EMPLOYEE STOCK OWNERSHIP PLANS (ESOPS)

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EMPLOYEE STOCK OWNERSHIP PLANS (ESOPS) ACIC Spring Investment Forum April 7, 2016 4:00 p.m. Scott Adamson (Moderator) Shareholder Vedder Price T: (424) 204-7715 sadamson@vedderprice.

1 EMPLOYEE STOCK OWNERSHIP PLANS (ESOPS) ACIC Spring Investment Forum April 7, :00 p.m. Scott Adamson (Moderator) Shareholder Vedder Price T: (424) Kreg Jackson Managing Director Houlihan Lokey T: (312) Betsy Perdue Partner Holland & Knight T: (312) Stephen Smith General Counsel Amsted Industries T: (312)

2 Introduction: Panelists Scott Adamson (Moderator) Scott Adamson is a managing shareholder of the Los Angeles office of Vedder Price. He represents public and private companies in complex transactions with a special emphasis on those involving ESOPs. As coleader of the Firm s multidisciplinary ESOP Team, Scott structures and implements transactions using ESOPs to provide employee ownership while creating liquidity on a tax-advantaged basis, and regularly represents clients involving in debt and equity financing involving funds, mezzanine lenders and banks. Scott is also a member of the ESOP Association and is a frequent lecturer on ESOP topics and matters. Kreg Jackson Kreg Jackson is a Managing Director in Houlihan Lokey s Chicago office, where he co-heads the Firm s national Employee Stock Ownership Practice. He has over a decade of experience providing financing advisory services to public and private clients in connection with strategic alternatives assessments, mergers and acquisitions, recapitalizations, leveraged ESOP buyout transactions, and capital-raising activities (senior, mezzanine and equity). He also renders fairness, solvency and transaction-related opinions to companies, board of directors, special committees, financial institutions and independent fiduciaries. Kreg is a member of the ESOP Association and frequently presents on ESOP-related matters. 2

3 Introduction: Panelists Elizabeth Perdue Elizabeth Perdue is a partner in the Chicago office of the law firm of Holland & Knight. A seasoned corporate and finance lawyer, Ms. Perdue has had over two decades of structuring and implementing ESOP transactions. Ms. Perdue represents many financial institutions in connection with financing for ESOP transactions, and is well-versed in the special credit and documentation issues facing senior, mezzanine and subordinated lenders. Mr. Perdue is the co-author of the chapter on ESOP Lending in the Mathew Bender Commercial Loan Documentation Guide. Stephen Smith Stephen R. Smith is Vice President-General Counsel and Secretary of Amsted Industries Incorporated, a Chicago-headquartered global diversified manufacturer supplying the rail, trucking, automotive, industrial and construction industries that is organized as a subchapter S corporation that is 100% owned by its employees through their ESOP retirement trust. Mr. Smith presently serves as Chair of Employee-Owned S Corporations of America (ESCA). 3

4 Tax Incentives for ESOP Companies Tax Deferred Sales to ESOPs Benefits to Sellers Tax Deferred Rollover Under Section 1042 Closely held Corporations 30% of the total value of stock owned by ESOP post transaction The proceeds are timely re-invested in securities of other U.S. corporations known as qualified replacement properties If the election is made, the seller cannot participate in the ESOP with respect to the stock so purchased 4

5 Tax Incentives for ESOP Companies Leveraged ESOP Stock Purchase Tax Deductibility of Financing Contributions to an ESOP are tax deductible by the sponsoring employer, subject to certain limitations. When such tax-deductible contributions are used by the ESOP to repay an exempt loan, the entire loan repayment becomes, in effect, tax deductible Contributions to an ESOP to pay principal on an exempt loan are deductible up to 25% of the annual covered compensation of employee participants 5

6 Tax Incentives for ESOP Companies S Corporations and ESOPs No current federal tax on the annual income to a 100% ESOP-owned S-Corporation But partially ESOP-owned S-Corporations typically require tax distributions to non-esop shareholders (and the ESOP receives its pro rata distribution even though it does not pay tax) 6

7 Tax Incentives for ESOP Companies Participant Tax Benefits No present taxation at the time of the employer s contribution to the plan or the allocation of employer stock to the participant s account The participants account balance grows tax-free prior to the date it is distributed Deferral of the tax until the date it is distributed 7

8 Legal Requirements for ESOPs An ESOP is an employee benefit plan, governed by ERISA Basic Requirements Written plan document Assets to be held in a trust, managed by a trustee Participation must be available to a broad cross-section of employees May exclude unions Non-US employees are excluded Other exclusions must meet certain coverage tests Benefits must be allocated on a nondiscriminatory basis (typically based on relative compensation) Distribution rules death, disability, retirement, termination Diversification rules 8

9 Legal Requirements for ESOPs Exemption from Prohibited Transaction (PT) Rules Under ERISA, many transactions between an employee benefit plan and a party in interest are considered prohibited transactions, such as: Purchase of property by ESOP from company, its shareholders, or other affiliates Loans to ESOP from company, its shareholders, or other affiliates Prohibited transactions carry high penalties, including disqualification of plan For ESOPs, there are special exemptions from the PT rules, if certain requirements are met: Company and shareholders may sell stock to the ESOP Company may make loan to the ESOP to finance its purchase of company stock Conditions of exemption include: ESOP cannot pay more than fair market value, supported by a valuation from an independent valuation company Transaction must be solely in the best interests of the participants 9

10 Borrower Considerations Sources of Capital Certain distinctions Public versus private S Corporation versus C Corporation ESOP Loans and Regular Course Capital Growing emphasis at major banks Mezzanine debt with equity play Seller notes OCC Regs issue 144A Debt Effect on rating and credit pricing 10

11 Borrower Considerations Management Reporting Public companies like any other public companies In the private context, no specific requirements, but can include SEC-style, but streamlined Quarterly reports with financials Audited annual financials with detailed footnotes MD&A Quarterly calls with bank group and 144A lenders 11

12 Borrower Considerations Repurchase Obligation The key distinction for lenders Regular share repurchases Distributions Diversification Dictated by ERISA Detailed modelling is essential Sufficient liquidity to handle all puts Loan agreement implications Use of proceeds include share repurchases Restricted payments any share purchases required by plan Restricted payments basket for non-mandatory repurchases Material amendments to ESOP require lender approval 12

13 Underwriting Considerations in ESOP Companies A lender will typically underwrite a loan to the ESOP sponsor company in the same manner as if the company was completing any other recapitalization transaction (e.g., a dividend recap) However, ESOP transactions do have certain nuances that the lender will consider: Accounting treatment of the transaction The ESOP s impact on financial covenants Future ESOP repurchase obligations The role of an ESOP trustee Finally, a lender may consider whether or not the company is receiving a solvency opinion in the transaction to avoid any retrospective fraudulent conveyance claims 13

14 Underwriting Considerations in ESOP Companies Accounting Considerations In a typical leveraged ESOP transaction, a contra equity account is booked that generally equals the dollar amount of the value of the shares purchased by the ESOP This negatively impacts the company s book value of equity, and is reduced as the loan between the company and ESOP is paid down As shares are allocated to employees, a non-cash compensation expense is booked on the company s income statement Generally, the amount of the expense equals the fair market value of the shares that are allocated in any given year 14

15 Underwriting Considerations in ESOP Companies Future ESOP Repurchase Obligations When a separation or diversification event occurs for an ESOP participant, they have the ability to put the stock to the sponsor company subject to the ESOP Plan Specifications (which are subject to ERISA mandated guidelines) This can create cash outflows that, if not properly managed, can impact the company s operations and attainment of strategic initiatives To address this issue: Proper analyses and plan structuring must be implemented when the ESOP is installed addressing allocation schedules, the timing and process of the put right, etc. The structuring should be accurately documented in the ESOP Plan documents The company should regularly assess its repurchase obligations based upon its employee demographics (there are a number of consultants that specialize in this work) 15

16 Underwriting Considerations in ESOP Companies ESOP s Impact on Financial Covenants Like other cash flow-based loans, it can be common for the lender to utilize a variety of financial covenants such as: Minimum cash flow covenant (or a cash flow sweep with a minimally amortizing loan) Maximum leverage covenant Minimum fixed change covenant Because the annual ESOP expense is non-cash, many lenders focus on EBITDAE (or EBITDA plus an add-back for the non-cash component of the ESOP expense) Additionally a borrower and lender may want to consider the impacts of future repurchase obligations 16

17 Underwriting Considerations in ESOP Companies The Role of the ESOP Trustee It is highly recommended that whenever a new ESOP is installed, that an independent institutional ESOP Trustee (which will have its own legal and financial advisors) is retained to review, negotiate and approve the Transaction on behalf of the ESOP This eliminates any conflicts of interest that may result should a selling shareholder or member of the company s senior management serve as the ESOP Trustee in the transaction Results in a robust transaction process that can withstand scrutiny should any parties retrospectively review the transaction such as the IRS or Department of Labor By hiring an appropriately experienced ESOP Trustee, the company reduces the risk that it will be subject to future fines or penalties as it relates to the ESOP Transaction, thus reducing the risk for the lender 17

18 Structuring Considerations Interagency Guidance for Leveraged Lending Definition of Leveraged Lending Proceeds used for buyouts, acquisitions or capital distributions Transactions where a borrower s: Total Debt divided by EBITDA exceeds 4.0 X EBITDA Or Senior Debt divided by EBITDA exceeds 3.0 X EBITDA Or other defined levels appropriate to the industry or sector Underwriting Standards The ability to fully amortize senior secured debt or repay a significant portion of total debt (commonly assumed 50 percent of total debt) over the medium term (commonly assumed a five-to-seven year period) A leveraged level in excess of 6 X Total Debt/EBITDA raises concerns for most industries 18

19 Structuring Considerations Structural Subordination Structural subordination means that the priority of payment of an obligation as a practical matter is determined by the structure of the financing transaction and the recipient of the loan rather than by any express contractual agreement by a lender to subordinate its priority ESOP Example Mezzanine Lender Holding Co. S-Corp. Contributes cash Receives notes and warrants Senior Lender Operating Co. LLC Contributes cash Receives notes Security interest in all assets Possible pledge of membership interests 19

20 Structuring Considerations Seller Note Issued by ESOP ESOP issues note to Seller in partial payment for stock Example Seller stock $ note ESOP Seller sells stock Receives cash and Note from ESOP Corp. $ Senior Lender Senior Lender contributes cash Receives notes and security interest in assets 20

21 Structuring Considerations Partial Sale Structure a series of two or more transactions rather than a single transaction 21

22 Structured Equity Sources 100% ESOP For sponsor companies that have achieved or are transacting to achieve the 100% ESOP-owned S Corporation structure, it is paramount that they protect the tax-advantaged structure and ensure that no other entity or individual holds stock Stock Company Non ESOP Shareholders Synthetic Equity To address this issue, these sponsor companies can issue synthetic equity (options, warrants, stock appreciation rights, etc.) to investors, senior management, selling shareholders, etc. We refer herein to an investment made in the form of subordinated debt plus synthetic equity (typically, detachable warrants) as Structured Equity 22

23 Structured Equity Structured Equity can be provided by a variety of parties Mezzanine Lender Structured Equity Selling Shareholders Private Equity Funds Other Non-Traditional Lenders Senior Lender While not Structured Equity per se, employees may also be able to fund a portion of the acquisition via accessing and transferring funds tax free to ESOP from other qualified plans (e.g., 401(k)) 23

24 Structured Equity Structuring Considerations The investor, company and ESOP Trustee will want to ensure that the expected all-in rate of return is appropriate for the investor holding the Structured Equity The investor will want to ensure that they have the appropriate/typical protections that they would receive in any other subordinated debt investment The synthetic equity can be structured in such a way as to ensure that the Structured Equity investors do not hold a share of stock, thus avoiding certain S Corporation restrictions: Only certain types of legal entities can hold S Corporation stock Limitation on the number of shareholders S Corporations can only have one class of stock 24

25 Structured Equity S Corporation ESOP Anti-Abuse Rules Under Section 409(p) Congress has enacted a set of special anti-abuse rules for S Corporation ESOPs, which are set forth under Section 409(p) of the IRS Code Goal was to avoid only a small number of people/investors from receiving significant benefits by significantly diluting the ESOP s ownership There is a two-step test The penalties for violating 409(p) can be severe and therefore, we traditionally see synthetic equity representing a maximum of 30-40% of the diluted ownership These issues must be taken into consideration when establishing the Structured Equity while also ensuring the investor receives an appropriate rate of return 25

26 Documenting Loans for ESOP Transactions Loan Documents Should contain: Representations and Warranties relating to ESOP matters, ERISA compliance, ESOP tax qualification, S Corporation status, etc. Covenants relating to ESOP compliance and tax matters Annual delivery and notice requirements relating to ESOP matters ESOP annual report and valuation 409(p) test Repurchase obligation studies DOL and IRS audit notices Customized financial covenants, to take into account ESOP-related matters EBITDAE Coverage ratios 26

27 Documenting Loans for ESOP Transactions Other Transaction Documents Other transaction documents will include: ESOP Plan review for compliance, benefit distribution provisions (affecting calls on the company s cash flow) diversification provisions (same), 409(p) protections, etc ESOP Stock Purchase Agreement review for compliance, covenants and indemnities which may burden the company, potential tax issues ESOP Loan/Pledge Documents review for compliance and consistency with projections Valuation and Fairness Opinion not addressed to the lender, but is key to the transaction Seller Financing Documents 27

28 Documenting Loans for ESOP Transactions Opinions Valuation and Fairness Opinion This is the opinion from the Trustee s financial advisor, addressed to the Trustee It is not addressed to the lender or the company, but is important to the compliance of the transaction Legal Opinions Legal opinions may be required for the company, the trustee, and the lenders Typical opinions include: authority, enforceability, compliance with laws, qualification of plan and trust, absence of prohibited transaction, compliance with exempt loan rules Tax Opinions Not as common, but depends on the transaction May be given by accounting firm or law firm Solvency Opinions 28

29 Disclaimer 2016 Houlihan Lokey, Vedder Price, Holland & Knight and Amsted Industries. All rights reserved. This material may not be reproduced in any format by any means or redistributed without the prior written consent of Houlihan Lokey. Houlihan Lokey is a trade name for Houlihan Lokey, Inc. and its subsidiaries and affiliates, which include: United States: Houlihan Lokey Capital, Inc., a SEC-registered broker-dealer and member of FINRA ( and SIPC ( (investment banking services); Houlihan Lokey Financial Advisors, Inc. (financial advisory services); Houlihan Lokey Consulting, Inc. (strategic consulting services); Houlihan Lokey Real Estate Group, Inc. (real estate advisory services); Europe: each of Houlihan Lokey (Europe) Limited and Houlihan Lokey (Financial Advisory) Limited, authorized and regulated by the U.K. Financial Conduct Authority; Houlihan Lokey GmbH; Houlihan Lokey (Netherlands) B.V.; and Leonardo Asesores Financieros S.A.; Hong Kong SAR: Houlihan Lokey (China) Limited, licensed in Hong Kong by the Securities and Futures Commission to conduct Type 1, 4 and 6 regulated activities to professional investors only; China: Houlihan Lokey Howard & Zukin Investment Consulting (Beijing) Co., Limited (financial advisory services); Japan: Houlihan Lokey K.K. (financial advisory services); Australia: Houlihan Lokey (Australia) Pty Limited (ABN ), a company incorporated in Australia and licensed by the Australian Securities and Investments Commission (AFSL number ) in respect of financial services provided to wholesale clients. In the European Economic Area and Hong Kong, this communication may be directed to intended recipients including professional investors, high-net-worth companies or other institutional investors. Houlihan Lokey gathers its data from sources it considers reliable; however, it does not guarantee the accuracy or completeness of the information provided within this presentation. The material presented reflects information known to the authors at the time this presentation was written, and this information is subject to change. Houlihan Lokey makes no representations or warranties, expressed or implied, regarding the accuracy of this material. The views expressed in this material accurately reflect the personal views of the authors regarding the subject securities and issuers and do not necessarily coincide with those of Houlihan Lokey. Officers, directors and partners in the Houlihan Lokey group of companies may have positions in the securities of the companies discussed. This presentation does not constitute advice or a recommendation, offer or solicitation with respect to the securities of any company discussed herein, is not intended to provide information upon which to base an investment decision, and should not be construed as such. Houlihan Lokey or its affiliates may from time to time provide investment banking or related services to these companies. Like all Houlihan Lokey employees, the authors of this presentation receive compensation that is affected by overall firm profitability. 29

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