and in control of your financial future.

5. To help you navigate: the complexity of financially moving into retirement.

My Retirement Plan

• When do I want to retire?

• How much do I want to spend?

• Tax minimization on withdrawals

• Social Security strategy

• Healthcare and Medicare plan

• Estate and Legacy

Principles for a Successful Retirement

1. Create the plan you need for the retirement you want – Define your goals and craft a plan.

2. Plan for a long life.

3. Make an informed decision about Social Security.

4. Know what to expect with health care costs.

5. Use time to your advantage – Save and invest based on your time horizon.

6. Minimize taxes to maximize your retirement.

7. Don't spend too much or invest too conservatively – Be flexible with your retirement income.

Secret Word for CE

Crossroads

CE Requirements - Onsite

1. Scan the session QR code upon entering the breakout room, using the Annual Conference Event app

2. Participate in the instructor-led question / discussion

3. Input the secret word in the CE Session Survey. The secret word will be revealed in the end of the is presentation

4. Complete the CE survey via the session page in the mobile app

Presentation Overview

• Economic and Debt Capital Markets Update •

Financing for New, Existing and Mature ESOPs

Economic and Rates Market Update

More Pronounced Curve Inversion

• Recent FOMC minutes kept a similar narrative to the one shared during the last meeting: further rate hikes would be necessary to tame inflation

• Officials notably highlighted that an “insufficiently restrictive” policy could stall recent progress on moderating inflationary pressures

• BofA Research still expects three 25bps hikes in March, May and June - taking the terminal rate range at 5.25-5.50%

• They hold their view for a first rate cut anticipated in March 2024

• Market is pricing c.80bps of hikes this year with a first cut seen in 3Q23

• Our economists see headline and core inflation at 4.3% and 4.4% by YE23

• In their view, a mild recession, goods deflation, restrictive monetary policy and fading supply-side factors will help drive inflation back towards the Fed’s 2% target – Research sees headline at 2.5% by the YE24

Evolution(1)

USD Swap Curve

Nominal and Inflation Swap Rate(1)

Economic and Rates Market Update

• BofA Research revised their rate forecasts for shorter tenors with both 2y and 5y swap rates now expected at 3.75% and 3.50% by year-end (vs. 3.25% before)

• The change is mainly due to the recently revised higher terminal rate

• Their forecasts now reflect a more pronounced curve inversion as the Fed might be slower to cut rates with sticky inflation

BofA Research USD Rates Forecasts(1,2,3)

Market Fundamentals

Tumultuous financial markets paired with challenging capital markets environment and geopolitical uncertainty

Market Fundamentals

VIX

Source: Bloomberg, FRED, S&P Global, Pitchbook Leveraged Commentary & Data, and FactSet as of December 31, 2022 (1) VIX > 20 implies an increasing concern of market conditions.

Credit Spreads

Leveraged Loan Market Conditions

Market environment has significantly reduced loan volume since record levels in 2021

Loan Market Update / Key Themes

Regulatory Hurdles

The Fed’s Dodd-Frank Stress Test hurdles were released in late Q2 which forced banks to hold more capital and become increasingly sensitive to cost of funds and RWA

 While banks were able to adjust and clear the new hurdles, the Fed and other central banks are expected to continue to increase scrutiny in 2023 and put further pressure on bank’s balance sheets

Focus on Credit Risk

 After easing during the post-COVID recovery, credit standards tightened in 2H’22 as recent macro headwinds are no longer viewed as transitory

 Expect this trend will continue into 2023 and likely result in tighter covenant structures and more moderate leverage levels

Sources: Board of Governors of the Federal Reserve System, Bloomberg, S&P, LCD and BofA Internal Databases.

Recalibration of Pricing

 After setting record lows in 2021, Pro Rata pricing began to increase in 2H’22 as banks adjusted their return hurdles to account for the challenging market environment and higher cost of funds

 Expect incremental capital raises and some refinancings to come at a pricing premium in 2023

Moderate Loan Growth

 Banks realized outsized loan growth in 2022 which is expected to normalize in 2023 as banks shift focus from loan growth to capital management

~3x normal growth

4 Change in Loans & Leases Held by Banks 98 100 102 104 106 108 110 112 1 6 11 16 21 26 31 36 41 46 51 2018 2019 2020 2021 2022 Week

Loan Market Update / Key Themes

Focus on Relationship Returns 5

 While banks are willing to deploy capital to support their clients, internal return hurdles are higher now, putting increased focus on ancillary business and ‘relationship returns’

 More banks are looking for deposits as balances have dropped precipitously, driven up bank funding costs

LIBOR Transition 6

 While most borrowers have already made the transition, the remaining LIBOR loans will need to transition to SOFR ahead of the June 2023 cessation date

 BofA advises clients to transition in advance of the last minute rush as we approach the deadline

Sources: Board of Governors of the Federal Reserve System, Bloomberg, S&P, LCD and BofA Internal Databases.

US Commercial Bank Deposits (6M change, $bn)

ESOP Market Observations / Trends

Several market factors have been contributing to 2023 activity for both new and existing ESOPs

New ESOP Activity Drivers

Mature ESOP Activity Drivers

Increased interest in ESOP feasibility despite market environment Companies navigating new interest rate environment

Failed M&A processes pivoting to ESOP ESOP restructuring and recap activity

More partial ESOPs as a diversification strategy Partial to 100% ESOP conversions

Constrained credit markets and access to capital M&A activity among existing ESOPs

Owner fatigue and demographic trends

Valuation impact given current interest rates

Recruiting and retention tool given labor markets

Framework for ESOP Financing

Character (Business Model & Fundamentals)

• Management history & depth

• Customer concentration

• Stability of industry (growth vs. mature)

The “4 Cs” of Credit

Capital

• Other demands on capital

• Seller subordinated debt

• Access to other sources of capital

Cash Flow (Primary Source of Repayment)

• Stability of cash flow & future cash flow

• Cash flow cushion

• Ability to meet covenants

Collateral

• Collateral coverage

• Advance ratios

• Time until fully collateralized

New ESOP Client Profile

Company Dynamics Observations

• Stable performers with meaningful taxable income and free cash flow (usually at least $5 million in free cash flow or EBITDA)

• Businesses where employees are a key asset

• Specialized niche business where other third party buyers may be difficult to find

• Strong employee culture

• Unleveraged firm if possible entering into the transaction

• Minimal or manageable capex needs

• Adequate liquidity pre and post transaction for operational and growth needs

• Business owners seeking partial / full liquidity and looking for an alternative to a strategic sale, private equity or IPO

• Family owned business where some family members seek liquidity and others not ready to exit

• Lack of second / third generation to take over the business

• Owners sensitive to income and capital gain taxes

• Owners wishing to retain governance in running operations

• Owners interested in retaining some investment in business

• Owners with a strong appreciation for employees

Debt Capital for New ESOPs

Capital Providers

• Senior debt

‒ Commercial banks

‒ Credit funds, Insurance companies, finance companies

• Uni-Tranche / Non-Bank Debt

‒ Business development companies (“BDCs”), credit funds, asset managers

• Mezzanine Debt

‒ Dedicated funds, SBIC funds, other

• Minority Private Equity/Structured Capital

Observations

• Commercial banks provide majority of financing for ESOP-owned companies (lowest cost of capital, prepayable, flexible)

• Broad menu of financing alternatives now available within middle market

• Generally, non-bank capital sources have higher leverage profiles and greater cost of capital with flexible repayment terms

• Institutional equity investors interested in investing alongside ESOPs

• Earnouts in traditional M&A transactions and potential impact on ESOP structures

Capital Sources & Trade-offs

Types

General Market Terms

Current market terms vary depending on size of Company, type of capital and leverage profile

Financial Covenants for ESOPs

Fixed Charge Coverage Ratio

Measures ability to adequately cover debt service requirements with free cash flow

Senior / Total Leverage

Measures amount of debt relative to free cash flow

Liquidity Ratios

Measures sufficiency & ability of short term assets or access to capital to pay short term obligations & liabilities

Negative Covenants

Limitations or restrictions on certain events that could impact risk profile

Capital Needs for Existing ESOPs

ESOP companies must proactively assess their capital structure and the trade-offs between investing in the business and returning cash to shareholders

Business

Capex Working Capital

M&A Debt

Repayment

Cash to Shareholder

Dividends / Tax

Distributions

Return

ESOP

Repurchase

Obligations

Warrants/ SARs / Mgmt Equity

ESOP Capital Needs Over Time

Similarly ESOP companies must balance the growing capital needs over time and throughout the ESOP lifecycle

Closing Thoughts for 2023…

• Continued economic uncertainty

• Recent increases in credit spreads impacting highest quality borrowers

• Recalibration of expectations as borrowers adjust to “new reality” of current interest rate environment

• Tighter covenants and leverage multiples

• Greater awareness of ESOP as a compelling transition alternative

• Strong bi-partisan support for ESOP tax benefits

• Employee engagement and retirement benefit opportunities drive new ESOP transactions

Secret Word Jayhawks

Questions

Thank you for participating in today’s program.

Please complete the session evaluation!

CE Requirements - Onsite

1. Scan the session QR Code on the door or directional signage nearby

2. Engage in the session content for all 60 minutes.

3. Input the secret word in the CE Session Survey. The secret word will be revealed in the speaker's presentation.

4. Complete the CE Survey.

Today’s Speakers

Cell: (860) 490-5481

Email: Rschatz@esopplus.com

Robert

Learning Objectives

At the end of the session, you will have a working knowledge of the roles and responsibilities of internal trustees including:

• The duty of the board of directors to monitor the trustee.

• The duty of the trustee to monitor the board of director.

• How each of the board and the trustee measures and documents how effective the other is.

• Best practices to follow to avoid any legal challenges or audits.

Agenda

Covered in Today’s Session:

• Corporate Governance

(Allocation of Duties and Authority Among Shareholders, Officers and Directors)

• The Corporate Fiduciary Standard & the Role of the Board in Corp. Governance

• The ERISA Fiduciary Standard & the Role of ESOP Trustees in Corporate Governance

• Special Issues (e.g., Offers; Executive Compensation; Conflicts)

• Best Practices

• Checklists and Select Documentation

Corporate Governance

Duties and Authority among a Company’s Shareholders, Board and Officers

Shareholders/ Trustee

Trustee acts as a fiduciary to the ESOP and as a shareholder. In a majority or 100% ESOP company, the ESOP is the controlling shareholder. In a minority ESOP company, the ESOP is often the single largest shareholder.

Board of Directors

The company’s governing body, responsible for hiring and evaluating senior management, particularly the CEO, and selecting the Trustee.

Management Runs the company’s day-to-day operations.

Role of the Board of

Directors

• Owes fiduciary duties under laws of Company’s State of incorporation of (a) care and (b) loyalty, to all shareholders (including ESOP)

• Grow shareholder value

• Set corporate goals and strategy • Appoint officers •

*Appoint, monitor and, if necessary, remove ESOP Trustee • Review annual ESOP valuation for reasonableness (with particular attention to financial projections) • Appoint ESOP Communications (a/k/a Culture) Committee

Role of the Board of Directors (cont.)

• *Serve as ESOP Plan Administrator or designate another person or committee as Plan Administrator (an ERISA fiduciary)

• Review and Establish Distribution policies for meeting Repurchase obligations

• Advise CEO and management

• Evaluate and approve significant corporate transactions, including complete sale of the company or its assets

• Review and approve corporate financial statements

Role of the Board of Directors (cont.)

• Evaluate senior officers’ performance

• Facilitate succession planning

• Determine senior officer compensation

• Establish corporate standards and conduct

• Engage ESOP third party administrator (TPA)

• *Direct the Trustee on (some or most) issues if ESOP Plan so provides

• *(Note: In carrying out these duties, the Board acts as an “ERISA Fiduciary”)

Who is an ESOP Fiduciary?

ESOP fiduciaries include anyone who is a “named fiduciary” (including the ESOP Trustee and Plan Administrator) or who:

• exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respective management or disposition of its assets

• renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so or has any discretionary authority or discretionary responsibility in the administration of such plan.

ESOP fiduciaries include:

Who is an ESOP Fiduciary? (cont.)

• Trustee (a named fiduciary)

• Board of Directors

• Plan Administrator (a, named fiduciary)

• Officers of the Company

• Members of Investment Committee or ESOP Committee Investment Managers and other advisors

Role of the Trustee

Owes fiduciary duties under federal law (ERISA) to act (a) prudently, and (b) for the exclusive benefit of ESOP participants and their beneficiaries

• Elect the Board of Directors

• Comply with ERISA fiduciary duties and avoid prohibited transactions

• Determine share value and monitor performance of ESOP’s shares

• Hire independent qualified advisors, including appraiser

Role of the Trustee (cont.)

• Ensure plan is operated according to plan document

• Cannot agree to restrictions on stock owned by ESOP, other than limited Right of First Refusal

• May be “directed” by the Board of Directors on (some or most) issues, or fully “discretionary,” as provided in ESOP Plan

• (Note: The Trustee cannot be directed with respect to determining share value – and the ”transaction” valuation report (as distinct from the annual update) should be kept strictly confidential by the Trustee and should not be shared with the Company or the Sellers)

Internal Trustee

Today we focus on the Internal Trustee and his/her/its duty to the Plan.

• Trustee is typically appointed by the Board of Directors (but could be appointed by the ESOP Plan Administrator who, in turn, is appointed by the Board)

• Trustee may be directed by Board or ESOP Plan Administrator) or be fully discretionary (or directed on some issues and discretionary on others) as provided in the ESOP Plan document

Directed Trustee (29 U.S.C 1003(a)(1)) must ensure:

Directed v. Discretionary Trustees

• Persons providing direction are authorized to do so under Plan document – (i.e., are they the correct named fiduciary?)

• Its role under the Plan document

• The direction given to the trustee is not contrary to ESOP Plan documents or ERISA

( Note: It is unclear whether a directed trustee has an independent fiduciary duty under (3) or not. Some courts have said that a directed trustee is “immune from judicial inquiry” to the extent that it lacks discretion; but other courts have held that a directed trustee could have liability if it knows or should know that a direction is imprudent)

Directed v. Discretionary Trustees (cont.)

A discretionary Trustee is required to meet each of the four main fiduciary duties imposed under ERISA:

• Duty of undivided loyalty to plan participants

• Duty of prudence (“the prudent expert”)

• Duty to diversify the investments of the Plan (except for ESOP*)

• Duty to administer the plan in conformity with the plan documents

• ESOPs do not have a duty to diversify, but . . .

What do Internal Trustees need to do?

• Take custody and control of Plan assets

• Read and understand all ESOP documents

• Know the Company

• With assistance of independent appraiser, determine the value of the shares held by the ESOP

• Vote stock

• Oversee trust activity

• Buy/sell shares to/from Trust

• Executive Compensation

Read and Understand all Plan Documents

• ESOP Plan document

• Plan trust

• ESOP Loan Documents (if outstanding)

• Stock Purchase or Redemption Agreement (ongoing covenants)

• Anything tied to stock performance:

• Stock Appreciation Rights Plan

• Phantom Stock

• Warrants

• Stock Options

Know the Company

Think: What would a prudent investor that sank his entire life savings into a single business want to know?

• Review Articles of Incorporation, Bylaws, Shareholder Agreements, etc.

• Review books and records of the corporation

• Review market and competition (ask for assistance from independent appraiser or Board)

• Review Repurchase Obligation Studies

• Review prior annual valuation reports

Determine Value of Stock

Trustee retains the appraiser:

• Ask How many ESOP valuations has this firm prepared?

• Interview more than one

• Is the appraiser independent? Has it done work for the Company (or the Company’s former shareholders/Directors/Management)?

• Request sample report (does it meet requirements of Revenue Ruling 59-60?)

• Has the appraiser’s work been the subject of DOL scrutiny that reached the lawsuit level?

• Keep written record of questions asked and answers received.

Determine Value of Stock (cont.)

With respect to Annual Appraisal Reports:

• Review prior year’s report.

• Verify appraiser remains independent/not conflicted?

• Has the appraiser become subject to DOL action or had work questioned?

• Ensure appraiser receives access to appropriate and accurate information (including Repurchase Liability studies)

• Do you have sufficient understanding of valuation processes?

• (Note: Internal Trustees still are held to the standard of a prudent expert)

Voting Company Stock

Trustee votes the ESOP’s stock at annual shareholders meeting:

• Ensure annual Shareholder meeting occurs

• Review Bylaws to verify Shareholder rights

• Are there any limitations in Stock Purchase or Redemption Agreement?

• Are you directed? Did you receive proper direction?

Oversee Trust Activity

• Process distributions directly or review the processing by Company/TPA

• Set up Trust Checking Account (in name of ESOP Trust)

• Ensure shares are allocated properly and consistent with ESOP Loan Documents and Plan Documents

• Request new Stock Certificates as shares are released from Pledge

• Verify amortization schedules and payments are correct

• Verify or pay plan expenses (ensure all such expenses are properly payable)

• Request and Review Repurchase Liability studies

Trustee Annual Checklist

Note 1: the "Period" represents the time either Before (-) or After (+) First Day of Plan Year to complete the task

Note 2: specific due dates are for calendar year end. Dates marked with an " * " are date certain

Buy/sell shares to/from Trust

Disclaimer: Wearenotcoveringtheissuesinvolvedin aninitialESOPtransactionorsubsequentlarge transaction(secondstage)(requiresitsownwebinar) Company may redeem shares to facilitate distributions, but:

• Cannot rely on annual appraisal when there is a transaction between the Plan and a “party in interest.”

• The Company is a “party in interest.”

• Must have appraised value as of the transaction date

Executive Compensation

Trustee has no specific duty re executive compensation

• However, as the shareholder the Trustee might be required to bring suit to stop corporate waste that dilutes the value of the shares.

• Excessive executive compensation is one mechanism that can dilute value to the ESOP participants (i.e., back-door looting)

Note: The Internal Trustee, if also an officer or director, should consider what “hat” he/she is wearing when setting compensation

Shuttlecocks Secret Word

Questions?

CE Requirements - Onsite

1. Scan the session QR Code on the door or directional signage nearby

2. Engage in the session content for all 60 minutes.

3. Input the secret word in the CE Session Survey. The secret word will be revealed in the speaker's presentation.

4. Complete the CE Survey.

SESSION OUTLINE

Part I. INTRODUCTION TO ESOPs

Part II. FINANCIAL CONSIDERATIONS

Part III. NON-FINANCIAL CONSIDERATIONS

Part IV. CONCLUSION

Part I: INTRODUCTION

WHAT IS AN ESOP?

“Employee Stock Ownership Plan”

Legal structure: it’s a “Qualified” Retirement Plan:

• Plan assets held in a Trust for the benefit of employees

• Trust is tax exempt

• Governed by ERISA

• Primary trust asset is Employer Stock

ESOPs Serve Two Major Purposes

1. For the Company Owner(s), the ESOP is… …a buyer of stock: an Exit Strategy for privately-held business owners

2. For Employees, the ESOP is… …an equity-based Employee Benefit Plan: a company funded, qualified retirement plan (like a 401(k))

Why ESOPs are Popular ?

1. The owner’s exit strategy is Funded with Pre-Tax Dollars, so less cash is needed

2. Owner can defer personal income tax upon sale of stock (IRC Section 1042)

3. Double Duty for the Dollar

4. Flexibility: not mutually exclusive from other exit strategies

5. Employees become more Productive

Part II: FINANCIAL CONSIDERATIONS

A. The Price / Valuation

B. Tax Benefits

C. Financing : How Are You Going to Pay for it?

A. The Price: Valuation Of Private Companies

Strategic Buyers v. Financial Buyers

Tiers Of Value

• CONTROL VALUE

• Strategic buyer

• Financial buyer (includes ESOPs)

MINORITY VALUE

• Public Company stock

• Private Company with an ESOP

• Private Company without an ESOP

• Liquidation value

Weighted

Is an ESOP price lower than a 3rd Party price?

ANSWER:….. It depends

• Is the 3rd Party buyer a Strategic Buyer or a Financial Buyer?

• The “put” option

• Sellers may be participating in the ESOP

• Some ESOP structures allow for Sellers to receive additional equity upside through warrants

B. Tax Benefits

1. Corporate Taxes: Pre-tax dollars used to buy out owners (C corp or S Corp)

2. Personal Taxes: No capital gains if Section 1042 election (C corp only)

“Double Duty for the Dollar”

Section 1042 Requirements

• Company must be a C Corp for now (change in the law starting in 2028)

• ESOP must own 30% after the transaction

• Seller must reinvest in “Qualified Replacement Property” (QRP) = U.S Companies

• Additional Requirements

Section 1042 “Qualified Replacement Property” (QRP)

• Any “U.S.” corporation, public or private

• Equity or debt securities

• Passive investments, gov’t securities, and mutual funds don’t qualify

C. Financing: How Do I Pay For It?

1.

ESOP Financing Options

2.

3.

4.

Bank or other financial Institution

Seller Financing

Company Cash

Combination of the above

Bank Lenders

• ESOP lending is a mature market and has been around for 40+ years

• Most major financial institutions welcome the idea lending to ESOP owned companies

• Why?

• ESOP companies tend to more stable

• Cash flow is better – tax deduction for interest AND PRINCIPAL on the loan value

ESOP Loan Balance Sheet Effect

• Equity is Reduced initially

• Bonding issues due to temporary negative impact to shareholders equity?

Part III. NON-FINANCIALCONSIDERATIONS

Corporate Governance

 Board of Directors

 ESOP Fiduciaries/ Trustees  ESOP Participants

ESOP Participants

ESOP shares are owned by a Trust, not by the Employees directly

 Employees are “beneficial”, not “direct” owners of stock

 Trustee votes ESOP shares, except in special cases

 The Trustee’s job is to represent the ESOP’s interests

 Participants have the economic benefit of owning stock, with virtually no corporate governance rights

 Employees are not entitled to company financial statements or the ESOP valuation report

Second Team Management

PROFESSIONAL ADVISORS

PROFESSIONAL ADVISORS

Seller & Company’s Professional Advisors

• Seller’s Financial Advisor / Appraiser

• ERISA Attorney

• Local Attorney

• CPA

• TPA/ Recordkeeper for ESOP Administration

PROFESSIONAL ADVISORS

ESOP Trust’s Professional Advisors

Trustee

Appraiser / Financial Advisor for Trustee

Trustee’s ERISA attorney

Part IV: CONCLUSION

Good ESOP Candidates:

• Owners want an exit or desire some liquidity

• Profitable Business - strong cash flow.

• ESOP valuation acceptable to owners.

• Company is large enough to warrant installation and maintenance expense.

• Owners seek to increase employee productivity through equity compensation.

Senator Russell Long

“The problem with capitalism is that there are not enough capitalists.”

Nobody washes a rental car

People work best when they work for themselves

Q&A

Secret Word TRUMAN

Plan Design and Redesign

CE Requirements - Onsite

1. Scan the session QR code upon entering the breakout room, using the Annual Conference Event app

2. Participate in the instructor-led question / discussion

3. Complete the CE survey via the session page in the mobile app

Today’s Agenda

• Allocations – How do you divide up the money?

• Vesting Schedules – When do folks become vested in their benefits?

• Benefit Distributions – What can you do to manage your repurchase obligation?

Three R’s Framework

Contribution Allocation Requirements

Service Requirement

• Typically 1,000 hours of service

Employment Requirement

• Typically must be employed on the last day of the plan year

May be waived for death, disability, and retirement

Contribution Allocation Formulas

• Nondiscrimination testing (IRC 401(a)(4))

• Qualified plans must be designed so that contributions or benefits do not discriminate in favor of HCEs.

• Two common allocation formulas which are considered safe harbor are:

• Proportional to Compensation

• Per Capita (same amount to each person)

Contribution Allocation Formulas

Contributions can be allocated on a “Unit” or “Points” allocation formula

• Example: 1 unit for each full $100 of participant compensation + 2 units for each Year of Service.

Contribution Allocation Formulas

Requires additional annual testing

• First compare allocation rates in the ESOP of non-HCEs and HCEs. If HCEs have too high of an allocation rate, then a second test is required.

• The second test compares rates across all defined contribution plans sponsored by the Company. If this test does not pass, the ESOP must be amended.

Example – Relative Compensation

ESOP has four participants: Andy, Beth, Carl and Doug. The ESOP receives a contribution of $100,000. Allocation formula is in proportion to relative compensation.

Example – Points Based on Service

ESOP has four participants: Andy, Beth, Carl and Doug. The ESOP receives a contribution of $100,000. Allocations are based on relative “allocation points” and one allocation point is awarded for each year of service.

Example – Points Based on Service and Compensation

ESOP has four participants: Andy, Beth, Carl and Doug. The ESOP receives a contribution of $100,000. Allocations are based on relative “allocation points” and one allocation point is awarded for each year of service and one point for each $10,000 of compensation.

Comparison

ESOP has four participants: Andy, Beth, Carl and Doug. Below is a comparison of the allocation based on the three methods we have described.

Compensation Used for Allocations

Could be more than one definition!

Exclusions

• Overtime?

• Bonuses?

• Commissions?

• Non-cash compensation

• IRS limit: $305,000 (2022)

Include full-year compensation for participants who enter the plan mid-year?

Earnings Allocations

Cash Accounts

• Pro rata to cash balances

Stock Accounts

• Dividends on allocated shares

• Pro rata to total account

balances

• Dividends on unallocated shares

Minimum Vesting Schedules

Vesting Considerations

• Average longevity of employees

• Incentive to join company?

• Incentive to stay with company?

Vesting – Year of Service

Typically a plan year in which a participant works 1,000 hours

• Can use a smaller number of hours

• Can use an equivalency method rather than actual hours

• Can use elapsed time method

Sue’s employment history with ESOP company: Example – Hours vs Elapsed Time

Sue’s years of vesting using hours: Example – Hours

Total years of vesting = 3

Sue’s years of vesting using hours: Example – Elapsed Time

Total years of vesting = 4

100% Vested

• Fulfill requirements of vesting schedule

• Retirement

• Death (optional)

• Disability (optional)

• Partial plan termination

• Plan termination or complete discontinuance of contributions

Forfeitures

Terminate before 100% vesting

Forfeiture event

• After 5 consecutive breaks in service

• Entire vested account balance distributed

Forfeiture proceeds

• Reinstate previously forfeited balances

• Allocated to eligible participants

• Pay plan expenses

ESOP Distribution Policy

What is an ESOP Distribution Policy?

An ESOP Distribution Policy is…

• A policy that describes how and when you will be making distributions from your ESOP.

• Often needed because the plan document itself may not detail how distributions will be made.

What Needs To Be In An ESOP Distribution Policy?

• What needs to be in an Distribution Policy?

• Timing of Distributions

• Form of Payment

• Can you change your Distribution Policy?

Repurchase Obligation Planning

If your ESOP’s distribution policy includes delays and/or installment payments, company may need to repurchase shares well after a participant leaves, at a higher price.

• Should you consider changing your ESOP’s distribution policy?

• Should you consider “reshuffling” to make the repurchase obligations less expensive?

What is “Reshuffling?”

According to the IRS, reshuffling is “the mandatory transfer of employer securities into and out of plan accounts, not designed to result in an equal proportion of employer securities in each account.”

Reshuffling

Pros

• No change to payment timing

• Dividends not allocated To terms

Cons

• Repurchase obligation is higher

• Diversification of investment – Terms

• Stock appreciationActives

• Cash to segregate is similar to immediate lump sum

• Fiduciary responsibility for investments

• Discrimination testing?

Secret Word

Setting the Stage for a HighPerformance Culture

Tim Everidge

President & CEO​

Radian Research, Inc​

Lafayette, IN

everidge@radianresearch.com

Renée Mundell

Manager – Customer Service & Support

Team Lead – RADIAN ESOP Ambassador Team​

Radian Research, Inc​

Lafayette, IN

rmundell@radianresearch.com

CE Requirements - Onsite

1. Scan the session QR code upon entering the breakout room, using the Annual Conference Event app

2. Participate in the instructor-led question / discussion

3. Complete the CE survey via the session page in the mobile app

Our Learning Objectives Today

• Understand how to “Set the Stage” with Culture.

• How to connect culture with high-performance.

• Understand the impact of culture on recruiting and retention of high-performance talent.

Overview of Radian Research, Inc.

Radian Research became a 100% ESOP in 2008.

110 employees with 2 facilities: Lafayette, IN & Pearl, MS

We design and manufacture products to test the accuracy of electricity meters and we develop software products to manage electricity meter test data. Our main customers are electric utility companies around the world.

WHAT IS WORK CULTURE?

WHAT IS WORK CULTURE?

❑ Work culture is what it feels like to come to work every day.

❑ It is the personality of a company.

❑ It is shared attitudes and behaviors of people who work together.

❑ It is how we treat each other at work.

❑ Work culture can be defined, changed and improved … over time.

Using Work Culture to Drive Results

Goal

Strategy

Culture starts at the Top

FIRST LAST

- An organization’s greatest influence on culture is the leader

- The CEO must be involved and engaged with the work Culture

- The CEO plays a key role in defining, implementing and maintaining the desired Culture

- The CEO must be seen as living and supporting the desired Culture

Define the Desired Culture

- Create a Culture Policy Statement

-

FIRST LAST

Radian Research Culture Policy: We are a team of employee owners with a continuous improvement mindset. We provide a safe, engaging and participative work environment where our employees can deliver their best effort. We learn from mistakes as we grow personally and professionally. We care about each other, our company, our customers and our community. We treat others with dignity and respect.

Indoctrinate the management team to the desired culture.

- Spread the word … post it around the business and on the website.

-

Policy Statements & A High- Performance Culture

Tell the employees who the company is, what it stands for, where it is going

FIRST LAST

- Give the employees a compelling reason to join the company and stay

- Create Corporate Policy Statements, such as:

- Mission, Value, Vision, Purpose, Identity, Culture, etc.

- Radian’s Purpose Statement:

“We exist to enrich the lives of our employee owners.”

Recruit, interview and onboard for the desired culture

FIRST LAST

- Make sure the candidates know the Culture Policy Statement.

- Make sure the candidates understand how the desired Culture is critical to the success of the company.

- Ask the candidate what your Culture Policy means to them.

- Try to determine if the candidate is a culture fit.

Employee Participation

FIRST LAST

- Find ways to engage the employees with participation that may be outside their normal role:

- Get employee input for Strategic and Operational Planning

- Drive improvements with Employee Participation

- Do Kaizen events to improve a process

- Create a Self-Managed Team to fix a problem or make an improvement

- Rethink annual performance evaluations for more employee involvement

Employee Participation

Strategic and Operational Planning:

- Conduct an Annual Company SWOT Analysis with Employees

FIRST LAST

- Strengths, Weaknesses, Opportunities, Threats

- Variations: What is going well? What is not going well? How can we improve? What is one action our department can take to improve? What is one action our company can take to improve?

- Once the Annual Plan is finalized, then share it with the employees

- Show the employees where their feedback was used in the Annual Plan

- Department Plans and/or Corporate Plans

- Have monthly Scoreboard Meetings to show the employees the score.

Show the Score: Scoreboard Meetings

Fans Know the Score… Players Change the Score!

Radian’s Belief:

The people who are closest to the process get to live the successes, problems, challenges, obstacles; those are the ones best able to contribute to the solutions!

Kaizen events being driven by Employees for Continuous Improvement

FIRST LAST

Employee Participation in SMTs Set the Stage

Rodney’s recommended Personality Test: CAPS – Public Domain

Controller Analyzer

Promoter Supporter

Employee Participation in SMTs

6 Suggestions for Self-Managed Team (“SMT”) Success

1. Support must come from the top (CEO)

2. If the CEO does not foster the SMT environment, the SMT will fail

3. CEO must hold Management accountable for positive SMT support

4. The Objective MUST be WELL defined

5. SMT sets their KPIs, with CEO approval

a) Buy-in

b) Accountability

6. Do not Micromanage the SMT

a) Micromanagement = Failure

SMT Lifecycle

⮚ Issue/Concern Identified

⮚ Team formed - Champion and Leader appointed

⮚ Teams sets Objective and Score Card

⮚ Team performs regular report outs

⮚ Misses are reviewed – 3 misses = 5 whys

⮚ Wins are reported and celebrated

⮚ Final solution(s) & report out = Team dissolved.

SAFE Process instead of Performance Review

⮚ Tim listened to Employees – annual performance reviews were:

✔ Excessively Time Consuming

✔ Too little; too late

FIRST LAST

✔ Management-driven: Felt like going to the principal's office

⮚ SMT created New Process, driven by Employee with the manager as the coach

✔ Timely and relevant – including connecting everyday work to company objectives

✔ Check-ins are a “safe place” to showcase talent, own mistakes, share ideas

✔ Empowers the employee to own their performance and growth

✔ Supports continuous improvement mindset

✔ Communicates Employee needs to supervisor or manager

✔ Creates a path for Employees to grow (in current position or a future position)

SAFE Check In Forms

Live the desired culture

- Culture is a journey, not a destination.

FIRST LAST

- Management must regularly reflect on how well the Culture Statement is being lived and find areas for improvement.

- Employees and Managers need to be coached whenever the behavior is not in alignment with the desired culture.

- Employees and managers can use the Culture Policy Statement as a frame of reference when dealing with undesired behavior.

- Some Managers and Employees may not be the right fit.

Sugar Creek Secret Word

Setting the Stage for a HighPerformance Culture

Tim Everidge

President & CEO​

Radian Research, Inc​

Lafayette, IN

everidge@radianresearch.com

Renée Mundell

Manager – Customer Service & Support

Team Lead – RADIAN ESOP Ambassador Team​

Radian Research, Inc​

Lafayette, IN

rmundell@radianresearch.com

The Effect of Turbulent Market Conditions on ESOP Transactions and Annual Valuations

CE Requirements - Onsite

1.Scan the session QR code upon entering the breakout room, using the Annual Conference Event app

2.Participate in the instructor-led question / discussion

3.Input the secret word in the CE Session Survey. The secret word will be revealed in the end of the is presentation

4.Complete the CE survey via the session page in the mobile app

CE Requirements - Virtual

1. Be signed into the virtual platform under your email you registered with

2. Fill out the 3 polling questions

3. Submit the CE survey

• Pandemic Aftershocks

• Inflation

Supply Chain • Labor Supply • Lockdowns, PPP, ERC, etc. • Inflation and Interest Rate Impact on Valuations

Pandemic After Shocks - Inflation

Too Much Demand and Not Enough Supply

• Too Much Demand:

• Fiscal Stimulus (government spending) and Monetary Stimulus (low interest rates) caused the money supply to grow by 37.8% from January 2020 to December 2021

• The growth in money combined with pent up demand from the pandemic drove an extraordinary appetite for goods and services

• Not Enough Supply:

• Inventories were “lean” prior to COVID

• COVID shutdowns, demographics and fiscal stimulus constrained labor output/productivity resulting in supply chain disruptions

• Hoarding of supplies further exacerbated the problem

• Geopolitical events reduced energy supplies

Pandemic “After Shocks”

Inflation: Questions To Contemplate for Valuation

1. Bifurcate (if possible) change in revenues due to production versus price point.

2. How are inflationary impacts reflected in the forecast?

3. How has inflation impacted customer contracts? Are there new items or language in their contracts or proposals that can help reduce the risk

4. Are the inflationary impacts on increasing interest rates preventing the subject company from making investments?

5. Passing along costs

6. Protective language in contracts re: inflationary pressures

Pandemic “After Shocks”

Supply Chain Constraints: Questions To Contemplate

1. Discussion of increased costs associated with getting product in a timely manner. Temporary or “new normal”?

2. Has the subject company reached out to new suppliers to help alleviate some of the supply chain burden?

3. Discussion of risk of overseas suppliers

4. How have supply logistics impacted spot purchasing decisions and build-up of inventory

5. Impacts to Net Working Capital based on changes in inventory build-up

Pandemic “After Shocks”

Tight Labor Supply: Questions To Contemplate

1. Discussion of retention of existing labor

• Pay increases, different types of incentives, increase in overall benefits?

2. Discussion of challenges in finding new talent

• Recruiters, employee bonuses, relationships, directly with colleges

3. How is your subject company dealing with increased expenses related to attracting and retaining employees?

4. What is the company workforce’s age distribution?

5. How is capacity to generate revenues impacted by labor trends?

6. Discussion of margin compression as a result of increased labor burden.

Lockdowns, PPP, ERC, etc.

• The government-imposed COVID lockdowns impacted businesses, industries, and regions differently

• Airline catering company vs. garbage removal business

• Different states, different policies

• The federal government created the Paycheck Protection Program (“PPP”), the Employee Retention Credit (“ERC”) and other financial safety nets to minimize business closures and bolster employment

• Some companies got the PPP/ERC proceeds even though they did not miss a beat while with other companies suffered operational and financial difficulties that eclipsed any PPP/ERC provided

• How does an appraiser consider this “black swan” event?

Inflation and Rising Interest Rates: Impact on Valuations

• Industry Specific

• How has inflationary pressures impacted your industry?

• Company Specific

• How has the company reacted to streamlining costs and revising purchasing decisions?

• How strong is communication with clients to address cost escalation?

• How does the company’s pricing and purchasing power come into play?

• Contract Specific

• Have the contracts been amended to address rapidly changing material prices and/or delays in jobs?

Interest Rate: Taming Inflation

• The Fed is raising interest rates in an effort to reduce demand with the hopes that this will impede inflation

• The current “inverted” yield: short term rates are higher than long term rates

• Inverted yield curves often are a precursor to a recession and are a prediction that over the longer term the Fed will need to reduce interest rates again to pull the economy out of the recession

The Inverted Yield Curve

Predicting Recessions

Inflation and Rapidly Rising Interest Rates:

Impact on Valuations

• Impact of Interest Rate Hikes on Valuation

• Existing Debt

• If company has existing debt at an interest rate lower than rising interest rates, the FMV of the debt may be lower than face value, having an upward impact on value.

(Ex., Subordinated Debt)

• Overall Cost of Capital of a Company

• To the extent a company requires debt to fund operations/ growth, the cost of debt is factored into the ultimate value of the company

• All else equal, higher the cost of debt, the lower the co. equity value

• Should higher interest rates result in deferral of investment opportunity, the opportunity cost is indirectly reflected in the value of a company.

Fed Funds Rate vs S&P 500 Value

Recent Economic Turbulence Impact on Valuation Methods

Guideline Comps

Market Approach/ M&A Comparable Comps

Impact of Market Turbulence Over the Past Two Years

Meaningfully Negative

Meaningfully Negative Slightly Negative

Three Approaches to Value – Income Approach, Market Approach and Asset Approach (asset approach is typically a floor valuation and, thus, we will focus on the Income and Market Approaches

Income Approach – Examines the cash flows of the Company and converts them to value, based on a risk rate. Such risk rate is sourced from the market and is meaningfully higher at 12/31/22 vs. 12/31/21 (which has a negative impact on value).

Market Approach –

a. Guideline Public Company – examines market multiples of publicly traded companies as indicators of value. Derived value multiples are then applied to the Company’s cash flows. Such market multiples are meaningfully lower at 12/31/22 vs. 12/31/21 (which has a negative impact on value).

b. M&A comparable method – examines market multiples of M&A deals as indicators of value. Derived value multiples are then applied to the Company’s cash flows. The data for market multiples have not yet had a meaningful movement. However, to the extent that the outlook of companies being acquired is pessimistic, this will eventually have a cooling effect on market multiples.

Market Data

Impact on Valuations

(2022 vs. 2021 Valuations): Income Approach Inputs

Market Data

Impact on Valuations

(2022 vs. 2021 Valuations): Market Approach Inputs

Market Data

Impact on Valuations

(2022 vs. 2021 Valuations): Market Approach Inputs

Market Data – Impact on Valuations

(2022 vs. 2021 Valuations)

• Holding all other factors constant, accounting only for the change in market data results in a 17% decrease in the Enterprise Value, based on the changes in market data considered.

• Total Enterprise Value considers both (i) the Income Approach and (ii) the Market Approach (and market inputs that enter into each of those 2 approaches).

• This is an overview of changing ONLY key market factors and assumes all else is held equal, which may not be the case with many companies. Each valuation is very “case-specific”.

Impact of Recent Events on Transaction Structures

• Higher interest rates generally impede more aggressive financing structures

• Banks will want to see greater interest rate protection on floating rate debt through swaps and other hedging instruments

• Sellers receiving seller notes may need to provide more lenient amortization schedules

• Overall rates of return on seller notes may be pushing higher given the overall rate environment (and risk!!!)

• Trustees may way to hedge against “blue sky” financial forecasts with claw backs or earnouts

The Effect of Turbulent Market Conditions on ESOP Transactions and Annual Valuations

The Impact of Assumptions on the Ownership Mindset

Victor Aspengren

Gina Rens

Ellen Patnaude

1. Scan the session QR Code on the door or directional signage nearby

2. Engage in the session content for all 60 minutes.

3. Input the secret word in the CE Session Survey. The secret word will be revealed in the speaker's presentation.

4. Complete the CE Survey.

Assumptions Education

Defined by Oxford Learner’s Dictionaries as:

“a belief or feeling that something is true or that something will happen, although there is no proof."

The Assumption Lesson

Ownership Mindset Assumptions?

 Being an owner means I have control over the company.

 Even as an owner, I don’t influence organizational results.

 It’s The Best model. Period.

 Everyone understands the “Ownership Mindset”

 Everyone embraces it

 Ownership means the same thing to everyone

 There’s no need to discuss how it evolves over time

Ciranda’s Assumption Story

Assumption Prevention Tools

1. Pay attention to cues

2. Ask questions

3. Reflect

4. Be willing to go back

5. Ask more questions

I Thought You Knew

• Visit your favorite online bookseller or local bookstore

• Also available on Kindle

Secret Word for CE

College Basketball

What to Do When You Find Mistakes with Your ESOP - And How to Avoid Them

CE Requirements - Onsite

1. Scan the session QR Code on the door or directional signage nearby

2. Engage in the session content for all 60 minutes.

3. Input the secret word in the CE Session Survey. The secret word will be revealed in the speaker's presentation.

4. Complete the CE Survey.

• Why worry about ERISA and Internal Revenue Code compliance?

• How do you find a problem? • How do you solve a problem? •

How do you avoid some of these problems?

Why Be Concerned About Correcting Errors?

• Tax Qualified Status of Trust

• Participant Litigation

• Penalties

• Corrections often include putting money into a plan • Administrative costs of computing corrections

Regulatory Authority

DOL

Penalties • Replace Fiduciaries

• ESOPs are a “National Project” • IRS • Penalties, Excise Tax

Plan Disqualification

Regulatory Authority (continued)

DOL

Enforces ERISA’s fiduciary rules and regulations

mission

Mission is to assure the security of the retirement benefits of America’s workers and their families

IRS

Enforces tax-qualified status of plans

Mission is to enforce federal tax laws governing retirement plans

Statutory Authority

• Both the IRS and the DOL have authority to:

• Perform on-site audits/investigations

• Require submission of records

• Inspect books and records

• Question individuals

• Subpoena records and testimony

• Enforce subpoenas in court

• Seek documents from plan sponsor, trustee, valuation firms, service providers, etc., even beyond the applicable statute of limitations and outside their statutory authority (e.g., IRS may ask to see the plan’s claims procedures and DOL may ask to see determination letter)

Statute of Limitations

ERISA

• Generally 6 years

• 3 years after the earliest date on which the plaintiff had actual knowledge of the breach or violation

IRS

• Generally 3 years

• 6 years if 25% understatement

•

3 years for excise tax, even if 25% understatement, if adequate disclosure

Pre-emptive Measures – How do you prevent a problem?

• In designing the ESOP, have it match 401(k) plan as much as possible

• Read the ESOP document, become familiar with it and ask your advisor if you have questions about how to apply any of its provisions

Pre-emptive Measures – How do you find a problem?

• Self-Audit

• Prepare an “Audit” Binder

• Annual Administrative Review with Third Party Administrator, ESOP legal counsel, and the Trustee

• Form 5500 Plan Audit Report

IRS Correction Programs

Employee Plans Compliance Resolution System (EPCRS)

Revenue Procedure 2021-30

Corrects “Qualification” Failures

Type of “Qualification” Failures • Plan document failure

Demographic failure

Operational failure

Qualification Failures

• Plan Document Failure

• A plan provision (or the absence of a plan provision) that, on its face, violates the requirements of IRC 401(a)

• E.g., failure to timely and properly amend the plan for required legislative updates

• Operational Failure

• Failure to follow plan provisions, resulting in the plan not being operated in accordance with its terms

• Demographic Failure

• Failure to satisfy nondiscrimination and coverage requirements of IRC 401(a)(4), 401(a)(26), or 410(b) –generally requires a corrective amendment to the plan to add more benefits or increase existing benefits

IRS Correction Programs

• Self-Correction Program (SCP)

• No IRS fee

• Only for insignificant failures (or significant failures corrected by last day of third plan year after year of failure)

• Voluntary Correction Program (VCP)

• Apply to IRS for “compliance statement”

• Cost – IRS fee (based on plan assets), preparation of application and correction

• Not available for a plan that is “under examination”

• Employee Plans Voluntary Closing Agreement Program (VCAP)

• Audit Closing Agreement Program (CAP)

• Cost – IRS sanction generally negotiated – Up to Maximum Payment Amount

IRS Correction Programs

• New IRS “pre-examination” compliance program

• 90 day period after receipt of notification of exam to voluntarily review plan for document and operational compliance

• Self-report errors and/or corresponding corrections by end of 90 day period

• After IRS review, IRS may issue a closing letter or may choose to conduct a limited or full scope audit

• IRS will schedule an exam if no response received within the window

• Can self-correct if eligible or enter into closing agreement at VCP cost (likely to be significantly less than if IRS discovers error)

• Self-Correction Program (SCP) may be used for:

• Insignificant Operational Failures (determined by several factors) – can correct even several years after the failure

• Significant Operational Failures and Plan Document Failures (a) for a plan with a favorable letter, and (b) corrected or substantially corrected within 3 years after the plan year in which the failure occurred (with some exceptions)

• Correction of operational failures by plan amendment that increases a plan benefit, right or feature, even if not applicable to all participants

• Voluntary Correction Program (VCP) may be used to:

• Disclose Qualification Failures to IRS

• Propose to IRS how to fix failures

• Negotiate with IRS if it disagrees with the sponsor’s proposal

• Make all corrections by the date specified in Closing Agreement

NOTE: Can no longer be submitted on an “anonymous basis” until a resolution is reached. Replaced with pre-submission conference for errors that may be corrected through EPCRS for non-safe harbor for plans eligible for and that intend to submit a VCP filing. No fee, but IRS may refuse to conference.

VCAP

• Employee Plans Voluntary Closing Agreement Program (VCAP)

• Resolves income or excise tax issues that cannot be addressed under EPCRS

• Will not negotiate tax amount, only penalty abatement

• Plan sponsor submits a detailed letter that includes:

• an explanation of the problem and how and why it occurred

• the number of people affected and amount of contributions, distributions, etc.

• an explanation of how they will correct the identified problem or issue

• an explanation of how they calculated the tax, interest or penalties

• proposed sanction amounts and an explanation justifying the amounts

• If tax is a result of a prohibited transaction, plan must correct through the DOL’s VFCP before making request

Audit CAP

• Closing Agreement Program (Audit CAP)

• Operational or Plan Document Failures found during audit or during determination letter review process (initial or final)

• SCP available for insignificant Operational Failures and for significant Operational Failures if correction was substantially complete before the examination began

• Instead of disqualifying ESOP, IRS will enter into an agreement where the ESOP sponsor pays a sanction for the disqualification defect(s) in the ESOP

• Sanction is negotiated based on a number of factors, including the “maximum payment amount”

IRS Correction Principles

• Full correction should be made for all participants for all years

• Correction method should restore plan to no-failure position

• Correction should, if possible, resemble an approved method

• Correction generally should keep assets in the plan

• Correction should not violate other legal requirements

• Corrective allocations should be adjusted for earnings

• EPCRS specifies methods for computing earnings

• Absent precise calculations, reasonable estimates are acceptable

Common Errors

• 409(p) Issues – Synthetic Equity not included in 409(p) test

• Synthetic Equity includes warrants, options, phantom stock, stock appreciation rights, split dollar life insurance, deferred comp., etc.

• Example – S Corporation ESOP has Stock Appreciation Rights (SARs) for key managers. TPA is unaware of the SARs and excludes from 409(p) test.

TPA didn’t ask? Plan sponsor left question blank on annual form? Person completing annual form wasn’t aware of SARs?

• Test is not correct and could result in 409(p) failure.

Common Errors (continued)

How to Fix?

• No correction, only prevention. Re-run 409(p) test and hope for the best!

• No retroactive correction available!

How to Prevent?

• Plan Administrator should review annual information form

• TPA should inquire each year if any changes in Synthetic Equity have occurred (or other factors included in 409(p) test such as family relationships)

• ESOP Trustee and Board of Directors should review test annually

• Confidential information requires special handling

• If your company is an S Corporation, make sure the test is being performed and reviewed annually!

TIP: 409(p) test is a “daily test” so make sure test passes BEFORE Synthetic Equity is issued

Common Errors (continued)

409(p) and Stock Price Drop

• The value of synthetic equity that is not based on employer stock, such as deferred compensation, has to be converted to a number of shares of employer stock based on the valuation of employer stock.

• A low valuation will result in a high number of synthetic equity shares, possibly risking a non-allocation year.

How to Prevent?

• Specify date in plan document to determine the value of employer stock, and therefore the number of synthetic equity shares.

• Date can be an annual date, such as the value as determined as of the last day of the prior plan year.

• Date can be set for three years, which would give the most stability to the determination.

Common Errors (continued)

• Diversification

• Example: TPA firm discovers new “takeover” client has never offered diversification elections to plan participants even though the plan has been in existence for over 15 years

• Diversification is required after 10 years of participation, thus, operational failure is for (potentially) the past 5-years

• What happens?

• Diversifications were consistently not offered timely

Common Errors (continued)

How to Fix?

• SCP – Insignificant or Significant? Not eligible for SCP if the failure is significant and if 2 years following the plan year in which the failure occurred

• VCP

• Identify the participants not provided an opportunity to diversify (and what years, number of shares and stock price involved)

• Provide participants with remaining election periods; participants beyond 6year period are given one election period to diversify 50% of shares

• Company may need to contribute funds if there is “lost opportunity”

How to Prevent?

• Know Plan Document – Do you have early diversification provisions?

• Attend conferences

• Is this service included in your TPA’s engagement agreement?

Common Errors (continued)

• Compensation issues

• Compensation used is not consistent with the plan document.

• Common examples – Include or exclude bonuses, various types of deferrals, or fringe benefits

• Don’t assume the definition of compensation in your 401(k) or other plans is same as ESOP’s definition.

• This is more likely to be an issue if two different attorneys draft the two documents.

• People assume they can send the same census data to both the 401(k) and ESOP TPA.

• Exclusions that require testing and the testing isn’t done or fails

Common Errors (continued)

How to Fix?

• Redo annual allocation work for all the years there is an error or compensation nondiscrimination testing problem

• This could mean people who were paid their balances could have more due to them or were over paid. This causes a new error that has to be properly corrected

How to Prevent?

• Know your plan document and the plan’s definition of compensation

• Communicate well with your TPA regarding the compensation being sent in the census data

Common Errors (continued)

• Exceeding 415 limits

• Total allocations to a given person cannot be more then 100% of compensation or $57,000 (2020) across ALL plans

• Correction can be done only under EPCRS

• Often times the correction can be done in the 401(k) plan by return of employee deferrals

• Correction can affect match and testing already done in 401(k) plan

Common Errors (continued)

• Economic fallout can create unique 415 potential failure

• For example, if a company has significant layoffs, furloughs, or pay reductions, a contribution in the amount of the required ESOP loan repayment might cause a 415 failure, as well as a 404 failure.

• Potential solutions:

• Supplement the contribution with distributions/dividends

• Modify the terms of the loan to allow temporary reduced payments—this involves fiduciary decisions by the trustee

Common Errors (continued)

• Release of Shares

• Formula used

• Principal only (rare)

• Principal and interest

• Does the amortization used reflect the loan agreement

• Correct interest rate

• 360 vs 365 days assumed

• Loan prepayments handled correctly

Common Errors (continued)

How to Fix?

• Redo annual allocation work for all the years the share release was computed incorrectly

• This could mean people who were paid their balances could have more due to them or could have been overpaid

• This causes a new error that has to be properly corrected

How to Prevent?

• Know your loan agreement and review the amortization

• Have your auditor review both the loan agreement and amortization the first year

• Review both again in years there is a prepayment to the loan

Common Errors (continued)

• Dividend/S-Distribution used for loan payments

• Must follow tracing rules

• Only dividends paid on shares acquired by that loan can be used to make payments on the same loan

• If dividends paid on allocated shares are used to make loan payments, the FMV of the shares released from those payments must be at least equal to the dividend the participant would have received

Common Errors (continued)

How to Fix?

• Redo annual allocation work for all the years the dividends were not properly allocated

• This could mean people who were paid their balances could have more due to them or were over paid

• This causes a new error that has to be properly corrected

How to Prevent?

• Review your TPA’s work to make sure TPA handled the tracing rules if you had more then one tranche of loans

•

If your stock has experienced a sharp decline, make sure the FMV of shares released to participants equals the dividends on allocated shares

IRS Focus on ESOPs

• IRS reviews Company and Plan tax returns, Company payroll records & Plan books and records

• Basic concerns include whether the contribution is timely, within the applicable limits, properly made, and title to physical plan assets is with Trustee

• IRS agent will often sample accounting of employees to see if all eligible employees included and receiving allocations and if allocations are within required limitations

IRS Focus on ESOPs (continued)

• S corporation ESOPs

• Special Distribution rules

• Anti-abuse compliance

• Prohibited transactions

• Valuation dates properly determined (i.e., a transaction between the plan and disqualified person requires an “as of” date)

• Compliance with ESOP loan exemption rules

• All required language in the Plan document and followed operationally

• Proper release of shares from suspense account

• Either principal and interest or principal only method properly used

IRS Focus on ESOPs (continued)

• Updated ESOP plan with all required legislative amendments

• In-Service Distributions

• Participant Loans

• Hardship Withdrawals

• Required Diversification at Age 55/10 Years of Participation

• Termination Distributions

• Retirement, Death, Disability

• Other Termination of Employment

• Anti-Cutback Rules

• Vesting

• Pass-through Voting Rights

DOL Examinations

• Generally, focuses on

• Transactions

• Qualifying Employer Securities

• Prudence

• Valuations (main focus as of late)

• Prohibited transactions

Problems Outside of EPCRS

• Form 5500 and Form 8955-SSA delinquencies

• Breaches of fiduciary duties

• Prohibited Transactions

• Deductibility and/or funding issues

• Section 409(p) violations

DOL Correction Programs

• The DOL provides compliance assistance through programs aimed at correcting fiduciary breaches under ERISA

• Delinquent Filer Voluntary Compliance Program (DFVCP)

• Voluntary Fiduciary Correction Program (VFCP)

DOL Correction Programs – DFVCP

• Delinquent Filer Voluntary Compliance Program (DFVCP)

• Available for late filing of the annual Form 5500 for all qualified retirement plans and

• NOTE – Health & welfare plans with 100+ participants (Enforcement Priority)

• May be used at a reduced penalty prior to an IRS or DOL notice or audit discovery

• Plans less than 100 participants - $750/year up to $1500 per plan

• Plans over 100 participants - $2000/year up to $4000 per plan

• C.f. Statutory Penalties:

• IRC - $250/day up to $150,000 per annual report

• Separate ERISA penalty unchanged: $2,200/day

• Following completion of program, the IRS also recognizes the Form 5500 as having been filed through DFVCP and will not penalize for late filings for those years

DOL Correction Programs – VFCP

• Voluntary Fiduciary Correction Program (VFCP)

• Other fiduciary breaches may be corrected through application to the DOL under VFCP

• Designed to encourage employers to voluntarily comply with ERISA by correcting fiduciary violations / breaches

• Procedure

• Identify violation

• Correct violation

• Restore losses or profits and interest to the plan

• Application to the DOL

• Upon acceptance, DOL will issue a “no action” letter

• IRS will also recognize no action letter

• No flexibility – Breach must fit squarely within one of the 19 categories

Secret Word Super Bowl

Takeaways

• Prevention of problems is best

• Draft the ESOP to be as similar as possible to your 401(k) plan

• Annual review/internal audit of ESOP

• If issue is correctable under a correction program, use the program

• If correction program is not available, hope that the statute of limitations will make the problem disappear

Brian D. Hector

Brian D. Hector counsels clients on Employee Retirement Income Security Act (ERISA) and employee benefits issues, including employee stock ownership plans (ESOPs), qualified benefits plans, executive compensation, fiduciary liability, and related securities matters. As head of Morgan Lewis’s ESOP Task Force, he advises public and private ESOP clients on corporate governance, succession planning strategies, ownership transition issues, and liquidity transactions. He also represents enterprises before the US Internal Revenue Service (IRS) and Department of Labor (DOL) in a range of ESOP and employee benefits matters.

Morgan Lewis

P: 312.324.1160

brian.hector@morganlewis.com

Brian counsels companies and shareholders in the use of ESOPs in a range of transactions, including equity repurchases, ownership succession transactions, leveraged buyouts, mergers and acquisitions (M&A), and corporate reorganizations. He represents lenders and trustees in ESOP transactions, as well as clients before the IRS and DOL in ESOP and other employee benefits matters.

With more than 25 years of experience addressing employee benefits and executive compensation issues, Brian is a member of, and lectures frequently before, the ESOP Association and the National Center for Employee Ownership. He also teaches executive compensation classes as an adjunct professor at John Marshall Law School, and he contributes regularly to the New York University Review of Employee Benefits and Executive Compensation.

Anthony Brunsvold

Blue Ridge ESOP Associates

D: 434.220.7941

Abrunsvold@blueridgeesop.com

Anthony Brunsvold is an associate at Blue Ridge ESOP Associates. He has more than 20 years of experience providing administration and consulting advice to ESOP clients. This includes all phases of the annual administration process, plan terminations, distribution processing, compliance testing and working with the plans other advisors and legal counsel to provide guidance on plan design and compliance issues. He has spoken at one other NCEO conference and several ESOP Association regional conferences. He is a CPA.