April 18, 2008 Selling to Your Employees Through an ESOP Presented by: Mary Giganti Waldheger Coyne Dave Gustafson Moore Stephens Apple Bill Rosenberg Columbia Chemical Richard Tanner Ownership Advisors, Inc.
7 C s of Successful Succession 1. Clarity of vision 2. Confidence that you can get there 3. Concentration on what it will take 4. Consistency in how you pursue your vision 5. Commitmentto the importance of what you re doing 6. Character to guide you 7. Capacity to enjoy the process
Key Questions and Concerns Can I retain control if I do an ESOP? Can my family remain involved? Am I big enough to do an ESOP? How much will this cost? How do I determine feasibility?
Common Use of an ESOP Tax advantaged Buyout vehicle for shareholders considering retirement / succession Provides a market for other shareholder Provide a stock based incentive for employees Provides benefits and job security for employees
What is an ESOP? Employee benefit plan Subject to Internal Revenue Code and ERISA Primarily invest in Employer Qualifying Securities Employees are the beneficial owners of the stock
Beneficial vs. Direct Ownership Shares purchased by the ESOP are owned in a trust, not by plan participants Eligible employees are beneficiaries of the trust Trustees are responsible for overseeing the plan
Benefits to Selling Shareholders Liquidity ($$$$$$) Selling shareholder may continue to lead or have active role at Company Selling Shareholder may maintain control Transaction is relatively private Stock Sale Selling Shareholder may defer gain on sale (C corp)
Benefits to Company Tax advantaged Vehicle to Buy-out Shareholders (provide shareholder liquidity) Principal, interest and dividends to fund are deductable Create stock-based incentive plan Tax distributions (S corp) can be used to fund Trustee holds title to shares
Benefits to Employees Allows employees to obtain a beneficial ownership in the Company Reduce uncertainty of ownership transition
How do you sell shares to an ESOP? Due Diligence Negotiate with trustee of the ESOP Sell for adequate consideration
Typical ESOP Transaction in Pictures Company Cash Note Payable Bank Cash Note Payable ESOP Company Stock Cash Shareholder(s)
Repaying the ESOP Loan Company 2 Note Payment Bank 1 Pre-Tax Contribution or dividend ESOP loan repayment 1. Company pays tax-deductible contributions or dividends to the ESOP and the ESOP repays the ESOP loan ESOP 2. Company repays Bank
The Valuation of Company Shares Company is a privately-held company its shares are not publicly traded The value of the shares must be determined by an appraisal performed by an independent expert The appraisal firm works for the ESOP, not for the company or its owner The stock is valued at least once each year
Definition of Value Fair Market Value The price at which property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Revenue Ruling 59-60 (Sec. 2.02) Regulations Sec. 20.2031-1 (b) and 25.2512.1 DOL Proposed Regulations (Sec. 2510.3 18) Willing buyer/willing seller is a hypothetical standard o Estate of Gallo vs Commissioner 50T.C.M. 470 (1985) o Shannon Pratt, et al., Valuing a Business: The Analysis and Appraisal of Closely Held Companies(Irwin Professional Publishing 1996), pp.24-25
Definition of Value Adequate Consideration Rule The ESOP can purchase stock for no more than adequate consideration or sell for no less than adequate consideration This is a two part test o Fair market value similar to 59-60 o Good Faith determination by the Trustee
ESOP Valuation Issues Independence of Appraiser Appraiser reports to ESOP Trustee Appraiser only represents the interests of the ESOP Negotiation Process
Determining ESOP Stock Value
Approaches to Value Income Approach Market Approach Asset Approach
Approaches to Value Market Approach Guideline Company method -Based upon comparison to the marketplace of stock of publicly traded corporations in the same or similar line of business having the stock actively traded in a free market Revenue Ruling 59-60 Estate of Joyce Hall v Commissioner, 92 TC 312 (1989)
Private Transaction Method Transaction data bases Mergerstat Review Pratt s Stats Done Deals Institute of Business Appraisers BIZ Comps
Market Approach Value Indicators Price to earnings Price to cash flow TIC to EBIT TIC to EBITDA Price to Sales Price to Book Value
Income Approach Discounted Cash Flow -A multi-period income model Project future benefit stream (typically free cash flow) Select an appropriate discount rate Determine a terminal value (by using multiples or capitalization of earnings) Calculate and add the present value of the annual cash flow and terminal value Adjust for any non-operating assets or liabilities
Income Approach Capitalization of Earnings - A singleperiod income model Estimate normalized cash flow stream Select capitalization rate Apply the capitalization rate to the cash flow stream
DCF - A Practical Explanation
Income Approach Discount/Capitalization Rate Capital asset pricing model Build-up method Weighted average cost of capital SWAG/WAG
Approaches to Value Cost Approach (Net Asset Value) 1. Book value is starting point. (However, book value is accounting concept based upon historical cost.) 2. Adjust Asset Value to current market. Inventories o LIFO vsfifo o Obsolescence o Commodity materials vs WIP that only has value if completed Real Estate o Tax value o Real estate appraisal Machinery and Equipment o More mobile equipment likely to have value o Blue book Stocks, bonds, investments
Cost Approach (cont.) Intangible Assets o (Patents, trade secrets, copyrights, goodwill) Off-Balance Sheet/Contingent Items o Pension - over or under-funded o Retiree medical (required by FASB) o Product liability o Tax audits o Lawsuits o Environmental concerns o Bargain lease 3. Costs of sale or liquidation generally not considered for tax purposes unless sale is likely.
1042 transaction Sale structure options o Seller incurs no taxable gain on sale of stock o ESOP must own at least 30% of the company o Reinvest in qualified replacement property within a 15 month period o 1042 must be elected in writing on a timely filed tax return o Limitation on participation o Holding period Non-1042 transaction
Sale structure options (cont.) Partial or 100% sale Leveraged o ESOP/Company borrow money o Contributions to ESOP tax deductible o C corporation dividends are tax deductible Non-leveraged
Financing alternatives Availability of senior, mezzanine or outside equity Willingness to provide seller financing Ability to use/fund rollovers from other retirement plans
Understanding company philosophy How will sale be viewed? Importance of employee communications Employee participation in the ESOP
How does the money flow? First, the company contributes cash to the ESOP Second, the ESOP pays the promissory note payment to the lender When the shares are paid, they are allocated to participant accounts Unpaid shares remain in a suspense account within the ESOP.
ESOP plan design Eligibility Allocation formula Release of shares Dividends Vesting Voting rights Diversification Distributions Trustee Administration committee
Voting Rights Normally the Trustee votes the shares for corporate matters Pass through voting is required for: Mergers Recapitalizations Reclassifications Consolidations Liquidation Sale of substantially all of the asset
Maintaining management team May continue existing nonqualified plans May implement new nonqualified plans
Repurchase liability Composition of workforce Impact on plan design Funding
Impact on other retirement plans Company continuing/not continuing contributions IRS limits
Affect on seller s estate plan Same value different asset 1042 exchange Potential loss of 6166 election Seller financing
What is a feasibility study and do I need one? The goal of an ESOP feasibility study is to determine as quickly and inexpensively as possible whether an ESOP is right for you, your family and your business.
Financial Company Value Growth Prospects Corporate Financing Cash Flow Impact- EBITDA Feasibility Non-Financial Values of Owner How much is enough? How much is too much? Fair versus Equal Management succession versus family ownership. Family Financial Independence Retaining Control & Balance Can you do an ESOP? Clearly defined Should you do an ESOP? Not easily defined