8/6/2019 June 15 2011 Viewpoint[1]
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Dow Jones Daily Bankruptcy Review| 12
Wednesday, June 15, 2011
Copyright Dow Jones & Company, Inc
All Rights Reserved
ViewpointOne of a series of opinion columns by bankruptcy
professionals
By Jonathan P. Friedland and David Solomon
Youre a private equity sponsor. One of your portfoliocompanies,
which historically had strong financial per-formance, has been
negatively affected by the greatrecession and is now distressed and
deemed to beoverleveraged. The prospects for the business,however,
remain strong. The companys lenders arepressuring your fund to put
in fresh money (somethingyou cannot or will not do) or to get out
of the way sothe company can be sold in order to generate fundsto
pay off at least a portion of the existing debt,resulting in the
lenders taking a haircut and leavingyour fund with nothing.
What do you do? There are a number of options andmany factors to
consider before selecting the optimalstrategy. Anyone who has been
down this road has beencounseled about directors duties in the zone
of insolven-cy; anyone who has concluded these negotiations has
atrue appreciation for that old adage, pigs get fat andhogs get
slaughtered.
One solution we like but that we think is underutilized isfor
the sponsor to cause the company to be sold to its
employees using an employee stock ownership plan(ESOP). A
well-structured ESOP transaction canenhance the cash flow of the
portfolio company afterthe transaction as a result of various tax
benefitsafforded a company that sponsors an ESOP. This, inturn, can
enable the company to more easily service itsdebt. Also, by
implementing an ESOP, the companysemployees will be provided with
incentives based on thevalue of the equity of the company, which in
our experi-ence comports with studies that have shown
thatequity-based compensation significantly improves theESOP
companys financial performance and its retentionof key
employees.
The cash-flow advantages of an ESOP company aregenerally derived
as a result of the fact that an ESOPcompany is essentially able to
repay its indebtedness ona pre-tax basis. When a company adopts an
ESOP toengage in a stock purchase transaction, the ESOPtypically
borrows money from the company (which fundstypically come, in turn,
from a bank or other third-partylender) to purchase the stock (the
ESOP loan). TheESOP loan is repaid with contributions made by
thecompany to the ESOP and, because the ESOP is a
tax-qualified retirement plan, the company receives a
taxdeduction for these contributions. The company, in turn,uses the
monies it receives from the ESOP to repay itsdebt to the companys
lender. This effectively enables thecompany to get a tax deduction
for both the interest andthe principal on its loans.
Also, if the company is an S corporation, there will beno
federal income tax (and, perhaps, no state incometaxes) to the
extent of the percentage of the ESOPsownership of the equity of the
company. The reason is
that an S corporation is a pass-through entity, so thecompany
does not pay any tax on its income. Instead,the companys
shareholders pay tax on that incomebased on theirpro-rata share of
the stock of thecompany that they own. However, an ESOP is a
tax-exempt trust for federal (and in many cases state)income tax
purposes. So, if the ESOP winds up owning100% of the companys
outstanding shares of stock, thecompany can operate on a go-forward
basis as an entityexempt from federal (and, in many cases, state)
incometaxes. This, of course, can have a dramatic impact oncash
flow.
In addition, what we really like about this strategy
when we represent the sponsor is that the sponsor canretain
control of the board of the company it just sold tothe ESOP even if
it owns none of the stock of thecompany after the sale. This is
because the stock heldby the ESOP is not directly owned by the
employee-owners but is controlled by a trustee who can beappointed
by the current board of directors of thecompany and who can be
required in the ESOP saledocuments to retain the current board of
directors andexisting company management after the closing ofthe
transaction.
An additional benefit to an ESOP transaction is that itcan be
structured internally, without taking the company
to market. The transaction can thus be more easilyclosed within
a specific time frame that meets thesponsors objectives.
Were not suggesting this strategy is likely to be apanacea. If
the sponsor is out of the money, the salesprice paid by a newly
formed ESOP is not any morelikely to go into the sponsors pockets
than if the buyeris a third party. The difference, however, is that
the
Using An ESOP To Exit A Distressed Portfolio Company
continued on next page
8/6/2019 June 15 2011 Viewpoint[1]
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Dow Jones Daily Bankruptcy Review| 13
Wednesday, June 15, 2011
Copyright Dow Jones & Company, Inc
All Rights Reserved
ViewpointOne of a series of opinion columns by bankruptcy
professionals
restructured company will be able to support more debt.This, in
turn, may encourage the companys currentlenders to remain committed
to funding the companygoing forward rather than going to market to
sell thecompany to a third party, particularly since such a saleis
not likely to generate enough cash to pay the lendersin full. In
addition, an ESOP transaction can be struc-tured to enable the
sponsor to retain a stake in thecompany after the consummation of
the sale. This isfar less likely if the company is sold to another
sponsoror a competitor.
A graceful exit from a troubled portfolio company is ofteneasier
wished for than achieved. Next time you have todeal with a troubled
portfolio company, consider whetherusing an ESOP is a viable
solution.
continued from page 12 Opinions expressed are those of the
author,
not of Dow Jones & Company, Inc.
Jonathan P. Friedland and David Solomon are
partners with Chicago-based Levenfeld Pearlstein, a
law firm representing businesses across the U.S.
and around the world. Solomon's practice involves
a great deal of ESOP work; Friedland's practice
involves a great deal of restructuring work.
Friedland can be reached at [email protected],
and Solomon can be reached at
[email protected].
