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Original air date: Oct. 24, 2013 View a recording at http://www.mhmcpa.com Employee stock ownership plans (ESOPs) can be an effective option for private equity firms seeking to exit a portfolio company position, as well as offering opportunities for investment and/or acquisition strategies while improving tax advantages. This course from Mayer Hoffman McCann P.C. will cover purchasing a company that is partially or wholly owned by a qualified ESOP, selling all or part of a portfolio company to a qualified ESOP, and providing mezzanine capital in a third-party’s qualified ESOP transaction.
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Executive Education Series: The Role of ESOPs in Private Equity Firms
Presenters: Hal Hunt and Cindy Dwyer – MHM Shareholders
Brooks Myhran – Managing Director, Verit Advisors Mark Welker – Partner, Husch Blackwell
October 24, 2013
Co-presenters from:
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Before We Get Started…
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This webinar is eligible for CPE credit. To receive credit, you will need to answer periodic polling questions throughout the webinar.
External participants will receive their CPE certificate via email immediately following the webinar.
CPE Credit
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Today’s Presenters Hal Hunt, CPA Shareholder 913.234.1012 | hhunt@cbiz.com
Hal leads MHM’s Employee Benefit Plan (EBP) Audit Practice. With over 25 years of diverse experience with EBP accounting, auditing and compliance issues, he is also a member of the firm’s Professional Standards Group as EBP subject matter expert. As the EBP National Practice Leader, Hal is responsible for providing internal training, along with providing technical support to engagement teams, serving as engagement quality reviewer and developing resource tools for our EBP audit professionals. He served on the AICPA’s Employee Benefit Plan Audit Quality Center (EBPAQC) Executive Committee and is currently a member of the EBPAQC ESOP Task Force.
Cindy Dwyer Shareholder 913.234.1022 | cdwyer@cbiz.com Cindy is the President of MHM Retirement Plan Solutions and a Shareholder of Mayer Hoffman McCann P.C. She supervises staff, oversees technical research, and provides quality control services. She has previously served as the national Chairperson of the American Institute of Certified Public Accountants Employee Benefits Technical Resource Panel (TRP) and has recently been reappointed as a member of the TRP. Additionally, Cindy has been a recurring speaker at the American Institute of Certified Public Accountants National Conference on Employee Benefit Plans. Cindy is also a committee member and current chair of the Employee Benefits Institute sponsored by UMKC School of Law.
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Brooks Myhran Managing Director, Verit Advisors 612.766.4055 | brooks@verit.com
Brooks has more than 25 years of investment banking experience executing mergers and acquisitions, going-private transactions, and recapitalizations, as well as extensive valuation experience providing a wide range of sophisticated financial advisory services, including all manner of fairness opinions, solvency opinions, and ESOP and non-ESOP appraisals and related valuation consulting. Mr. Myhran has broad industry experience with particular expertise in the consumer products, education, ethanol, financial services, household products, plastics, specialty retail, transportation, and travel-services industries.
Today’s Presenters
Mark D. Welker Partner, Husch Blackwell 816.983.8148 | mark.welker@huschblackwell.com Chair of the firm's Tax & Benefits Department, Mark is considered clients’ go-to advisor on any important benefit or compensation matter. He focuses on all benefit and compensation matters, including the creation and operation of employee retirement plans, deferred and equity executive compensation, employee stock ownership plans, and health and welfare plans. Mark is highly regarded for his strategies and management of fiduciary and tax disputes.
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The information in this Executive Education Series
course is a brief summary and may not include all the details relevant to your situation.
Please contact your MHM service provider to further
discuss the impact on your financial statements.
Disclaimer
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Today’s Agenda
1
2
3
4
Intersection of Private Equity and ESOPs
ESOP Overview
Private Equity as a Buyer, Seller and Investor
Key ESOP Considerations for Private Equity
5 Case Studies
6 Summary
INTERSECTION OF PRIVATE EQUITY AND ESOPS
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Where Private Equity and ESOPs May Intersect
Sale of a portfolio company to an ESOP As a Seller
Purchase of a company that has an ESOP in place As a Buyer
Provide capital to a company implementing an ESOP or to an existing ESOP company in need of financing
As an Investor
There are a number of interesting and unique strategies for private equity firms that may involve ESOPs.
ESOP OVERVIEW
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What is an ESOP?
ESOPs, which can and do pay fair market value, often compare favorably to more traditional transition alternatives such as private equity, a strategic sale, or a dividend recap, depending on transaction objectives and current market dynamics.
Transition Alternative
An ESOP is an innovative liquidity tool that provides tremendous flexibility for shareholders.
Liquidity
An ESOP provides distinct tax incentives to businesses and their owners. Tax Advantages
An ESOP provides an incentive for employees to grow the company’s value because they share in company stock appreciation.
Employee Benefit Plan
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(1) Company sets up an ESOP Trust. (2) Company makes annual tax-deductible
contributions in cash or stock to the ESOP.
(3) Cash is used to buy stock from current shareholders.
(4) Shares are allocated to the accounts of eligible employees within the ESOP based on salary.
(4) ESOP holds stock for employees and annually notifies them of how much they own and how much the stock is worth.
(4) Employees receive stock or cash after they retire or leave the company, a vesting schedule applies.
How Does an ESOP Work?
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The ESOP receives a loan and uses the proceeds to purchase stock from current shareholders.
These shares are held in trust and are released into employee accounts at a rate corresponding to debt amortization.
How Does an ESOP Work?
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1) Lender lends to company. 2) Company lends to ESOP. 3) ESOP buys stock from existing shareholders. 4) Company makes annual tax-deductible contributions to ESOP. 5) The ESOP then repays company and company repays lender -- although those two amortization
schedules are usually different, so the repayments won’t be the same dollar amount. 6) Employees receive stock or cash when they retire or leave (vesting schedule).
How Does an ESOP Work?
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Owner/Selling Shareholder Take back a note in exchange for shares Taxed on principal upon receipt at capital gains and interest as ordinary
income (if installment sale treatment is elected) Advantage: Entitled to higher interest rate; subordinated to bonding
company and bank Disadvantage: 1042 Tax Free Roll over requires proceeds to be reinvested
within 12 months Bank
Loan is to the company which makes a loan to ESOP Typically 7 years Assessment of company credit Advantage: Selling shareholder ends up with cash up front Disadvantage: Lenders look to collateralize short fall with proceeds, Bank will
not subordinate to bonding company The Company
Cash rich company can make loan to the ESOP Advantage; Company repays itself with market rate of interest
ESOP Lenders
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Approximately 11,000 ESOPs in the U.S., covering 10.3 million employees (10% of the private sector workforce) across a wide spectrum of industries About half of ESOP companies are majority-owned by the ESOP
At least 70% of ESOP companies are or were leveraged, meaning they used borrowed funds to acquire the employer securities held by the ESOP
Total assets owned by U.S. ESOPs is estimated to be $870 billion
ESOP Overview
Source: The ESOP Association
ESOP concept developed
Employee Retirement Income Security Act of 1974 (ERISA)
2001: Clarification and definition of abusive S-Corp ESOP structures – 409 (p)
ESOP TIMELINE ~4,000 ESOPs by
1980
~8,000 ESOPs by 1990
3,700 S-Corp ESOPs 57% of S-Corp
ESOPs are majority owned
~1,600 ESOPs by 1975
ESOPs used as a hostile takeover defense – selling or contributing equity to an ESOP
ESOPs become eligible to hold shares of S-Corporations Jan. 1998
1950’s 1970’s 1990’s Today
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Company Characteristics Strong cash flow and debt capacity Labor is a significant contributor to company value Company currently pays meaningful income taxes (e.g., service businesses with few or
no available deductions) Strong and experienced management team Significant employee ownership is operationally beneficial through culture and best
practices Little or no presence of aggressive strategic acquirers or an initial public offering
alternative Modest but reliable growth prospects Failed M&A process
Where ESOPs Work Well
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Seller Characteristics Confidentiality, certainty to close, and abbreviated process length
are highly valued Diversification and some liquidity at closing is sought but ongoing
operating and governance influence is desirable Desire to sell business today and retain the opportunity to
participate in significant future equity appreciation
Where ESOPs Work Well
Over the decades ESOPs have been in place, certain characteristics , including both industry and company
dynamics, have contributed to ESOPs being a superior transaction alternative.
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S-Corporation ESOPs Company
ESOP is a tax-exempt shareholder of an S-Corp. 100% ESOP-owned S-Corps pay no federal income taxes ESOP counts as one shareholder Per IRC 409(p), there are anti-abuse provisions to ensure the company cannot dilute
the ESOP’s claim below 50% via warrants or other forms of synthetic equity while paying no federal income taxes
C-Corporation ESOPs Company
Tax shield (i.e., deductibility of principal and interest) up to 25% of payroll Dividends are tax-deductible (to the extent they are used to repay the ESOP / “inside”
loan) Selling Shareholder
Tax-free rollover (IRC Section 1042) At least 30% of company equity must be sold to the ESOP Sale proceeds are subject to certain reinvestment restrictions
Special ESOP Tax Incentives
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Implications: ESOP valuations are competitive with other alternatives. Private equity values are frequently constrained by their LBO models’ comparatively high
IRR targets (as well as the vicissitudes of the credit markets).
ESOP vs. Private Equity Valuation Methodologies
In our experience, both ESOP trustees and private equity funds rely upon public-company and transaction comparables for valuation purposes (to a lesser extent for ESOPs). Their use of income approaches, however, varies. ESOP trustees employ DCF analyses that
rely upon management growth forecasts and ascribe considerable weight to their implications; private equity does so to a limited extent. Conversely, ESOP trustees do not
consider LBO models, whereas private equity relies on this methodology extensively.
Market Approaches Income Approaches
Transaction Structure
Guideline Public Company
Precedent Transaction
Discounted Cash Flow (DCF)
Leveraged Buyout (LBO)
ESOP Yes Limited Yes No
Private Equity Yes Yes Limited Yes
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Valuation Multiples of Verit’s Recent ESOP Transactions
Project Name IndustryTotal Enterprise Value /
EBITDA Multiple
Oregon Packaged Food & Meats 10.0x
Colt Consumer Products 9.4x
Carly Transportation 9.2x
Black Swan Heavy Electric 8.1x
Spike Office Furniture & Supplies 7.7x
Shared Values Plastics & Packaging 7.6x
Timberwolf Construction & Engineering 7.0x
Echo Government Contractor 5.6x
Razorback Metal Manufacturing 4.5x
Average: 7.7xMedian: 7.7x
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Traditional ESOP and M&A Deal Terms Comparisons
ESOP trustees typically rely heavily on extensive representations and warranties, so the due diligence process is generally simpler than other corporate finance
alternatives.
* Deal terms are subject to market conditions and change over time
Traditional M&A Deal Terms* Traditional ESOP Deal Terms Trust Factor/Due
Diligence Third party sale; more complex contract, generally forensic due diligence
Unless seeking third party junior capital, “forensic due diligence” is not a requirement and highly unusual
Transaction Form Buyer preference to purchase assets, or 338 (H) 10 election
ESOP can only buy stock, cannot buy assets
Purchase Price Adjustment
Typically based on working capital or earnings targets Generally not part of ESOP transaction
Earn-outs Median earn-out can exceed 15% of purchase price Earn-outs are not generally part of an ESOP transaction
Escrow/Holdbacks Ranges from 5% to 30% and is dynamic for specific companies and specific times
Varies from transaction to transaction; generally an ESOP has either no or significantly fewer holdbacks
Basket Average is +/-1% of transaction value About the same as an M&A deal
Indemnification Cap Average is +/-15% of transaction value About the same as an M&A deal
Survival Period 18 months to 36 months Generally 18 months
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An efficient ESOP transaction can be completed in approximately three months ESOP transaction can provide greater certainty of closure and shorter process M&A transaction requires more steps, third-party due diligence, and a less certain
outcome In M&A process, there is risk that the potential acquirer may delay or change the terms
ESOP vs. Traditional M&A Timeline to Close
1 2 3 4 5-8 8-12
Due Diligence, Valuation and Design Feasibility
Negotiate with Trustee, Credit Underwriting and Legal Documentation begins
Final Documentation, Implementation, and Closing
Due Diligence and Offering Memorandum Preparation
Contact Potential Acquirers
Receive Initial Indications and Hold Management Presentations
Data Room, Due Diligence and Final Offers
Negotiations and Final Due
Closing
Months
ESOP Transaction
M&A Transaction
Close
Close
Diligence
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Initial interest Owner or management learns about ESOPs Education period Conduct feasibility / alternatives analysis ESOP financial advisor or investment banker prepares debt feasibility analysis ESOP advisory team presents feasible transaction structures Desired structure selected ESOP appraiser presents preliminary valuation Prepare transaction description Form ESOP trustee team Interview and select trustee and ESOP advisors Secure financing arrangements Advisor prepares confidential memorandum, pursues funding sources, and initiates process to
raise senior, mezzanine, and/or junior capital Negotiate with trustee Client and advisor present transaction structure to the ESOP trustee team Client and its advisors negotiate transaction terms with trustee and its advisory team Manage investor due diligence ESOP advisory team manages due diligence for all transaction parties Manage documentation and closing
ESOP Transaction Process
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ESOP Transaction Timeline
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Transaction Steps: Portco borrows money from lender(s) (“outside loan”). Portco exchanges debt-raise proceeds with private equity firm (i.e., the seller), along
with other types of consideration (e.g., seller notes with warrants), for Portco stock. Portco issues shares of stock to a newly formed ESOP (i.e., the buyer) in exchange
for a promissory note; the ESOP will pay for the shares over time by retiring the note with cash contributions treated as an employee benefit from the company (typically 20 years).
How an ESOP Works - 100% ESOP Transaction Overview
3
Portco
Lender(s) — Senior — Mezzanine — Other
ESOP TRUST*/
Employee Benefit Plan
Stock Sale
Private Equity Firm
Cash and Seller Financing
Promissory Note (“Inside Loan”)
*The ESOP Trustee is represented by independent legal and financial advisors
Stock Sale / Redemption
2
Cash
Debt (“Outside Loan”)
1
PRIVATE EQUITY AS A BUYER, SELLER AND INVESTOR
PRIVATE EQUITY AS A BUYER
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ESOP-controlled companies offer many of the same opportunities for improvement as traditional privately-held businesses
Succession planning for founder who has stayed involved since the formation of the original ESOP
Roll-up opportunities Professionalization of organization Access to capital for shareholder liquidity and growth capital Shift in industry dynamics challenges firm’s competitiveness on a
stand-alone basis Opportunity for employees to have asset diversification Could keep partial ESOP in place
Private Equity as a Buyer – Why?
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Fundamentally the same process as traditional M&A; however, an ESOP is a different kind of seller Earn-outs are unusual Fewer seller representations and warranties in many cases Primarily cash deals
Partial ESOP companies may be interesting from two points of view Take out the ESOP Take out the non-ESOP shareholders
Private Equity as a Buyer – How?
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0
2
4
6
8
10
12
14
16
Equity Value Enterprise ValueTime
Value
ESOP Creation
Equity Value
Enterprise Value
Valuation Observations Over Time
While a privately held business may have selected an ESOP for its original transaction, such companies may see their enterprise value grow more slowly over time due to the impact of leverage, ESOP repurchase liability and a lack of proactive strategies to grow value (e.g., operational engineering, strategic acquisitions, brand development). The impact of these realities may be substantial and can offer a unique buying opportunity for private equity.
Once transaction
debt is repaid (and cash begins to
accumulate), absent a robust
strategy to grow share
value, ESOP companies can see diminishing
IRR.
PRIVATE EQUITY AS A SELLER
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Traditional M&A process has been unsuccessful Portfolio company is neither “star” nor “dog” Management team has significant equity stake and a clear, well-
articulated vision for the future Certainty and timeliness of close at fair market value highly
desirable; all cash at close less important ESOP valuations are competitive with other transaction
alternatives
Private Equity as a Seller – Why?
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ESOP pays fair market value Portfolio company borrows senior and subordinated debt on a
tax-advantaged basis Additional, unique capital sources (e.g., 401(k) raise, direct
investment by management/others) may be accessed “Gap” financing provided by seller (which offers opportunity to
participate in future upside via warrants) at mezzanine-like returns
Private Equity as a Seller – How?
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An ESOP transaction can provide competitive price, terms and conditions; ESOPs offer greater confidentiality and a higher certainty of close relative to non-ESOP sale alternatives
Cash from the ESOP “buyer” comes at close and/or over time Selling shareholders’ consideration can range from all cash at close to virtually
no cash at close; overall consideration is generally captured through the following: Cash at close: Dependent on company’s debt capacity and other factors Seller notes: Annual interest payment (taxed as ordinary income) plus return of
principal (capital gains); rollover of management equity provides unique economic opportunity for key leaders
Warrants: Participation in future equity upside with an all-in yield comparable to prevailing market terms; capital gains treatment is often claimed for warrants Warrants often appreciate over post-close (debt-reduced) value and therefore appreciate as debt is
repaid and returns from tax exempt status are realized
Why an ESOP Exit Strategy Makes Sense
An ESOP transaction provides selling shareholders liquidity at full, fair market value, and also allows for participation in future equity upside. At close and over
time, an ESOP can enhance overall value derived from a portfolio company.
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Previous attempt to sell via conventional M&A process was unsuccessful History of non-recurring/extraordinary events Partial leveraged ESOP buyout as an alternative to traditional dividend
recapitalization Portfolio company is held by a fund with 4-5 years remaining on its term Modest growth prospects in mature industry with highly compensated
employees Existing portfolio company culture consistent with employee ownership Strong management team in place poised to generate growth, but the
growth has not yet been realized
Sale to an ESOP – Relevant Portfolio Company Characteristics
Portfolio Company Liquidity Alternatives:
IPO
Financial Buyer
Strategic Buyer
Dividend Recap
ESOP
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Professional Advisors to the “Seller”
Private Equity Fund
Investment Banker ESOP
Administration and Communication
Legal Counsel
Negotiate price, terms, and conditions on behalf of seller
Overall transaction support and structuring
Provide capital placement, if applicable
Provide detail on plan design
Provide guidance on communications
Provide detail on plan requirements and compliance
Provide repurchase liability and 409(p) analysis
Assist with transaction structure
Draft ESOP Plan and related ESOP transaction documents
Can be the same law firm as company counsel; often a special ESOP firm assists company counsel for the transaction
Advisor:
Scope:
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Professional Advisors to the “Buyer”
ESOP Trustee
Legal Counsel Financial Advisor
Review ESOP Plan and related transaction documents for the Trustee
Provide independent valuation to the Trustee Ongoing annual
valuation update
Advisor:
Scope:
PRIVATE EQUITY AS AN INVESTOR
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Mature ESOP company requires capital to pursue growth opportunities
100% ESOP transaction requires incremental financing between senior debt and seller notes
Large non-ESOP owner desires an exit but does not want to sell the entire business
Successful ESOP companies may have significant claims on cash flow for repurchase obligation, which may reduce overall debt capacity to achieve strategic opportunities
Private Equity as an Investor – Why?
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Invest as minority equity shareholder, sometimes with partial or full control
Invest as a source of subordinated debt (with warrants) Flexibility with ownership structure (S-Corp, C-Corp, and LLC)
Private Equity as an Investor – How?
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A drop-down LLC structure can be utilized to achieve the benefits of a pass-through structure while avoiding complexities of seller note and warrant/derivative structures.
Private Equity as Owner of an S-Corporation
Private Equity Firm
ESOP
Common equity
ownership
Portco S-Corporation
Minority or majority common or preferred
equity*
Lenders
Portco LLC (or Partnership)
* This could take the form of member units or partnership interests
Typically, operating assets and liabilities of Portco S-Corp are contributed to Portco LLC in exchange for common equity ownership.
Employees remain at Portco S-Corp level and provide all or virtually all services required for Portco LLC to operate, in exchange for which Portco S-Corp is paid a fee.
KEY ESOP CONSIDERATIONS FOR PRIVATE EQUITY
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Valuation: An ESOP sponsored by a privately held company cannot
pay more than adequate consideration for employer securities purchased by the ESOP,
The ESOP trustee is required by law to have an independent appraisal performed to determine the fair market value of any non-public company stock acquired by the plan.
Perceived Challenges Regarding ESOPs
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Financing: Many large commercial lenders and non-bank financial institutions are active in the
leveraged ESOP marketplace Certain subordinated debt/mezzanine funds find ESOPs especially attractive credit
candidates There are numerous other sources of financing for ESOP transactions, including
management rollovers, 401(k) raises, sale of warrants, “friend and family” raises, and others
ESOP companies frequently secure incremental debt financing due to tax advantages Underwriters view fixed-charge coverage ratio as key credit metric, which is an advantage for
ESOP borrowers
Competitive debt capital market conditions will further drive 2013 transaction activity “Borrower-friendly” terms and market conditions Larger lender hold levels Strong access to capital for middle-market companies and sponsors
Perceived Challenges Regarding ESOPs
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Seller Financing: Seller financing includes warrants that can offer the selling private equity
firm up to 49% of fully diluted future value Expected all-in returns on seller financing are benchmarked against
prevailing mezzanine market IRRs Seller note can be structured to accommodate a subsequent sale to a third-
party investor; such sales generally require a layer of equity, which can be achieved through: Management rollover 401(k) raise Time, as the post-closing company deleverages and compounds its earnings growth
via tax shield
Warrant strike prices can be set at pre-transaction or post-transaction value and vary with transaction design Warrants benefit from company not paying income tax
Perceived Challenges Regarding ESOPs
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Tax Issues: Tax treatment on retained seller note
Transaction proceeds are capital gains – interest income is ordinary income Warrants are usually claimed as capital gains
Installment sale is common, but prepayment of tax is an option
Ownership of warrants on stock in an S-Corporation S-Corporation shareholder laws do not apply to synthetic equity holders
409(p) disqualified person issues Disqualified persons cannot hold synthetic equity in excess of 49% of fully diluted
equity
Distribution of pro rata pieces of notes and warrants to LPs Note and warrant holders are not subject to S-Corporation limitations
Perceived Challenges Regarding ESOPs
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Management Conflict of Interest: Management less able to influence buyer (i.e., the ESOP) than in
traditional M&A exit Management more incentivized to consummate a transaction than in other
exits
Perceived Challenges Regarding ESOPs
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Dividend Recap: The dividend recap does not effect a sale of the company’s equity, whereas
an ESOP can partially or completely monetize the private equity firm’s investment
An ESOP provides tax savings not available for a straight dividend recap – allows for faster deleveraging in an ESOP-owned company
Perceived Challenges Regarding ESOPs
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Trustee Fiduciary Objectives: Trustee does not have an affirmative obligation to shop the company The trustee does, however, have an obligation to consider bona fide offers
from prospective buyers
Perceived Challenges Regarding ESOPs
Each private equity fund has its own unique characteristics and rules – ESOP transactions can be structured to accommodate
such constraints.
CASE STUDIES
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Case Study – Project “Shared Values” Quasi-private equity investors controlled a leading manufacturer and distributor of pressure-sensitive labels and other materials with revenues in excess of $100 million Situation
The company, already moderately leveraged and in need of continued access to capital to support growth, had a track record of non-recurring events and exposure to certain environmental liability issues
Challenge
Evaluate liquidity alternatives by benchmarking traditional M&A valuation and ESOP alternatives
Project
Execution of a 100% ESOP-owned S-Corporation at a 45% premium to the established M&A valuation
Solution
Observations:
Superior returns relative to M&A alternative if warrants provide the projected value Continued equity participation in future earnings growth via warrants or SARS Excellent legacy for company and its leadership team Employees participate in generous retirement tied to company performance and
stock appreciation
(a) 6% coupon for years 1-3 and 8% for years 4-7 with warrants for 30% of the company’s fully diluted equity
ESOP Sale Economics Projected Year-7 Economics
▪ Cash at close 3,250$ ▪ Cash at close 3,250$
▪ 7-year seller note (a) 24,250 ▪ Seller note principal 24,250
Total 27,500$ ▪ Seller note interest 12,125
▪ Warrants 29,866
Total 69,491$
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Case Study – Project “Maple Leaf” A private equity firm was the majority shareholder of a service provider and manufacturer of equipment for niche projects in the timber, construction, and oil and gas industries with revenues in excess of $150 million and EBITDA of $25 million
Situation
The company suffered two significant quality-of-earnings events (loss of a contract that contributed 30% of gross profit and a significant asset impairment) while the private equity owner was assessing its transaction options
Challenge
Explore the sale of the company to management and an S-Corp ESOP as an alternative to the traditional M&A process that had been initiated by the fund Project
Develop an ESOP "stalking horse" bid to compete with the traditional M&A process Solution
Observations:
ESOP provided a stalking horse to optimize price, terms, and conditions from M&A process
Greater certainty of close relative to M&A buyer ESOP was able to deliver a firm and fully financed and negotiated stock purchase
agreement within 60 days ESOP team expenses paid by private equity firm
M&A Buyer / M&A Buyer / Benefit ofInitial Offer ESOP Offer Final Offer Dual Track
▪ Valuation 166,000$ 208,000$ 190,000$ 14.5%
▪ Tax escrow 15,000 5,000 5,000 66.7%
▪ Indemnification baskets 25,000 15,000 15,000 40.0%
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Case Study – Project “Beat the 2013 Tax Increase” Owners of company were motivated to sell. Several traditional M&A attempts had failed. By the Spring of 2012, they want to be assured of a 2012 closing Situation
Sellers want all cash. Challenge
Structure a realistic ESOP transaction that could be closed during 2012. Project
Sales price of $170 million; closed December 2012; financing as follows: (1) first and second senior secured loans: $130 million, (2) first subordinated loan from an investor: $15 million (3) second subordinated loan (seller note): $25 million No warrants were issued. First subordinated interest: 17.5% cash. Second subordinated interest: 13% cash/4% PIK, with ratio changing to more cash and less PIK through year 6, and rate increasing to 18% starting in year 7.
Solution
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Case Study – Project “Breeze” A private equity firm was 70-percent shareholder of a national leading niche business-to-business service company with EBITDA of less than $10 million – which had been acquired from another private equity fund
Situation
The company had a colorful history, including numerous "non-recurring" events, contributing to inconsistent sales and earnings results Challenge
Advise the company and management on the formation, valuation, structure, and financing of an ESOP transaction Project
Execution of a management-led ESOP MBO at a purchase price equal to 8.0x EBITDA with 100% cash at closing for the private equity firm Solution
Observations:
Transaction was completed in less than 90 days Private equity firm was looking for full and fair price and all cash at close…and got it
EBITDAType of Capital Multiple
Senior debt 4.00x
Mezzanine 1.50x
Seller debt -
"Friends and family" 1.25x
Equity raise from 401(k) 1.25x
Purchase price 8.00x
Management rolled most of its equity; in addition, former corporateexecutives invested on a pari passu basis
All in, 401(k) investments in employer securities represented less than 35%of total plan assets
Sources / Comments
Cash flow loan, raised at one turn above market at the time; ESOP tax shield,strong relationships, and management investment / strength contributed tothis above-market commitment
Mezzanine provider had a prior relationship with management, familiaritywith the ESOP tax shield, and an understanding of the improved debt serviceprovided by the structure
While common in many ESOP transactions, there was no seller financing inthis transaction
SUMMARY
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Summary: Review of Each of the Three Categories
Seller
Buyer
Investor
In select niche situations an ESOP can be a superior corporate finance alternative for private equity investors.
Large minority shareholder wants to stay Private equity majority owner wants to sell Private equity firm wants to divest a subsidiary
of a newly acquired company
Carve out of subsidiary/division using an ESOP Terminate existing ESOP
Maintain partial ESOP Acquisition financing potential Growth capital potential Take-out of minority, non-ESOP shareholder
potential Investor able to negotiate typical covenants,
including covenants related to activities of the company
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Questions?
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Join us for these related EES courses: Nov. 14 and 19: Employee Benefit Plan Accounting Issues
Update Accounting & Management Issues of Employee Stock
Ownership Plans (recorded on 5/23/13)
ESOPs for the Construction Industry (recorded on 6/18/13)
Read these related publications: MHM Messenger 11-13: FASB Proposal Affects Employee
Benefit Plans Employee Stock Ownership Plan Primer
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