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At the end of the discussion, you will be able to:
1. Identify types and characteristics of capital available to ESOP-owned companies
2. Understand key trends and themes that are currently impacting the capital markets
3. Learn best practices for companies when seeking capital
• What are the general types of financing available?
• Are the capital market conditions favorable today?
• How do I know how much third-party capital to obtain?
• Is financing an ESOP-owned entity different from conventional ownership structures?
• Are there capital providers that know ESOPs?
• How do I prepare for a financing? What can I expect?
Other questions from the audience?
a) Forms of Capital
i. Senior Debt
ii. Junior Capital
o ESOP Transaction
o Refinance Seller Notes
o Accelerate prepaying Seller Notes
o Reduce overall cost of capital
o Working Capital
o Support Company growth
o Repurchase Obligations
o Growth/Acquisitions
REVOLVER
TERM LOAN A PRIVATE PLACEMENT NOTES (SECURED & UNSECURED)
LOAN MARKET
SENIOR DEBT
TERM LOAN B SENIOR SECURED
NOTES
2ND LIEN TERM LOAN
SENIOR SECURED & UNSECURED
NOTES
SENIOR & JUNIOR SUBORDINATED
NOTES / MEZZANINE DEBT
JUNIOR DEBT
CONVERTIBLE DEBENTURES
PREFERRED STOCK
EQUITY
COMMON STOCK
How much debt/capital to take on?
- Only as much as can be repaid/refinanced
- Only as much as the market will accept
1042 Considerations
- Feasibility study analysis
- Cash at closing and seller note financing
- Need at least 25%-30% cash at closing (or personal liquidity) to execute a 1042 election strategy*
*must be C-Corp selling shareholder
*must sell at least 30% combined ownership
ESOP Monetization Loan
$20,000,000 – FRN Holdings
Pays Interest Income
($18,000,000 – Monetization Loan)
Charges Interest Expense
Investible assets
Diversified
$18,000,000 (minus seller note)
Earns Interest, Dividends and Capital Gains
Notes: The amount of funds to be invested will be reduced by the amount of any seller notes used in the financing of the sale. If interest expense exceeds interest income there is a cost to the holdings. If all holdings are held in the estate of the Seller, the heirs can sell the FRNs (for a likely permanent deferral of the capital gain) and pay off the monetization loan. The taxation of these transactions should be determined by consulting with qualified tax counsel.
1042 Portfolio Construction: Year One Cashflow Five FRN Purchase
HISTORICAL 10-YEAR TREASURY & 1-MONTH LIBOR RATES
o Rising inflation and the post-pandemic recovery have caused the Federal Reserve – as well as other sovereign banks – to indicate rate increases in the near-future, which will drive borrowing rates up
Source: S&P CapIQ Database
Lower long term rates typically signal likelihood of recession
As
o Capital markets are tightening, driven by a higher rate environment, worries of an impending recession, and general wariness to deploy capital
o U.S. Leveraged Loan issuances dropped considerably in 2022, with Dec. 22 volume 48.0% lower than Dec. 21 levels. In 2023, rising interest rates and persistent inflation continue to impact lender appetite
Source: S&P LCD Comps & GF Data
o Leverage levels decreased in the back half of 2022
o Today, leverage remains below levels experienced in late 2020 and 2021
o Calculate asset-based borrowing capacity
✔ Apply market advance rates to working capital and PP&E
o Calculate senior and total leverage capacity on a cash flow multiple basis
✔ If generating >$5mm of EBITDA annually, apply going market multiple (i.e., 2.5x – 3.0x)
✔ Depending on industry and exposure to volatility in economic cycles, most borrowers may assume an additional 1.0x – 1.5x of junior capital above the senior tranche
o Most importantly, measure your fixed charge coverage ratio quarterly (multiple of net cash flow to obligations)
✔ ESOP tax savings should help!
o Raising capital is a Board, not Trustee, decision
o Identify total financing needs (including excess availability)
o Prepare a five-year business plan forecast
o Review state of accounting records and financial control systems
o Be prepared to market your company as you would your products and services
Assuming
Assumptions:
Loan amount estimated at 90% of face amount of Qualified Replacement Property (QRP) Portfolio
Hypothetical Bank Loan Rate = Daily Simple SOFR plus 75 basis points
Assumed current yield on hypothetical QRP portfolio
Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in a decline in the bond's price.
Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower rated bonds. If sold prior to maturity, fixed income securities are subject to market risk.
All fixed income investments may be worth less than their original cost upon redemption or maturity.
Yields are given as of 03/30/23
The above summary of prices/quotes/statistics contained herein has been obtained from sources believed to be reliable Bonds are subject to price and availability but is not necessarily complete and cannot be guaranteed. If capital gains or realized results only are shown, please Additional information is available upon request be advised that current total account performance may be affected by unrealized losses or gains. This is not a substitute Investment and Insurance Products are: for a Verification of Deposit (or similar form) or the official statement of account holdings at the firm.
• Not Insured by the FDIC or Any Federal Government Agency
• Not a Deposit or Other Obligation of, or Guaranteed by, the Bank or Any Bank Affiliate
• Subject to Investment Risks, Including Possible Loss of the Principal Amount Invested
Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC, Member SIPC CAR# 1221-00284
o Package = Present the request in an organized way
o Storytelling – why this is the right deal?
o To Debt Providers – key words are safe/secure/defensible/downside protection
o To Equity Investors – key words are growth/scale/synergy/upside potential
o Financials – numbers must make sense
o Due Diligence matters especially in current market condition
o CPA
o Accounting Due Diligence
o Tax Planning
o Lawyer
o Legal Due Diligence
o Documentation
o Investment Banker
o Valuation & Negotiation
o Deal Packaging
o Process to Source Options
o Close the Deal
o Wealth Advisors
o Liquidity management / estate planning
o Attest (Audit or Review)
o AICPA, PCAOB, and COSO Standards
o Provide an opinion and need to be independent
o Generally Accepted Accounting Principles (“GAAP”)
o Historically focused
o Materiality based; Sample selections based on testing
o Fiscal Period Focus
o Consulting / Diligence
o AICPA Consulting Standards
o Advisory role providing fact/judgement-based findings
o “Normalized EBITDA” over GAAP
o Forward looking
o Monthly Focus for Trend Analysis
o Concentration Risks (Customers, Vendors, Employees)
o One-Time Events (Revenue or Expense Normalization)
o Working Capital & Cashflow Management
o Discretionary Expenses
o Market Rate Compensation or Rent
o Post Close Management
o Changes in Accounting Policy or Estimates
o Contractual Requirements
o EBITDA
o GAAP Compliance
o Changes in Current Products or Customer Situations
o Pro Forma Analysis
o Non-recurring Revenues, Expenses, Gains, and/or Losses
o Discretionary spending
o Working Capital
o Seasonality
o Agreement Definitions
o Seasonal Trends
o Adjustments (GAAP, Normalization, Pro Forma)
Investor Size
▪ Commercial banks
Advantages
Maturity
Amortization
Pricing/Returns
Typical Covenants
▪ Tied to appraisal of assets with applicable advance rates
▪ Higher advance rates on inventory and PP&E
▪ Lower cost
▪ 5 years
▪ Straight line for term loans
▪ Bullet for revolver
▪ Limited covenants (FCC)
Considerations
▪ Appraisal costs/field exams
▪ SOFR + 1.50%-2.25%
▪ More reporting possibly weekly or daily
▪ Debt capacity tied to the balance sheet
▪ Springing fixed charge coverage ratio
▪ Maximum Capex
▪ Minimum working capital
▪ Commercial banks
Investor Advantages
Size
Maturity
Amortization
Pricing/Returns
Typical Covenants
▪ Typically tied to working capital assets or hard assets
▪ Potential for cash flow loan
▪ 3 to 5 years
▪ Straight line (typical)
▪ Potential excess cash flow recapture (if cash flow loan)
▪ SOFR + 2.0%-4.0%
▪ Low cost
▪ Largest source of capital
▪ Relationship oriented
▪ Total senior leverage: 2.0x – 2.5x LTM EBITDA
▪ Minimum fixed charge coverage greater than 1.2x
Considerations
▪ Limitation on leverage based upon
collateral coverage
▪ Multiple financial covenants
▪ Finance companies/ CLOs
Investor
Size
▪ Based on cash flow and enterprise value (min EBITDA of $5 million)
Advantages
▪ Higher leverage
▪ Based on the enterprise value of the company
Maturity
▪ 5 years
▪ Back-ended
Amortization
Pricing/Returns
Typical Covenants
▪ SOFR + 7.0-10.0%
Considerations
▪ Higher Pricing
▪ SOFR floor
▪ More restrictive covenants
▪ Max Senior Leverage: 3.0x-3.5x
▪ Max Total Leverage: 3.5x-4.0x
▪ Min Fixed Charge Coverage: >1.2x
▪ Minimum EBITDA
▪ Maximum Capex
Junior Capital
Subordinated Debt (Mezzanine)
Junior /Seller
Subordinated Notes
Convertible
Preferred
▪ Mezzanine Funds
Investor Size
▪ Based on cash flow and enterprise value
Advantages
▪ Bullet Amortization
▪ Looser/almost no covenants
▪ Long Term capital
Maturity
▪ 5 to 7 years
▪ Maximizes leverage
Amortization
Pricing/Returns
Typical Covenants
▪ Bullet at maturity
Considerations
▪ Cash: 10.0%-12.0%
▪ PIK: 2.0%-4.0%
▪ Warrants: 0.0%-10.0%
▪ All-in-Return: 12.0%-18.0%
▪ Higher cost of capital
▪ Prepayment penalty
▪ BOD observation rights
▪ Equity Dilution
▪ Maximum Total Leverage: ~4.0x
▪ Mezzanine Funds
Advantages
Investor
▪ Private Equity
▪ Selling Shareholders
▪ Fewer covenants
▪ Lower cash option
Size
Maturity
Amortization
Pricing/Returns
▪ Based on cash flow and enterprise value
▪ Patient capital
▪ 6+ years
▪ Bullet at maturity
Considerations
▪ Equity dilution
▪ Structure based on returns of 12.0%-18.0%
▪ Current pay of 3.0%-12.0% (as permitted)
▪ PIK possible
▪ Warrants to achieve all-in return
▪ Prepayment penalty
▪ BOD governance rights
▪ Subordination rights differ for institutional junior subordinated notes
TJ Genz, ASA
Managing Partner
ESI Equity
Peter DeLong
Executive Director
J.P. Morgan Chase
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• Overview of Macro Economic Trends and Impact on Valuation
• Recent M&A Activity and 2023 Outlook
• Financing and Structuring Discussion
• An oversimplified explanation of inflation
• Borrowing rates super low + fiscal & monetary stimulus + significant increase in spending habits (goods from services) creates surge in demand after initial pandemic panic abates
• Trade wars + actual wars + shut downs
+ price gouging + one-off supply chain shocks creates challenges with supply curve
• Result = Historic inflation
• Rising interest rates have the potential to hinder consumer spending, capex, and other investments.
• However, the adverse impacts of rising interest rates are not often immediate; the risk is greater to the longer-term GDP outlook than to the 2023 outlook.
• For your business, understand that higher borrowing costs are not necessarily reason to halt investments.
• Given the tight labor market, investments that will help limit a business’s dependence on labor will likely prove worthwhile, as will those that improve operating efficiencies.
• Despite hitting it’s all-time peak in Jan. 2022, the S&P and other major stock indices finished 2022 with their worst annual returns since 2008
• The S&P lost nearly 20% of its value while the Nasdaq lost 1/3 of its value
• The tech-heavy Nasdaq fared much worse than the Dow and S&P, which reflects the declines in growth stocks in 2022 in a rising interest rate environment
Equity risk premium
Weighted average cost of capital
Cost of equity
Industry Risk
Cost of equity
Cost of debt
Risk free rate
Average yield on debt
Cost of debt
(after-tax)
Weighted average cost of capital
Tax shield
In Q1 2023, early data suggests M&A values and number of deals closed were the lowest in over a decade
Strategic Buyers
• Significant cash / dry powder
• Large publics have low leverage compared to prior years
• Less sensitive to financing risk
• Divesting non-core business
• Less cross-border M&A
Financial Buyers
• New fundraising in 2022 was four year low, but still sitting on over $1.3 trillion in dry powder
• Direct lenders became more conservative and deals are requiring larger equity contributions and taking smaller hold sizes
After significant M&A activity during the low interest rate era, 2023 should be a transition year as PE firms adjust to a new age of more normalized rates. Nevertheless, private equity is a deep and liquid market now relative to prior economic downturns, with proven ability to transact in changing macro environments
M&A activity in 2022 underscored the importance of the lending markets to deal making by PE firms.
•Following a hectic 2021, U.S. deal counts for sponsor acquisitions and portfolio company M&A exits decreased roughly 20% in 2022.
•Many PE firms delayed their buying and selling plans due largely to reduced liquidity, increased pricing, and lower leverage in the credit markets after indications that the Fed’s rate hikes would far exceed initial expectations.
•While direct lenders thrive during periods of market dislocation, private credit was able to take up only some of the slack caused by much lower issuance volumes in the public lending markets, as direct lenders turned more conservative on hold sizes through the course of 2022.
2023 will depend largely on conditions in the debt financing markets.
•As the year begins, lending markets remain bifurcated, with M&A financing more available for high-quality credits than for second-tier borrowers.
•Credit availability should broaden as the market gets a firmer grasp on when the Fed will stop raising its benchmark rates and as the shape of the economic cycle becomes clearer.
•Recent dynamics translate to direct lenders avoiding large holds on any single credit, resulting in significantly reduced availability for larger unitranche deals relative to a year ago. With pressure on hold sizes increasing the complexity of financings, an assessment of this trend in early 2023 will be an important indicator of how much support direct lenders will provide to the M&A market.
Private equity firms continue to have the means and motivation to transact when the lending markets are cooperative.
•Dry powder for private equity funds represents a record level of $1.6 trillion on a global basis, nearly doubling over the past five years and up moderately from the year-ago level. With lenders currently requiring larger equity contributions for buyouts, sponsors are well stocked to secure prized platforms and to execute the add-on strategies often favored in 2022.
•Based on preliminary data, aggregate capital raised by buyout funds in 2022 dropped to a four-year low, putting more fundraising pressure on 2023, when a normalized fundraising cycle could create a more pressing need for exits.
https://www.rwbaird.com/newsroom/news/2023/01/ma-recovery-depends-on-improvedmacro-outlook/
• Reliance that cash flow will “be there” throughout term of loan to service/repay debt
• Key Considerations & Factors:
Strong management
Strong competitive position/product or service differentiation
Product/market/client diversification
Larger sized companies
Strong sustainable cash flow, better profit margins
• Collateral used to backstop cash flow, provide secondary source of repayment if cash flows deteriorate
• Compensates for lack of some of characteristics above
• Asset Based - more focused on asset values and control of collateral
• Cash flow / collateral based lending hybrid
–
Substantial collateral exists to secure majority of loan but not all of loan; portion not secured by collateral – “airball”
– Focus will be on time necessary to amortize the airball to zero
• Factors that help in acquisition financing
–
Synergies – the larger (in $ terms) and more qualitatively tangible the synergies, the greater potential to incorporate them into analysis of airball –
Available collateral on acquirer’s balance sheet – if buyer has excess collateral that can be combined with target’s collateral, helps to reduce airball –
Tax free status (100% ESOP) increases cash flow, facilitates faster amortization of airball
• Mezzanine – Subordinated, generally unsecured.
– Mix of cash pay and PIK interest.
– Because not collateral based, totally cash flow focused. Smaller size can be impediment.
• Junior capital
– Structured Equity – structured like debt with warrants to create return profile like equity. Considered debt for purposes of 100% ESOP ownership.
– Real Equity – direct equity investment in parent or operating subsidiary (e.g. – “drop down LLC”).
–
Opportunity for growth of combined entity is important because it will goose potential returns
• Building the capital structure is about balance of competing needs:
– Size of debt service claim on cash flow from each tranche (senior, mezzanine, junior & equity)
– Need to balance preservation of cash flow against need to deliver
• Structuring ideas that can help
– Match longer term financing (i.e. with longer term amortization schedules) with longer lived assets (e.g. R/E or long life machinery)
– Include stretch senior that will have lower amortization requirements
– Judicious use of mezzanine, junior sub debt or seller paper that require no amortization and pay interest on cash pay & PIK basis
– Even if buyer is 100% ESOP, equity capital can still be used
• The deeper into the capital structure company goes to source capital, the more expensive it is
– Purpose of using junior capital is to preserve annual cash flow to comfortably service senior debt, invest in the balance sheet (i.e. capital expenditures, working capital growth) as needed;
–
$ cost of junior capital tranches has to make sense in this context.
– Must contrast cost of financing against return on assets being acquired.
–
If total cost of capital available is too high relative to return on assets, may need to reconsider purchase price
• DON’T FORGET TAX CONSIDERATIONS
– S-Corp ESOPs have many critical tax characteristics; must make sure structure of debt instruments issued don’t undermine S tax status
• Understanding how the acquisition and debt will affect the value of stock held by the ESOP
• Structure: Acquisition by ESOP vs Company?
– Ability to pay different prices?
– What synergistic premiums can be paid?
– Can ESOP use cash in the deal?
– Opinions needed? Who provides?
– Effect on participants
• Is the acquisition covered by ERISA rules or is it strictly a “business judgement” question?
• Will/When will target company’s employees become ESOP participants?
• How will acquisitions affect repurchase obligation cash flows?
• Issues arising if acquirer is an older ESOP, whose shares are fully allocated?
• Should Company acquire target if accretive on a Company-wide basis, but dilutive on a participant basis?
Legally, asset purchases are less risky. The buyer selects the specific assets to acquire and the liabilities to, which limits risk
Generally, in a stock purchase buyer assumes ALL of the risks known and unknown associated with assets & liabilities of seller. Buyer can secure indemnities from the seller, escrow arrangements, holdbacks and earn-outs.
Buyer favor asset purchases
• Step-up basis of assets to purchase price (not an issue for many ESOP buyers)
• Limit liabilities to those assumed in APA
• If C-Corp, seller/shareholders may face double tax
• If S-Corp, seller/shareholders may face recapture tax
Seller favors stock purchases
• Buyer takes target subject to target’s liabilities, except as limited by SPA
• If C-Corp, no double tax on gains – possible 1042 option
• If S-Corp, no recapture tax
• Section 338 election permits buyer of S-Corp to treat taxable stock purchase as asset purchase for federal tax purposes (Not an issue for many ESOP Buyers)
• In some circumstances, C-Corp profits are taxed at lower marginal tax rates than S-Corps
• May be more attractive to third party buyers / investors
• No limitations on shareholder count, classification, citizenship, etc. Cons
• Double taxation of profits, though dividends/contributions to ESOP are deductible
• More permanent than subordinated debt (and warrants) as S-Corp election cannot be renewed for 5 years post-termination
• Some tax liability will be incurred, which if a 100% ESOP-owned S-Corp creates additional cash cost
Pros
• Flexibility
• Alignment of equity interests with LLC owners
• Maintain S-Corp tax benefits to the extent of ultimate ESOP ownership
• Ability to attract outside capital
• Lenders prefer this structure, in certain situations, as it provides additional equity
Cons
• Compliance with legal requirements of employee leasing
• Equity in LLC may be more costly than debt to the ESOP
• Drop down tax leakage and complexity
• Fiduciary hurdles with regard to distributions
Selling shareholders may receive most or all of proceeds in cash and ability to elect to defer capital gains taxes through§1042 election
Structure may make acquirer more competitive against other bidders or be able to win with lower nominal price due to tax savings achieved through § 1042 election
Target employees become participants in acquirer ESOP, aligning corporate culture and employee incentives
Sellers can participate in Target management equity incentive plan (typically a SAR plan) if desired
Target’s corporate legacy may be better preserved with a transaction that may allow for continuity of operational management and opportunity for employees
Complex transaction with many moving parts
Potential for increased regulatory risk (DOL & IRS)
Cost to implement may be higher
TJ Genz, ASA
Managing Partner
ESI Equity
Peter DeLong
Executive Director
J.P. Morgan Chase
Linshuang Lu, MSOD
Managing Principal
Leslie Moulton-Post President & Chief Executive Officer
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»Envisions desired future
»Builds alignment and commitment among key stakeholders
»Responds to the current environment and anticipates future trends
»Articulates how that future will be achieved
»Establishes priorities; Guides the allocation of resources
»Establishes clear priorities
»Creates shared commitment and understanding
»Guides department and individual planning, decisionmaking and actions
Strategies
How you will accomplish your goals and objectives
Objectives (1 year or shorter; or components of the goals)
Metrics
Goals (3-5 years)
How you will measure whether you’ve met your goals/objectives
Mission
Vision (10-30 year)
Values (Long lasting)
“Anchors”
About the identity of your organization
• Tap into valuable insights, knowledge and ideas
• Create shared understanding of the company’s environment and current state
• Gain commitment to strategy
• Develop people’s capacity to think strategically
• Activate energy and attention to start implementing your strategic plan
• Who to involve and when?
• What are decision-making expectations?
• What’s the right balance of broader participation and efficiency?
Phase 1
Planning
Phase 2
Data & Implications
Phase 3
Strategic Priorities
Phase 4
Operational Alignment
EXTERNAL RESEARCH
RECONFIRM AND/OR
ESTABLISH ANCHORS
IDENTIFY BIG QUESTIONS
INTERNAL ASSESSMENT
ORGANIZATION GOALS, OBJECTIVES & STRATEGIES
DEPARTMENT GOALS, OBJECTIVES, TIMELINES
FORMAL STRATEGIC PLANNING PROCESS
INDIVIDUAL GOALS
IMPLEMENTATION
Identify Big Questions Reconfirm Mission, Vision and Values
Conduct External Research & Internal Assessment
Set Goals and Strategies Align and Implement
Planning committee develops with input from board and senior leadership
Board approves final draft recommended by task force All employeeowners provide input
Planning committee to guide process All staff via survey External stakeholder Interviews Select areas for external research
Planning committee makes recommendation after goal-setting retreat with managers and directors Board approves final goals and strategies
Annual goalsetting meetings conducted in departments with all staff involved
All employee-owners are regularly updated throughout process
Formal planning process begins
Formal strategic plan complete
Involving and engaging employee-owners during the planning process makes implementation easier
Engage employees with regular planning, monitoring and communication
involvement
Survey or focus groups
Communication
All-company communication on strategic plan goals
Plan guides department and individual goal-setting
Leadership, crossfunctional and/or department monitoring teams
Task forces working on specific issues
Visual displays of strategic plan goals
Cross-functional teams created to work on different goals or actions
Meetings or retreats dedicated to lessons learned & addressing challenges
Feedback and input on preliminary goals
Strategic plan referenced in regular conversation
Annual planning begins with strategic plan
Revision to goals & strategies as needed
Process Principles
Broad and diverse participation
Leadership development
Organization development
External/internal alignment
Develop Purpose Statement (Purpose, Vision, Values)
Gather Data from Stakeholders
Identify
Themes
Develop 5-Year Goal, Outcome Statement, Objectives & Strategies
Adoption & Implementation
• Are the goals and objectives clear? What would help clarify them?
• How will individuals contribute to achieving these strategic plan goals? (ownership and influence)
• What challenges do you see to implementation (i.e., changes needed and possible resistance to change)?
What can we do to address/anticipate some of these challenges?
• Create a comprehensive strategy to share plan with employees and integrate into day-to-day operations
Making it Real
• Engaging your Leadership Team
• Roadmap for Success
• Employee Connection to the Plan
Monitoring, Tracking, Reporting Progress
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• Full service law firm serving ESOP companies and Trustees
– Implementation and maintenance of ESOPs
– DOL and IRS Audits – Sale of ESOP companies
• Experience with a diverse spectrum of industries
• Clients nationwide
• Largest ESOP administration firm with over 1,500 clients, and ~500k employee-owners
• Unmatched reputation as the highest quality service provider
• Unique expertise in the industry underpinned by – Comprehensive solution set addressing complex and mission critical ESOP needs including ESOP and 401(k) administration, consulting, repurchase obligation studies and full communication and education services
(1) ERISApedia 2021 based on Form 5500 data; Represents plan assets of current ESOPs that operates within the US (data as of 2021)
(2) Based on number of ESOPs served
Source: ERISApedia 2021 based on Form 5500 data
• Rapid expansion of Value to Comp ratios
• Companies with a large union workforce that is not participating
• Professional service firms, etc.
• Other issues
• Increasing instances of ESOP loan stretches
• Loans are regularly seen in excess of 50 years (multi-generational)
• Some in excess of 100 years
• Legal
• No litigation, minimal guidance
• “Exempt loan” refers to a loan that satisfies the provisions of Treas. Reg. § 54.4975-7(b).
• Sustainability
• Contribution vs. Annual Benefit vs. Aggregate Benefit
• Impact to RO
• Administration and Compliance
• Impacts to testing
• Loan admin complexities (Benefit Protection periods)
Misconceptions
• Contribution amounts are benefit levels
• Sequential transactions
• Participants may not see Contribution $
• Higher loan lengths alone create immense risk
• Depends on supporting evidence
• Administration is the same with a longer loan.
• Maybe… Depends on Benefit protection periods
• Most companies cannot justify a multigenerational loan.
• Slowing RO is not justification
• Risk to all parties if expectations are not met
• May carry higher advisor fees due to negotiated complexities
• Fiduciary Liability • Prohibited Transaction • Participant litigation • Potential Loan Stretch
• Immediate impacts to 404
• Longer Term impacts to 409(p)
• Testing issues if Company is sold
• Complexities of a loan stretch
• Trustee is responsible to participants now and in the future.
• How far into the future?
• Benefit review process
• Should be considering the following as a % of pay
• Contribution
• Economic Benefit (annual % received by participants)
• Aggregate benefit over benefit protection period
• Should confirm benefit projections were prepared using the same data as financial projections used in the valuation
Details:
• Started 12 years ago with rapid growth over the last 5 years
• Seller electing 1042
• Company Value range - $30MM - $36MM
• Eligible Comp - $2.5MM
• Expecting value growth to outpace comp growth substantially
• Transaction debt to be paid back over 12 years
Details:
• Started 25 years ago with moderate growth over the last 5 years
• Sequential transaction
• Company Value range - $30MM - $36MM
• Eligible Comp - $8.5MM
• Expecting value growth to slightly outpace comp growth
• Transaction debt to be paid back over 10 years, no other leverage
Ted Hall
ShopBot Tools
Anne-Claire
Broughton
Broughton Consulting
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6,467 ESOPs in U.S. with 14 million participants • 465 worker cooperatives in the U.S. with about 6,700 participants • ~28 EOTs in U.S. as of March 2023
• A relatively new form of employee ownership common in the UK
• A trust holds shares of the company on behalf of the employees, who participate in annual profit sharing
Unlike an ESOP, an EOT is not a retirement plan. Employees are part of profit sharing ONLY during their employment tenure
• Regulated by state trust law
•
Allows company to remain employee owned in perpetuity if desired
• Flexible, not regulated by ERISA
• Low administrative costs, no annual valuation
• No favorable tax treatment
• Current profit sharing rather than payout at retirement • Allows for (but does not require) democratic governance • Relatively untested
• EOTs cost about $40K - $60K in legal fees to install and about $5K - $10K annually to administer (versus $150K+ in legal fees to install an ESOP and roughly $30K annually to administer one)
• Employers could contribute to a 401K to help employees also save for retirement in addition to annual profit sharing
• Small manufacturer of Computer Numerical Control (CNC) tools based in Durham, NC with 35 employees
• Tools used worldwide in:
• Manufacturing
Cabinet and furniture making • Sign making
Education
Maker Spaces
• Always shared numbers
• Explored ESOP as an exit
• Implemented GGOB open book management 2017-2018
• Developed EOT 2019-2021 • Established EOT June 2021
• Explored options and settled on EOT
• Commissioned outside valuation
• Secured agreement among shareholders and option holders
• Chris Michael drafted trust document •
Local lawyer drafted promissory notes and formed trust
Anne-Claire drafted EOT Abstract & Governance
• Ted owned 65% of stock
• Key employees (current and former) owned 35% in stock and options
• At trust formation, small shareholders paid out completely
Larger shareholders received partial payment and a 10 year note
• The Notes are not for an absolute amount or a fixed valuation, but an amount defined as a portion of Shopbot’s earnings each year for a period of 10 years
• The payment retires 1/10th of the Note debt every year
8 Members
One+ year of employment
Training in company history, structure, and open book management
Can serve multiple but non-consecutive terms
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• Get executives at market on cash compensation
• Consider transaction implications for any existing LTIP arrangements
• Consider your compensation & ownership philosophies
• Reset cash compensation (if needed) & consider an LTIP
• It is common to issue LTIP awards on the heels of a transaction
• Major terms are often negotiated with ESOP trustee as value placeholder; details come after transaction
• FNB Process Agreement Control Requirements
• Major terms: Award form, % dilution, retention vs performance, evergreen or not, strike price
• Review existing plans/arrangements and determine what changes need to be made
• Will transaction trigger a CIC and distribution?
• Types of arrangements
• SARs – time and performance
• Annual bonus
• LTIP
• Compliance concerns
• 409A
• 409(p)
• Distribution structure
• Tie to shareholder loan payoff/warrants?
• Other timing concerns/strategies
CURRENT RETURN
MID-TERM RETURN
STAKEHOLDERS PRIMARY STRATEGY ALL EMPLOYEES EXECUTIVES OR NEXT LEVEL LEADERS
CASH COMPENSATION
LTIP (synthetic equity)
NQDCP (KPI driven; ER dollars)
RETIREMENT RETURN
ALL EMPLOYEES ESOP
EXECUTIVES & SOMETIMES NEXT LEVEL LEADERS
LTIP (often real equity)
NQDCP (often EE dollars)
• Common to see some management transitions at this point
• Newer management team might have missed big ESOP & LTIP run -up
• Dramatic appreciation may be ending; senior transaction debt mostly repaid; moving into seller debt
• Good time to reassess all compensation
• First tranche of LTIP awards might be maturing
• Start to see switch from LTIP payout value to grant date value
• Grants to new management hires
• Reservation of units in plan
• Trustee input
• Changes in structure/type of award
• What changes need to be made to continue to incentivize executives
• Distribution trigger changes or timing changes?
• Changes in goals
• Change in types of plans
• PE investment for cash flow purposes and effect of same
• May be triggered by repurchase obligations
• Move to actual stock?
• How to handle existing plans – including 409A concerns
ESOP cash flow demands shift over time requiring continual management
• Have and have-not culture
• Newer employees missed both ESOP and even LTIP glory days – particularly if prepaid internal loan
• Repurchase obligation (“RO”) challenges as RO consumes a lot of cash flow
• This can lead to high ESOP contribution levels, yet you must be competitive on cash compensation
• Show total compensation statement to capture the large ESOP benefit
• Sometimes companies distinguish the LTIP for those executives with little in the ESOP
• Most LTIPs now are at grant date value
• Disposition of plans –
• Accelerated vesting
• Tying payment terms to sale terms
• 409A compliance
• Accelerated payment
• Termination of plans
• 280G concerns
• Type of entity
• Retention Agreements
Leadership
• Often selling shareholders
• Retained employment per agreements
• Sometimes precluded from LTIP
• Selling shareholders might transition to board at this point
• Succession leadership promoted
• If leaders are new, they missed significant ESOP & LTIP values
• Have & have-not culture emerges
Cash Compensation
• Bonuses often reset from “profits” approach to market
• Assess market comp. for new leaders
• Align bonuses with new roles
• Must be at market to recruit from outside the company
LTIP
• Rapid appreciation
• Typically focus on payout value
• Major LTIP terms are baked in
• Dramatic appreciation might be over
• Reassess LTIP design and size
• Some LTIPs run at payout value & some grant value
• Some companies do focused grants to jumpstart alignment of new leaders with shareholders
• Sometimes see phantom stock as an ESOP replacement
• Many LTIPs run at grant value now
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The best companies are those that generate the most ideas and identify to most problems from the most people. Imagine if your company could generate just one good idea or identify just one unnoticed problem per employee per year. How much better would your company be?
It’s a simple idea, but it takes persistence and commitment to make it happen.
Companies with Ownership Culture Perform the Best Companies that combine broad-based employee ownership with high-involvement cultures grow 6% to 11% per year faster than those with either.
Ownership alone and involvement alone have much more modest effects.
Many companies think that if they communicate ownership effectively, employees will work harder and the company will perform better. Turns out, that is not true.
Do this exercise:
1. % of employees likely to work harder because they are owners. Exclude those who already are “incorrigibly good” and “incorrigibly bad.”
2. % of total day you would get in extra effective work time.
3. % of costs attributable to labor
Multiply 1 x 2 x 3
Surveys show about 50% or more of workforce is “incorrigible.” It may be more at your company because you are probably a good employer already.
Most companies would be happy with another 30 minutes of effective work per day (6.7%)
Labor costs vary widely, but average about 30%
.5 x .067 x .3 = 1% reduction in costs
Great ESOP companies are idea factories. They set up structures that get more people identifying more problems and generating more ideas.
You need an ownership culture
A culture where people feel and act like this is their company.
A company that communicates what an ESOP is and how it works effectively and regularly.
A company that shares information about performance at the company and work levels.
A company that does not just ask for people to identify problems and share ideas but provides a specific structure and expectation about how to do it.
A company that focuses decision making on expertise not titles.
A culture where employees owners have more rights—and more responsibility.
So does everyone!
When should an employee walk in?
Will employees feel like they can articulate the idea well enough?
Will they be told “we have done that before” or “I’ll get back to you later?”
Will the boss take the credit?
Anything you do to try to encourage identifying problems or solutions that is ambiguous and uncertain will not work!
• At least once a year, but preferably more often, share the overall basic numbers on how you are doing.
• Make sure to explain them in simple terms line by line.
• Don’t just focus on income statements and balance sheets. Share the critical metrics for your business (such as overhead absorption, new customers, returns, new product development and deployment, etc.)
• Develop critical number metrics for each work unit— numbers people can use day-to-day to measure performance (see next slide).
• If the income statement is the score of the game, critical numbers are the statistics to measure the game within the game.
• Each area of the company, and the company overall, has a few key performance indicators that do not appear on financial statements. The best companies build these from the bottom up with employee input, chart them prominently, and teach people how to use them.
• Examples include overhead absorption, customer satisfaction, return rates, defects, contributions to overhead and profits for sales contracts, new customers, customer retention, and many, many more.
Manufacturer of specialized equipment for high-risk rescue environments.
Line of sight program gives each employee a chart with a graphic that links individual to department to company performance. The individual's line of site is a specific set of metrics and commitments each employee makes, with a heading of “How My Contributions Affect CMC Rescue’s Performance.” They are all posted on a common site. For instance, a planner and scheduler’s included:
• Improving on-time delivery percentage.
• Providing the right due date to the right team.
• Identifying if orders are late and letting customers know.
• Communicating priorities to shipping, manufacturing, and warehouse to make sure everyone is on the same team.
• Providing accurate information to those who need to know about scheduling issues.
Don’t bother me with a problem unless you have a solution!
Too many ideas programs insist “if you don’t have a solution, don’t bother me with the problem.” As in, “if you smell a gas leak but don’t know how to turn off the gas, don’t bother me.”
Identifying problems is harder to identify and more critical than finding solutions—with the right problems to solve, solutions are mush easier to find.
Don’t bother me with a problem unless you have a solution!
Too many ideas programs insist “if you don’t have a solution, don’t bother me with the problem.” As in, “if you smell a gas leak but don’t know how to turn off the gas, don’t bother me.”
Identifying problems is harder to identify and more critical than finding solutions—with the right problems to solve, solutions are mush easier to find.
Teams need to know what they can talk about, what they can decide, and what they can only recommend.
Consider having a dollar limit that, if under, they teams can carry out any idea without permission. Have a bias towards yes. Even if there are errors, employees will learn.
1. Create a team of volunteers (and maybe a couple of critical “voluntolds”) to form an ideas team. If you have multiple locations, you may need multiple teams.
2. The team is in charge of creating an ideas process that works for your company—and that will vary from company to company.
3. In some companies, any employee with an idea or who identifies a problem brings it to the team to figure out what the next steps are.
4. In other companies, the ideas team leads the structuring of teams at the work level and cross-functional teams across the company to make decisions about their areas. Teams may be ad hoc or permanent.
5. Use web-based systems to track ideas, measure progress, and get feedback.
• The problem buster committee
• Idea tracking systems in dispersed workforces
• Incentives for ideas or problem identification
• Work level teams
• Self-managing cross function teams
• Mini-Games
A six-person Idea Engine Committee from three locations makes up the ideas team. Team members had previously gone through some Lean training together and were best equipped to implement a process for implementing improvements. The team manages the MSA Idea Engine process of obtaining, reviewing, and steering the implementation of ideas received from within the company. That involves employee huddles, an idea board, ideas email, and a vetting process for the ideas. All employees participate in one or more teams based on their functions.
Huddles by each team in the company are held every month, and at every third huddle (quarterly) there is a goal of generating three ideas per employee. The team then has an idea vetting discussion and then votes for the winner, with each employee getting three votes. The whole process takes 20-30 minutes or less. The winning idea from each team is submitted on an idea card.
Idea
Name Date
What is the problem/waste?
Why is it happening?
Idea:
Date implemented:
Huddle day and time
Ideas and Progress
Huddle steps:
1. Review metrics
2. Ideas in progress
3. New ideas
4. Celebrate!
Parking lot ideas Needs help that need help Review every three months and move to in progress when a task is assigned.
Completed ideas
Parking lot ideas are those that got the second, third, or fourth highest votes, and are revisited at subsequent huddles and discussed for five minutes. Ideas from outside the teams are welcome as well. The process generates a lot of ideas, but now there needs to be a vetting process to implement them. The Idea Engine Committee can assign subcommittees and designate responsibilities if it believes an idea can be implemented. The idea generator is contacted, and often more information is sought. Subcommittees are synced with the team’s schedule.
Ideas team leaders send the ideas that are chosen (see vetting process next slide) to a designated email, and a tracking systems—the “idea pipeline”—is posted so that everyone can see. The pipeline shows what ideas have been submitted and what their status is.
Number of Barriers:
Level of impact: Low High High
Implement
Consider
Ideas that will be enacted on because they have few barriers and high potential.
Not
Ideas to be investigated further because they have high impact potential but significant barriers. Low Possible Ideas that might be acted on because they have few barriers but also limited impact.
Almost all of the ideas here work through some kind of team structure. Teams can be great, but can also fail because of:
Groupthink
Excess faith in consensus
Negative geniuses
The wrong issues
Lack of follow-through
Poor team leadership
Wrong people on the team
Lack of diversity
Above all, lack of psychological safety
Matrix structure with three groups of teams: Functional teams, such as finance and human resources, support the entire organization
Business teams focus on a particular family of products, contributing extensive product expertise
Regional teams, divided by global region, are charged with a deep understanding of the company’s customers. If one team has excess capacity, it can send associates to other teams in need of resources.
Within these broad teams, smaller teams of employees at all levels meet regularly to submit ideas, called “continuous improvement activities,” or CIAs, for making the company better. Teams themselves are charged with the responsibility of bringing their own ideas into practical use. There is extensive training for team leaders.
Traditional strategic planning is top down, driven by management.
High-involvement strategic planning is iterative: top-down, bottom-up, and back again.
The goals are:
• Create more employee buy-in into strategic planning
• Get ideas from employees about new marketing, product development, process and quality improvement, and customer service opportunities
• Reality-test management initiatives
• Identify key influencers in company who are not necessarily in management
• Share financial information about company overall
• Develop and share metrics for projects
• Teach employees how to do project costing for new ideas
• Track the results
• Have a tolerance for missteps
• Set up templates to follow what is happening— identify project, goals, owners, metrics, and results
• Share stories about what works and what doesn’t— and why.
• Every company faces specific challenges and opportunities
• Start somewhere, evaluate, and change
• Don’t reinvent the wheel—start with a model from another company and adapt
• In this presentation, we will look at a variety of models
Beyond Engagement: How to Turn Your Company into an Idea Factory
The ESOP Communications Sourcebook
The ESOP Committee Guide
The ESOP Communications Crash Course
The NCEO annual conference
Joel Davis, Vice President of Consulting Principal Financial Group ® Minneapolis, MN Cell: 651-302-8218
Davis.joel@principal.com
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4. Complete the CE Survey.
• Understand the requirements for receiving benefits under the ESOP as well as the pros and cons of alternative approaches
• Identify and discuss alternatives to plan rules based on a company’s objectives
• Explain the roles of all parties in the ESOP plan design process
• Questions – Ask them as you have them!
• ESOP plan rules are typically established at ESOP formation
• Focus at the time is closing the transaction – negotiating purchase price, deal terms, etc.
• ESOP rules are often afterthoughts
• Re-evaluate plan rules as the plan matures
• Are they meeting your objectives?
• Do you understand your other options?
• How do you evaluate impact of changes?
Age requirement
• Maximum is 21
Service requirement
• Maximum is 1 year if using a vesting schedule
• May require 2 years with full and immediate vesting
• Very unusual
• Option of more liberal rules for the first plan year
Certain classes may be excluded as long as the plan can meet coverage and participation requirements:
• Union Employees
• Non-Resident Aliens
• Leased Employees
Must enter the plan the earlier of:
• The first day of the plan year which begins after the date the employee completes the statutory age and service requirements, or
• Six months following the date the employee completes the statutory age and service requirements
Rethinking eligibility
• Do you regularly hire employees who are younger than 21 years old?
• Does the plan cover the desired employee groups?
• Does the service requirement still make sense?
Rethinking plan entry rules
• Is the ESOP too intangible for newer employees?
• When have employees waiting long enough?
• Impact of changing entry rules
Service Requirement
• Typically 1,000 hours of service
Employment Requirement
• Typically must be employed on the last day of the plan year
May be waived for death, disability, and retirement
Plan must have a definite allocation formula
• Proportionate to each participant's compensation
• Points allocation based on compensation and service
• Per capita
Plan must define compensation
Definition – Many common definitions are “safe harbor”
definitions
Most common exclusions
• Overtime
• Bonuses
• Commissions
• IRS limit: $330,000 (2023)
Include full-year compensation for participants who enter the plan mid-year?
Rethinking allocation rules
• Ongoing part-time employees
• Special allocation formula still relevant?
• Appropriate to incentivize employment through 12/31? (Last day rule)
Rethinking compensation definition and rules
• Align 401(k) and ESOP definitions?
• Include full year pay for initial year of eligibility?
• Be sure to understand the impact of excluding types of compensation, such as –
• Excluding commissions for salespeople
• Excluding bonuses to “levelize” allocations
New ESOPs almost always include the same basic distribution language (see below)
• No later than the plan year following the event
Other termination
• No later than sixth plan year after the plan year of termination
• Can be delayed further with leveraged ESOPs in some cases
• Most ESOPs allow for distributions in the form of shares or cash
• Company determines form of distribution, subject to specific situations
• ESOP participants may have a right to demand distribution in the form of stock (subject to “put rights”) unless –
• Charter or bylaws restrict the ownership of substantially all outstanding employer securities to employees or to a qualified plan trust;
• Plan Sponsor is an S Corporation (although an S Corporation may still distribute stock with the requirement that it be immediately sold to the company or ESOP); or
• Banks that are prohibited from purchasing their own stock.
• Lump Sum
• Installments
• Over a period not exceeding 5 years
• Longer time frame for large balances
According to the IRS, reshuffling is “the mandatory transfer of employer securities into and out of plan accounts, not designed to result in an equal proportion of employer securities in each account.”
Reshuffling and “segregation” are often used synonymously.
• The accounts of terminated participants in assets other than company stock so they don’t continue to share in the appreciation of the company. This practice is sometimes called segregating terminated participants’ accounts.
• Terminated participants receive other investments from active participants in exchange for stock. Active participants receive stock from the terminated participants in exchange for other investments.
• Limited by cash in plan
Rethinking distribution commencement rules
• Understand “commencement date” is typically when the participant must be offered a distribution, not required to take a distribution
• Understand the impact of delaying the participant’s right to request a distribution
• Does plan allow forced distributions if vested account balance is $5,000 or less?
Rethinking form of distribution rules
• Does plan allow company to pay in shares or cash?
• Does plan allow participants the right to choose stock or cash?
Rethinking form of distribution rules
• Does plan allow company to pay in shares or cash?
• Does plan allow participants the right to choose stock or cash?
• Impact of redemptions v. recycling on repurchase, and imbalance of shares within the plan
• Difference with minority v. 100% ESOP
Rethinking distribution methods
• Analyze the balance of protecting the company’s cash flow with paying participants sooner
• Understand options and best practices
Rethinking reshuffling/segregation rules
• How are segregated, non-stock assets invested?
• Accelerate payment commencement timing for segregated assets?
• What if only a portion of the total terminated participants’ account balances can be segregated?
415 Testing (Maximum Annual Additions)
• Lesser of Contribution or Fair Market Value of Shares Released
• Limitation Year
• Correction method
410(b) Coverage Testing
• Limit Highly Compensated Employees (HCEs) to Top Paid Group
• Include failsafe language
409(p) Testing
• Include provisions to make sure test passes
• Regular check-ins with professionals if concerns exist
Best practices:
• Interest of plan participants
• Multiple perspectives in the room
• Regular meetings and coordination between advisors (TPA, legal, valuation)
• Clear decision process (and parties) for making changes to the plan
• Board approval
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The Presenters gather their data from sources they consider reliable; however, they do not guarantee the accuracy or completeness of the information provided within this presentation. The material presented reflects information known to the Presenters at the time this presentation was written, and this information is subject to change. The Presenters make no representations or warranties, expressed or implied, regarding the accuracy of this material. The views expressed in this material accurately reflect the personal views of the authors and do not necessarily coincide with those of their employers.
The Presenters do not provide accounting, tax or legal advice. The information and material presented herein is provided for educational and informational purposes only and is not intended to constitute accounting, tax or legal advice or to substitute for obtaining accounting, tax or legal advice from an attorney or licensed CPA.
Martin Drake and Stevens & Lee are not affiliated with any company of the Principal Financial Group®.
Karen Ng
Nixon Peabody LLP
Ashleigh Newlin
Chartwell
Leveraged ESOP = An ESOP which acquired shares of Company Stock by issuing a promissory note i.e., borrowing funds.
Releveraged ESOP = A previously Leveraged ESOP which acquires additional shares of Company Stock by issuing a new promissory note i.e., borrowing funds again.
COMPANY
TERMINATED PARTICIPANTS
Internal Loan & Pledge of Stock
• Company redeems ESOP shares due for repurchase
• Company sells some or all redeemed shares back to the ESOP in exchange for an internal loan
• Shares sold to the ESOP are held in unallocated loan suspense
• Shares are released over time based on internal loan payments; the released shares are allocated to participants
MANAGE REPURCHASE OBLIGATION
No new shares to allocate -- “Haves and Have-Nots”
Large number of terminated participants
Lack of control over annual contribution levels
Balance with Non-ESOP shareholders
• Releveraging reduces the number of shares to be repurchased in the future versus recycling by reallocating shares gradually over a long period of time, typically 30+ years
• It results in a lower stock price versus redeeming by maintaining a greater number of outstanding shares
• 100% ESOP-owned S corporation
• Distribution business model
• Repurchase obligations are >25% of qualified payroll
• Company makes 22% contributions to ESOP. How should shortfalls be handled?
• Recycling with S distributions,
• Redeeming, or
• Releveraging
• Fewer shares need to be repurchased relative to recycling
• Share price is lower relative to redeeming
Shares Repurchased (10-Year Total )
Recycle Redeem Releverage
Year 10 Estimated Per Share Value
Recycle Redeem Releverage
Releveraging reduces the 10-year repurchase obligation by $34 million (12%)!
No new shares to allocate -- “Haves and Have-Nots”
• Releveraging provides additional shares which can be allocated to “have-nots” based on compensation
• While most commonly, releveraging follows a Company redemption in conjunction with normal ESOP distributions, there are other options:
• Company sells newly issued shares to the ESOP
• Company redeems all shares from terminated participants’ accounts including those still in the ESOP (via segregating)
Large number of shares held by terminated participants
• Releveraging is often paired with a one-time distribution offering or segregation of terminated participants’ accounts
Lack of control over annual contribution levels
• Establishes a baseline for annual contributions versus annual benefits
Balance with Non-ESOP shareholders
• Keeps ESOP’s percentage ownership within a desired range
Myth #1 - Once the ESOP loan is paid off, you need to releverage to provide a future benefit to participants.
Debunked!
Often the repurchase obligation is increasing, and the recycled shares alone provide an adequate benefit to active participants.
Myth #2 – Releveraging will, by itself, solve any “have vs. have-not” problems.
Debunked!
Releveraging only helps if the “haves” are due benefit distributions. Could accelerate benefit distributions by offering one-time in-service distributions and/or amending contribution allocation formulas.
Myth #3 – The more releveraging, the better. In other words, you could/should releverage every year.
Debunked!
If loans are layered year after year, loan payments can become high, which locks in a high benefit and limits future flexibility. Also, at some point a higher % of unallocated shares (>50%?) may be undesirable.
• Same 100% ESOP-owned S corporation
• Remember, repurchase obligations are >25% of qualified payroll
• “Releverage more” scenario: The company limits contributions to just 5% (instead of 22% as shown previously) and releverages the entire shortfall annually.
• Releverage amounts are large; in fact, no shares can be recycled starting in 2024 because the entire contribution is needed for loan payments
• Annual loan payments grow to 12%; well beyond the desired contribution
5%Target Contribution
• With too much releveraging, fewer and fewer shares are allocated to participants over time.
Price protection related to post-transaction drop in value
a) Is it prudent to releverage?
b) Why should the ESOP take on debt to buy shares when it already owns 100% of the company?
c) What impact will releveraging have on current participants?
Administrative/ legal costs
Managing Repurchase Obligation – consider changing the ESOP’s benefit distribution policy i.e., incorporating delays in timing and/or paying in installments and/or moving away from segregation.
Managing Benefit Level - consider recycling up to a certain percentage of payroll and then handling remainder of repurchase obligation by redeeming shares or making S corporation distributions. [Beware of managing the benefit level too low!]
Addressing “have and have-not” issues –
• Consider making higher contributions and/or segregation and/or in-service distributions.
• Consider making contributions in the form of newly issued shares of company stock.
• Consider modifying the ESOP’s formula for allocating contributions to favor participants with fewer years of service.
• Consider using a non-qualified plan, such as SARs or phantom shares to “make up” for missed benefits to key executives.
Think about impact on all stakeholders –
• What will happen to the accounts of new and tenured active participants?
• What will happen to the accounts of terminated participants?
• Will there be any issues with the company’s balance sheet and/or financial covenants?
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.
1. Understand the steps for securing external financing for an ESOP transaction
2. Learn strategies for a successful ESOP financing process
3. Understand key decision points for selecting an ESOP lender
1. Overview of a Typical ESOP Process
2. Approaching Lenders
3. Preparing the CIM
4. Framework for Making a Decision
Education
Feasibility Transaction
Preliminary Financing Conversations
Valuation
Overview of ESOP Structures and Alternatives
Select Trustee Team Prepare Management Presentation / CIM
Diligence with Trustee Team and Lenders
Legal Documentation Fund and Close
1. Company borrows money from lenders
2. Selling shareholders redeem stock for a combination of cash and seller notes
3. Company lends cash to ESOP in exchange for a promissory note. The ESOP will pay for the shares over time
4. ESOP purchases shares from selling shareholders for cash
Preliminary Conversations with Lenders:
Gauging preliminary interest based on a high-level company profile, industry, financials, etc.
Formal Diligence
Execute NDAs and provide the details / source information that backs up the story and investment merits presented in the CIM.
Preparation of a CIM:
Providing potential lenders with the information and context they need to make an informed decision, and get the best price, terms and conditions
Continued Diligence
Provide additional diligence information as requested to move through the full underwriting process
Legal Documentation
Compare term sheets and select top banks for meetings with management
Select Bank/Lead
Potential syndication process
Fund and Close
• Bank financing is a cornerstone of many new ESOP transactions
• Provides selling shareholders with cash at close to finance their lifestyle and/or fund reinvestment strategies such as I.R.C. 1042
• Typically the lowest cost of capital source of financing for a transaction
• A well-organized process can be the difference between successful and unsuccessful transaction
images: Flaticon.com
• The strategy for approaching lenders is customizable and should be based on your specific situation
•
Common Objectives:
Maximum cash at close
Higher certainty of close
Retain current lender relationships
Charitable endeavors
Realize non-operating asset value
Maintain a conservative balance sheet
• Your objectives will tell you and your lenders how you should approach the ESOP financing process
• Key questions to discuss with your advisors are:
• When do you initiate the conversations in your deal cycle process?
─ Need to be conscious of management resources
• Which employees do you involve in the process?
• How many parties are invited to the process?
─ Relationship with and capacity of the incumbent bank?
• Key questions to discuss with your advisors are:
• How do you evaluate a bank’s abilities?
• When do you provide more information (i.e. the CIM)?
• When is it appropriate to schedule management meetings with lenders?
─ Do confidentiality concerns determine where you meet?
images: Flaticon.com
• Reputation
• Depth / breadth of management
• Relationships with existing lenders and
• Experience with debt
• Sustainable Competitive Advantages
Competitive Environment / Substitute products
• Stability of current and future cash flow
• Concentration of client revenues
• Ability to meet covenants
• Margin of safety
• Other demands on capital
• Subordinated seller debt
• Access to other sources of capital
• Acquisitive of organic growth
• Loan structure –conventional or asset-based loan
• Collateral coverage
• Types of assets held by the company
• Advance ratios
• Unencumbered real estate
• A key underwriting document for prospective lenders
• In an early RFP situation, it’s a substitute for a management meeting
Comprehensive Company Overview Sales Document
• Company History
• Organizational Structure
• Industry Overview
• Strategic Plan/Competitive Advantages
• Key Management Personnel
• Customer/Vender Relationships
Transaction Description
• Company’s goal for the transaction
• Requested Loan Terms
• Sources and Uses
• Ability to Repay
• Summary Historical Statements
• EBITDA Adjustments
• Projections
• Present the Investment Thesis
• Identify Risk and Mitigants
• Growth Opportunities
• Timeline for Responses
• Closing Timeline
• Company History/Historical Timeline
• Corporate Ownership Structure
• Post-Transaction Management Team (+Seller’s continued involvement)
• Products & Services
• Competitive Position and Sustainable Advantages
• What risks could impair the company’s success?
• What are the Seller’s goals for selecting an ESOP?
• Historical Financial Statement Summaries
• Income Statement and Balance Sheet – Typically 5 years
• Highlight key Performance Metrics
- Gross profit and EBITDA margins
- Backlog and pipeline
- Working capital analysis (receivables and inventory turns)
- Maintenance vs. growth capital expenditures
- Revenue/profitability per employee
- Others as relevant by industry
• Include Logical Breakouts:
• Division/Product
• Geography
• Adjustments to EBITDA
• Defensible
• Numerous or complex:
- Supported by a Quality of Earnings?
• Supported by changes in transaction documents
• Explain Inflection Points Where Business Shifted
• Causes and Resulting Management Reaction
• Onboarding new talent/leadership
• Covid Impact, PPP, Pricing Power (inflation), Supply Chain Disruption
• Customer Concentration
• Supplier Concentration
• Document the assumptions behind the projections
Growth Cash Flow
• Slow or rapid growth?
• Early years backed up by backlog, contracts, or trend lines?
• Continued strategy or change in direction?
• Organic growth or acquisitions?
• Explain changes in margin assumptions
• Fixed or variable cost structure
• What capital investments are required to support growth or maintain stability?
• Will working capital requirements change?
• What is the magnitude of expected ESOP repurchase obligation?
What is sustainable free cash flow?
• After receiving the CIM and a going through a formal diligence process, interested lenders will provide term sheets
• The term sheet will outline the overall price, terms, covenants and other conditions that are being offered
Sample Term Sheets
Terms
Covenants
• Minimum Fixed Charge Coverage Ratio: X.xx
•
• Who needs to agree on the outcome?
• Sellers, Succession Management, Trustee
• How do you judge capacity to close?
• Bank group (sole bank or syndicated/club process)
• How does the timing of the bank process fit into the overall timing of the ESOP transaction process with the trustee team?
Decision Checklist
Structure Terms Rate
Tenor
Personality/Connection
Local/Regional/National
Industry Understanding
History with Advisors
ESOP Experience
Reputation
Legal Understanding
Incremental Fees
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Finance: Revenue, Profit, EBITDA
Shareholders: Stock Value / Future Appreciation Potential
Human Capital: Labor Dollar per Revenue/Profit
Employees: The Ability of a Business To Deliver on Its
Employer Brand
Finance: Reports/Dashboards
Shareholders: Stock Report / Shareholder Report
Human Capital: Dashboards
Employees: How they feel
The degree to which an organization is successful
Social Engine Financial Engine
Capital Working
Cash Health
Investment/Risk
Individuals Groups
Markets/Buyers
Individual Performance: Head, Heart, Hands
Team Performance: Interaction, cooperation, coordination
Organizational Citizen: The critical few behavioral norms, skills, and knowledge
Markets/Buyers: The businesses distinctive DNA and expressed culture
How can I own something else if I cannot first own myself?
lower direction
higher direction
Understands the value proposition, purpose, mission, plan, and values and productively contributes critical thinking, makes autonomous dailydecisions, and works with others on future oriented ideas and solutions. Knows that the value proposition for distinction transcends a financial report.
Financially Aware
Understands the state of the company and pivots actions to meet and exceed the current and foreseeable business needs. Possesses a solver and builder orientation.
Socially Emotionally Intelligent Team contributor adept at communication and integration. Possesses a transmissible codetermination.
Capable & Determined
Doing the job/tasks/goals well, evolving skills with the business, leveling up
10% books, workshops, classes, etc. (formal learning)
20% coaches, mentors, bosses, etc. (social learning)
70% application/practice/microlearning (experiential learning)
And … of this 70% at least 10% should be through failure
How do I show up?
What am I capable of now and in the future?
What were my contributions and how did support others in making an impact?
What results and goals did I achieve?
• Clarify inputs/outputs
• Teach and model selfleadership
• Diagnose and set goals/task clarity
• Focus on needs
• Think beyond the job to organizational citizenship
• Define what good looks like for your vital few behaviors
