Tim Garbinsky NCEO
ESOP = “Employee Stock Ownership Plan” In an ESOP transaction, you sell your shares at fair market value to a trust, and the trust holds the shares for the benefit of your company’s employees. • ESOPs own company shares. • ESOPs are retirement plans governed by federal law.
ESOP companies … … grow faster (2.5% more new jobs generated) … are more stable (0.2% loan default, 50% reduced risk of failure during last two recessions) … generate more wealth (employee-owners have 92% greater net household wealth).
Shawn Eastham, president of Polyguard
“I really believe the secret is employee engagement, and the fact we are an ESOP company. There’s lower turnover, a better attitude, a better work ethic. It’s people making sure the quality is good, going the extra mile for the customer.”
Nancy Prewitt, Technical support specialist, Polyguard
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esopinfo.org/videos See “Award Winners”
OwnershipEconomy.org
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Your name
Company name City / State
Line of business One goal for this seminar
Compared to what?
an exit strategy?
OR a retirement benefit?
OR a way to run a business?
OR a manifestation of your personal values?
an exit strategy
AND a retirement benefit
AND a way to run a business
AND a manifestation of your personal values
1. Effective sales price 2. Cost and risk of transaction
3. Timing of ownership transfer 4. Timing of management transition
5. Timing and form of payout 6. Legacy: impact on company
7. Impact on work force
Cross Company • Founded in 1954 -
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Partial ESOP in 1979 → 100% ESOP in 2006
• 620+ associates in 5 operating groups all focused on
Innovating the industrial world one customer at a time…
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Where do you see the ownership of your company in the next 5 to 10 years?
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Are the exit timelines consistent?
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What strategies are available that will meet these expectations?
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How do you assess your choices in ownership transition?
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Do you understand the tax consequences of various exit types?
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How can you prepare yourself and the company for an exit in order to maximize value?
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How will ownership transition impact your estate plan?
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How do you identify management succession issues?
These paths move
External Sale
ownership in very different ways; however, each has its pros and cons
Strategic buyers Financial buyers (i.e. private equity) Whole or partial sale
Internal Sale Employee stock ownership plan (ESOP) Management buyout (MBO) Leveraged recapitalization
Family Transfer
✓ Ownership Is, or Should Be, Considering Transition ✓ Profitable and Growing
✓ Strong Management Team ✓ Solid Operating Model
✓ Desire for Independence ✓ Looking For Tax Favored Exit
✓ Debt Capacity
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Liquidity Strategy
Tax Efficiency
Retirement Plan
Owners can sell a fractional amount or
Debt is repaid with pre-tax dollars
The ESOP is an ERISA protected
the entire company to an ESOP
It’s a more controllable and friendly process compared to a third party sale
100% ESOP-owned S-Corporation does not pay taxes Capital gains deferral on C-
retirement plan Value within participants accounts grow tax deferred
Provides continuity of corporate
Corporation transactions if certain
Company is responsible for
culture and company legacy
criteria is met
repurchase of all stock when employees leave
Company Concerns • Unproductive debt on balance sheet
Company
• Board composition • Management succession
Seller Expectations • Cash at close
• Value expectations • Corporate legacy
ESOP Trustee Concerns
Seller
Employees
• Adequate consideration • Relative fairness • Dilutive impacts
Consideration should be given to all impacted parties
Size of Transaction
Financing
ESOP Features
Minority vs. Control
Senior Debt / Subordinated Debt / Mezzanine Debt
Benefit level / Vesting
Other Features
Tax Treatment
Synthetic equity / Warrants
S-Corp v. C-Corp / 1042 deal
Prairie will provide structural guidance tailored to a seller’s objective
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Benefits of C-Corp. Transactions
C-Corp ESOPs have significant tax benefits
Qualified Replacement Property (QRP)
Some motivating factors:
Proceeds must be invested in QRP within 1 year after closing
• Capital gain tax deferral when 30% or greater sold to ESOP
QRP may include:
• Seller must own stock for at least 3 years
• U.S. stocks and bonds
• Must be C-corp. at time of deal
• No passive income investments (i.e. REITS, mutual funds)
• Seller (or any descendants) cannot participate in ESOP if 1042 is elected • Tax basis of shares become tax basis of QRP • Permanent tax deferral (upon death, stepped-up benefit to estate) • Tax is deferred as long as QRP is held. Seller can time triggering of capital gains
• No government entity or partnership interests
S-Corp ESOPs have compelling economics Some motivating factors: • 100% S-Corporation ESOP does not pay taxes • Transaction debt (principal and interest) can be repaid with pre-tax earnings • Sellers can participate in newly established ESOP • No investment restrictions
• ESOP counts as one shareholder • No capital gains tax deferral to sellers
Benefits of S-Corp. Transactions
The least expensive form of debt Level of financing will depend on company cash flow, borrowing base, and liquidity requirements of the seller
Seller financing can be flexible
Seller has the ability to finance entire transaction. Seller financing returns may be difficult to replicate in the public markets
This debt can be costly Senior Bank Debt
Subordinated or Mezzanine Debt
Seller Financing
Cash or 401(k) Rollover
If the seller’s goal is to maximize liquidity at close, a form of subordinated / mezzanine debt will be required
Unique funding mechanisms Employees may have an option to rollover a portion of their 401(k) to fund the ESOP purchase
Bank
Company external loan
$
Transaction Process 1. Bank loans $ to company, creating the external loan
Leveraged ESOP Flow of Funds
$
4. Purchased shares are held in “suspense” as collateral for the internal loan
$ cash
2. Company loans $ to ESOP to fund the purchase, creating the internal loan
3. ESOP uses proceeds to purchase shares from seller
shares
Seller
interna l loan
ESOP
Bank
Company loan repaid
Employee Allocations
$
1. Company makes pre-tax contribution to ESOP Trust 2. ESOP receives contribution and immediately repays the internal loan causing a release of shares 3. Company receives funds from the ESOP and pays back the external loan
How Shares are Allocated to Employees
4. The resulting flow of funds provides a tax deduction to company with no impact to cash flow Employees
contribution
stock allocation
$
$
ESOP
intern al loan repaid
Who Performs it?
Who is involved?
Seller Advisor
Financial Advisor
Trustee Financial Advisor
Senior Management
When is it done? Value should be established before transaction process begins
How long? 45 to 60 days to complete
The valuation and feasibility study will be completed in order to gauge the likelihood of a transaction taking place
The Valuation Process is 45 to 60 days Engagement and data collection
Due diligence
Build valuation models
Review assumptions with management
Prepare deliverables
Present conclusions
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Investors expect profit
The outside world has an impact too
• Looking at historical profits can be a useful indication but change happens and profit tends to shift
The stock market reflects:
• Investors are buying the future; not the past • Risk of achieving profit expectations should be considered
Liquidation Value
Guideline Public Comparables
• Fundamental performance • Market perceptions • Macroeconomic / industry factors • M&A / financing markets
Discounted Cash Flow
M&A Transactions
Company Valuation = Internal Company Factors + External Market Factors
($ Millions) Source: GFData
Equity and Debt Capitalization
EV $10-$250 Million Source: GFData
Employee Benefits
Liquidity & Solvency
Financing
$ Plan Design
Valuation
The Feasibility Study Analyzes post – transaction effects Does the proposed structure “work”
Scenario testing and structure changes Presented to ESOP Trustee
External Strategies
Internal Strategies
How a buyer views your company
How a bank views your company
Is a skilled management team in place? Do they want / have an equity interest?
Can the company prosper without the former owner?
Are key customer relationships with the Seller or the Company?
Is the current management team properly incentivized?
The business owner might stay on for a transition period, but what happens after that?
Who is going to be here to make sure my loan gets repaid?
Am I going to have to bring in my own people?
These things impact the bankability of your Company
These things impact the attractiveness and value of your Company in the marketplace
If a strong team is in place, then it is a lessrisky loan and the bank may loan more
If a strong team is in place, then it is a lessrisky investment and the buyer may pay more
The bottom line: Management succession leads to more ownership succession choices and better values
C o r p o r a t e Te a m • Selling shareholder • Financial advisor • Accounting firm • Corporate counsel • Special ESOP counsel • Third Party Administrator • Lender
ESOP Team • ESOP trustee • ESOP financial advisor • ESOP legal counsel
C o r p o r a t e Te a m
E S O P Te a m
• Manage transaction process
• Due diligence
• Produce requested information
• Valuation / feasibility
• Provide access to management
• Review / negotiate offer
• Raise external financing
• Produce ESOP legal documentation
• Structure transaction • Make initial offer
• Produce legal documentation
• Fairness opinion • Post-deal implementation • Annual ESOP valuation
It is essential that management has minimal distractions and remains focused on the business during the transaction process
A successful transaction may not be defined as getting the highest price
Factors that impact a decision:
Motivation
• Price / Valuation • Legacy • Employee well-being • Community
The Sweet Spot
• Sustainability • Cash at close or fixed income
Deal Terms
Valuation
• Equity participation • Indemnification • Escrow / Earn-outs / Claw-back
Prairie Capital Advisors, Inc.
Securities transactions are effected and offered through Prairie Capital Markets, LLC (“Prairie”), member FINRA/SIPC. PRAIRIE and Prairie Capital Advisors are service marks registered with the U.S. Patent & Trademark Office. This document is prepared by Prairie and is for informational purposes only. It is not intended as an offer or solicitation with respect to the sale or purchase of a security. Prairie shall not be liable for damages resulting from the use of or reliance upon the information presented herein. For further information on our services, please contact the presenters above.
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How does the transaction work? It’s the same as an ESOP.
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