esops and private equity - long point capital · • long point capital is the leading peg invesng...
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ESOPSANDPRIVATEEQUITY
• EmployeeOwnershipcanTransformaCompany“Doneright,employeeownershipcantransformacompany,improveperformanceandaccelerategrowth.Itcancreateasustainedcompe;;veadvantage,drivingbusinesssuccessthatbuildswealthforfounders,investorsandemployeeshareholdersalike.”-BeysterIns;tutewebsite.
• PrivateEquityFocusesonAcTvelyManaged,LongTermValueCreaTon“Weliketothinkofourselvesasindustrialists.I’musingindustrialistsinabroadsense.WebuyacompanyandlookatwhatwecandotomakeitbeCer.Howcanweimproveopera;ons?…It’sourlong-termapproach,thefactthatwefocusonstakeholders.WeusedtopaymoreaCen;ontothestockholder:Howwelldidyoudoonthisinvestment?Todayweworryabouttheenvironment,thecommunity,theemployees—they’realltopofthemind.”-ExcerptsfromaHenryKravisInterviewwithBloomberg,June2016
ESOPsandPrivateEquityInvestorsShareCommonGoalofLongTermValueCrea>on
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PRIVATEEQUITYANDESOPSWHYITSHOULDMAKESENSE?
• ComparableReturnforComparableRiskcanbeAchieved– PEGcanoVenstructuretheinvestmentsothattheprojectedreturnsareroughlyequal
inbothalterna;vessincethePrivateEquityGroup(PEG)istakingthesamecomparableriskintheTradi;onalPEstructureandthePE+ESOPstructure
– PEGshouldberoughlyindifferentastostructurebasedonprojectedreturns
• PE+ESOPOffersSignificantEmployee,TaxandMoTvaTonalBenefits– Employeere;rementplanbenefitscreatedatnocosttoemployees– Corporateincometaxescanbereducedoreliminated– Allstakeholdersaremo;vatedtocreateequityvalueandwealth
• PE+ESOPisAlignedwiththeObjecTvesoftheESOPandtheTrustee– Valua;on-Privateequityestablishesamarket-basedvalua;on,i.e.professional
investorsriskingmoneyonanarms-lengthnego;atedtransac;onvalue– Governance–Privateequityestablishesgovernanceprocedurestomaximizegrowthin
equityvaluewhichbenefitstheinvestmentbytheESOPandtheprivateequityfirm
• RobinHoodResults?
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ESOPSANDPRIVATEEQUITYGROUPSWHEREDOTHEYINTERSECT?
• ESOPCreaTon-AsanInvestorinaNewESOP– APEGmayprovidecapitaltoallowanownertogenerateliquiditywhen
sellinghiscompanytoanESOP• ESOPCreaTon-AsaSellertoaNewESOP
– APEGmaysellaporeoliocompanytoanESOP
• ExisTngESOPFinancing– APEGmayprovidecapitaltoanexis;ngESOPcompanyinneedoffinancing
• ESOPTerminaTon– APEGmaypurchaseacompanyfromanESOP
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PRIVATEEQUITYINESOPSWHENWILLAPRIVATEEQUITYGROUPINVESTINANESOP?
• TheProjectedInvestmentReturnsJusTfytheRisk– Thereturnsaresimilartothereturnsthatwouldbegeneratedfora
similarriskprofileinanalterna;veinvestment• ThePEGcanCreateValueandProtectandExitItsInvestment
throughProperGovernanceProvisions• ThePEGcanStructureitsInvestmenttoMeettheConstraints
ImposedbytheTaxcodeandERISA
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PRIVATEEQUITYANDESOPSWHATAREPEGALTERNATIVESFORINVESTMENT?
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TransactionAlternative
HowDoesitWork?
Bene6its
TraditionalPrivateEquityTransaction
– CashisgeneratedthroughanequityinvestmentbythePEGandthird-partydebt9inancing
– Ownersreceiveproceedsconsistingofcashandanequityinterestintheongoingcompany
– Typicaltransactionsplitofvalue–80%plusincash,20%inequityreinvestment
– PEGroupcanprovidesigni9icantvaluethroughadditionalexpertise,relationshipsandcapital
– Incentivescanbecreatedthroughmanagementoptionsandculturechangemaybeminimal
PE+ESOPTransaction
SAMEASABOVEBUT:– Typicallystructuredasa100%S-
CorpESOP– Syntheticequityinvestment(notes
andoptions)usedbythePEGinsteadofatraditionalequityinvestment.
– Ownersreceiveproceedsconsistingofcashandsyntheticequity(notesandoptions)
SAMEASABOVEPLUS:– Employeeownershipandretirementbene9its
created.– Seller’staxablegaincanbereducedor
eliminatedifstructuredthroughaIRC1042exchange,potentiallyeliminatingataxliabilitythatcouldapproach35%ofproceeds.
– Corporatetaxescanbereducedoreliminated.– PEG,SellerandESOParealignedindesirefor
fairpriceandfutureequityvaluecreation
PRIVATEEQUITYANDESOPSWHATARETHEOBSTACLES?
• StructuralConsideraTons– LegalandOwnershipformofcorpora;onmayreducetaxbenefitsofaPE+ESOP
transac;on–capitalgaindeferral/elimina;ononlypossiblewithaC-Corp• ComplexityandExperTseConsideraTons
– MostPEGsandM&Aadvisorstypicallydonotpossesstheexper;setoevaluatethePE+ESOPstructureandoVenwillshootitdownratherthanengageoutsideexperts
• AwarenessandPercepTonConsideraTons– “TooGoodtobeTrue”–Ifitispossibletoeliminatecapitalgainstaxesand
eliminatecorporatetaxes,thenwhyisn’teveryonedoingit?– ESOPmythsandmisunderstandingsleadtonega;vepercep;ons
• IntermediaryIncenTveConsideraTons– Ifaninvestmentbankerisengagedbyaseller,heisvirtuallyalwaysincen;vizedto
maximizetheprice/valua;onwithoutanyregardfortaxconsidera;ons– Inthemindofaninvestmentbanker,thePE+ESOPtransac;oncreatesaddi;onal
risk–;ming,complexity–withoutanyeconomicupside• RegulatoryConsideraTons
– DOLregulatesre;rementplans,includingESOPs,addinganotherpartytothemix
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PRIVATEEQUITYANDESOPSHOWTOOVERCOMETHEOBSTACLES?
LongPointCapital 8
IntenTon IdeaMakeESOPsMoreAaracTvetoSellers• WilldrivesellerstodemandtheESOP
alterna;vetoachieveitstaxbenefits
ExtendIRC1042ExchangetoS-Corps,thecorporatestructureforthevastmajorityofprivatecompanies,allowingmoresellerstobenefitfromcapitalgaindeferral/elimina;on.
MakeESOPsAaracTvetoImpactInvestors• Willincen;vizePEGstolearnaboutESOPsto
createnewinvestorbase
EducateImpactInvestorsonthesocialbenefitsofESOPcrea;on.EducateImpactInvestorsthattheycanachievesocialbenefitswithoutsacrificingreturnsthroughaPE+ESOPinvestment.
MakeESOPsLessComplicatedtoExecute• Execu;onofanESOPissome;mesasmuch
anartasascience–clearcutguidelineswillmakesitmoreaCrac;vetoPEGs
PE+ESOPtransac;onsaremarketbasedvalua;ontransac;ons–thereisabuyerlookingforthelowestpriceandasellerlookingforthehighestprice.Atradi;onalESOPisaaself-dealingtransac;on.ESOPtrusteesmustlearntoevaluatePE+ESOPdealsdifferentlyfromtradi;onalESOPs.
DemysTfyESOPSandClearUpsMyths• Don’tdriveawayPEGsandSellersbecauseof
misinforma;on.
ESOPindustryassocia;onscouldcreatebeCercommunica;onprogramstocreateclarity.
PRIVATEEQUITYANDESOPSHOWTOOVERCOMETHEOBSTACLES?
LongPointCapital 9
IntenTon IdeaPublicizeESOPSuccessStories• Crea;ngaposi;vepublicpercep;onofESOPs
wouldleadmorePEGs,sellersandemployeestosuggestacompanysaletoanESOP.
ESOPsindustryassocia;onsshouldhelptopublicizesuccessfulESOPs.Newspaperstendtorunnega;vestoriesaboutESOPs,e.g.ChicagoTribune,crea;ngnega;vepublicpercep;on.
EducatePEGsonProducTvityBenefitsofESOPs• IfPEGsbelievethatemployeeownershipwill
createmorevaluefortheirinvestors,theywillbemoreopentothePE+ESOPtransac;on
CreateacademicstudiesthatmeasuretheeconomicbenefitsofESOPsandemployeeownership.
PRIVATEEQUITYANDESOPSSUMMARYOBSERVATIONS?
• ItCanWork-PEGsHaveInvestedinESOPs– AtleasthalfadozenPEGshaveinvestedinESOPs,buttypicallyeachhas
investedone;meonly• LongPointCapitalistheLeadingPEGInvesTnginESOPs
– LongPointCapital(LPC)hascreatedover3,000employeeownersinsevenESOPssince2004
– LPCoffersthePE+ESOPtransac;ontosellerswhovaluethebenefitsoftheESOPversusatradi;onalPEtransac;on
• PEInvestmentinESOPsWillGrowIf:– PEGsseeacompe;;veadvantageinofferinganESOPalterna;ve.– SellersrecognizethebenefitsofanESOPanddemandthatPEGsofferitasan
alterna;ve
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Appendix
LiquidityOpTonstoOwnersofCompanies
LongPointCapital 11
WHYMIGHTANOWNEREXPLORELIQUIDITYOPTIONS?
• ExitStrategyPlanning– Youwanttodiversifyyourassetsandreducetheriskofhaving“allyoureggs
inonebasket”– Youwanttopreserveanongoingroleandmaintainequityownershipinthe
Company
• Re;rement– Youarelookingtoselltheen;reCompanyandre;re
• FamilySuccession– Youneedtoprovideforliquidityforanoldergenera;onaspartofan
appropriatesuccessionplan
• PartnerBuyout– Youneedtogeneratethecashtorepurchasethestockofasignificant
shareholder
LongPointCapital 12
WHATARETHEGOALSOFANOWNERWHENEXPLORINGASALETOANESOP?
• Liquidity(Cash)&WealthDiversifica;on
• TaxMinimiza;on• ManagementTeamIncen;ve• EmployeeOwnership• Minimiza;onofCultureDisrup;on• LegacyforOwner• MaintainOpera;ngControl
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WHATARETHEALTERNATIVESTOANESOP?
• HireanInvestmentBankerand• SelltoaPrivateEquityFirm• SelltoaStrategicBuyer
• DoNothing
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HOWDOTHEALTERNATIVESMEETTHEGOALS?Traditional
ESOPPrivateEquity
StrategicBuyer
ESOP+PrivateEquity
Up-FrontCashLiquidity
TaxMinimization
After-TaxLiquidity
ManagementIncentive
EmployeeOwnership
MinimizeCultureDisruption
LegacyforOwner
MaintainOperatingControl
TheESOP+PrivateEquityAlternaTvelooksaaracTve–whyisn’titmorepopular?
LongPointCapital 15
• Whatisit?– Cashisgeneratedusingonlyaseniorloanfromabank– Ownersreceiveproceedsconsis;ngofcashandasellernote– Typicaltransac;onsplitofvalue–30%to40%cash/60%to70%
sellernote
• Benefits– Thetaxablegaincanbereducedoreliminatedifstructuredusing
IRCSecTon1042,potenTallyeliminaTngataxliabilitythatcouldapproach35%ofproceedsinCA
– Corporatetaxescanbereducedoreliminatedifstructuredasa100%S-CorpstructureorusingcertainESOPloanstructures
– Incen;vescanbecreatedthroughop;onsandemployeeownershipandculturechangeisminimized
– Controlismaintainedbytheowner,ifdesired
• Issues– Significantwealthdiversifica;onisnotachievedbecauseoflimited
cashliquidity
SELLTOATRADITIONALLYFINANCEDESOP
16
$100MMTradiTonal
ESOP
$70MMNoteReinvestment
CashProceeds$30MM
AVer-Tax
LongPointCapital
• Whatisit?– CashisgeneratedthroughanequityinvestmentbythePE
groupanddebtfinancingarrangedbythePEgroup– Ownersreceiveproceedsconsis;ngofcashandanequity
interestintheongoingcompany– Typicaltransac;onsplitofvalue–80%plusincash,20%in
equityreinvestment
• Benefits– MorecashatclosingbecauseofPEinvestmentand
addi;onaldebtfinancinggeneratedbyPEgroup– PEGroupcanprovidesignificantvaluethroughaddi;onal
exper;se,rela;onshipsandcapital– Incen;vescanbecreatedthroughmanagementop;ons
andculturechangemaybeminimal
• Issues– TaxInefficient–Ownerspaycapitalgainstaxes/Company
payscorporatetaxes– PEgroupwilltypicallycontroltheCompany
SELLTOAPRIVATEEQUITYGROUP
17
$100MMSaletoaPEGroup
$20MMEquityReinvestment
$24MMCapitalGainTaxes
$56MMAVer-TaxCash
Proceeds
LongPointCapital
• Whatisit?– Strategicbuyer,oVencompe;tor,payscashorstock,if
public
• Posi;ves– PotenTalformostpre-taxliquidityifbuyeraCributesvalue
toandpaysforsynergies– Nofurtherriskincompanyinvestmentforexis;ngowner
• Issues– TaxInefficient–Ownerswillpaycapitalgainstaxesoncash,
poten;allymi;ga;ngvalueofhigherprice– Elimina;onofownerupsideinCompany– Completelackofcontroloverfutureofbusiness– Mostpoten;alforcultureshocktomanagementteamand
employees– Riskofreleaseofcompe;;veinforma;onthroughthesale
process
SELLTOASTRATEGICBUYER
18
$100MMSaletoaStrategicBuyer$30MM
CapitalGainsTaxes
$70MMAVer-TaxCash
Proceeds
LongPointCapital
WHATISPRIVATEEQUITYANDHOWCANITBEUSEDINANESOP?
• PrivateEquityisins;tu;onalcapitalusedforinvestmentinprivatecompanieswiththegoalofgenera;ngarisk-adjustedequityreturn
• PrivateEquitycanprovideaddi;onalliquiditytoanownerinanESOPtransac;onthroughaninvestmentintheCompany,whichallowstheownerstoreceivemorecashandcreatemorewealthdiversifica;on.
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PRIVATEEQUITY101RISK-ADJUSTEDRETURNONINVESTMENT
• Inves;ng-TheGreatertheRiskTaken,theHighertheReturnRequired• RiskisAssociatedwith:
– CertaintyofCashFlow– SizeofCompany–thelargerthecompany,thelesstherisk– Leverage–thelessthedebt,thelesstherisk– IndustryCyclicality–themorestabletheindustry,thelesstherisk– Diversifica;on–themorethediversifica;on,thelesstherisk– Liquidity–theeasieritistoselltheinvestment(e.g.public),thelesstherisk– Maturity–thelongerthecompanyhasatrackrecord,thelesstherisk
• PrivateEquitytakesRisks– Typicallyinvestsinsmallerprivatecompaniesusingequityanddebt(highestriskprofile)– Typicallyseekannualreturnsof25%+oninvestments
• Valua;onMul;plesarebasedbothonriskandongrowthpoten;al
LongPointCapital 20
PRIVATEEQUITY101OBJECTIVES,GOVERNANCEANDLIQUIDITY
• Objec;ve–growthofequityinvestmentvalueisparamount;thatishowprivateequityprofessionalsarepaid
• Governance–ac;veinvestorsalignedwithmanagement– Ac;vewithmanagementteamtogrowcompany– AlignmentofInterests–managementteamsincen;vizedtocreateequity
value– Control–Ifcompanyisnotperforming,PEgroupmusthaveabilitytochange
team
• Liquidity–investmenthorizonstypically5years,requireabilitytogeneratecashliquidityforPEGinvestors,typicallythroughsaleofcompany
LongPointCapital 21
PRIVATEEQUITYINESOPS–TAXISSUES
• MostTaxEfficientESOPStructure–100%S-Corp.Structure• ButiftheEquityoftheCompanyisOwned100%byanESOP,
howcanaPrivateEquityfirminvest?• Synthe;cEquityneedstobeu;lized
– ConsistsofaJuniorDebtInvestmentwithanEquityKicker(e.g.Op;ons)
– Designedtogenerateaninvestmentreturnwhichmimicsthereturnthatwouldbegeneratedthroughatradi;onalprivateequitytransac;on
• Complicatedtostructureandexperiencedtaxadvisorsrequiredtoinsurethatallrulesaremet
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PRIVATEEQUITYINESOPS–FINANCINGISSUES
• 100%S-CorpESOPsare100%DebtFinancedCompanies• FinancingConsistsof:
– SeniorLenderDebt–maybebankornon-banklender– StructuredEquity(JuniorDebt)– SellerNotes(JuniorDebt)
• Banksrequirethejuniordebttobeappropriatelysubordinatedtothebank’sseniordebt
• Requiresasophis;catedseniorlenderwhounderstandsthestructure
• Investmentbyprivateequitymayincreaseconfidenceofseniorlender
LongPointCapital 23
PRIVATEEQUITYINESOPS–FINANCINGBENEFITS
• 100%S-CorpESOPsgeneratesignificantlyhigherfreecashflowduetotheelimina;onoftaxes.
• Thehigherfreecashflowmayallowthelenderto:– Stretchandlendmoretothecompanythanitwouldlendtothesame
companythatisatax-payer,or– Providemoreflexibleratesandtermssincethecompanyshouldbe
perceivedasabeCercredit.• Thehigherfreecashflowprovidessignificantbenefitstothe
Company,providing:– Morecapitalforgrowth,and/or– Morecapitaltodeleveragerapidly,and/or– Currentcashyieldonthesynthe;cequitynotes
LongPointCapital 24
PRIVATEEQUITYINESOPS–REGULATORYISSUES
• PrivateEquityiswellalignedwiththeprimaryobjec;vesoftheESOPandtheTrustee– Valua;on-Privateequityestablishesamarket-basedvalua;on,i.e.
professionalinvestorsriskingmoneyonanarms-lengthnego;atedtransac;onvalue
– Governance–PrivateequityestablishesgovernanceprocedurestomaximizegrowthinequityvaluewhichbenefitstheinvestmentbytheESOPandtheprivateequityfirm
• Constraints– ESOPsareregulatedbytheInternalRevenueCodeandERISA,socareful
adherencetoIRCandERISArulesisrequired
LongPointCapital 25
PRIVATEEQUITYINESOPS–WHENDOESITWORK?
• WhenwillaPrivateEquityGroup(PEG)investinanESOP?– Theprojectedinvestmentreturnsjus;fytherisk
• Thereturnsarenolessthanthereturnsthatwouldbegeneratedinatradi;onalPEGpurchaseofthecompany
– ThePEGcancreatevalueandprotectitsinvestmentthroughpropergovernanceprovisions
– ThePEGcanstructureitsinvestmenttomeettheconstraintsimposedbythetaxcodeandERISA
– ThePEGcanfindsufficientdebtfinancingforthetransac;on
• Ifitworks,itprovidesanewalternaTve……
LongPointCapital 26
NEWALTERNATIVE:SELLTOAPE-BACKEDESOP• Whatisit?
– Structuredasatradi;onallyfinancedESOP,butcashisgeneratedthroughasynthe;cequityinvestment(notesandop;ons)bythePEGandbankloansarrangedbythePEgroup
– Ownersreceiveproceedsconsis;ngofcashandsynthe;cequity(notesandop;ons)
– Typicaltransac;onsplitofvalue–80%plusincash,20%insynthe;cequityreinvestment(notesandop;ons)
• Posi;ves– Thetaxablegaincanbereducedoreliminatedifstructuredthrough
aIRC1042exchange,potenTallyeliminaTngataxliabilitythatcouldapproach35%ofproceeds.Corporatetaxescanbereducedoreliminatedifstructuredasa100%S-CorpESOPoralterna;vestructures.
– MOSTAFTER-TAXLIQUIDITY–morecash,lesstaxes– PEGcanprovidesignificantvaluethroughaddi;onalexper;se,
rela;onshipsandcapital– PEG,ownerandESOParealignedindesireforfairpriceandfuture
equityvaluecrea;on– Maintainincen;vesthroughop;onsandemployeeownership
• Issues– PEGwillplayimportantroleingovernanceoftheCompany
$100MMPE+ESOPTransacTon
$20MMStructuredEquityReinvestment
$80MMAVer-TaxCash
Proceeds
LongPointCapital 27
HOWDOTHEALTERNATIVESMEETTHEGOALS?Traditional
ESOPPrivateEquity
StrategicBuyer
ESOP+PrivateEquity
Up-FrontCashLiquidity
TaxMinimization
After-TaxLiquidity
ManagementIncentive
EmployeeOwnership
MinimizeCultureDisruption
LegacyforOwner
MaintainOperatingControl
TheESOP+PrivateEquityAlternaTvelooksaaracTve–whyisn’titmorepopular?
LongPointCapital 28