Tim Cleary Chartwell 33 South 6 th Street Minneapolis, Minnesota

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Presented by: Tim Cleary Chartwell 33 South 6 th Street

com 1 Effectively allocating finite resources among

challenge for business leaders of any operating company

1 Presented by: Tim Cleary Chartwell 33 South 6 th Street Minneapolis, Minnesota Tim.Cleary@ChartwellFA.com 1 Effectively allocating finite resources among alternative capital claims is a common fundamental challenge for business leaders of any operating company Tax Code IRS Repurchase Obligation Regulations DOL COMPETING CAPITAL CLAIMS 1

2 3 PLAN PROVISIONS Modify distribution policies (i.e. delay vs. immediate payment; installments vs. lump sum) Expand diversification rights Modify allocation formula Modify eligibility provisions Segregate terminated participants Rebalance FUNDING METHODS Modify contribution level Modify dividend / satisfaction Recycle Redeem Redeem & contribute shares Releverage Combination CORPORATE ACTIONS Create internal market using 401(k) Delay / accelerate capital investments Divest business Freeze ESOP Terminate ESOP Sell Company 2

3 Expand diversification rights Segregate terminated participants Move RO forward Helps in rising share price environment Modify distribution policies, (i.e. delay vs. immediate payment; installments vs. lump sum) Move RO out to future Temporary fix Modify allocation formula Modify eligibility provisions Rebalance Limited impact Modify contribution level Modify dividend / satisfaction Recycle Redeem Redeem & contribute shares Releverage Combination Company Impact Trust Impact Participant Impact Allocated on compensation Allocated on share balance Need to evaluate options: Balance sheet Income statement Cash flow Valuation Equity value Cash in plan Account value Benefit level 3

4 RECYCLING SHARES Company contributes cash and pays S distribution COMPANY Active Shares ESOP Cash Terms Cash Terminated Participant(s) ADVANTAGES Provides annual share allocations to current participants Maintains a constant number of shares within the ESOP Price per share will grow at a similar rate to equity value CONSIDERATIONS Benefit level is driven by the annual repurchase need, potentially leading to an inconsistent year over year annual benefit to participants Dividends / S distributions are allocated on share balances rather than compensation which can lead to disproportionate account values Repurchased shares are immediately allocated to active participants which can lead to higher repurchase obligation, especially if dividends / S distributions are used to fund the repurchases 7 Shares Cash COMPANY No cash contribution ESOP Shares Terminated Participant(s) REDEEMING SHARES ADVANTAGES Requires no annual contribution Neutral impact to price per share at time of redemption Participants ownership percentage accretes as shares redeemed Price per share will grow at a faster rate compared to equity value as value is spread over fewer shares over time CONSIDERATIONS Shares reduced annually as shares are repurchased accelerating future per share value growth and repurchase obligation New or existing participants will not receive additional allocations Concentration of account balances leads to have and have-not situation and increased repurchase obligation 8 4

ESTIMATED ESOP RO AS A % OF QUALIFIED PAYROLL ESOP RO as a percent of qualified payroll is slightly higher in the Redeem Over 25% scenario Max. Contribution: 25.

0% ESTIMATED ESOP RO AS A % OF FREE CASH FLOW Similarly, ESOP RO consumes a slightly higher percent of Free Cash Flow in the Redeem Over 25% scenario 9 Company sells shares back to the ESOP Step 1:

benefit level, creating a consistent benefit level Provides pool of shares available for new and current participants Maintains constant number of shares within the ESOP (assuming all redeemed share

5 ESTIMATED ESOP RO AS A % OF QUALIFIED PAYROLL ESOP RO as a percent of qualified payroll is slightly higher in the Redeem Over 25% scenario Max. Contribution: 25.0% Recycle All Redeem Over 25% Max. Contribution: 25.0% ESTIMATED ESOP RO AS A % OF FREE CASH FLOW Similarly, ESOP RO consumes a slightly higher percent of Free Cash Flow in the Redeem Over 25% scenario 9 Company sells shares back to the ESOP Step 1: Redeem Step 2: Releverage COMPANY Unallocated ESOP ESOP creates new Exempt Loan with the Company Allocated RELEVERAGE TRANSACTION ADVANTAGES Breaks the connection between repurchase obligation and benefit level, creating a consistent benefit level Provides pool of shares available for new and current participants Maintains constant number of shares within the ESOP (assuming all redeemed share are re-sold to the ESOP) Price per share will grow at a similar rate to equity value Repurchased shares are allocated over a longer period of time providing significant control over annual benefit level Increases corporate cash as repurchase obligation is reduced Shares are released and allocated to participants over the term of the Exempt Loan CONSIDERATIONS Dilutive to price per share Increases annual transaction and administrative complexity and cost Reduces value allocation to current participants to provide value to future participants 10 5

6 11 Prefund in ESOP Pay as you go Borrow when needed Set aside Cash, money market Sinking fund Insurance 12 6

7 Make extra contributions / dividends in low RO years Steady benefit level Limited investment choices Leakage 13 The time to fund RO claims is during periods of strong business performance when cash flow exceeds the obligation, not when RO exceeds cash flow! IDEAL FUNDING TIME POOR FUNDING TIME Projected RO Spike in RO Projected Cash Flow Drop in Cash Flow Establishing a sustainable plan to pre-fund the RO takes a commitment to understanding various pre-funding strategies and the discipline to invest today to ensure future success 7

8 Cash / money market Safe Low returns 15 Mutual funds, equities Greater risk / returns Can liquidate when needed But when you need it and your business is down, it may be when the market is down Can borrow up to only 50% of value 16 8

9 COLI (Corporate Owned Life Insurance) Can invest in similar products Can liquidate when needed Can borrow up to 100% of value Gain not taxable; higher after tax return Added benefit of death benefit protection 17 RO is similar to deferred compensation Promise to pay as employee in the future based upon an investment 75% of Fortune 1000 companies utilize COLI to fund deferred compensation arrangements 77% of commercial banks with over $30 million in equity capital utilize Bank-Owned Life Insurance ( BOLI ) to fund corporate liabilities, primarily deferred compensation arrangements 1 1: Michael White and Associates

10 Sold by insurance brokers who may not understand business and/or ESOP issues Often immediate hit to balance sheet $1 premium may provide $ $0.85 of cash surrender value Still can outperform taxable investments when paying taxes But 100% ESOP owned S Corporations don t pay taxes So we need a better solution! Private Placement Life Insurance 100% Conversion on Asset Acquisition Cash Assets Liabilities Equity Death Benefits Cash Value (PPLI) Repurchase Obligation Total Assets Total Liabilities & Equity Not Included in Valuation But Can Fund This Obligation 10

11 $25,000 $20,000 $50,000 $15,000 $40,000 $30,000 $10,000 $20,000 $5,000 $10,000 $0 $ $ in thousands PPLI Cash- PPLI Net Net Death Benefit- PPLI Sinking Cash- Fixed FundIncome Manage RO Determine goals Evaluate options Execute Fund Establish a financial discipline to address RO Create a contingency reserve Evaluate options Execute Repeat 22 11

12 Tim Cleary Chartwell 33 South 6 th Street Minneapolis, Minnesota Tim.Cleary@ChartwellFA.com 23 12

Issues for Mature ESOPs

The ESOP Association California Western States Annual Conference October 11 13, 2017 Issues for Mature ESOPs Presented by Michael A. Pasahow Sr. Corporate Counsel Menke & Associates (415) 362 5200 mpasahow@menke.com