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Equitable Edge Services LLC
Covered in Today’s Session:
1. Roles in Valuation
2. Forms of Communication
3. Challenges
4. Communication with Employees
5. Dorian Drake International Case Study
• Undergo process and making a record of steps undertaken
• Selects and engages valuation firm
• Information gathering--documents and due diligence
• Review and understand analysis
• Communicate to company
• Valuation firm advises the trustee, but the trustee determines and approves the value per share
• Reminder: Read the ESOP plan documents
• Select and appoint a qualified trustee(s)
• Provide essential tools to the ESOP trustee(s) to oversee and set valuation as necessary
• Note qualifications of trustee(s) and their process
• Information to the ESOP trustee valuation team
• Complete and accurate information
• Projections: reviewed by Board before provided to valuation firm?
• How predict financial performance years ahead?
• Historical financial statements and any other information relevant to the valuation
• Monitor the actions of the ESOP trustee (and any other plan fiduciaries it appoints)
• Understand repurchase obligation considerations and valuation implications
• Review process and understand methods used in the valuation
• Confirm ESOP trustee is setting value appropriately--ensure process is adequate
• Supervise communication to ESOP participants
• Verbal communication of the price per share
• Valuation opinion letter
• Full valuation report
• Offer to present summary of analysis and illustrate value drivers
Note: Board must understand the report is for ongoing valuation purposes (not applicable for M&A use) and is authorized for plan administration functions only
• only available to be shared with appropriate process and written acknowledgement (not intended for banks, potential suitors, etc.)
Consult ESOP legal counsel
• What actions can the company take if it disagrees with the conclusion:
1. Compare changing metrics, assumptions and industry/market research year-to-year
2. Focus on changes in input information versus change in value
3. Discuss with ESOP trustee to understand analysis and logic
4. Ask the trustee to consider soliciting a valuation peer review (not a new valuation)
5. Replace the ESOP trustee and/or valuation firm for the next valuation
• Clear on purpose—not for board to tell the valuation firm how to value company, but to hear board insight to improve future valuations
• Clear on process—valuation firm advises trustee, trustee sets value
• Illustrate credibility—relevant experience, guidance, and practices
• Goal by all to get the best estimate of fair market value, so need some level of flexibility to hear both sides
• Audit committee oversee financial statement production
• Thorough scrutiny of projections
• Repurchase obligations: would an RO study be beneficial?
• Review final valuation report
• Discuss valuation with ESOP trustee and its valuation firm
• Focus on drivers of value
• Align long term strategic initiatives with value drivers
• Integrate analysis into funding and resource planning
• Inform and guide senior leadership executing plans
• Ensure management has the resources needed
• Monitor progress of company pursuing long term plans
• Adjust course as necessary
Setup & Ongoing Select and monitor ESOP trustee(s)
Review information to be used in valuation
Goal for everyone: complete & defensible valuation for the company and ESOP participants
• Every company is different
• Make a plan to determine how much communicate and in what form:
• How much ranges from very high level to the key drivers with financial numbers
• Form: can be a written/verbal presentation, contests, email/newsletter announcement, etc.
• Illustrate what could impact them and their ESOP account--make meaningful
Tips:
• Make relevant for the employees:
• Draw connection between drivers and their wealth accumulation
“Ownership Culture” Influence
• Getting the most out of your ESOP
• How create a cycle of implementing company’s mission and values to influence behavior to drive processes which create value
Co Goals & Values
• Export Management Company
• $50M annual sales
• Staff of 60
• 100% employee-owned
• 20+ years as Great Game of Business practitioners
• Started practicing open book management in 2002
• Created partial ESOP and PSP beginning in 2012
• Completed transaction to become 100% employee-owned in 31Dec21
• Appointed independent trustee
• Attended NCEO conferences in April and September 2021
• Organized Ownership Communications Committee
• Created fiduciary board beginning in January 2023
Advantages of OBM for ESOP Companies
• Transparency and Accountability
• Stake in the Outcome
• High degree of financial literacy
• Ownership Culture
• Easy transition to employee ownership
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To be a steward of employee ownership, resulting in increased employee production, profitability, and wealth, in addition to establishing an employer legacy.
Consistently ranks as a Top 10 Fairness Opinion Provider, as reported by Thomson Reuters and was named the 2021 USA Valuations Firm of the Year by M&A Atlas.
OwnersEdge is a 100% ESOP holding company. We are structured to acquire new operating companies and invest in the organic growth of our existing businesses. Everything we do is intended to deliver value to our collective employee owners, so they have a pathway to their American Dream.
Our ESOP journey began in 1992, when our legacy operating company, CC&N, sold the business to the employees. Over the years, the success of CC&N provided an opportunity to create our diversified holding company.
OwnersEdge was founded in 2015 to protect and serve the sustainability of wealth creation for employee owners. Today, we buy and hold healthy businesses with healthy cultures. and hold healthy businesses with healthy cultures.
1995
CC&N becomes 100% employee-owned
OwnersEdge acquires BAYCOM and TourGuide Solutions
OwnersEdge acquires Qcomp Technologies
Implecho is formed with merger of Rhino Communication Rentals and TourGuide Solutions
OwnersEdge plans to grow to 10 operating companies
CC&N takes 1st steps towards becoming employee-owned
OwnersEdge
100% ESOP holding company is launched; CC&N becomes first operating company
BAYCOM acquires Communications Service Wisconsin
OwnersEdge acquires Rhino Communication Rentals and Infinity Wireless merges with BAYCOM
OwnersEdge acquires Asche & Spencer
Rayser Holdings Inc. (“Rayser”) was created in 2018 to act as a holding company for various current and potential future subsidiary companies. Rayser is located in Cedar Rapids, Iowa, and currently has a portfolio of four operating subsidiaries. The holding company maintains sponsorship responsibility of the ESOP and provides operational, financial, human resources, and accounting support for the subsidiaries. buy and hold healthy businesses with healthy cultures.
1971
Ray Buser founds C.R. Pharmacy Service, Inc. - the beginning of CarePro Health Services.
2004
The Employee Stock Ownership Plan was formed, transitioning ownership of CarePro Health Services to eligible employees.
2018 Rayser Holdings is formed to serve as the umbrella under which the ESOP can diversify beyond healthcare.
2019 KELTEK Inc. becomes the first acquisition under the Rayser Holdings umbrella.
2019 Des MoinesWinterset Memorials, known internally as Midwest Memorials becomes a part of Rayser Holdings
2020
J-TEC Associates becomes the most recent aquisition to join Rayser Holdings in December of 2020.
• Potential drivers to form a holding company
• Broaden cash reinvestment horizon
• Diversification
• Vertical industry integration
• Scale efficiencies
• Enable small companies to become ESOPs
• Liability protection
• Integrated or diversified acquisition strategy
• What roles do advisors and the board play
• How investments are sourced, made, managed and assessed
• Buy vs build
• Internal vs external
• Annual valuation
• What are key operational considerations?
• How does integrating new operating companies play a role?
• What management roles and decisions are at the holdco level versus the operating entity?
• How are overhead allocation decisions made?
• What fits in shared services versus the operating company?
• Can a shared culture be created across an array of different companies?
Our team has extensive acquisition experience and deep expertise in managing an ESOP. In addition, we provide strategic shared services to our family of companies to enhance the culture and long-term sustainability of each business to fuel growth.
Human Resources
Accounting I T
Support Services
Marketin g Systems & Processes
• Transaction Process
• Trustee’s role
– Financial advisor
• Board of Director’s role
– Financial advisor
• ESOP Participants
• Impact acquisitions will have on sustainability
• Target Company integration into the ESOP
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Learning Objectives:
•Identify ways in which to capitalize on increased cash flow attributed to an ESOP through strategic acquisition
•Understand the importance of truly committing to creating a business of businesspeople through employee education and leadership development
•Recognize common pitfalls to avoid when integrating another company into an existing culture
• Industrial Plumbing & Heating Company in Salina, KS
• Founded in 1979
• ESOP Formed in 2015
• Operates 7 different companies.
• Have grown from 13 employees in 2015 to 130+ in 2023
• And…we keep growing!
1. Substantial Tax Benefits, Especially as a 100% SCorporation/ESOP.
2. Maintain Control
3. Create a Culture Around Building a Business of Businesspeople
1. Pay Down Debt
2. Fund Future Acquisitions
3. Invest in Growth Initiatives
4. Improve Employee Benefits
1. Value Creation
2.
3. Mange Risk
4. Diversification
5. Synergies
6. Access to New Technologies and Intellectual Property
7. Leadership Development
8. Succession Planning
• Embrace Strategic Planning
• Seek Shared Vision and Values
• Share Concern for the Welfare of Employees
• Use Open-Book Management Strategies
• Embrace Open-Door Communication
• Encourage Employee Engagement
Source: Acquisition Strategies for ESOP Companies, 2nd. Ed., NCEO
Loren Rodgers Executive Director
National Center for Employee Ownership
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Employee ownership makes the world better.
• Better company performance
• Financial security for employee owners • Lower quit rates • Locally rooted economics
But that’s not enough.
What makes it feel real?
• If someone acts like an owner, she’ll start to feel like an owner.
• It sneaks up on people.
• “Click!”
Employee Ownership Month: Four Tips from the Pros
1. Instead of talking about “retirement,” focus on “wealth building”
2. Account value can matter more than stock price
3. What’s a six - letter word for something every ESOP company does?
Blog post: Employee Ownership Month: Four Tips from the Pros
4. Invite guests
Strongly Disagree Strongly Agree
Generally speaking, I understand the ESOP idea and how it works at this company.
Strongly Disagree Strongly Agree
Generally speaking, I understand the ESOP idea and how it works at this company.
Value (of my own account!)
How does it grow?
• Can I lose it?
When do I get it?
What form do I get it in?
How risky is it?
• BP has about 3,140,000,000 shares
• The value of one BP share on the New York Stock Exchange
April 20, 2010 $60.48
June 17, 2010
$31.71
April 20: $60.48 x 3.14 billion shares = $190 billion
June 17: $31.71 x 3.14 billion shares = $99 billion
Thanks to Yahoo! Finance
To decide, you need to think like an appraiser.
How much are comparable assets worth on the market?
How similar are those comparable assets?
How important are the differences?
The value of the house
“What the buyer pays for the house.”
The value of the ownership in the house
“What the seller ends up with after the sale.”
Ownership Value = House Value minus debt.
See the Employee Ownership Report, May-June, 2008, p. 3.
If the ESOP did not own your company,
who would?
• Be patient
• Talk with peers at other companies
• Track the small signs
• Build a rhythm
• Assemble a group
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An Investment Policy Statement is a written document outlining an investment plan.
• Helpful roadmap for today and for those who will be fiduciaries later
• Creates clarity and transparency for the board and trustee
• Serves as a guide rather than a strict set of rules
What’s in it?
Typical items found in an IPS include:
• Investment Philosophy/Investment Goals
• Allowed/Prohibited Investments
• Monitoring/Review schedule
• Liquidity Needs/Risk Tolerance (can vary depending upon what the monitoring and review bring)
• A newly formed ESOP may have little liquidity to be managed, but being prepared for when that day comes is important
• Provides documentation around investment choices in the event of an audit, and evidences a fiduciary process
• Gives consistency to the plan investments and performance over time as new fiduciaries take over
• IPS is a road map, but where are you going?
• Need to establish goals and priorities for cash and investing
o Working capital
o Capital expansion
o Acquisition
o Repurchase Obligation
• When will the cash be needed?
• Should excess cash be invested within the Company or within the ESOP Trust or both?
• Need to consider how you are going to use the cash
o Working capital - Company
o Capital expansion - Company
o Acquisition - Company
o Repurchase Obligation – Company or ESOP Trust
• Decision impacts the IPS
• Pros and Cons
• Company:
• Use cash for different purposes
• Impact to valuation
• Fiduciary responsibility
• ESOP Trust:
• Can only be used for repurchase obligation or ESOP expenses
• Impact to valuation
• Fiduciary responsibility
What is in an IPS?
• All qualified Retirement Plans should have an IPS
• Not one size fits all
• Can be stand alone but often in ESOP and/or Trust
• As ESOP matures stand alone may become desirable
• Can coordinate with other qualified plans
• Philosophy Statement as an overall guide
• Risks and the benefits
• Acknowledge market-value fluctuations
• Outline Investments that can be made
• Allows for investment in employer stock
o Loans for purchase of company securities
• Other recommended investment is primarily cash
• Example: may recommend two to three years of obligation payments on hand depending on repurchase analysis
• Cash Need Timeline - as cash accumulates may allow other investments
• May identify specific types of investments for Diversification and Segregation
What is in an IPS?
• Outline Decision-making framework for Plan fiduciaries
• Responsible parties and roles (Trustee and/or Committee)
• Decision making process
• Criteria for Investments and Advisors
• Documenting decisions – minutes
• Investment or Oversight Committee
• Periodically reviewed and updated
• Acknowledge ERISA, IRC and ESOP Control
Ryan Graham Managing Director
Scot Storjohann Senior Vice President
SStorjohann@greatbanctrust.co
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• Defining Sustainability
• Common Sustainability Concerns
⁻ “Haves vs. Have-Nots”
⁻ Repurchase Obligation
• Young ESOPs: Understanding the consequences of your plan design
• Mid-Life ESOPs: Revisiting distribution policy and diversification
• Mature ESOPs: Benefit levels, releveraging, & other creative solutions
• Conclusions
• Sustainability: To keep in existence, maintain, continue, or prolong
⁻
What makes an ESOP Sustainable?
• Company is able to afford ESOP cash requirements in the long term
• Long-term benefit is provided for ESOP participants
• ESOP policies are aligned with corporate strategies and long-term goals
⁻
Who is responsible?
• Board, Trustee, Management?
• ESOP sustainability is dependent on business sustainability
• Starts with overall structure of ESOP transaction
• First 5 to 10 years:
⁻ Paying off the ESOP transaction financing
• Cash flow concerns, rapid increases in share value as debt is repaid
• Years 10 – 15: ⁻ Repurchase obligation increases
• Diversification & termination distributions to vested participants, growing account balances
⁻ Share price recovered from impact of debt load
• Years 15 – 20+:
⁻
Mature ESOP
• All shares are allocated, larger repurchase obligations
• The “Haves”
• Shares largely concentrated in accounts of long-term participants
• vs.
• The “Haves-Nots”
• Not many shares in accounts of newer participants
• Could also refer to large % of shares in accounts of former employees (“haves”) vs. active employees (“have-nots”)
• “Haves vs. Have-nots” might emerge if:
⁻
ESOP is heavily funded with dividends or S corporation distributions (partially-owned S corporation ESOP)
⁻
Short ESOP loan schedule, or prepayments on ESOP loan
⁻ Long distribution delays / installment periods
⁻ Repurchase obligations handled with redemptions (more on this later)
• ESOP repurchase obligation (“ESOP RO”): Privately-held ESOP company’s obligation to buy back shares of stock from participants
⁻ Termination of employment (death, disability, retirement, or turnover)
⁻ Election of diversification rights at age 55 with 10 years of plan participation
• Large ESOP RO may mean: ⁻ ESOP cash needs exceed Company cash flow, or limit ability to invest and grow ⁻ ESOP cash needs exceed qualified plan limits
• 404 Deduction Limit (25% of qualified payroll): Limits company’s ability to contribute to other plans, Requires supplemental funding strategy for ESOP
• 415 Allocation Limit ($66,000 for which 2023): Limits individual participation in 401(k) and individual benefit in ESOP
• 409(p) – Anti-Abuse Limits: Too many shares allocated to too few people
• ESOP loan term (the internal loan)
⁻
Dictates period over which shares are allocated & what level of benefit is provided
⁻ Impacts timing of ESOP RO
⁻ Generally, the longer the better
• Vesting
⁻
Credit for prior service immediate RO
• Distribution policy
⁻
Many ESOP companies pay lump sum distributions when ESOP RO is low
• Statutory Diversification
⁻ Age 55 with 10 years of plan participation
⁻ Eligible participants can diversify 25% of stock account in first 5 years, cumulatively, and an additional 25% in sixth and final year of window
⁻ Actual ESOP RO depends on election rates
• Enhanced Diversification / In-Service Distributions
⁻ Can be used smooth out ESOP RO
⁻ Gets shares to new participants sooner
⁻ Additional diversification opportunity for participants
• Distribution Options
⁻ Immediate vs. delayed distributions
• Immediate distributions tend to accelerate ESOP RO; delayed distributions result in former employees holding stock
⁻ Lump sum vs. installments
• Lump sum distributions tend to accelerate and increase year-to-year variability of ESOP RO; installment distributions smooth out ESOP RO ⁻
Segregating accounts
• Similar to lump sum distributions, though can be employed differently
• Distribution policy document
• May be appropriate to amend policy from time to time
• Redeeming: ⁻ Shares are purchased by company and leave ESOP
⁻ Repurchased shares can be retired, recontributed, or sold back to ESOP in a “releveraging” transaction (more on this later)
• Recycling: ⁻ Company puts cash into ESOP to repurchase shares ⁻ Repurchased shares are reallocated immediately to eligible participants
• If redemption strategy results in a declining number of shares outstanding:
⁻ May affect ESOP’s ownership % (if < 100% ESOP)
⁻ May cause value per share (“VPS”) to rise more rapidly than aggregate equity value
• Potential issues communicating company performance to participants
• Repurchase obligations not likely to be any less expensive – ESOP will own fewer shares, but shares will be repurchased at a higher value
• In fact, obligations are likely to be more expensive, due to concentration of value that occurs in the accounts of long-term participants nearing retirement age
• 2 Ways to get cash into ESOP to recycle shares: ⁻ Contributions: Allocated pro rata to compensation
• Provide a “benefit to participants”
• Subject to 25% contribution limit
⁻ S corporation distributions: Allocated pro rata to shares
• Provide “shareholder return”
• Can concentrate shares in accounts of long-term participants nearest retirement age, increasing RO
• Can also be “inefficient” funding source, depending on distribution policy
• A declining number of shares outstanding results in value per share growing faster than equity value
• Benefit level:
⁻
Value of stock or other investments from contributions (net of ESOP loan payments) +
⁻
Value of reallocated forfeitures +
⁻
Value of shares released from ESOP loan suspense
• Note distinction between contributions used to fund ESOP loan payments & value of shares released from ESOP loan suspense
Does not include dividends or changes in VPS ⁻
⁻
Measured as a % of qualified payroll
• Many companies make ESOP contributions on an as-needed basis to recycle repurchased shares (i.e., “pay-as-you-go” funding)
• Consequences:
⁻
Benefit levels are driven by ESOP RO
⁻ Contributions (and therefore, benefit levels) are high compared to nonESOP companies ⁻
Contribution requirements may vary significantly from year to year
• Common advice: ⁻ Manage ESOP RO in ways to avoid benefit levels that are “too high”
⁻ Shareholder return vs. employee benefits
• Recommended strategy:
⁻ Limit benefit (contributions plus value of shares released from loan suspense) to target level, and handle excess ESOP RO by either redeeming shares or paying S corporation distributions to recycle shares
• Myth: high benefit level makes an ESOP unsustainable
⁻
Sustainability depends on cash
⁻ Many ESOP companies with very high benefit levels also generate ample cash flow
⁻
Techniques for managing benefit levels (i.e., redemptions & S corporation distributions) have consequences that can exacerbate ESOP RO
• Repurchase obligations in 100% ESOP companies are usually high relative to a “normal” benefit level in a non-ESOP company
• Shares are redeemed by company and sold back to ESOP with internal loan; shares are reallocated as loan is repaid
⁻ Can be used on one-time or periodic basis, in years of high ESOP RO, or on annual basis to fund shortfalls
⁻ Reallocating shares over long period of time provides smooth, long-term benefit and keeps shares outstanding
⁻
However:
• Transaction costs, administrative complexities
• Can be dilutive
• Can be overused – must consider loan payments & benefit levels
• Refinancing an existing internal loan:
⁻ Reduces annual principal and interest requirement
⁻ Stretches out share allocation, in turn:
• Reducing annual benefit level
• Reducing future ESOP RO
• Creating pool of shares for future participants
⁻ Requires negotiations with ESOP Trustee
• Demographics & Succession Management
• Mechanical challenges of ESOP
• Old vs New
• Approaches to Reserving
• The sooner you start thinking about ESOP sustainability, the better!
• The factors affecting sustainability will evolve as the ESOP matures
• The Board of Directors should be discussing ESOP sustainability, including methods for handling ESOP RO, at least annually
ryan.graham@chartwellfa.co
Scot Storjohann Senior Vice President
Andrew Berger, CPA
Director, Tax Strategies
Kreischer Miller
Dan Sailer, CPA/ABV, CFA
Director, Valuation
Services
Katz, Sapper & Miller
1. Scan the session QR Code on the door or directional signage nearby
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Discuss the Attributes of Warrants
How Warrants are Used in the Context of ESOP Transactions
Accounting & Tax Considerations of Warrants
Best Practices for Utilizing Warrants During ESOP Negotiations
•A Warrant is a type of Derivative – its value is derived from the value of an underlying asset: in this case the Company’s stock (gives you the right, but not the obligation, to buy or sell a security)
•Corporations may issue warrants that allow you to buy a company's stock at a fixed price during a specific period of time in the future
•Similar to a stock option except the warrant is:
• Issued directly from the company
• New shares are issued which can cause dilution (in an ESOP, warrants are typically settled in cash, however)
• Long-term investments that can expire 10-15 years in the future
• Seller Note is issued at ESOP Formation
• Cash Interest payments made at 5.50% fixed rate
• In addition, Warrants are issued, with expected payout in Year 10. Value of Warrant is projected to add 3.50% return.
• 9.00% expected Rate of Return on Seller Note
Warrants Provide a Market Rate of Return
Seller Notes used in many ESOP Transactions are subordinate, or second in line, behind Senior Debt (Bank Loans) used to finance the ESOP’s purchase of Stock
In corporate finance markets, Seller Notes have similarities to Mezzanine Finance
Pepperdine University publishes an Annual Private Capital Markets Report to provide data about required
• Required Rates of Return per Pepperdine University’s Annual Private Capital Markets Report
• Seller notes with warrants would generally be compared to mezzanine financing
Discuss the Attributes of Warrants
How Warrants are Used in the Context of ESOP Transactions
Accounting & Tax Considerations of Warrants
Best Practices for Utilizing Warrants During ESOP Negotiations
•Most ESOP transactions do not rise to the level of negotiation complexity where warrants are introduced as a means to help bridge a seller’s risk/return gap
•Generally, a trustee and a seller would first focus on negotiating a purchase price, and the general seller note characteristics like term and cash interest rate (then when necessarily, proceed to potential payment-in kind [“PIK”] interest and warrants)
•Use of Event Protection in ESOP Transactions
• Part of the consideration received during the sale of stock to an ESOP
• ESOP transactions are typically a leveraged buyout
• Warrants are commonly issued in association with debt to provide a better rate of return
• Seller may accept a smaller upfront cash payment AND warrants
• Warrants are synthetic equity, and you need to be considerate of IRC Section 409(p)
• Provides seller with potential company appreciation from increased productivity
• Has properties that are like that of an earnout
• Can keep selling shareholder engaged in the business as they may benefit from share price appreciation
• Helps the company's ability to service debt as the current cash flow requirements are lower
• Can be used to compensate the selling shareholder for the risk of holding a note
Simplified for illustration; actual transaction had different tranches of seller notes with varying terms.
Sellers like warrants because:
•They provide additional IRR for assuming additional risk (i.e. not receiving interest payments in cash)
•The upside is unknown and certainly not guaranteed, but the warrants might become valuable if/when the company/ESOP is successful
Trustees like warrants because:
•It saves company cash flow in the early post-ESOP years when leverage is generally elevated
•The seller will only benefit if the company/ESOP grows in value
•Thus, the seller remains motivated in the company’s success
$2mm seller note with 5% cash interest generating a 10.1% IRR with warrants
Thus, if strike price set at $1.00, warrant is initially out-ofthe-money
Goal: Company achieves/exceeds projections, repays transaction debts, and value is created for all ESOP-related constituents
•
In this example, the warrant holder would receive a payment of approximately $1.0 million upon exercise
• Including this derivative essentially doubles the IRR of holding a seller note: from 5% to 10% (market-rate IRR)
•
Worst-case scenario: the warrant expires worthless
Discuss the Attributes of Warrants
How Warrants are Used in the Context of ESOP Transactions
Accounting & Tax Considerations of Warrants
Best Practices for Utilizing Warrants During ESOP Negotiations
Primarily two methods for determining the number of warrants issued:
• Estimate the Internal Rate of Return of the company
• Estimate company value at the date of exercise
• Estimate company cash flows required from warrant exercise
• Value all cash flows from the debt and warrant instruments
• Black-Scholes method
• Strike price or exercise price
• Exercise period
• Exercise dates
• Relative volitivity of the underlying stock value
IMPORTANT ASSUMPTION: Holder owns a call/put option
Consideration received for selling shares to ESOP
• Cash • Note Receivable
• Warrants
Each need to be valued and recorded on company financials
• Cash = cash paid
• Warrants = ????
• Note Payable = remainder
Owner sells 100% of stock for $10MM in exchange for:
• Cash = $3,000,000
• Note Receivable = $7,000,000 (face value)
• Warrants!!!
Equity is reduced by $10MM (debit)
• Cash = $3,000,000 (credit)
• Warrants = ????
• Note Payable = $7,000,000 (credit)
Warrants have a deemed value of $175,000 (AT ISSUANCE)
• Cash = $3,000,000 (credit)
• Warrants = $175,000 (credit)
• Note Payable = $6,825,000 (credit)
Recommended Entry:
• Cash = $3,000,000 (credit)
• Warrants Liability = $175,000 (credit)
• Note Payable = $7,000,000 (credit)
• Warrant Discount = $175,000 (debit)
Shown on the financial statements together (netted)
• How is the fair value of the warrants measured at issuance?
- Typically using the Black Scholes pricing model
• In a perfect world, the value at issuance will approximate the value upon exercise
• Unfortunately, nothing is perfect… adjustments will be needed each year
• Recap:
• Warrant Discount = $175,000 (contra-debt)
• Warrant Liability = $175,000
• Warrant discount is amortized (accreted) into interest expense over the term of the associated loan (using effective interest method)
• Debit – Interest Expense
• Credit – Warrant Discount
Warrant Liability is adjusted at the end of each reporting period to its current fair market value
• Warrant Exercise Entry:
• Warrant Liability = DEBIT
• Cash = CREDIT
• Upon exercise holders receive a cash payment for the difference between the current value and the strike price (call/put option)
• Note: Warrant Discount amortization period may be different that the warrant’s life. In other words, the date the warrant becomes exercisable may be shorter (or longer) than the term of the associated debt
• Warrants issued with debt for cash loan
• Tax reporting becomes much more complicated
• Creates Original Issue Discount ("OID") over the life of the warrant
• Principal repayments on the debt are recharacterized as interest income
• Holders pickup interest income until warrant exercise
• Warrants issued with debt instrument in a redemption of stock
• Tax reporting becomes much easier
• Capital gain on issuance
• Capital gain on exercise
• Need to make sure that warrants are not deemed to be a second class of stock. S Corporations are required to have a single class of stock
• Need to be considerate of 409(p) issues
• 5 or fewer individuals own > 50% of the value = BAD
• Many times, warrants are not properly reported on tax return, particularly when they are tied to the debt and create OID
• May cause phantom income to the recipient
Discuss the Attributes of Warrants
How Warrants are Used in the Context of ESOP Transactions
Accounting & Tax Considerations of Warrants
Best Practices for Utilizing Warrants During ESOP Negotiations
•100% ESOP formation
•More extensive use of Seller Note financing
•Selling shareholder(s) remaining in management for longer periods post-sale
•Size of transaction to make use worthwhile
•Experience and capabilities of ESOP advisor team
•Partial ESOP formation
•Less extensive use of Seller Note financing or if additional bank financing is available
•Selling shareholder(s) not remaining in management for longer periods post-sale
•Smaller Size of transaction
•Selling shareholders who do not want the complexity
•Ensure the Senior Debt provider(s) are aware of plan to include Warrants in the Seller Financing
•Bank Loan documents may have to be drafted or modified to reflect Senior Debt restrictions on Warrant payment
o Often, repayment of warrants will be deferred until Senior Debt is repaid in full
o Once Senior Debt and Seller Notes are both paid in full, the ESOP Company could use new Bank borrowing to pay-off Warrant balance (“callability”)
o Pro-rata considerations for partial pay-downs
•Warrants can complicate your accounting for the ESOP deal post-transaction, so consult with your CPA during the planning and drafting stage
•Guidance can be found from FASB ASC 470-20 (Debt with Conversion and Other Options)
•The cash used to pay Interest on a Seller Note will get recorded as an ESOP Company expense when paid
•The obligation from the Warrant, however, may not become material until several years after the ESOP formation
•Therefore, the Valuation firm will analyze the posttransaction obligation payable due to the Warrant, and account for that impact on the valuation
Since warrants are generally not valuable when they are extensively “out of the money:”
•A seller can potentially gift the warrants at a lower valuation in hopes that they will one day be more valuable (risk: seller uses up some/all lifetime gift exemption and the warrants become worthless)
•Warrants must be “detachable” from the seller note, so documentation is important
“Sanity Check” In Connection With Implementation
• Stock Valuation
• Feasibility
• Financing
• Management Commitment
Independent, Experienced ESOP Advisors
• Counsel (Company and ESOP Trustee)
• ESOP Trustee
• Independent Financial Advisor (engaged by ESOP Trustee)
Feasibility Analysis
• Projections and forecasts on based past earnings
• Sensitive analysis to gauge “cushion” for economic downturn
Characteristics of Well-Planned, Implemented ESOPs
Carefully Designed ESOP Distribution Provisions
• Forms (lump sum thresholds, installments)
• Timing
Non-dilutive “Sweat Equity” Plan for Management
• Stock Appreciation Rights
• Phantom Stock
Integration of ESOP to overall Estate Plan
• Gifting and/or Charitable Contribution timing
• Employment plan & compensation plan for Selling Shareholder