Employee Stock Ownership Plans: An Attractive Opportunity for Banks and Their Business Clients

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1 2nd Quarter 2018 Employee Stock Ownership Plans: An Attractive Opportunity for Banks and Their Business Clients From its founding over a decade ago, Ambassador Financial Group has always had as its primary objective to be a trusted advisor regarding topics aligned with helping clients achieve their strategic goals. We endeavor to bring forward useful ideas not only in managing securities portfolios but also related to capital market and merger and acquisition advice. In recent years we have expanded our scope to include ideas that help you, our clients, help your customers. This article falls exactly under that theme. As most of us know, business owners are among the few sources of new wealth generation in the U.S. That makes them targets for a wide range of financial services. As bank clients, they are arguably the most attractive of your customer segments, and it is prudent client management to ensure that your business owner clients benefit from your best idea generation on a timely basis. This article highlights one such important opportunity, the employee stock ownership plan, or ESOP. While not a household name, the ESOP is increasingly gaining popularity as an attractive exit and succession planning tool for closely held business owners of all sizes across the U.S. Moreover, and most importantly, understanding the lending opportunity that an ESOP may provide could lead to a new revenue stream and augment client retention in an increasingly competitive marketplace. What s an ESOP (and Why Should I Care)? An employee stock ownership plan is an amalgamation of things: part tax-advantaged exit strategy for the small- to middle-market business owner, part employee benefit plan, part succession planning tool, part tax-free business entity, and part factory of American capitalism. Although only vaguely familiar to most local and regional commercial bankers, there is a small army of ESOP attorneys, valuation consultants, M&A advisors, lenders, and wealth managers who are peddling the virtues of this strategy to your clients. If you fail to help your clients understand and appreciate this attractive corporate and personal financial strategy, then rest assured that your competitors and other centers of influence will step in to fill that void. The risk of not doing so is that your bank might lose a key opportunity to strengthen your existing and hard-won business lending relationships to more specialized competitors and, just as likely in our experience, lose the client altogether. Beyond client retention, the beneficial economic impact of ESOP companies on their employees and communities reaffirms why banks should be initiating client dialogues to introduce this important strategy. Below, we present an efficient path to building an in-house ESOP financing capability that is both comfortable from a credit perspective and also attractive as a complementary loan origination channel. How Can an ESOP Grow My Bank s Business? One facet of an ESOP typically entails the releveraging of the company in order to fund the plan s purchase of shares on behalf of the company s employees. As a result of Department of Labor effective oversight, leverage levels for ESOP companies are prudent, with both management and the plan s trustee working continued on page 2 2nd Quarter 2018 Employee Stock Ownership Plans: An Attractive Opportunity for Banks and Their Business Clients 1

2 Employee-Owned Companies Are Everywhere! Map shows the number of ESOPs in each state. WA (107) OR (75) NV (25) CA (819) ID (30) UT (57) AZ (108) MO (32) ND (56) WY (15) CO (110) NM (43) SD (24) NE (75) KS (107) TX (394) OK (89) MN (275) IA (174) WI (178) MO (196) AK (58) LA (82) IL (362) MS (56) MI (215) IN (171) TN (111) AL (69) OH (287) KY (111) WV (29) GA (145) PA (312) NC (126) SC (62) NH (33) VT (29) NY (331) VA (302) ME (25) MA (130) RI (15) CT (77) NJ (155) MD (135) DE (8) DC (15) AK (26) FL (181) HI (65) For more information, see the interactive map at esopinfo.org/maps/. carefully alongside the lender to ensure a sustainable capital structure is put in place. Senior bank debt forms the basis of this new capital structure, in 9 out of 10 transactions, frequently supported by a subordinated promissory note to the selling shareholder(s) for any remaining purchase price proceeds. ESOPs by the Numbers¹ Research shows that employee ownership creates stronger companies that provide more stable jobs and result in more prosperous employees and communities. The reason for this is simple: Ownership culture encourages employees to think and act like owners. ESOP companies grow 2% per year faster than competitors, with similar increases in employment levels versus non-esop companies. They also experience productivity increases of 4 5% on average in the first year of adoption. A 10-year study of all privately held ESOP companies revealed they are only half as likely as non-esop peers to go bankrupt or close their doors, while employee owners report greater employment stability: In 2014, the layoff figure was 9.5% for all working adults compared to 1.3% for employeeowners. A new study examining employee-owners ages found that, compared to their peers in non-esop companies, they enjoyed: 92% higher median household wealth 33% higher income from wages 53% longer median job tenure 1 Source of research data quoted in this article: Employee Ownership: Building a Better American Economy, available at nceo.org/r/resources, accessed on February 15, continued on page 3 2nd Quarter 2018 Employee Stock Ownership Plans: An Attractive Opportunity for Banks and Their Business Clients 2

3 As if these advantages weren t enough, some qualifying business owners who sell their company stock to an ESOP can defer or avoid entirely the recognition and payment of capital gains taxes on that sale. Further, as qualified retirement plans, ESOPs pay no income taxes. Consequently, ESOP companies that are entirely employee-owned can be structured so as to be income tax-free entities. A company s ability to deleverage and accumulate cash for growth and investment is obviously greatly enhanced when income taxes are no longer an ongoing liability. Congress created these incentives, actually writing them into the tax code, in recognition of the broadbased prosperity that ESOPs bring to their local economies. After all, employee-owned companies are less likely to move manufacturing jobs overseas or shutter local operations. The promotion of ESOPs and employee ownership is strongly supported on both sides of the political aisle, where the creation of broad-based prosperity and business-friendly tax advantages hold something of interest for everyone. By now you might be wondering: If ESOP companies can be such attractive customers, then why don t more banks develop an in-house ESOP financing skill set? There are several reasons why most banks stumble in this effort. First, ESOP companies are geographically dispersed, and banks don t run into them every day. At about six months in length, the typical ESOP implementation is a relatively quick process. By the time financing sources are drawn in to the discussion, there is little time for a relationship banker to grasp the complexity of an ESOP and to form an opinion as to the creditworthiness of the pro forma entity. Second, it is banking orthodoxy that any loan intended to finance the business owner s exit must be inherently riskier than the status quo credit facility. Prima facie, it is oxymoronic to suggest that an ESOP company with a transitioning owner will be a stronger credit, but common sense and research support this fact. Third, and perhaps more insidiously, the ESOP advisory community is very small and, in the words of one observer, overly incestuous. Specialization is critical in a practice area that is actively regulated by both the Department of Labor as well as the IRS. This has contributed to the development of lucrative referral relationships among specialist advisors that have the effect of sidelining relationship banks in favor of more reciprocal financing sources. What is needed by banks seeking to enter this attractive niche is an ecosystem of specialist co-advisors who have the integrity and independence to work alongside the lender without displacing the lending relationship. That is not to say that a lender who proposes uncompetitive lending terms should be permitted to hold hostage the client at the expense of the company and the ESOP participants. However, it is our observation that relationship lenders who can approximate the lending terms of competing specialists tend to enjoy more than enough client goodwill to win the day. In light of your longstanding familiarity with your client s credit and character, you should be able to carry that advantage into a superior offering when a client evaluates ESOP financing proposals. Add to that the tailwind from bringing the idea to the client in the first place, and relationship lenders have a formula for cementing the client s trust and goodwill. What s Required to Form an ESOP? ESOPs operate successfully across a broad range of industries large and small, public and private but most ESOPs are established by private companies. The ideal private company candidate for an ESOP will share many of the following criteria: 1. The company has strong cash flow and a history of increasing sales and profits. Annual growth of 5 10% is optimal. 2. The company has strong second-line managers in place who are capable of succeeding the owner(s) over time. 3. There are 15 or more full-time employees in the company. 4. The company is in a high federal income tax bracket. 5. The company is not heavily leveraged and has substantial stockholder equity. 6. The owner seeks to leave a lasting legacy among employees and the community. continued on page 4 2nd Quarter 2018 Employee Stock Ownership Plans: An Attractive Opportunity for Banks and Their Business Clients 3

4 Any four of the above six criteria would suffice to merit a deeper evaluation as to whether an ESOP can meet a business owner s goals. For such a company, an ESOP represents a ready and willing buyer who is able to pay Fair Market Value for a company, including a premium for control. If you are interested in learning more about ESOPs or have clients with these attributes, we encourage you to give your Ambassador Financial Group advisor a call. Working together with the experts at Alpha Architect, we will happily get you up to speed on the strategy, educate you about typical lending structures and market credit parameters, and, where appropriate and requested, introduce you to an ecosystem of straight-shooting ESOP formation advisors who would typically work alongside the company lender. These are among the foremost national experts in the ESOPspecific fields of law, company valuation, ownership culture, and IRC Section 1042 qualified replacement property. They are independent, both in terms of the quality of their advice as well as their ability to work alongside lending institutions without competing for or referring away the client. In that manner, interested banks can confidently invest the time and effort required to master ESOP company credit analysis with the knowledge that their efforts will be rewarded and their clients won t be referred away by their co-advisors. Jack Payne, CFA, CFP, Finance & Operations Ambassador Financial Group, Inc. Doug Pugliese Director of Portfolio Services, Alpha Architect Mr. Pugliese heads the firm s ESOP 1042 solutions practice. In this role, Doug is responsible for assisting clients to implement tax-efficient strategies for monetizing their business holdings to create diversified, investible wealth. Previously, Mr. Pugliese was a in the Investment Banking Division at Bear, Stearns & Co. Inc. and also served as an officer and pilot in the United States Navy. Mr. Pugliese received his B.A. in Economics and Spanish Literature (with honors) from the University of Pennsylvania and his MBA in Finance from the Stern School of Business at New York University, where he was a Dean s Scholar and a Stern Scholar. 2nd Quarter 2018 Employee Stock Ownership Plans: An Attractive Opportunity for Banks and Their Business Clients 4

5 THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA Executive Blvd. Suite 503 Rockville, MD Chicago Mercantile Exchange 30 South Wacker Drive 22nd Floor Chicago, IL Joshua A. Albright, CFA Allen R. Collins Executive Vice President Chief Compliance Officer Arnold G. Danielson Chairman Emeritus Danielson David G. Danielson Executive Director Ryan G. Epler Charles Gorman Associate Director, Business Development Mike Harrison Director Strategic Advisor Mark A. Neff Karl J. Ostby Strategic Advisor Robert J. Pachence, Jr. Co-Founder & Managing Principal Jack E. Payne, CFA, CFP Finance & Operations John Putman Director of Analytics Michael Rasmussen Matthew T. Resch, CFA Co-Founder & Managing Principal Eric Tesche Executive Director Mark B. Trinkle John S. Walker, Ph.D., CFA Chief Economist Ryan Walker Vice President, Strategic Analyst Rick Weiss Chief Bank Strategist The information presented is for informational purposes only. This is not an offer or solicitation to purchase or sell any security through Ambassador Financial Group, Inc., a current member of FINRA/SIPC. For more information contact us at Ambassador Financial Group, Inc. Important Disclosure: Ambassador Financial Group does and seeks to do business with companies included in this report. As a result, readers should be aware that the firm may have a conflict of interest that could affect the objectivity of the report.