The Art Of Seller Financing ESOPs - Beyond The Basics

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Rodney Hawkins
6 years ago
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CA 95110 (408) 467-3860 kgl@seethebenefits.com James F.

07901 (908) 897-0826 jhiggins@pilothilladvisors.

1 Presented by: Kevin G. Long Chang, Ruthenberg & Long PC 2033 Gateway Place, Suite 500 San Jose, CA (408) James F. Higgins Pilot Hill Advisors, LLC 55 Union Place, Suite 131 Summit, NJ (908) The Art Of Seller Financing ESOPs - Beyond The Basics 1 Michael E. New Evolve Bank & Trust 6070 Poplar Avenue, Suite 100 Memphis, TN (901) mnew@getevolved.com

2 Acme LLC Case Study "So I got this call from a very a very good CPA firm we work with.." 2

3 Impacts On Transaction Which transaction structure used Cost of doing the deal Loan documentation and built in checks and balances of ALL parties Transaction trustee vs. post deal fiduciary concerns Need for quality independent counsel Contingency planning 3

4 The Constituencies Affected Selling Shareholder Corporation Other creditors ESOP Trustee Management? 4

5 Corporation's Concerns Longer terms for "inside" ESOP loans Cost seller vs senior debt Cost seller vs secondary financing Flexibility Known creditor Ease of "work outs" Board presence of creditor Subordination requirements deal and future 5

6 Seller's Issues Risk, Return, Control Lend to ESOP or company? Collateral Retain control over corporate risk? Comfort with senior lender, trustee, management Compared to: holding back equity guaranteeing bank debt Mezzanine / portfolio / secondary financing 6

7 Trustee's Concerns Pricing / optimizing interest costs Mezzanine Debt? Really? Real? Post transaction board composition Involvement and monitoring Secondary stage refinancing timing? 7

8 Credit 101 A seller taking a note must think like a bank and investor A lender wants: a) sustainable cash flow; b) assets that can be liquidated to pay off debt if necessary; and c) flexibility to modify terms if necessary The better seller note structure would be with the company? the ESOP? 8

9 Pros And Cons Of Bank vs. Seller Financing Cash at Closing Ability to Diversify Flexibility Easier 1042 Fulfilment Independent Oversight Potential Warrant Upside Interest Income for Seller Faster Close and Lower Fees Bank Financed Seller Financed 9

10 Bank & Seller Financed Leveraged ESOP Step 1 "Outside" Loan Bank Company Selling Shareholders Step 1 Seller Guarantee? Cash Step 3 Corp Guarantee? Seller note Step 3 Stock Transaction Company Stock ESOP Step 2 "Inside" Loan 10

11 Seller Financed Corporate Redemption ESOP Step 1 Redemption to Corp Company Step 2 Issue Stock to ESOP Step 1 Corp Note Step 2 ESOP Note Selling Shareholders Third party beneficiary rights ESOP 11

12 "Day Loan" Resulting In Company Note Step 1 "Day" Loan Bank Step 4 Day Loan Repayment Step 3 Seller Loan to Company Company Step 2 "Inside" Loan Selling Shareholders Cash Company Stock Step 3 Stock Transaction ESOP 12

13 ESOP Note Swap Buy-Out: Step 1 Company Annual Contributions Corporate Guaranty ESOP Stock Sale 7-Year Notes Seller Start with stock sale directly to ESOP for subordinated 7 yr 6% notes, secured by corporate guaranty, company pays notes via ESOP contributions 13

14 ESOP Note Swap Buy-Out: Step 2 ESOP Gives combined note Annual Contributions Company Company assumes and secures 7-year notes Annual Note payments ESOP Seller ESOP assigns and company assumes the 7 yr notes in exchange for the ESOP giving it a note for the combined balances. Corporate guaranty extinguished in favor of direct creditor relationship to sellers. 14

15 Seller Financing Considerations Tax Treatment Interest Income is taxed as ordinary income Potential Capital Gain Taxation on Warrants Capital Gains Treatment On Principal - non 1042 Terms of Seller Financing Collateral Corporate Direct or Guarantee Return on Investment Cash Interest Payment In Kind (deferred interest) Warrant (equity kicker) Expected rate of return is commensurate with the perceived risk Loan regs allow terms that would be commensurate from a third party lender Generally, leverage is a metric that is used to tier the seller financing Seller financing positioned like senior debt risk should be paid a return similar to a bank 100% seller financed transactions may "tranche" seller notes based on relative risk profiles Maturity and Excess Cash Flow Board Involvement Financial Covenants 15

16 Corporate Capital Structure Req. Return Senior 5-10% Debt Risk Increases Risk Increases Subordinated Debt & Mezzanine 10-24% 25 - Equity % 16

17 Transaction Documentation Purchase agreements Redemption and issuance issues Loan Agreements Corporate and personal guarantees (secured vs. not) Subordination agreements Contribution agreements Assignment of pledges Voting trusts 17

18 Corporate Guarantees May achieve same protection as direct loan to corporation Very careful drafting required Third party beneficiary rights often overlooked equitable remedies Events of default can be tied to performance of funding ESOP 18

19 Subordination Agreements The senior lender wants to have the strongest position in getting repaid before others Seller financing always expressly subordinated to a bank Bank will typically require the seller to: Wait for a period before receiving any principal Forego interest and principal payments if the company is underperforming (i.e., a bank financial covenant is violated) Agree to standstill on pursuing rights and remedies if the company is in default on the senior loan 19

20 What About 3 rd Party Sub Debt Lenders? Typically require borrowers to have at least $5-10 million of historical annual EBITDA Are an additional "complicating factor" in getting a transaction closed Are typically not as lenient if the company underperforms May want to be involved in corporate governance Can be expensive Sellers will often prefer to remain with the company post-transaction and would prefer to get the sub debt return rather than provide it to a "stranger"; or prefer it to third party leveraged 1042 portfolio even at capital gains rates on principal 20

21 Seller Note Return "Mix" Some assume that due to the risk profile of a note, a seller is justified in expecting a 15% rate of return (like a third party) The return is a function of the amount "invested" in the note and the subsequent cash flows received Cash flows received: Cash interest income Principal both original as well as payment in kind "PIK" Warrants 21

22 PIK Payment In Kind PIK is interest that is compounded into the note's principal rather than paid in cash (Reverse amortization?) A $10 million note with a 5% PIK interest compounded annually would result in the following principal balances over time (assuming no principal payments) Beginning Balance PIK Interest Ending Balance Year 1 $10,000,000 $500,000 $10,500,000 Year 2 $10,500,000 $525,000 $11,025,000 Year 3 $11,025,000 $551,250 $11,576,250 Year 4 $11,576,250 $578,813 $12,155, Year 5 $12,155,063 $607,753 $12,762,816

23 Warrants Are Essentially a stock option issued in connection with a financial instrument / transaction A contractual obligation of a company to sell a specific number of shares to the warrant holder in the future at a preestablished price Example: Jane owns a warrant that provides her the option to purchase 100 shares of Acme Co. for $10 per share on or prior to 12/31/17 Scenario A: If on 12/31/17 the value of Acme stock is $30 per share, then Jane should exercise the warrant (pay $10 per share) and receive the stock Scenario B: If on 12/31/17 the value of Acme stock is $9 per share, Jane should do nothing and the warrant would expire as worthless to her 23

24 Warrants (continued) Essentially allow the holders to conduct a "cashless" exercise to trade some of the warrants for cash. Example: Instead of writing a check for $1,000 to exercise the 100 warrants, Jane instead forfeits 50 warrants to pay the exercise price in lieu of cash Each warrant is worth $30-10=$20 and therefore 50 warrants would be worth $1,000 Warrant holders typically want to get cashed out rather than holding company stock, so warrants typically have "put" features that requires the company to cash out the warrant at a specific date If an ESOP owns all or a portion of the company, the ESOP's tax benefits (i.e., 100% S Corp ESOP) provide a strong desire to avoid additional share ownership outside of the ESOP In ESOP transactions, warrants are typically structured so that company can buyout the warrant (a "call") before the holder proceeds to exercise and take ownership of shares Beware IRC 409 (p): Too many warrants in too few hands may trip the anti abuse test 24

25 Degrees Of Control Legal Or Effective? Creditor's rights in non ESOP scenarios Overall governance structure issues Seller's protections in ESOP deals: Compare guarantee agreements with retaining stock Upside of warrants vs retaining stock Voting trust duration Desire of Sellers to sit on board until: Bank Loan is paid off? Their loan is paid off? 25

26 So What About Acme And Mr. Big? Sale of 74% of stock to ESOP Senior debt for X% of transaction at Y% interest Seller subordinated note for Z% of transaction Board seat protected by cumulative voting of 26%. Projected good return and protection of ensured participation Industry gyrations required Trustee / seller actions to restructure in subsequent year 26

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