AC 23 Concurrent Session 4

The following information is for discussion and illustration purposes only. The information contained in today’s presentation is just an example transaction. This is not meant to be all encompassing for every transaction. Please consult your accountant.

• Showcase an example transaction

• Demonstrate the entries required to record the transaction and annual activity

• Discuss liability vs. equity treatment of synthetic equity

• Walk through financial covenant considerations and adjustments

• Detail example footnote disclosures

Initial Transaction - Accounting

Understand transaction economics

• Obtain final closing binder that details transaction economics

• Determine sequence of events

• Evaluate financing package (warrants, if any)

• Evaluate management incentive plan (ISOs/SARs)

Initial Transaction - Accounting

Understand the Sequence of Events

• Transaction can include:

• Pre-closing distribution

• Redemption

• ESOP Purchase

• Debt to third parties is a liability of the employer (Plan Sponsor)

Initial Transaction - Accounting

Sample Transaction

• ABC Shareholders sold 100% of their shares in ABC Company for $10 million on January 1, 2022.

• The transaction was funded with $4M senior (bank) financing and $6M seller financing.

• The transaction included a $2M preclosing distribution, $7M redemption followed by a $1M ESOP purchase. ($10M)

• The ESOP borrowed the $1M from the Company to establish the leveraged ESOP (internal loan).

Initial Transaction - Accounting

Understanding Leveraged ESOP Accounting

• ESOP is an employee benefit (ASC Topic 718-40)

• Leveraged ESOP – ESOP borrows $$ to purchase shares

• Unearned ESOP shares

• No “receivable” from ESOP reported by the employer

• Contra equity account

• Always measured and adjusted at cost (not fair value)

Initial Transaction - Accounting

Initial Transaction - Accounting

Understanding Warrants

• Typically used to compensate seller financed ESOP purchase

• Stated rate on Seller Note typically below market

• Allows sellers to participate in the success of the business

• Not considered outstanding stock for S corporation purposes, if designed correctly

Initial Transaction - Accounting

Understanding Warrant Accounting - Liability

• Company can’t settle warrant for equity

• Typically, holder has a put option to sell warrant back to company • S Corporation considerations

Initial Transaction - Accounting

Understanding Warrant Accounting - Liability

• Warrant recorded at fair value

• Warrant’s fair value booked as a liability with a corresponding debit to Note Payable-Discount

• New amortization schedule required due to discount on note payable

• Net effect, increase in interest expense

Initial Transaction - Accounting

Understanding Warrant Accounting - Equity

• Warrant is converted/settled in only shares

• Holder cannot settle the warrants for cash

Initial Transaction - Accounting

Sample Transaction – Financing Package

• The bank note will be amortized over 5 years at 7.5% interest. Annual payments of $988,658.87

• The seller notes will be amortized over 10 years (interest only while the bank debt is outstanding) at 5% interest. Annual interest only payments of $300,000 and annual principal and interest payments of $1,385,849.

• Simultaneous to the transaction, 20,000 warrants are issued on the Redemption Notes. At date of issuance, the warrants have a fair value of $400,000.

• The warrants contain a put option to sell the warrants back to the company therefore they are classified as a liability.

Initial Transaction – Pro Forma Balance

Impact to Common Balance Sheet Covenants

• Before considering incremental debt service costs, bank covenants that were in place before the transaction may be impacted

• When executing a leveraged ESOP transaction, your current banking covenants will likely need to be modified

• It is important to work with a lender that understands leveraged ESOP transactions and the impacts to a company’s financial statements and cash flows

Impact to Common Balance Sheet Covenants

• Tangible Net Worth is a common bank covenant that is used to measure a company’s actual book net worth (with intangible assets removed)

• Due to the increase in debt (and increase in contra equity), this covenant is often negatively impacted by a leveraged ESOP transaction

Impact to Common Balance Sheet Covenants

• Due to the increase in debt, senior and total leverage will increase

Ongoing Accounting

Annual, Recurring Entries

•

Annual payment on bank and seller notes

•

Amortization of note payable – discount

Change in fair value of warrants •

•

Annual ESOP contribution and loan payment •

Fair value of management incentive plan (SARs/ISOs)

Ongoing Accounting

Understanding Warrant Accounting - Liability

• New amortization schedule required due to discount on note payable

• Net effect, increase in interest expense

• Each year, the warrant liability is revalued to FMV and the liability is updated

Ongoing Accounting

At 12/31/22, the company makes a $688,659 payment on the bank term note and $300,000 interest only payment on the seller notes.

Ongoing Accounting Bank Note

Ongoing Accounting

At 12/31/22, the warrants have a fair market value of $550,000.

Ongoing Accounting

Understanding Leveraged ESOP Accounting

• Annual contribution to the ESOP is made and contribution is used make a payment on the internal loan

• No cash flow impact!

• Shares are released and allocated to participant accounts

• Company records compensation expense equal to the number of shares released times the price of the shares during the period

• Company records the cost basis of shares released to unearned ESOP shares

Ongoing Accounting

At 12/31/22, the Company makes a contribution of $50,000 to the ESOP. The ESOP uses the contribution and makes a $50,000 loan payment on the internal loan. Before the loan payment, there were 100,000 shares in suspense. The loan payment released 5,000. The share price at 12/31/22 was $15.

Ongoing Accounting

Understanding Leveraged ESOP Accounting

• Often, on Day 1, the unearned ESOP shares balance is the same as the dollar amount the ESOP borrowed to purchase the shares.

• After Day 1, the balance of unearned ESOP shares will NOT represent the internal loan balance

• On a go-forward basis, unearned ESOP shares should always represent the number of unallocated shares times the historical purchase price of those shares

Ongoing Accounting

Understanding SARs/ISOs

• Used to attract, retain and motivate management

• Deferred compensation – stock-based compensation

• Accounted for as equity or a liability – dependent on language

Ongoing Accounting

Understanding SARs/ISOs

• Generally, stock-based compensation is accounted for as equity unless:

• Settled for cash instead of equity

• Company right to purchase, and likely will

• Employee has the right to sell it back to the company

• Governed by ASC718 – stock-based compensation

Ongoing Accounting

Understanding SARs/ISOs

• Accounting for Compensatory SARs/ISOs

• Compensation cost measured at fair value

• Option Pricing Model to determine value (Black-Scholes Model)

• Cost recognized over vesting period

• Cost is a compensation expense with a corresponding credit to paid in capital.

• Non-public companies have option to measure award using the intrinsic-value method

• Intrinsic value is the difference between the strike price and the stock price

• The company must remeasure the intrinsic value at the end of each period

Ongoing Accounting

• During 2022, the Board awards 5,000 SARs to key employees. The strike price of each SAR unit is $4.50. The SARs vest equally over 4 years.

• At 12/31/22, the fair value of a SAR unit is valued at $6.00. On the same date, the fair value of common stock is valued at $5.00

Financial Statement Presentation

Financial Statement Presentation

What is my EBITDA-E?

Example Cash Flow Covenant

Financial Statement Presentation

Footnote Disclosures

• Repurchase obligation is not required to be reflected as a liability on the plan sponsor's balance sheet for private companies

• Plan sponsor should disclose the existence and nature of any repurchase obligation, including disclosure of fair value of shares allocated as of the balance sheet date

Financial Statement Presentation

Footnote Disclosures

• ASC Subtopic 718-40 requires the following disclosures:

• Description of the plan, basis for determining contributions and employee groups covered

• Description of accounting policies followed for ESOP transaction, including method of measuring compensation, classification of dividends on ESOP shares and treatment of ESOP shares for earnings-per-share computations

• Amount of compensation cost recognized during the period

• Number of allocated, committed-to-be-released and suspense shares held by ESOP as of balance sheet date

Financial Statement Presentation

Footnote Disclosures

• ASC Subtopic 718-40 requires the following disclosures:

• Fair value of unearned ESOP shares at balance sheet date

• Existence and nature of any repurchase obligation, including the fair value of the shares allocated as of the balance sheet date, which are subject to the repurchase obligation

Financial Statement Presentation

Footnote Disclosures

• Example warrant footnote would include:

• Description of warrants

• Method of determining fair value

• Inputs for determining fair value (if using Black-Scholes method)

• Estimated fair value at end of year

Financial Statement Presentation

Footnote Disclosures

• Example SARs footnote would include:

• Description of SARs along with vesting period

• Method of determining fair value

• Inputs for determining fair value (if using Black-Scholes method)

• Estimated fair value at end of year

• Number of SARs granted, exercised, forfeited and outstanding during the year

Secret Word for CE

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What

is

your company structure?

ⓘ Start presenting to display the poll results on this slide.

Company Structure

Why we became an ESOP?

 Considered selling to licensed employees only – fairness?

 Hard to get a bank loan for professional services owners to buyout shares

 Major tax benefits

Company Structure

Why a Minority ESOP?

 Woman-owned, Native American-owned

 Government clients with set-asides

 Minimum 15% increase in work

 Federal work pursuits

 Tribal work

 Needed additional work to offset decrease in other lines of work

 Clear person in control of final decision-making

How

old is your ESOP?

ⓘ Start presenting to display the poll results on this slide.

Our Minority ESOP

Source: https://www.moneylion.com/learn/6-strategies-on-how-to-pay-off-debt/

Problems We Faced



How to get shares to new employees?



What is the goal? – Retainment, Recruitment, or Retirement?

Contribution vs Distribution

Profit distribution to owner causes issues for ESOP

Contribution vs Distribution

 Contribution goes to current employees, NOT former employees

 Owner can get bonus or salary increase (or nothing)

$0 to Owner

$100k contribution

$100k to ESOP

TAX FREE

Dist based on current year SALARY

Problems We Faced

Initial items noted:

 Paid internal loan too fast

 Repurchase obligations spread out too far

 Did not convert to cash/segregate upon retirement

 Need advice from experts

Have and Have Nots

Haves: significant amount of shares (can include terminated participants)

Have Nots: have little to no shares or they are not available

 Too many shares allocated early on

 Repurchase of terminated shares lengthy (3 year waiting period, followed by 5 installments)

Contribution vs Distribution

Contribution vs Distribution

All cash goes to current employees!

Have and Have Nots

How to prevent? One tool is Safe Harbor.

 Gave employee accounts some excess cash

 Helps cover the cash needs of the internal loan and repurchase obligations

 Pays majority of ESOP repurchase obligations

 Helps with cash outlays

Safe Harbor

This helps reduce have’s vs have nots

Problems We Faced

Initial items noted:

 Paid internal loan too fast

 Repurchase obligations spread out too far

 Did not convert to cash/segregate upon retirement

 Need advice from experts

Problems with Minority ESOPs

Add shares? Nope

 Majority owner would need to have shares bought (no flexibility since 49/51)

Do a stock split? YES!

 But does it help? Nope

Plan Design - Repurchase

1. Bring in the experts!

 Repurchase Obligation

Study done by ESOP plan administrator

2. Repurchase faster

 More shares available to employees

Plan Design – Repurchase

 Increase minimum payout lump sum amount and increase gradually (started at $5k, currently at $15k)

 Add segregation (conversion to cash) to the plan document

 Focus on accelerating payments to terminated participants to allow available stock for newer participants

 Conserve future cash outlays by buying while the stock values are lower, all things equal

Plan Design - Rebalance

All accounts are rebalanced at the end of the plan year to have the same ratio of stock to cash

 Amendment added rebalancing to SPD

 Safe Harbor and contributions help newer employees get cash in the plan to purchase some stock

Plan Design - Segregation

Separate terminated participants and convert them to cash

 Written into plan document

 Do this as soon as ESOP and company have more stable cash flow

 Helps ensure that active participants will be the ones holding the stock shares

 Does create need for cash at participant termination but can be made relatively flexible

 Major buy-in! Keeps terminated participants from participating in growth

 Do this as cash is available

Plan Design - Releverage

In the future… Repurchase all shares from the former participants in 1 or 2 years and then stretch the allocation of the repurchased shares over several years

Plan Design - Releverage

Step 1 : Accumulate enough cash in ESOP to purchase all shares from terminated participants

Step 2 : Purchase shares from terminated participants

Step 3 : ESOP acquires the shares from the company using internal loan

Step 4 : New loan spreads the distribution of shares over the life of the loan, i.e., 7 years

What ways are there to prevent have's versus have not’s?

ⓘ Start presenting to display the poll results on this slide.

What we learned

 Do contributions in lieu of distributions

 Pay majority stockowner in bonuses or salary instead of distributions

 Provide for some flexibility – do a 60/40 ownership structure instead of 51/49 so there is room for the ESOP to purchase additional shares over time

 Make rebalance a part of the SPD from the very beginning

 Incorporate segregation into the SPD earlier

Takeaways

Review your actual ESOP SPD Advisors/Building your team

 Experienced lawyer

 Good ESOP administrator

 Strong CPA

This Photo by Unknown Author is licensed under CC BY-SA-NC

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What is Executive Compensation?

• Executive compensation is composed of the financial and other non-financial awards received by an executive or other service provider from their Company for service to the Company

• It is the role of the Company’s Board of Directors or a committee thereof to set the compensation for management team of the Company

Objectives of Executive Compensation Program

• Recruitment and retention

• Incentivize performance and shareholder return

• Increase ownership stake

• Target key individuals

• Motivate performance to advance the Company’s longterm interests

• Wealth accumulation based on financial performance

Equity-Type Awards

• Advantages/Positive Results

• Align service provider interests with interests of shareholders

• Provides performance incentive that is contingent on the ESOP’s performance

• Retention and recruitment of key employees and other individuals

• Often you can avoid Code Section 409A

• Tie awards to annual valuation

Equity-Type Awards

• Disadvantages/common mistakes

• Failure to understand the complexity and need to get it right

• Failure to adequately plan for payout potential

• Limited alternatives for terminating the program

• Failure to adequately document and manage the program

Types of Awards

• Two Broad Categories:

• Awards that provide the full value of the underlying shares

• Awards that provide the appreciation in value of shares

• Real or Synthetic Equity

• Considerations:

• Dilutive effect of additional shares

• ESOP ownership (if 100%, no real shares available)

• Value proposition to employees may be more attractive with real equity

• Eligibility for awards

• Cash Awards

Overview of Compensation Plans

• Compensation plans can meet a variety of goals

• Retention of key employees and contributors

• Alignment of interests between management and shareholders

• Provides performance incentives

• Can and should be used in 100% ESOP-owned companies

• Management incentive plans can take numerous forms

• Profit sharing plans

• Discretionary bonuses

• Equity based compensation

Issue with Equity Awards?

• What is the potential problem with these equity award grants?

• If your goal is to be a 100% ESOP-Owned company, you don't want to pass out additional equity to employees.

• Can also create control issues for partially owned ESOP companies

• Solution:

• Equity-Based Awards-Measured by the stock value, but payment in stock is not required

Corporate Governance and Administration

• Establish plan and form of award agreements

• Board should decide whether to delegate authority to grant or set terms of awards (e.g., Board committee or CEO)

• Establish award implementation process with stakeholders (e.g., accounting, payroll)

• Establish recordkeeping and administrative procedures - some vendors provide a commercial platform

• Establish FMV of stock subject to awards

• Even though these types of equity incentive plans are not subject to ERISA, good ERISA-like administrative practices are important!

Employee Education

• Receiving an equity award is a new experience for many employees who may have little or no prior knowledge

• Explain the basis for their selection for an award and the potential value to them

• Be careful not to provide tax advice, but outline the basics and encourage them to consult independent tax advisors

• Emphasize that employees are responsible for monitoring their own awards (for example, exercising an option before it expires)

Using External Advisors

Make sure to use external advisors, including:

• Legal counsel

Valuation firms

• Compensation consultants

Recordkeepers

• Accounting/tax advisors

Stock Appreciation Rights

• Right to receive value equal to the amount by which a given number of shares of stock have appreciated since grant

• Time and/or performance vesting conditions can be attached to SARs

• Like options, employees must exercise a SAR to receive the award

• Usually paid in cash, but can be paid in an equivalent value of stock

• Employee recognizes compensation income equal to the value of the payment (whether in cash or stock) upon exercise of the SAR

Stock Appreciation Rights - Example

• Employee receives a grant of 100 SARs, vesting after 2 years, at a time when the value of the underlying stock is $10 per share

• After 2 years, SARs become vested and the stock is worth $11 per share but the employee chooses not to exercise them, so there is no income event

• After another 2 years, the stock has increased to $13 per share and the employee exercises the SARs

• The employee receives a cash payment of $300 (less tax withholding)

• The employee recognizes ordinary income of $300

Phantom Stock

• Promise to pay a bonus equal to the value of an umber of shares of stock or some other calculation based on stock price

• Ordinary income at vesting/payment

• Usually a full value award (i.e., no exercise price)

• Can be tied to performance standards or not

• Can promote retention, performance or not

• Generally, subject to Code Section 409A

Phantom Stock-Example

• 100% ESOP company wants to promote executive retention and performance.

• Phantom stock plan has set number of "Phantom Units" to award to participants.

• Award of units tied to measure of company performance (e.g., EBITDA target).

• Awarded Units credited to phantom unit account.

• Participants may also receive a credit equal to cash or stock dividend equivalents attributable to shares.

Phantom Stock-Example

• 5-year vesting schedule:

• 20% per year on each anniversary of grant date

• Payout on a specified date after vesting or on termination of employment for full value of shares as of most recent valuation date prior to payment.

• Payment alone promotes retention.

• Tying payment to performance measure and also basing the amount of the payment on the value of stock encourages performance.

Phantom Stock-Example

• Company has both domestic and international employees

• International employees not eligible for ESOP

• Create phantom stock plan that largely mirrors ESOP so that international employees can effectively participate.

Other Types Of Awards

ISOs vs. NQSOs

Cash Bonus/Performance Awards

What about Warrants?

• Warrants are similar to stock options in that the allow the purchaser to purchase stock at a fixed price for a certain period of time

• Rarely used for compensatory purposes

• Commonly used in ESOP transactions with seller financing

• Seller receives warrants in exchange for accepting a lower interest rate.

• Seller paid the difference between the strike price when the warrants are issued and the appraised ESOP stock value when exercised

Warrant-Example

• ESOP transaction financed with seller financing

• Market rate for debt estimated at 10%.

• Instead of paying that much cash interest, rate on debt is set at 5%.

• Saves company cash (often very helpful when significant leverage taking on for transaction)

• Less taxable income in short term for seller

• Difference in value between note at 10% and 5% made up with warrant grant to seller

• Keeps "skin in the game" for the seller

• Pushes out payment for company

• Warrant can be structed to pay cash (not stock) to preserve 100% S-Corp ESOP

Plan Drafting Issues for All Types of Awards

• Administration by Board or Compensation Committee

• Plans will usually specify a limit on the number of shares that may be issued under the plan

• Adjustments for stock splits, etc.

• Treatment of awards upon death or disability of participant

• Treatment of awards upon a change in control

• Frequently, all awards will become vested and "cashed out" upon a change in control

• Awards can also be "rolled over" into the new company, but this is less common in private company context

Code Section 409A

A deferred compensation plan must provide that deferred compensation can be paid only upon the occurrence of one or more of the following events:

• Separation from Service

• Disability

• Death

• Specified time or pursuant to a fixed schedule

• Change in Ownership

• Unforeseen Emergency

The plan must not permit acceleration of the time or schedule of payments under the plan.

Code Section 409A

• Code Section 409A governs deferred compensation plans

• Amounts subject to Code Section 409A are subject to strict payment timing rules with little flexibility to change

• Failing the requirements of Code Section 409A subjects the employee to an additional 20% tax, plus interest

• Code Section 409A regulations provide exceptions that can keep equity arrangements outside the reach of Code Section 409A

• Make sure that your plans and awards are reviewed by someone with expertise in this area so that you can avoid Code Section 409A

Code Section 409A

• The plan must irrevocably specify the amount, time of payment and form of payment of deferred compensation

• Violations of Code Section 409A will result in a 20% penalty, income inclusion, and additional interest rate on the tax on the income for an earlier year

• Consult your lawyer and ask whether your company' s plan is Code Section 409A compliant or subject to an exemption

• Stock Options and SARs do not constitute deferred compensation under Code 409A if structured properly

Code Section 409(p)

• Code Section 409(p) is an anti-abuse rule that applies to ESOPs sponsored by S corporations

• Failing to meet Code Section 409(p) is a disaster for the ESOP

• Company is subject to 50% excise tax of value of prohibited allocations and synthetic equity for "disqualified persons"

• ESOP no longer qualifies as an ESOP

• Equity compensation plans are "synthetic equity" that is taken into account in the Code Section 409(p) testing - even if the ESOP owns 100% of the outstanding stock

• If you have an ESOP that owns an S corporation - or are thinking about it - plan for Code Section 409(p) before implementing the program, and constantly monitor it

• Proper coordination of all your incentive compensation programs can avoid Code Section 409(p) issues.

Company Perspectives

• Use independent board members to review compensation and approve arrangements overall, and to make individual grants

• Analyze aggregate compensation to ensure it is reasonable and competitive

• Ensure someone owns the administration and management of the programs

• Consider using a compensation consultant to provide market analysis and support a clean corporate governance process

• Documentation is key (for Company and Trustee considerations)

Trustee Perspective on Equity Awards

• Tying executive/management interests to increasing value for shareholders/ESOP Participants is good Retention tool for keeping key executives on-board

• If Company does well, ESOP does well and Executive does well

• Conversely, a large cash bonus program may be sending $ out the door even when Company is not delivering on projections

• Performance Awards are generally favored by Trustees, so awards only happen if company projections are met or exceeded

• Overall dilution should be considered

• Awards may be tied to non-competition provisions

Trustee Perspective on Equity Awards

• Good plan design can ensure Trustee concerns are addressed:

• Create an executive retention incentive with adequate vesting schedule

• Limit dilution via pool of total awards

• May include annual award limitations

• Use performance hurdles to initiate awards

Valuation Overview

• Valuation is undertaken at the time of an ESOP transaction and then, annual valuations thereafter

• Make sure that the executive compensation plans are being properly taken into consideration in ESOP valuations (both transactional and annual)

• Understand what valuation method is being utilized to value the executive compensation plans/awards that are in place/issued

• Intrinsic Value Method v. Option Pricing

Potential Impact on Annual Valuations

• The terms of the plan are key to analyzing the dilution, including the related “benchmarks”

• If performance-based benchmarks, the dilution is generally related to future appreciation

• If benchmarks are strictly driven by the passage of time (i.e. annual vesting), the dilution may be more immediate

• The relevant "exercise" or "strike" prices for the plans are typically based upon the post-transaction ESOP values (which incorporates the effect of any transaction debt)

Next Steps

• Questions?

State Street Global Advisors: CIT 101

Tracking code: 5521915.1.1.AM.INST

Ned McNally, Sr. Retirement Director

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

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

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The Proliferation of CITs in DC Plans

48% of 401(k) assets are CITs 33% of target date funds are CITs –a 11% increase since 2017

Sources: Department of Labor, Cerulli Associates: Cerulli Report, U.S. Retirement Markets 2022 as of February 27, 2023. Analyst Note: Mutual fund assets include variable annuity mutual funds. Tracking code: 5521915.1.1.AM.INST

CITs in the Small Plan Space

Tracking code: 5521915.1.1.AM.INST

21% increase in CIT interest by the $5m–$24m plan asset segment from 2021 to 2022

$5-$24m Plan Asset (USD) 2021 2022

Source: Cerulli Edge, U.S. Asset and Wealth Management Edition as of December 2022

CIT and Mutual Fund Characteristics

At a Glance Comparison

What They Are

CITs

• Commingled investment vehicles typically maintained by a bank or trust company and offered only to certain qualified retirement plans

Mutual Funds

• Commingled investment vehicles typically maintained by an asset management company and available to most retirement plans as well as the general public

Oversight and Regulation

• Often regulated by the Office of the Comptroller of Currency (OCC) and the IRS and Department of Labor (DOL)

• Fund trustee can be subject to ERISA standards aimed at protecting plan participants

• Regulated by the Securities and Exchange Commission (SEC), among other statutes, under the Investment Company Act of 1940, as amended

• Manager not held to ERISA standards

Governing Documents

• May be governed by a declaration of trust and investment/operating guidelines

• For participants, usually provide fund fact sheets or work with third-party provider to create them

• Primarily a prospectus and statement of additional information

• For participants, usually provide fund fact sheets or work with third-party provider to create them

Reporting

• Audited financial statements

• Subject to DOL and ERISA reporting requirements, including but not limited to Form 5500 Schedule C and Sections 404a-5 and 408(b)(2) of ERISA

• Annual report

• Subject to DOL and ERISA reporting requirements, including but not limited to Form 5500 Schedule C and Sections404a-5 and 408(b)(2) of ERISA

Fee Structure

• May have multiple share classes

• Potential for negotiated pricing arrangements

• May have multiple share classes

Trading

Source: State Street Global Advisors

Tracking code: 5521915.1.1.AM.INST

• Most can trade via National Securities Clearing Corporation (NSCC)

• Usually daily valuation

• NSCC trading

• Usually daily valuation

Lower Costs and Greater Flexibility

Typically lower expenses due to lower overhead

Source: Mercer Global Asset Manager Fee Survey 2020. Fees Assume $100M asset minimum level. Tracking code: 5521915.1.1.AM.INST

Meaningful CIT Tax Benefits

Investing Internationally Keeps More Money in the Fund

Source: MSCI Index Data, published ERISA and RIC Tax Rates, as of Date 12/31/2021. Past performance is not a reliable indicator of future performance. Tracking code: 5521915.1.1.AM.INST

Securities Lending in DC Funds

Returns Securities lending returns are relatively straightforward to assess. However, as with most investments, returns often reflect risk in the program, and should be considered along with the objectives and risk tolerances of the program. It is important to confirm that return figures provided are net of all costs and fee splits, and are provided relative to total fund assets

Questions to ask:

1. Are the returns indicated net of all fees? Are the returns expressed relative to total fund assets?

2. 2. Is the program focused on intrinsic value of securities lending, or enhancing returns with aggressive reinvestment guidelines?

3. 3. Does the fund benefit from preferential withholding rates for retirement funds on foreign dividends

Risk Management The risks associated with a securities lending program can be complex to identify and measure. Investors should understand and may want to consider three primary types of risk associated with securities lending:

1. Reinvestment risk derives from the reinvestment of cash collateral received to secure a loan.

2. 2. Borrower default risk derives from a borrower’s inability to return securities in accordance with agreed terms.

3. 3. Operational risk derives from the increased transaction volumes and management complexity associated with a lending program

Questions to ask:

1. Do your collateral reinvestment funds adhere to quality, maturity, liquidity, and diversification requirements set forth in Rule 2a-7?

2. 2. What are the maximum weighted average life (WAL) and weighted average maturity (WAM), and other liquidity guidelines for the collateral reinvestment pools? What are the credit quality guidelines and permissible instruments for the reinvestment pool?

3. 3. Do you accept non-cash collateral? What types of non-cash collateral do you accept?

4. 4. Is there borrower default indemnification? What entity provides it?

5. 5. Do you have dynamic lending limits at the fund and position level? What determines those limits?

Costs There can be significant costs associated with managing a securities lending program, and it is important to understand where the costs are borne, and who is receiving compensation. While the “fee split” is often the headline expense communicated by an investment manager, there are many ways this fee can be calculated. Additionally, the “fee split” may not be the only expense paid in a lending program. There are often fees embedded within the cash reinvestment pool, or additional operational or administrative fees applied to the program either by the lending agent or the lending fund manager. This all needs to be understood to make an informed decision regarding a securities lending program.

Questions to ask:

1. What is the fee split with the lending agent? Are there other fees charged to the lending program?

2. 2. Are all transactional costs borne by the lending agent? Does the lending fund manager charge any additional fees?

3. 3. What are the total expenses of the cash collateral reinvestment vehicle?

4. 4. Does the lending fund manager (or an affiliate) benefit from the fees charged to the reinvestment fund?

5. 5. Are there any conflicts of interest inherent in the lending program?

Public Policy’s Role In CIT Growth Lifetime Income Only Available in This Vehicle

SECURE 1.0

Broadens fiduciary safe harbor for plans selecting an annuity provider

Enables portability of lifetime income products in retirement plans

Requires annual Lifetime Income disclosure benefit statement

SECURE 2.0

Increases Qualifed Longevity Annuity

Contracts (QLAC) dollar limit to $200,000 Clarifies 90-day free look period

Payment of the lifetime income is subject to the claims-paying ability of the issuing insurance company; it is possible that the issuing company may not be able to honor the income payouts at any time. Neither IncomeWise nor the QLAC are insured by the FDIC or by another governmental agency; they are not obligations of the FDIC or deposits or obligations guaranteed by SSGA. The QLAC is not provided by or guaranteed by SSGA or any affiliate of SSGA. QLAC purchases are subject to regulatory limitations.

Tracking code: 5521915.1.1.AM.INST

Indexing Is In Our Core

Suite of index CITs designed to serve as a simple and effective foundation of a 401(k) investment menu:

• Range of low-cost exposures allows investors to build portfolios to achieve a variety of investment objectives

• Securities lending capabilities intended to enhance returns in a risk-controlled framework

• Net NAV Fund structure

1991 Launched Inaugural CIT

58% Of 331 CITs allow securities lending

2 State Street Global Advisors, Business Intelligence Gateway as of December 31, 2022.

Source: State Street Global Advisors Tracking code: 5521915.1.1.AM.INST

Important Disclosures

For Investment Professional Use Only.

Investing involves risk including the risk of loss of principal.

Securities lending programs and the subsequent reinvestment of the posted collateral are subject to a number of risks, including the risk that the value of the investments held in the collateral may decline in value and may at any point be worth less than the original cost of that investment.

SSGA Target Date Fund are designed for investors expecting to retire around the year indicated in each fund’s name. When choosing a Fund, investors should consider whether they anticipate retiring significantly earlier or later than age 65 even if such investors retire on or near a fund’s approximate target date. There may be other considerations relevant to fund selection and investors should select the fund that best meets their individual circumstances and investment goals. The funds' asset allocation strategy becomes increasingly conservative as it approaches the target date and beyond. The investment risks of each Fund change over time as its asset allocation changes.

The guaranteed lifetime income benefit is a type of deferred income annuity, called a qualified longevity annuity contract (QLAC), which is an insurance product that guarantees money at a future date, typically for the rest of an individual’s life. Participants who redeem from the fund prior to the QLAC purchase will not be eligible for the QLAC benefits. The QLAC is subject to regulatory limitations. The QLAC purchase is subject to market availability and cannot be guaranteed in any given year. The QLAC is not provided by or guaranteed by SSGA or any affiliate of SSGA. Neither IncomeWise nor the QLAC are insured by the FDIC or by another governmental agency; they are not obligations of the FDIC or deposits or obligations guaranteed by SSGA. You cannot reverse the purchase of the QLAC.

None of State Street Global Advisors or its affiliates (“SSGA”) are acting in a fiduciary capacity in connection with the provision of the information contained herein. State Street Global Advisors’s role as a fiduciary with respect to the products and services described herein commences once State Street Global Advisors has been retained to act in a fiduciary capacity pursuant to a written agreement in exchange for a fee. Prior to such time, State Street Global Advisors is not undertaking to provide impartial investment advice or to give advice in a fiduciary capacity in connection with the sale or distribution of the products or services described herein. State Street Global Advisors has a financial interest in the sale of our investment products and services.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent.

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

Web: www.ssga.com

United States: State Street Global Advisors, 1 Iron Street, Boston, MA 02210-1641.

© 2023 State Street Corporation. All Rights Reserved.

Tracking Code: 5521915.1.1.AM.INST

Expiration Date: 3/21/2024

Secret Word for CE

College Basketball

State Street Global Advisors: CIT 101

Tracking code: 5521915.1.1.AM.INST

Ned McNally, Sr. Retirement Director

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.

What is a Talent Management Strategy?

A talent management strategy is a formal plan to hire, develop, and keep employees.

Ideally, a talent management strategy is guided by data, and customized to the company’s needs.

Why is Having a Talent Management Strategy Important?

Here are some of the most notable pros:

#1 Your costs drop.

• Labor accounts for as much as 70% of business expenses (Paycor).

• Every time someone leaves your company, it costs you the equivalent of 6 to 9 months of their salary (SHRM).

• Talent management strategies can reduce turnover by improving the employee experience.

Why is Having a Talent Management Strategy Important?

#2 Your employees power up.

• Economists call people human capital for a reason.

• Organizations with a strong learning culture are 52% more productive (Deloitte).

• As your employee skill sets grow, so does your business.

Why is Having a Talent Management Strategy Important?

#3 Your business strategy becomes easier to execute.

• Ensures your talent matches your business strategy.

• Right people right roles = productivity & engagement.

• Focusing on strengths increases employee performance by up to 18% (Gallup).

• Align the behaviors of your employees to their role and in turn, align each team to their business objective.

The study covers more than 82,000 teams over 1.8millionemployeesin 230 organizations across 49 industries and in 73 countries.

Why is Having a Talent Management Strategy Important?

#4 You gain a huge competitive advantage.

• Many companies constantly lose their top performers which impedes their ability to compete.

• Hiring the right managers and individual contributors boosts company revenue by a combined 33% (Harvard Business Review).

• By improving your talent acquisition, talent management strategies make sure you have the best people.

Core Components of a Talent Management Strategy

Plan

Every talent management strategy starts with strategic workforce planning.

Asking questions, such as:

• How many people do you need to hire?

• Which roles or departments do you need them in?

• What skills or behaviors mean success in those roles?

• When do the positions need to be filled?

To answer these questions, you need other information, such as:

• Your business goals.

• Your business strategy and department strategies.

• Your desired company culture.

Identify

Identify where your plan is succeeding, and where it’s falling short. That requires data.

Data such as:

• Employee turnover rates to identify if a retention problem exists.

• Employee engagement surveys to identify the causes of turnover.

• Exit interviews and employee interviews to identify ways to improve the employee experience.

• KPIs for individuals to identify when an employee’s performance needs improvement.

• KPIs for departments to identify systematic causes of underperformance.

Hire

Talent management strategies emphasize effective hiring practices.

Several common ways companies achieve this:

• Expand the talent pool through referral programs.

• Attract better candidates through a strong employer brand.

• Select better candidates through candidate assessment tools.

• Hire candidates that add unique value to their teams with team assessment tools.

Train

Training is one of the most important parts of a talent management strategy.

HR departments often use the following tools:

• Comprehensive onboarding, so that new employees start the job with more confidence.

• Internal learning and development programs to refine employee skills.

• Reimbursements for external classes, to help employees gain new skills.

• Mentoring programs to develop employees and share knowledge across the company.

Retain

Employee retention is another major focus of the Talent Management Strategy.

Tactics include:

• Reward high performance to encourage the best talent to stay.

• Create a positive company culture so that employees feel happier at work.

• Connect work to a compelling mission so employees feel driven and excited about work.

• Analyze/adjust the total compensation package to improve the employee value proposition.

• Create succession plans for senior leaders.

How to Implement a Talent Management Strategy Model

Identify Business Objectives.

Start with the basics:

• Which goals is your business pursuing over the next year?

• What about over the next five years?

• How do the initiatives of each department play into those goals?

• What does long-term business success look like?

Once you know your business objectives, you can start matching your talent to your objectives.

Match Talent to Your Objectives

Next, you’ll need to work with HR and your leaders to figure out how talent can help you achieve those objectives.

Questions might include:

• Which roles are most important to achieving each goal?

• What will strong employee performance look like in those roles?

• Which skills or behaviors will help people perform?

• How many people will we need in those roles?

Then, you need to diagnose your current talent problems.

Diagnose Your Talent Obstacles

Gather Metrics and Data.

Some approaches include:

• Use employee engagement surveys to find out where problem areas exist.

• Implement KPIs to identify underperforming departments and individuals.

• Use behavioral assessment tools to find out where people might be misaligned with their jobs.

• Create analytics for outreach emails, job postings, and other hiring elements.

• Interview recruiters, managers, and employees to find out the biggest obstacles to retention, hiring, and performance.

Now that you know your core obstacles – let’s focus

Decide Where You Need to Focus

It makes sense to focus on the most pressing issues.

Areas of focus typically are places where:

• Your current talent strategy is falling behind your business goals.

• Your current talent strategy is underperforming other businesses in your sector.

• You can create large efficiency gains through minimal effort or expense.

After you decide where you need to focus, you can create a plan of attack.

Create a Plan of Attack

You should have all the information you need to start developing solutions. If not, consider revisiting one of the previous steps.

⁻ You need to state the who, what, when, where, and why the solution is being implemented.

The solution needs a clear gauge of success and is tied to one of your talent problems.

⁻ Consult with affected departments to ensure the goal is reasonable to achieve with the time and resources available.

⁻

Have a specific date it must be completed and tracking mechanism.

Get Input and Buy-in From Key Stakeholders

A key to organizational change is stakeholder management.

Without support from key leaders, you may have trouble implementing key parts of your strategy. In addition, you may also gain useful ideas and approaches you hadn’t considered.

Some assumptions may change and some may fall to the wayside. That’s OK.

Stakeholders are bought in & move to the final step, Technology.

Identify Where Technology Could Help

Companies sometimes reinvent the wheel when solving talent problems. Often, the software already exists to make these solutions easier.

Talent Management Systems can help your company:

• Create consistent employee onboarding.

• Quickly develop new learning courses.

• Implement effective performance management.

Talent Optimization Software can help your company:

• Discover if a candidate is naturally suited to a job.

• Create teams that align with your business goals.

• Develop targeted strategies to solve low engagement.

Quarter Reviews

We have a hypothetical company: FarmCo. They’re a medium-sized business that sells agricultural equipment. Identify business objectives Match talent to objectives Identify talent obstacles Create a plan of attack Identify where technology could help

Expand sales by 30% in 2024

Hire an experienced Sales Director to grow domestic and international sales teams. Must be independent, and drive change.

Salespeople are good at selling themselves which makes interviewing salespeople difficult. The company does not have a good compensation plan for achieving sales growth.

Standardize interviews with validated behavioral data tools. Create a new pay-forperformance incentive plan that rewards top performers.

Invest in pre-employment assessment tools to make sure candidates are the right fit based on job target.

Secret Word

Crowne Center

Information Sharing in Employee-Owned Companies

What to Share and How

Jennie Msall Jesse Tyler

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

Why share information?

What information do employee owners want and need?

What’s needed to make information sharing effective?

Information sharing at Hypertherm

Icebreaker

In your group, discuss:

• What was a food you hated to eat as a kid?

• Right now, what information or clues give you a sense of whether your company is winning or losing financially?

Be prepared to share the answers.

WHAT DOES IT TAKE TO WIN FINANCIALLY?

“How can players decide on their strategy if they don’t know the score?” – Jack Stack

It’s a Whole Process

Participation: Let them Play

Incentives: Share the Win

Communication: Show the Score

Training: Teach the Rules and Equip People with the Skills

Foundation: Leadership vision for how ownership should contribute to achieving strategic business objectives

From the Employee Owner’s Perspective

What “ownership” means:

• Transparent communication - I should know…

1. Our goals and general strategy

2. How we’re progressing

3. How what I do impacts company value

4. Successes and challenges

• Having a “voice” – being asked to offer ideas/suggestions – and listened to; Participate in solving problems about which I have knowledge

• Being treated fairly and respectfully

• Sharing in the financial success of the company and knowing how you contributed

What information does an owner need to know?

Company financial profitability goals

Goals for key business unit metrics

Company progress on its goals

Business unit progress on its goals

Numbers that identify opportunities for improvement

Lessons from Hypertherm

What information does the company share with employee-owners?

What has been most impactful?

What challenges have you experienced with information sharing?

What’s your experience?

What are the opportunities for employees to learn about the business where you work? What additional opportunities would you like to see, if any?

Do you have access to company information that you want as an employee-owner? What else, if anything, would be useful?

Building Financial Literacy

• How the company makes or loses money, how money is spent, and what happens with whatever money is left.

• How to read and understand the numbers in company reports that are shared.

• Which numbers they can impact, and which they can’t, and how their actions impact company profitability.

• How company performance connects to share value

• How they benefit from financial success through job stability, profit sharing, the ESOP, other incentives

Lessons from Hypertherm

Why did you decide to invest in building financial literacy?

What were the challenges in investing in financial literacy?

What have been the positive outcomes of investing in financial literacy?

Systems for Engaging Financial Literacy Skills

All Employees Select Group

Company-wide contest for best idea for improvement

Managers use regular department meetings to review financial information and generate ideas for improvement

A committee meets regularly to generate ideas for improvement Employee Involvement Frequency of System

Regular

Make Engagement Part of Every Manager’s Job

Expectations for Managers

• Regularly share and report out on business unit metrics in individual check-ins or regular team meetings, along with

• Regularly ask for ideas for improvement in any specific numbers

• Support employee-owners in vetting ideas to determine which ideas to act on

• Support employee-owners in collaboratively implementing ideas

Investing in Managers Skills

• Communication

• Coaching team members

• Delegation

• Accountability

Secret Word Penn Valley

Lessons from Hypertherm

What systems do you have at Hypertherm

that engage employeeowners’ financial literacy skills?

How do you ensure this happens at all levels of the company?

Lessons from Hypertherm

• Everyone wants it to work

• How to teach the information you already share fosters excellent discussion around EO values, culture, and more

• Consensus + fresh eyes = best outcome

• Get the right decision makers at the table

• Check the content in development with non-experts

• Keep it relatable. “It’s like when…(they are the experts).”

• Start with leaders, then train the rest of the organization

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.

Preparing for a CEO or Other Key Executive Transition

It’s a Board Thing

“CEO succession is the #1 role of the Board.”

“A change of CEO is one of the most crucial events in the life of a company.”

“Most important job of a board is to choose the CEO.”

Other Roles

Outgoing/Retiring CEO Consultative Development

Service Providers Specific tactics/to do’s Human Resources Coordination Development

5-4 Years from Transition Getting Started

Well Functioning Board of Directors​

• Outside Board Directors​

• Solid Governance Structure​

- Bylaws, Articles of Inc., Guidelines​

- Expectations of Board Directors​

- Board Review Process

4-3 Years from Transition

Begin discussions at Board level regarding Transition/Succession

• Potential Timelines/Formats

• Goals for the Transition Period

• Begin Discussing Potential Successors

• Create Access for SLT Members

• Build/Revise Strategic Plan

4-3 Years from Transition (cont.)

Strategic Planning

Strategic Planning is an ongoing process that provides a roadmap for taking us from a well-defined Present State to a compelling and significantly different Future State.

3-2 Years from Transition

Build the Org Chart of the Future (5-7 years out)

Build the CEO Profile (CEO of the Future)

Key skillsets, experience, abilities tied into strategic plan

3-2 Years from Transition (cont.)

• Evaluate current leadership team against new CEO profile, identify potentials and gaps

• Assessments (Hogan, OMNIview, DDI)​

• 360 degree reviews​

• Create training/development for any gaps that could be bridged​

• Mentoring, Coursework, etc.

18 Months – 1 Year from Transition

• Evaluate progress on internal candidates​

• Create recruiting/hiring plan

• Internal Only, Internal/External, External Only​

• Build list of goals and objectives for outgoing CEO​

• Transition items, Training, Relationships​

• Identify appropriate “overlap” time between outgoing CEO and new CEO

9 – 3 Months from Transition

• 7-9 Months Out

• Begin recruiting/search/hiring process

• 3-6 Months Out

- Hire, internally communicate and publicly announce new CEO

- Complete onboarding plan Specific development/assimilation for new CEO

Post Hire

• 30, 60, 90 Days & 1 Year After Hire​

• Execute and tweak onboarding plan​

• Intentional/Additional Communication with Board Director(s)

• Potential Coaching & Development Work​

• On-Going Communication with Employee Owners

Don’ts

• WAIT TOO LONG​

• Wherever you are, just get started​

• SKIP THE BACKGROUND WORK​

• Board

• Strategic Planning​

• Team Evals​

• BE PASSIVE​

• Board members highest responsibility is to make sure right CEO is in place, don’t be afraid to discuss transition, start planning​

• ASSUME

• That People Know, That People Don’t Know

Secret Word for CE

Midland

Private Capital Investments in ESOP-Owned Companies –The Developing Trends

Matt Ewing Director

Matt Dennison Vice President

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

Learning Objectives

At the end of the discussion, you will be able to:

1. Better grasp the universe of alternative private capital investment strategies for ESOP companies

2. Understand the advantages and considerations of adopting these forms of investment/ownership

3. Feel prepared to engage with your board of directors and professional advisor team regarding corporate strategic alternatives and optimal capitalization

Poll Questions:

1. Who currently has third-party investment (whether debt or equity; senior bank, junior capital, or PE)?

2. Who has ever considered non-bank, private institutional capital investment as a funding source?

3. Why did you pursue private capital investment? Organic growth initiatives, acquisition financing, lack of bank market interest or unfavorable terms, strategic partnership?

Table of Contents

I. State of the Capital Markets

II. Private Capital’s Growing Interest in ESOPs

III. Representative Use Cases and Illustrative Structures

I. State of the Capital Markets

Leveraged Loan Financing Market

• FY2022 institutional loan issuances of $225.1 billion marked the lowest level of issuances since 2010, when total issuances were $157.8 billion

• Refinancing activity spiked to a 12-month high in the fourth quarter of 2022, as issuers used the window of opportunity to address near-term maturities

• The majority of institutional loan issuances in Q4 2022 occurred in November ($22 billion)

Source: Leveraged Commentary & Data (LCD); $ in billions

U.S. Private Equity Update

U.S. Private Equity Dry Powder Breakdown1

U.S. Private Equity Fundraising Activity1

II. Private Capital’s Growing Interest in ESOPs

Private Capital Investments In ESOPs

Private capital, and in particular private equity, is playing an increasing role in a variety of ESOP investment and transaction scenarios

• Private equity (PE) and financial advisors are developing structures to combine the best of ESOP ownership with the resources of private investment to create bespoke outcomes – i.e., flexible shared equity models

• Private equity and institutional non-bank debt is being utilized to fill the capital gap between ESOP valuation and traditional third-party senior debt financing

• As a result of employee base evolution and repurchase obligation, ESOPs are generally not permanent capital structures; this often forces sales, refinancings, or other recapitalizations where private capital providers can play a key role

• Private capital investors can provide the flexibility and financial sophistication to structure complex transactions and investment scenarios needed by mature ESOPs

ESOPs = More Investment

Opportunity

The world of ESOPs provides an expansive opportunity set for private equity and institutional capital investors

Investment Types

• New Formations

• Growth Capital

• Secondary Market Seller Notes

• Repurchase Liability Funding

• ESOP Buy-Outs

• Portfolio Cos. Exit

Investors

• Private Equity

• Family Office

• Mezzanine/Uni Tranche Funds

• Pension Funds

• Non-Bank Institutional Debt Funds

Growing ESOP Acceptance

• Across the universe of institutional capital, whether private equity, family office, non -bank debt, etc., there is accelerated acceptance of equity sharing models where a broader base of employees, rather than exclusively management, can participate in ownership

• Existing private equity firms are investing more team resources in exploring ESOP strategies

• ESOP-dedicated funds are cropping up continually

• Private equity investors priorities often align well with core characteristics found with most ESOPs and ESOP-owned company management teams:

• Rollover equity

• Retention of key employees

• Mitigation of founder-operator walk-away risk

• Incentivization of employee base

• Heightened emphasis on ESG investments (ESOPs can check the box)

• More broadly, one of the critical goals of a potential private equity investor is to align management and employees’ incentives with its own in order to cultivate a strong company culture. This is already fundamental to ESOP ownership

Private Equity’s Role in ESOPs

Differentiator On Entrance

• Proposing an ESOP vehicle can distinguish a private equity group in an auction process

• Flexibility – PE can own majority or minority and, provide sub debt or equity capital

• By providing a structured equity security, i.e., junior debt financing instrument with warrants, PE can achieve fully-diluted ownership which can accrete up to a majority position

• PE can also provide incremental capital over time for growth

Provide Liquidity For Mature ESOP Companies

• Mature ESOP companies can face cash flow issues arising from increasing repurchase obligation and/or diversification

• To achieve diversification for plan participants and reduce the cash flow demands of the ESOP, PE can recapitalize an ESOP company, as well as provide capital for future growth

• PE can provide liquidity through a minority or majority recapitalization, providing debt or equity

Portfolio Company Exit

Private Equity’s Role in ESOPs (cont.)

• Sale to an ESOP can be a useful alternative to an LBO or strategic sale for a PE sponsor, especially if:

• No logical buyer

• Failed sell-side process or dual track process

• Release of confidential information to prospective buyers might have significant adverse impact on the business

• ESOPs can often pay a comparable, full price on par with a financial sponsor

• Opportunity for PE sellers to obtain partial liquidity while retaining equity upside via seller notes with attached warrants

Investor Selection

ESOP Experience

Investors that have experience with and have demonstrated success working with employeeowned companies will be more familiar with an ESOP-ownership structure

Industry Knowledge

Prior knowledge and/or experience in the industry will allow the investor to provide beneficial guidance and financial support, particularly as new growth opportunities arise

Key Relationships

Leveraging a potential investor’s relationships in the industry will broaden the universe of potential customers as well as growth opportunities

Shareholder Rights

Potential equity investors will negotiate for shareholder rights such as veto power depending on their ownership stake

Vision Alignment

Selecting an equity partner that believes in management’s strategic vision will create a cohesive path to accretive growth, as well as support for new growth initiatives not yet identified

Future Appetite

Selecting an equity investor with an appetite for future followon growth equity investments provides additional coverage to support future strategic initiatives

A variety of considerations should be evaluated when selecting a capital / equity partner

Minority / Majority Investment

Factors

Advantages

• Receive growth capital while retaining existing governance / Board control

• Existing leadership will reserve right of final say on key decisions and strategic initiatives with guidance from the minority equity partner

• The minority equity partner can still provide additional follow-on capital to support new growth initiatives as they arise

Considerations

• Minority equity investors will expect a discount for lack of control to be applied to equity value, increasing their ownership percentage

• The minority equity partner will hold certain veto rights for significant business decisions

• Investors will expect the majority of proceeds to be allocated for growth initiatives, with less earmarked for payment of the seller note

Majority Equity Investment

• Receive increased dry powder to pursue strategic growth initiatives

• With greater funding, a majority equity partner will look to capitalize on more ambitious growth opportunities

• A greater portion of the investment proceeds will be allocated to pay down the seller notes commensurate with the risk associated with loss of control

• The majority equity investor will gain board control and ultimately possess the final say in key business decisions

• Strategic growth initiatives will be largely led by the majority equity partner

• Assuming greater risk, the majority equity partner will expect to be more involved in strategic direction and control capitalization

Emergence of Non-Bank Market

Bank and non-bank financing structures each provide their own set of unique considerations

Bank

+ Provides lowest cash-on-cash interest over the course of the term loan

+ Ability to provide ancillary treasury management services to develop a deeper relationship with the Company

+ Many national commercial banks posses dedicated ESOP lending groups

‒ Higher mandatory amortization reduces flexibility and amount of capital available to execute corporate objectives

‒ Elevated regulatory restrictions

+ Provides more adjustable financing with lower mandatory amortization

+ Heightened covenant flexibility

+ Fewer regulatory requirements

‒ Higher cost of debt capital

‒ Credit appetite has decreased, and parties may be reluctant to negotiate an aggressive structure

III. Representative Use Cases and Illustrative Structures

New Formation

International Pension Fund Invests in New ESOP Formation

• Healthcare of Ontario Pension Plan (HOOPP) and Social Capital Partners (SCP)

• Unique and flexible financing structure

• Fixed rate, no amortization, 10-year bullet, seller note repayment allowance (as compliant), interest postponement to support growth (as desired)

• Alignment of goals and objectives

• HOOPP and SCP both place an emphasis on ESG investing, in particular, employee-owned companies, aligning with Taylor’s focus on sustainable wood sourcing for guitar production

Secondary Transaction In Existing Seller Notes

Growth Investment

Private Capital Investment Use Cases

Project McLaren Project Whittier

Private Equity Bids to Purchase Long-Dated Seller Notes / Warrants

• Immediate liquidity event for the seller note holders

• A discount to face value required by acquirer to provide market return

• Seller can reinvest after-tax proceeds into a more diversified portfolio

• Increased Company flexibility

• Eliminated pressure on Company to prepay seller notes

• A bank debt refinancing would have increased leverage (vs. retaining deeply subordinated, equity-like junior capital and warrants)

• Partnering with a sponsor that values ESOP ownership ensured continued alignment among all stakeholders

Private

Equity Provides Growth Capital to ESOP-Owned Company

• Company sought a PE partner for growth capital

• PE made control investment into a newly formed drop-down LLC

• Preserves ESOP ownership at S-Corp. and provides greater flexibility

• Proceeds used for acquisitions, internal initiatives, and partial seller note refinancing

• Access to additional future investment

• Company gained a PE partner

• Enhanced industry expertise

• Accretive to the ESOP’s value

Illustrative PE Investment

Structures STRUCTURED EQUITY & ESOP RE-LEVERAGE S

• PEG provides Structured Equity (Jr. note and warrants) and, if desired, mezzanine financing

• ESOP uses PEG funds to re-leverage the ESOP

& DROP-DOWN LLC C CORPORATION & ESOP CONVERSION C CORPORATION & DROP-DOWN LLC

BUYOUT & PARTIAL ESOP ROLLOVER

Summary Description

• PEG receives “equity-like” return through warrants and note interest

• PEG invests equity and, if desired, mezzanine financing

• PEG holds direct equity in the form of LLC units

• Some liquidity available for warrant holders, seller note holders, SAR participants

• Retains Company taxexempt status through ESOP holding 100% of S Corp. ownership

• Revoke S election / C Corp. conversion

• Settle ESOP Loan

• Convert ESOP to profitsharing plan and merge with existing 401(k) plan

• PEG invests preferred equity into HoldCo. and mezzanine debt into Operating Co.

• Third-party and/or PEG recap refinances outstanding third-party and seller note debt, as well as warrants

• PEG, former seller note / warrant holders, and management reinvest in exchange for participating preferred stock in the LLC

• ESOP is diluted from 100% ownership

• PEG acquires 100% of ESOP-owned equity with debt (third-party and mezzanine, as desired), equity, and a portion of ESOP rollover proceeds

• ESOP receives proceeds in cash (~90%) with the balance rolled (~10%)

• Accounting for leverage, the PEG retains ~80% ownership to the ESOP’s ~20% ownership

S Corporation & Structured Equity

Private Equity & S Corporation ESOPs

S Corporation & Drop-Down LLC

*All examples herein are purely illustrative in nature

Private Equity & C Corporation ESOP

C Corporation & Drop-Down LLC

*All examples herein are purely illustrative in nature

Thank you for joining us!

Pros and Cons: Rebalancing, Account Segregation, and Early Diversification

Dan Markowitz, CPA Partner Boulay PLLP

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.

• What is Repurchase Obligation?

• Distribution Policies Options

• What is Segregation and Options? •

Why Use Segregation?

Case Study

Alternatives to Segregation

What is Repurchase Obligation?

• Terminated participants request a distribution according to the terms of the ESOP and/or a distribution policy

• A number of factors that lead to repurchase obligation

• Distribution policy, demographics, stock price growth, etc.

• Repurchase obligation is another form of debt

• Timing of Repurchase Obligation

• Repurchase obligation is small in the earlier years

• Mature ESOPs typically have significant repurchase obligation

What is Repurchase Obligation? (cont.)

• Repurchase obligation is driven by the length of the internal loan

• Longer the internal loan, the less shares allocated each year

• Growth of the Company

• The higher the growth rate, the higher the repurchase obligation

• Timing of distributions will have an impact on repurchase obligation

• How quickly are shares reallocated from terminated participants to active participants, assuming the ESOP provides for segregation

How to Monitor Repurchase Obligation

• Role of management and Board of Directors

• Other Plan Provisions

• Continuous review of plan provisions

• Important to monitor repurchase obligation

• Repurchase Obligation/ESOP Sustainability Studies

• Distribution Policy

• Review every three to five years

• ESOP Sustainability

• What are the other strategic initiatives of the Company

Timing of Repurchase

• Retirement, Death, Disability

• No later than 1 year after plan year in which termination took place

• All other terminations

• No later than 6 years following the plan year in which termination took place

• Diversifications

• Comes into play when a participant has 10 years of plan service

• In Service Distributions

• Typically for individuals who hit normal or early retirement age (as defined by the plan)

Method of Repurchase

• Lump Sum

• Installments over a period not to exceed five years

• Extend for up to another 5 years for large account balances

• Stock distribution

• Subject to automatic put option

• Payment comes form the company

• Effect on current and future valuation

• Reducing the number of shares outstanding

Funding Options for Repurchase Obligation

• Obligation of Company

• Cash in the ESOP vs. Company

• 80-26 loan to the ESOP

• Administration loan to fund distributions

• Short-term in nature

• Contributions to the ESOP

• Redemptions by the Company

• Dividends to the ESOP

• Need to monitor who is benefiting

Distribution Policy

• Managing repurchase liability often requires managing an ESOP’s Distribution Policy, if there is one (considered part of the plan document, and any changes require a formal plan amendment)

• Unlike other types of qualified retirement plans, ESOPs are generally permitted to change the timing and form of distributions

• This allows ESOPs to manage repurchase liability by extending payment terms or limiting lump-sum distributions

• Review every 3 to 5 years

What is Segregation?

• Segregation is the method of using available cash in the ESOP to exchange shares of company stock into an alternative investment within the plan (Company decision)

• Many companies have this provision in their plan document in order to avoid terminated participants reaping stock appreciation after they leave

• Also, a way to get more stock back to active participants and not dilute the ESOP

• A particular form of investment is not a protected benefit

What is Segregation? (cont.)

• IRS approves of segregation, provided:

• ESOP terms authorize such actions and have a definitive formula for determining how many shares are segregated, how the price at which such segregation will be determined, and to whom the shares are to be allocated

• Must be nondiscriminatory

• Plan administrator or other fiduciary may not use discretion to pick and choose which accounts may be segregated

• Application of segregation is within the plan document

• Must be adequately communicated to ESOP participants

Who is Using Segregation?

• New ESOPs

• Almost all new ESOPs are including segregation in their initial document

• Actively using segregation because stock price is low

• Mature ESOPs

• Adding segregation to their plan document

• Starting to actively use segregation

• Cash requirements can be significant

• Staged approach

Application of Segregation

• Pro-Rata – Across all individuals eligible for segregation

• Participants may be invested in company stock and alternative investments

• Ordering by earliest termination date

• First in, first out method of segregation

• Segregate full balances

• Ordering by type of termination

• First - non-retiree terminations by termination date

• Retirees by termination date

Why Use Segregation?

• Segregation of accounts prevents former employees from sharing in future gains

• Segregation of accounts protects former employees from sharing in future losses

• Speeds up the repurchase obligation to the time of segregation

• Can transfer the segregated accounts to company’s 401(k) plan or make the segregated accounts participant directed (reduces fiduciary risk)

• Segregation can also free up more shares for allocation – helps with the “Haves and Have Nots” issue

Why Use Segregation? (cont.)

• What does management believe?

• Increasing stock vs. decreasing stock

• Philosophic discussion

• Who is benefiting – active vs. inactive participants

• Repurchase obligation is another form of debt

• How fast is the stock appreciating?

Distribution of Segregated Accounts

• Immediate payout of segregated accounts is typical

• Use of existing Distribution Policy which clearly outlines the segregation process

• Trustee responsible for managing segregated accounts

• Pooled account vs. participant-directed investment

• Alternative investment within the plan

• Preserve capital with a return on the investment for participants

• Investment choices subject to the investment policy statement

Case Study – Background

• Company had a “RIF” in 2008/2009

• A significant turnover event

• Employees went to work for a competitor

• As of December 31, 2015

• 50% of the stock was allocated among terminated participants

• Distribution Policy

• 5-year wait; 5-year installments

• Participants were not requesting distributions

• Stock price annual growth from 2010 – 2015 was 15%-30%

Case Study – Issues

• Installment payments were not covering the appreciation

• Terminated participants were not requesting distributions

• Return on the Company stock

• Total amount held by terminated participants = $13 Million

• Contributions = 15% of eligible compensation

• Contributions just covered current year distributions

Case Study – Use of Segregation

• 2016 Approach

• Current year distributions were paid via stock distributions

• Current year contribution (15% of eligible wages) was used for segregation

• Allowed to fund two years of repurchase obligation funding in one year

• Term debt to fund the stock distributions

o Company made stock contributions over 5 years

o Allowed shares to be put back in circulation

Case Study – Use of Segregation (cont.)

• 2017 – 2020

• Company performance remained strong

o Stock price doubled in 4 years due to significant growth

• Continued use of segregation

o Only part of the contribution was being used for segregation

o Part of current year distributions funded by the previous year contribution

• Active participants benefit

o Held the majority of the outstanding shares (morale improved)

o The value accreted to the active participants

Case Study – Results

• 90% of the stock was held by active participants

• Saved the Company over $10 million in the short term

• Terminated participants started to request distributions

• Morale improved among current employees

• Company had significant growth, which was projected in 2016

• Allowed the Company to fund strategic initiatives

Alternatives to Segregation - Redemptions

• Distributions in form of stock with put to the Company

• This is essentially a redemption with payments from the Company made directly to former participants who receive distributions in the form of stock, pursuant to the put option requirements

• Reduces the number of shares outstanding

• Can artificially increase the stock price in future years

• The shares can be contributed or sold back to the ESOP

• Stock contributions

• Re-leverage transaction

Alternatives

to Segregation – Early Diversifications

• Provide for a non-statutory diversification to participants

• Pros of Early Diversifications

• Allows participants access to account balance sooner

• If share price is increasing, allows company to “pre-pay“ repurchase obligation

• Employees don’t leave the organization to receive their funds

• Can recycle more shares to newer and younger employees

• Cons of Early Diversifications

• Immediate cash need

• Accelerates expected repurchase obligation

• Reduce cash available for other strategic initiatives

• If a down year, may see an increase in diversifications

Alternatives to Segregation – Rebalancing

• Each year, the ESOP accounts are rebalanced so that each participant has the same percentage of his or her account invested in employer stock and cash

• Takes from long-term for the benefit of newer participants

• Requires cash contributions

• Must be expressly provided for in the plan document

• Clear communication to participants

• Difficult to implement in mature ESOPs

Alternatives to Segregation – Releverage

• Annual Leveraged Repurchases

• Instead of recycling the shares distributable to former participants in one year, why not stretch the allocation of these shares over several years?

• Could accomplish this by distributing shares to former participants and having the ESOP acquire such shares using the proceeds of an exempt loan

• The form of this transaction is important as the IRS regulations allow an ESOP to borrow as long as the proceeds are used to “acquire employer securities” or to refinance an existing loan

• Downfall - cost of annual releveraging transaction

Alternatives to Segregation – Other

• Provide for one-time diversification window

• Nondiscrimination requirements must be met

• Can possibly be implemented as different diversification percentages for different age ranges

• Provide for a distribution window offering in-service withdrawals to a group of employees with disproportionately more stock in their accounts, provided nondiscrimination requirements and distribution event requirements are met

State Line Secret Word

Question and Answers

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 Speaker

• Curt started his career 21 years ago on a trading floor in New York, where he used his background in economics and derivatives to develop investment solutions for wealthy investors. However, his life changed when he started working more exclusively with business owners. His love for problem solving was a natural fit to help business owners and their families navigate some of life’s more difficult financial decisions.

Curt Rubinas, CEPA Managing Director

• Today, as a partner of The ESOP Group, he works closely with business owners and their families. Curt and his team are uniquely qualified to assist on all aspects of clients’ financial lives including asset management, tax, estate and retirement planning, insurance solutions, lending and strategic philanthropy. The team specializes in ESOP Section 1042 deferrals and also provides advice to corporate clients on areas such as cash management, repurchase obligation objectives, executive compensation and captive insurance company asset management.

Today’s Speaker

• As a partner of The Capital ESOP Group, Nick focuses on educating business owners on tax-efficient exit strategies. He is committed to helping clients recognize their options, understand the pros and cons of each strategy, and choose the best succession plan for themselves and their families.

Nick Francia, CEPA Managing Director UBS Private Wealth Management

202-585-5354

203-515-9220 (direct)

Nick.Francia@ubs.com

• Nick also creates tailored cash flow models comparing the taxable sale of privately held businesses and a tax-deferred sale to an ESOP under §1042 of the Internal Revenue Code. Nick seeks to earn his clients’ trust through open, transparent communication and by working with clients’ tax and legal advisors to construct an overarching strategy.

Learning Objectives

At the end of the session, you will be able to:

1. Discuss when it makes sense to consider a 1042 deferral and the characteristics of a good candidate.

2. Explain the different options for structuring and implementing a 1042 deferral.

3. Identify the right questions to ask a service provider and how to navigate the process

Covered in Today’s Session:

1. What is a §1042 rollover?

2. §1042 qualifications and requirements

3. Common investment strategies and best practices

4. Case studies

The §1042 Rollover

• Allows owner(s) of a C corporation to defer or, with proper planning, eliminate capital gains taxes on a qualifying stock sale to an ESOP

• Seller must reinvest an amount equal to the ESOP sale proceeds into Qualified Replacement Property (QRP)

Post-Sale Options Transaction

Pay capital gains tax

Business Owner sells $10mm of qualifying company stock with cost basis of $0 to an ESOP

Elect 1042 exchange and purchase qualifying securities to defer capital gains*

*With proper planning, capital gain taxes could be potentially eliminated

What is §1042?

• Under IRC §1042, eligible shareholders can defer capital gains taxes on eligible stock sold to an ESOP

• Amount equal to sale proceeds must be reinvested in qualified replacement property ("QRP")

• Taxes will not be owed until the taxpayer has a disposition of the QRP

• If structured properly, the taxpayer can avoid paying all long-term capital gains taxes

§1042 Eligibility

• Must be C-Corporation at time of sale to ESOP

• Minimum 3-year holding period of stock sold to ESOP

• Must sell at least 30% of value of company’s equity

• Must sell most senior stock

• Must reinvest proceeds in QRP within 15-month period (within 3 months prior to closing and12 months after closing)

• File appropriate documentation with next returns

What is QRP?

• Qualified Replacement Property (QRP) includes common stock, preferred stock, bonds, and convertible bonds of "operating companies" incorporated in the U.S.

• Operating company: A U.S.-domiciled company with the following characteristics:

• ≥50% of assets used in active conduct of a trade or business

• ≤25% of its gross receipts come from passive sources

What is QRP?

QRP does not include securities issued by:

• U.S. government agencies

• Non-U.S. entities

• U.S. subsidiaries of non-U.S. parents

• FDIC-insured certificates of deposit

• Mutual funds

• Municipal bonds

• Hedge funds

What is QRP?

If the QRP is sold, redeemed, or matures, the taxpayer must recognize a capital gain (or loss) on the difference between the amount received and the tax basis in QRP

Eligible investments

• Common stock

• Preferred stock

• Convertible bonds

• Corporate fixed rate bonds

• Corporate floating rate notes (FRNs)

Ineligible investments

• Bank CDs

• US government bonds

• Municipal bonds

• Foreign securities

• Exchange traded funds (ETFs)

• Mutual funds

• Real estate investment trusts (REITs)

• Master Limited Partnerships (MLPs)

The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest. Mutual funds and exchange traded funds are sold by prospectus. For more complete information about a fund, including the investment objectives, charges, expenses and risk factors, contact your Financial Advisor for a free prospectus. The prospectus contains this and other important information that you should read carefully before investing.

Polling Question #1

• Which of the below investments does not qualify under section 1042 as Qualified Replacement Property (QRP)?

A. Common stock

B. Preferred stock

C. Mutual funds

D. Convertible bonds of operating companies incorporated in the United States

§1042 Reinvestment Options

The investment strategy decision should take into consideration:

• Treatment of other investment assets

• Overall business succession plan

• ESOP transaction design

• Liquid net worth of the seller

• The seller's estate plan

• Philanthropic goals

Passive (hold) strategy

• Purchase a QRP portfolio that will be held for life

• Can choose to recognize capital gains from the ESOP transaction through the disposition of some or all of the QRP

• Often generates income for the shareholder

• Provides the flexibility to decide whether to use margin

Active strategy

• Invest a portion (typically 10%) of the ESOP sale proceeds and enter into a monetization loan for the remaining amount

• Use loan proceeds to purchase FRNs as QRP

• Enables shareholders to reinvest remaining sale proceeds in other investments

• May or may not qualify as QRP, but can be traded freely without triggering capital gains taxation

Blended strategy

• Combines both the passive and active strategies to further accommodate the selling shareholder's investment goals and objectives

Passive

• Portfolio of qualifying stocks and/or bonds designed to remain constant over the selling shareholder ’s lifetime

• Provides flexibility to use margin

• Capital gains realized on the ESOP transaction only if/when QRP is sold

• QRP can be passed on to heirs—with a step up in cost basis—upon death of the selling shareholder

• Often generates income / yield for the selling shareholder

Blended

• Combines passive and active strategies to further accommodate the selling shareholder’s investment goals and objectives

Active

• Leveraged FRNs enables selling shareholder to diversify into a flexible portfolio

• Capital gains realized on the ESOP transaction only if/when QRP is sold. QRP can be passed on to heirs—with a step up in cost basis— upon death of the selling shareholder

• Provides the selling shareholder with greater liquidity and flexibility

• Use of leverage increases complexity and incurs higher expenses

1. Seller receives total proceeds from ESOP sale in cash and seller note

2. 10% of the total proceeds are deposited into a brokerage account with margin. The remainder of the cash proceeds are fully unencumbered

3. A lender provides a monetization loan for up to 90% of the total proceeds*

4. Seller uses the deposit and loan proceeds to purchase Floating Rate Notes (ESOP bonds) as QRP

5. Seller note principal payments that are paid over time are also unencumbered**

What is a floating rate note?

• A floating rate note (aka "FRN" or "ESOP bond“) is a senior secured corporate debt instrument

• Corporate bonds with long maturities, floating rate structure and put provisions

• Used primarily by those who have sold stock to an ESOP and are looking to defer or avoid paying long-term capital gains taxes connected to the sale

What is a floating rate note?

• The majority of FRNs purchased for §1042 deferrals are newly issued securities

• In today’s environment, we would expect between 6 to 8 different issuers to print FRNs per year

What is a floating rate note?

Companies that have issued floating rate notes in the past:*

• Florida Power & Light

• US Bank

• JP Morgan

• UPS

• Bank of America

• Consumers Energy

• P&G

• Goldman Sachs

• Colgate

• Citi

*These companies have issued FRNs in the past; this is not a guarantee that they will continue to issue FRNs in the future

What is a floating rate note?

• Why is UBS comfortable lending up to 90% of the value of FRNs?

• FRNs usually have a rating of AA-/Aa3 or A+/A3 (investment grade)

• With most structures, the interest rate resets every 90 days

• Typically, the bonds have a put feature, allowing the holder to force the issuer to repurchase the note anywhere between 97% to 100% of the purchase price (helps to reduce liquidity risk)

• No single issuer can represent more than 1/3 of the collateral in order to limit concentration risk to any single issuer

What is a floating rate note?

• FRN maturities typically range from 40 to 50 years

Sample FRN Offering

Example FRN and key attributes

Issuer Florida Power & Light Industry leader

Rating A1/A High degree of safety/credit quality

Coupon Overnight SOFR minus 35bps Low interest rate sensitivity

Reset Calculated quarterly and paid quarterly Frequent payments

Maturity 50 years

Long maturity

Unlikely to mature while living

Historical FRN issuers

Citigroup

Consumers Energy

Florida Power & Light

Goldman Sachs

J.P. Morgan Chase

Procter & Gamble

United Parcel Service

US Bank

PNC Bank

3M Company

AIG

Bank of America

Bank of New York

Chevron/Texaco

Colgate

DuPont Nemours

Emerson Electric

General Electric

Call Option Non-callable for 30 years

Eliminates risk of early call and involuntary taxable event

Walt Disney

Wells Fargo

Merck

Put Option Years 1 – 5 @98.00

Years 6 – 10 @99.00

Thereafter@100

Critical for price stability

Hypothetical Analysis. This report is for illustrative purposes only. The asset allocation(s), investment strategies, and/or securities presented do not constitute any type of recommendation and is not intended to provide, and should not be relied on for accounting, legal, or tax advice.

Polling Question #2

• Traditionally, what loan to value can you expect on ESOP bonds?

A. Up to 80%

B. Up to 90%

C. Up to 60%

D. Up to 50%

How do I elect §1042?

• The shareholder must reinvest sale proceeds within the "replacement period" – starting 3 months before the ESOP transaction and ending 12 months after

How do I elect §1042?

• Three statements must be filed with the IRS to complete the §1042 election:

1. Statement of Consent

2. Statement of Election

3. Statement of Purchase

Important §1042 Documents

Corporate document executed by officer of company

 Should be completed at closing

Statement of Consent

 Corporation files with its tax return

 Shareholder attaches to his or her ESOP 1042 election

Shareholder executes with 1042 election

Statement of Election

 Shareholder must execute and attach with tax return in tax year of ESOP sale

 Timing is very important

 Tax return must be filed timely, including all extensions, and the tax payer cannot amend his/her tax return to attain ESOP 1042 treatment

Shareholder executes when 1042 complete

Statement of Purchase

 Shareholder purchases QRP within 12 months of sale to ESOP

 Shareholder files notarized Statement of Purchase for QRP with their appropriate tax returns

Disposition of QRP*

• A disposition of QRP will trigger capital gains tax based on the taxpayer's basis in the original shares sold to the ESOP

Disposition of QRP*

• Sale of the QRP would be considered a disposition, but the following events would not qualify as dispositions:

• Gift of QRP

• Transfer upon death of the QRP holder

• Transfer of the QRP in connection with divorce

• Certain tax-free transactions between the QRP issuer and other companies

*As outlined in the Internal Revenue Code §1042(a) and §1042(b)

Disposition of QRP*

• Strategies can be employed to continue deferring capital gains while diversifying into other asset classes, such as:

• Transfers to grantor trusts (for example, a charitable remainder unitrust or CRUT)

• Borrowing against the QRP

*As outlined in the Internal Revenue Code §1042(a) and §1042(b)

Case Study #1: Bob the Baby

This case study is shown for informational purposes only and may not be representative of the experience of all clients. It is not intended to represent the performance of any specific investment or financial advisory program. Each client's circumstances may be different. There is no guarantee of the future success of any of the strategies discussed.

Case Study #2: Jim the

This case study is shown for informational purposes only and may not be representative of the experience of all clients. It is not intended to represent the performance of any specific investment or financial advisory program. Each client's circumstances may be different. There is no guarantee of the future success of any of the strategies discussed..

Secret Word for CE

Paul Rudd

Questions?

Important Disclosures

Disclosures

Information contained herein is of a general nature and is provided for informational purposes only. Laws governing ESOP transactions and the rules under Section 1042 of The Internal Revenue Code of 1986, as amended (“Code”), are complex and persons considering an ESOP or Section 1042 transaction s hould seek professional guidance from their tax and legal advisors. Specific structures and decisions can only be developed based on a thorough review of the facts and circumstances relative to a particular company and its shareholders. Neither UBS Financial Services Inc. nor its employees provide tax or legal advice.

In addition, shareholders to sell into an ESOP should understand the applicable rules of the Internal Revenue Code of 1986, as amended (“Code”), including requirements for qualified replacement property as defined by Code section 1042 (“QRP”). Shareholders should understand the potential risks that may be associated with obtaining securities as QRP, sufficiency of available QRP in the market that satisfy the shareholder’s investment objectives, limitations on UBS’ ability to offer margin or financing for the purchase of a new-issue QRP where UBS has participated in the underwriting of such new issue, availability of QRP with put features and whether available QRP offers appropriate diversification. The foregoing is a general description of potential risks. Shareholders who invest in QRP should consult with their tax and legal advisors regarding their personal circumstances.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, any U.S. federal tax information in this article is not intended, or written to be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code, or (2) promoting, marketing, or recommending to another party any transaction or matter contained in this presentation.

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