the path to 100% esop ownership - welcome! - oeoc · prior sales attempts recent share transactions...

The Path to 100% ESOP Ownership

Ohio Employee Ownership Center Annual Conference April 24, 2014

Presenters

Ben F. Wells, Office Managing Partner Dinsmore & Shohl LLP 801 Pennsylvania Ave. NW, Ste. 610 Washington, DC 20004 (202) 372-9119 [email protected]

Ted Lape, Principal Lazear Capital Partners, Ltd. 401 N Front St., Ste. 350 Columbus, OH 43215 (614) 221-1701 [email protected]

Julie Williams, Senior Vice President Chase Bank, NA 200 Ottawa Ave. NW, Floor 1 Grand Rapids, MI 49503 (616) 771-7200 [email protected]

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What we will cover

Transaction Steps

Key considerations/planning issues

Financing Issues

Case Study

3

Transaction Steps

Examine the landscape

Determine the transaction structure

Assemble the teams

Negotiate the terms

Implement and close

Follow up

4

Step One: Examine the Landscape

Company’s legal/tax status LLC S corp C corp

Ownership Individual Family Small group Public ESOP

Who are the seller(s) Active owner Passive/retired owner(s) Investor

5

Step One (continued)

Goals of Sellers (lifestyle) Continue working Phase down Retirement Intangible (Legacy/benefit to employees/community)

Goals of Sellers (financial) Cash now Tax deferral Income Charitable Transfers to family

6

Step One (continued)

History Prior sales attempts Recent share transactions Changes to competitive landscape Existing ESOP Recent company valuations

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Step Two: Determine Transaction Structure

Key considerations 1042? Converting entity Deferral vs immediate income Seller risk tolerance Existing ESOP (Dilution, Repurchase Obligation, etc.) Key employees Company workforce/payroll Governance

Common components: Senior bank financing Mezzanine financing Temporary/short term loans Seller notes Warrants Management incentives

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Step Two (continued)

Feasibility Analysis A feasibility analysis from a knowledgeable professional would include (but is not

limited to) the following: An initial estimate of value Preliminary thoughts on a financing structure Seller Proceeds net of Taxes (and timing of such payments) Cash flow impact on the company (under various sensitivities) Preliminary overview of compliance issues, 409 (p), etc.

A feasibility analysis may entail an assessment of numerous alternative structures to identify the structure that most closely meets the objectives of the seller and the Company.

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Common ESOP Transaction Structures

One-Time Sale of Minority Ownership Interest to ESOP Common when there is a desire for some employee ownership, but family or key

executives require controlling ownership

Allows seller to “take chips off the table” and diversify wealth while maintaining voting control of the business

Multiple Transactions to Eventually Achieve 100% ESOP Ownership Size of transactions typically dictated by available bank financing

Common with owners that want to gradually exit the business

Common with owners that want to participate in “upside” of business

Sale of 100% to the ESOP Companies immediately benefit from being income-tax free

Selling shareholders often receive notes as part of their consideration

Seller notes can be attractive investments for sellers

Proceeds may include warrants to share in future upside gains

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Step Three: Assemble the Teams

Company Financial advisor Attorney Accountant/Tax Advisor

Seller Financial/Investment Advisor(s) Attorney Accountant/Tax Advisor Other?

ESOP Trustee Attorney Independent Financial Advisor TPA

Bank/Lender(s) Attorney

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Prepare LOI/Term Sheet

Solicit Lender proposals

Conduct due diligence process

Step Four: Negotiate the Terms

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Step Five: Implement and Close

Finalize agreements

Often the most stressful phase

Expect the unexpected!

Continued communication is key

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Step Six: Follow Up

Often ignored

Monitor post-closing items

Communicate with employees

Begin annual administration process

Decide on post-closing fiduciaries/governance

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Common Transaction Structures

Getting to 100% ESOP Ownership…

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Initial Sale (partial ESOP – 49%)

2

$50MM ESOP Internal Loan

$50M

M S

tock

$50MM Cash

$50M

M C

ash

$50M

M C

ash

$50M

M E

xter

nal L

oan

ESOP

Bank Selling

Shareholder

3

Company

1

1

2

3

The Company obtains senior financing from the Bank

The Company lends the proceeds (the ”ESOP Loan” or “Internal Loan”) to the ESOP, taking back a note from the ESOP

The ESOP pays the Selling Shareholder $50MM, purchasing 49% of the stock from the Selling Shareholder (Implied total value of $102MM)

Sources Uses

Bank External Loan $50.0MM ESOP Stock Purchase $ 50.0MM

Seller Subordinated Notes 0.0MM Stock Redemption 0.0MM

Draw on Line of Credit 0.5MM Transaction Costs 0.5MM

Total $50.5MM Total Uses $ 50.5MM

Note: This example is based on hypothetical numbers and is intended for illustrative purposes only. 16

2nd Stage ESOP to 100%: Redemption

Sources Uses


Seller Subordinated Notes (Note flip) 30.0MM Stock Redemption 80.0MM



$50M

M C

ash

$50M

M N

ote

Bank

Loa

n (E

xter

nal) 2

1

1

2

3


The Company buys (and retires) stock directly from shareholder for $50MM Cash and $30MM Subordinated Seller Note.

The ESOP becomes the sole shareholder of the Company (increasing its ownership from 49% to 100%)

3


Transaction Overview - Redemption

Non ESOP Sellers convey remaining ownership percentage ESOP owns 100% of the Company No internal loan created ESOP does not participate in the transaction ESOP fiduciary should still review the transaction if material

S Corporation seller May have higher tax basis Not eligible for 1042

Seller note may be eligible for installment sale treatment Can opt out Current pay interest subject to ordinary income taxes Sale of warrant (or shares from warrant exercise) may be eligible for capital gain tax

treatment

Participants Day one – no immediate impact on price per share Per share value should increases over time (shares outstanding lower) Only recycled shares will be available for new employees Advantages current employees

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2nd Stage ESOP to 100% – Sale to ESOP

$50MM ESOP Loan (Internal)

$80M

M S

tock

$50MM Cash 2

$50M

M C

ash 3

$50M

M

Cas

h

$50M

M N

ote

Bank

Loa

n (E

xter

nal)

1

Sources Uses


Seller Subordinated Notes (Note flip) 30.0MM Stock Redemption 0.0MM



$30M

M N

ote

1

2

3


The Company lends the proceeds (the ”ESOP Loan” or “Internal Loan”) to the ESOP, taking back a note from the ESOP

The ESOP pays the Selling Shareholder $50MM cash and issues a $30MM subordinated note for remaining stock – becoming 100% shareholder.

a) The Seller Note may remain between the ESOP and the Selling Shareholder and is guaranteed by the Company – or -

b) The Company may assume the obligation on behalf of the ESOP

4

4b

4a


Transaction Overview – Sale to ESOP (Note Flip)

Sellers sell all remaining stock to the ESOP ESOP owns 100% of the Company Large internal loan created – equivalent to transaction price Fiduciary must decide to purchase

Entire transaction is eligible for 1042 (Must be a C Corporation) Seller’s don’t typically want a note from the ESOP

Note flip One day loan

Seller note may be eligible for installment sale treatment Can opt out Current pay interest subject to ordinary income taxes Sale of shares from warrant exercise may be eligible for capital gain

Participants Per share value decreases (post-transaction decline in value due to debt) New employees will receive allocations May be dilutive to existing participants Price Protection

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2nd Stage ESOP to 100%: Combo Redemption + ESOP Purchase

Sources Uses

Bank External Loan $50.0MM ESOP Stock Purchase $50.0MM

Seller Subordinated Notes 30.0MM Stock Redemption 30.0MM


Total $81.0MM Total Uses $81.0MM

$50MM ESOP Internal Loan

$50M

M S

tock

$50MM Cash

$50M

M C

ash

ESOP

3

4

Company

2

Bank Selling Shareholder

$50M

M C

ash

$50M

M E

xter

nal L

oan

1

The Company obtains senior financing from the Bank (the “Bank Loan” or “External Loan”)

The Company redeems $50MM in stock from the Selling Shareholder, with the Selling Shareholder taking a Seller Note from the Company for $50MM

Immediately following (or contemporaneous with) the redemption, the Company lends the proceeds of the External Loan to the ESOP, taking back a note from the ESOP (the ”ESOP Loan” or “Internal Loan”)

The ESOP remits the proceeds of the ESOP/Internal Loan to the Selling Shareholder, purchasing the stock from the Selling Shareholder. The ESOP owns 100% of the Company’s outstanding stock

1

2

3

4


Transaction Overview – Combo ESOP Purchase + Redemption

Sellers sell a portion to the ESOP and a portion to the Company ESOP owns 100% of the Company Reasonable internal loan created – equivalent to ‘ESOP Purchase’ Fiduciary must decide to purchase

ESOP Purchase is eligible for 1042 (Must be a C Corporation) Seller note may be eligible for installment sale treatment

Can opt out Current pay interest subject to ordinary income taxes Sale of shares from warrant exercise may be eligible for capital gain

Participants Per share value may be relatively neutral Number of shares outstanding declines New employees will receive allocations Advantages everyone equally

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FINANCING THE TRANSACTION

The Bank’s Perspective

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Sources of ESOP financing

Senior

• Senior lenders provide senior debt, on cash flow or asset backed basis, up to a multiple of EBITDA

Mezzanine/

Seller

• Mezzanine lenders can provide second lien and subordinated financing; Seller paper is an alternative to mezzanine debt

PE/Seller

• Private equity can provide deeply subordinated equity- like debt financing, typically including a warrant package, or in some more complex structures, preferred stock; Seller paper is an alternative to junior sub debt

Existing Qualified

Plan

• Assets in an existing qualified plan (401k overfunded Defined Benefit) can be transferred to the new ESOP by account holders to provide equity capital on a pre-tax basis

6x E

BIT

DA

Senior 2x – 3.5x EBITDA

Transfer from 401(k)

Private Equity/

Seller

Mezzanine / Seller

1x – 1.5x EBITDA

A 100% S Corporation ESOP may have many layers to its final capital structure:

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The Senior Lender’s Perspective

An ESOP Loan is underwritten similar to a traditional loan with a few key differences Cash Flow (tax benefits, repurchase obligation) Complexity (Regulatory, Subordination of Seller Debt, Etc.)

Banks generally like to see loans used for “productive” purposes

It is challenging to view an ESOP loan as productive: Cash is leaving the company Shareholders may be leaving No new assets No new cash flow

Regulatory requirements limit the amount of risk Banks can take on (according to the “riskiness” of the loan portfolio)

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ESOP-Specific Credit Considerations

Tax position going forward Loss of ESOP tax deductions or tax shield would mean company will pay higher

income taxes going forward If transaction depended upon those tax savings, Company cash flow may be

insufficient to service debt

Repurchase obligation Could become too large to finance out of operating cash flow Growth in annual cash claim relative to operating cash flow Lender wants to understand that it is being properly examined

Impact of ESOP Regulations on credit worthiness Excise & income tax penalties could harm liquidity & capital Company exposed to private litigation brought by participants

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ESOP Financing Challenges

Never Borrowed

Money

Negative Equity

Challenge Not Enough Collateral

Personal Guarantees

Too Much Debt

Already

My Bank has Never Heard of an

ESOP Bank

Covenants

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ESOP tax advantages Deductible contribution to ESOP ESOP Trust is non-taxable shareholder (S-Corp)

Inclusion of seller financing Flexible and often Favorable Terms

Often interest only until Bank is repaid Subordinated to the Bank

Can expect higher ‘all-in’ returns via current pay interest and warrants

Pledge of QRP (FRNs) High quality collateral ->> Strong advance rates Low interest rate margin.

Company’s ESOP Advisors/Professionals

Mitigating Factors to Challenges

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“The Four C’s of Credit”

Collateral

Capital

• Type of collateral (receivables & inventory, real estate, fixed assets, etc.)

• Amount of collateral – is there an “airball” • Timeline for payback of any collateral

shortfall portion of the loan • Off balance sheet support – guaranties,

side collateral

Character

• Management’s history and depth • Industry volatility is understood, predictable • Good credit history • ESOP issues (e.g. Repurchase Obligation)

addressed

Cash Flow

• Total amount of leverage relative to cash flow and equity capital

• How large is the cushion in the case of a deterioration in performance

• Stability of historical cash flow and expected future cash flow

• Realistic projections (hockey sticks are for hockey)

• Coverage ratios (fixed charge/debt service, interest) are solid

• Cash flow is sufficient to handle leverage while still financing growth

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Primary source of loan repayment is cash flow Secondary source of repayment is liquidating collateral

Debt Capacity - Collateral

Balance Oderly BankSheet Liquidation Advance LoanableValue Value Rate Value

Cash 4,000,000$ 4,000,000$ 0% -$ Accounts Receivable 10,392,157 8,833,333 75% 6,625,000 Inventory 9,000,000 6,750,000 50% 3,375,000

Machinery & Equipment 25,000,000 15,000,000 50% 7,500,000 Real Estate 7,000,000 10,000,000 75% 7,500,000

55,392,157$ 44,583,333$ 25,000,000$

Less: Existing Debt 10,000,000

Net New Debt Collateral Capacity 15,000,000$

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Debt Capacity - Cash Flow

Equity Value EstimateEBITDA 15,000,000$ Valuation Multiple 6.0xEnterprise Value 90,000,000$

Less: Existing Funded Debt 10,000,000

Equity Value 80,000,000$

Senior Debt CapacityEBITDA 15,000,000$

Senior Debt Multiple 3.0xTotal Senior Debt Capacity 45,000,000$

Less: Existing Senior Funded Debt 10,000,000

Incremental Senior Debt Capacity 35,000,000$

Target ESOP Stock Purchase 80,000,000$

Financing Need in excess of 3.0x EBITDA 45,000,000$

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Many times the cash flow of the company can support greater debt than the collateral, especially in 100% ESOP sales:

Depending on the size and a number of other factors, banks may lend on an uncollateralized basis and/or other options include:

Subordinated Debt / Junior Capital Mezzanine Capital Seller Financing Equity Off balance sheet support – guaranties, side collateral

Enterprise Value Lending (“Airball”)

Max. New Debt Capacity Per Cash Flow Requirement 35,000,000$

Max. New Debt Per Collateral Requirement 15,000,000$

Collateral Shortfall 20,000,000$ -- Multiple of EBITDA 1.3x

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Mezzanine/Subordinated Debt

Allows for additional cash at close with Minimal to No Equity Dilution Funded Amount - 1 – 1.5x EBITDA Subordinated (behind) bank debt in terms of collateral and payment Total Leverage of 3 - 4.5x EBITDA (higher for an ESOP vs Non-ESOP) Pricing – 12-22% all in (current pay/accrued interest and potentially

warrants) 5 Year Term, No Amortization Pre-payment penalty – 3% - year 1, 2% - year 2, 1% - year 3 Other – restrictions on how quickly employees vest in early years

3rd Party Junior Capital

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Structured Equity

Enables cash at close similar to a private equity transaction Structured as Debt Subordinated to Bank Debt and Mezzanine Maintains 100% tax free company Returns similar to Equity Returns, 20%+ Returns achieved through accrued interest and warrants Likely will require board representation

3rd Party Junior Capital

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Where to hold the note Company issues note ESOP issues note

Tax treatment of seller note proceeds Capital gains recognized in year of sale Capital gains recognized when note proceeds received (installment sale)

Terms of note Typically no principal while senior debt outstanding Subordinated to the Bank Can expect higher ‘all-in’ returns via current interest and warrants Ability to refinance down the road Control provisions for note holder

Seller Financing Considerations

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Case Study

High Tech Equipment Rental Company

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The Company

Founded in the Living Room of the Selling Shareholder in 1986

National Leader in High Tech Equipment Rentals

Strong Reputation within their niche

A Significant Concentration of Revenue with a small group of customers

History of High Capital Expenditures

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The Business Situation

Selling Shareholder had historically retained all earnings in the company rather than taking distributions Thus, almost all of his wealth was locked in the business

He wanted Liquidity and a Fair and Full Value

Selling Shareholder preferred to remain active with the Company for several more years

Selling Shareholder was concerned that a Strategic Buyer would likely move the company and cut most of the workforce He wanted to preserve his legacy rather than cash out at the expense of the

employees

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The Strategy

Market The Company to Strategic Buyers and the ESOP Trustee (“Dual-Track”)

Obtain a Fair and Full Value

Understand the Impact of Both Strategies on the Selling Shareholder’s Economics/Role and the Employees

Understand the Tax Impact of a Strategic Sale versus an ESOP Sale Work to Maximize Selling Shareholder’s after tax purchase price

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The Tax Situation

The Company was a C-Corporation with Heavily Depreciated Assets The sale of depreciated assets would have triggered “recapture” which causes

prior depreciation expense to be reversed Recapture creates tax liability

An Asset Sale would also have also triggered Two Layers of Tax Federal Tax at the C-Corp level, with a 35% marginal tax rate

Thus, on each $1 million of proceeds, only $650,000 would remain to be paid to the shareholder as a dividend; plus:

Federal Tax at the Shareholder level, at a 23.8% rate 20% Dividend rate, plus 3.8% Affordable Care Act rate; plus

State (5.9% for Ohio) income tax rates

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The Tax Calculation

Tax Rate Example per $1 million of sales proceeds: Federal Tax At the Corporate Level:

$1,000,000 X 35% Federal Rate = $350,000; $1,000,000 - $350,000 = $650,000 net of tax

Federal Tax At the Shareholder Level: $650,000 net of Federal X 23.8% Federal Rate = $154,700 $650,000 - $154,700 = $495,300

State Tax at the Shareholder Level: $650,000 X 5.9% = $38,350 $495,300 - $38,350 = $456,950

The proceeds to the shareholder, net of all marginal tax rates would only be 45.7 percent of the gross sales proceeds

Note that this analysis is for demonstrative purposes only and ignores the Seller’s debt and makes other simplifying assumptions

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The ESOP “Double Tax Free” Advantage

Since an ESOP is a Stock sale rather than an Asset sale, the Recapture (and attendant tax) is eliminated

A sale to a 100% owned S-Corp ESOP renders the ESOP Tax Free on post-closing earnings The ESOP’s tax free status enables the ESOP to repay the Bank and Seller debt

at about twice the speed of a taxable entity

If the Selling Shareholder elects IRC 1042 Treatment, then their proceeds can be tax deferred, or with optimal planning, potentially tax free.

Thus, with an ESOP, both the Buyer and Seller may be Tax Free 1042 is only available to C-Corps and, after some intermediate steps, LLCs, but

not S-Corps.

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After Tax Comparison

43

ESOP Purchase Financing

The financial information has been modified for confidentiality but the ratio of the numbers to each other is approximately the same.

Purchase Price: $25 Million

Prior 12 month’s EBITDA: $5.7 Million

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Timing of Cash to Seller

45

Timing of After Tax Proceeds

46

As A Tax Free Company Cash Flow is Strong

47

The Bank Financing

$14.5 Million Term Loan 10 Year Amortization Cash Flow Recapture

$2 Million Line of Credit with No Draw at Closing

$2 Million Capital Expenditure Line Interest Only the First Two Years

48

The Seller Note

$11.1 Million

$1 Million of Principal Paid Annually

10% Interest Rate

The Principal Amount is Fixed (Not Contingent like an Earnout)

Will be Repaid Early with Periodic Refinances

Pays $14.3 Million to Seller, including Interest

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Bank Term Loan Balance

50

Seller Note Balance

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The Result

The Company received strong Indications of Interest from Strategic Buyers

The ESOP also provided an Attractive Offer

The After-Tax Cash to Selling Shareholder was $21 Million versus $9 Million with a Third Party Sale

With an ESOP, Selling Shareholder continued to lead the company and his employees retained their jobs

Seller maintained a tenant in the building he owned

The ESOP offered a fixed value with no Earnout

Selling has a highly motivated workforce and the company is thriving

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Questions?

Ben F. Wells [email protected]

Julie Williams [email protected]

Ted Lape [email protected]

the path to 100% esop ownership - welcome! - oeoc · prior sales attempts recent share transactions...

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