A Trustee s Perspective on Equity Compensation Plans for ESOP Companies

Transcription

1 A Trustee s Perspective on Equity Compensation Plans for ESOP Companies Joni Andrioff, Partner Steptoe & Johnson LLP (202) jandrioff@steptoe.com Neil M. Brozen, CPA, Managing Director Bankers Trust Company of South Dakota (612) nbrozen@bankerstrust.com Erin Durand Hollis, ASA, CDBV Director Valuation Marshall & Stevens Incorporated (312) ext ehollis@marshall-stevens.com April 13, 2016

2 The Law - ERISA An ERISA fiduciary has a duty of loyalty and a duty of prudence to the ESOP s participants and beneficiaries. o ERISA 404(a). BUT a company has no fiduciary duty to the ESOP when it establishes executive compensation levels. o Eckelkamp v. Beste, 201 F. Supp. 2d 1012 (E.D. Mo.), aff d, 315 F.3d 863 (8th Cir. 2002). Executive compensation may reduce the value of company stock, but all significant business decisions affect the stock value and the benefits that ESOP participants will ultimately receive. o Martin v. Feilen, 965 F.2d 660, 666 (8th Cir. 1992). 1

3 The Law ERISA and State Law Trustee is the shareholder of record of allocated and unallocated ESOP shares. The courts have held that an ESOP Trustee has a fiduciary duty under ERISA to exercise its rights as a shareholder in a state law derivative action if it believes executive compensation is unreasonable. o Martin v. Feilen, 965 F.2d 660, 666 (8th Cir. 1992); Delta Starr, Inc. v. Patton, 76 F. Supp. 2d 617 (W.D. Pa. 1999). A Trustee s failure to exercise its shareholder rights may breach of its fiduciary duties under ERISA. The DOL is cognizant that reducing the amount of executive compensation can increase corporate revenue for valuation purposes. o Perez v. Ginsberg, Case 1:14-cv AJN (S.D.N.Y.). 2

4 ERISA Relief Restitution o Directly to the ESOP, with interest; o To the Company for inappropriate use of Company assets, which makes restitution to the ESOP (a problem for a 100% ESOP owned company). May take the form of: o A commitment by the Company to contribute to a 401(k) plan or other defined contribution plan; or o A stock redemption from the ESOP at a value that reflects current FMV, plus a premium to compensate for the lost value resulting from inappropriate use of corporate assets. 3

5 The Law Internal Revenue Code The IRS is cognizant that increasing the amount of executive compensation can reduce corporate income taxes (i.e., reducing taxable corporate revenue). o Multi-Pak-Corp., T.C. Memo Five-factor reasonableness test: o Employee s role in the corporation o Comparable companies o Condition of the corporation o Potential conflict of interest o Internal consistency of executive compensation within the corporation 4

6 Compensation in ESOP Companies Board responsibilities: o Setting and monitoring executive compensation o May delegate to a Compensation Committee Trustee issues: o Has greatest influence during ESOP acquisition o Assesses impact of unreasonable executive compensation on ESOP o Responsible for evaluating whether executive compensation approved by the board is unreasonable o Responsible for valuing the company stock o Engages assistance of a valuation expert 5

7 Compensation Issues in ESOP Transaction Items Trustee typically negotiates when purchasing company stock: o Compensation for seller(s) and key executives o Salary o Incentives and bonuses o Deferred compensation and benefits o Other o If there is a Management Incentive Plan (MIP): o Total dilution o Retention vs. performance o Targets o Vesting Post-transaction compensation when selling an ESOP company 6

8 Forms of Cash Compensation Base comp fixed salary o o Core compensation Year to year changes? Cash incentive (bonus used by 73% of respondents) o Discretionary: 20% o Formula/target: 49% (% of profit, sales growth, EBITDA) Cash deferred comp (used by 14% of respondents in NCEO survey) o o Fixed amount awarded in one year and paid in the future 409A Compliance 7

9 Forms of Equity Compensation Stock options o Allows recipient right to buy a specified number of shares in the future at a fixed price o Provides award equal to the increase in value of shares over time, with stock ownership at exercise Stock appreciation rights (SARs) o Similar to stock options, except recipient receives cash on exercise equal to the increase in share value since grant, rather than receiving actual shares. Restricted stock o Gives recipient actual shares that become transferable (i.e., vest), typically based on passage of time; unvested restricted shares are forfeited. Phantom stock o A grant of units equal to FMV of an equivalent number of shares, typically subject to vesting, and paid in cash at FMV upon a specified event. 8

10 Compensation Philosophy Statement Expresses sponsoring company s intent regarding executive compensation Helps to evidence a reasoned process Document, document, document! Often discusses: o Positioning on total pay o Aligning pay with corporate objectives (grow, diversify, etc.) o Aligning pay with company culture o Process for setting pay o Goals and formulas for variable pay 9

11 Do Incentives Work? If not properly structured: o May not motivate employees over the long run o Could produce burnout o May lead to myopia, inattention to long-term results If properly structured: o Solidify link between employees efforts and successful company outcomes o Make employees feel like valued partners o Encourage creativity in spurring results 10

12 Valuation Methodology Overview Methodologies for Valuing Equity Based Compensation o Intrinsic Value Method o Black-Scholes-Merton Option Pricing Formula o Discount Cash Flow For Valuing Securities in Privately-Held Entities o Discounted Cash Flow o Capitalization of Economic Income Method o Guideline Company Method 11

13 Valuation Methodology Intrinsic Value Method (APB #25) o Used for valuing warrants o Based on the difference between the FMV of the underlying stock and the exercise or strike price of the options on the date granted o Sponsor company recognizes a compensation expense only if the exercise price is less than FMV at the grant date o Even if no impact on net income for sponsoring company (i.e., no compensation expense),the real impact is dilution or cash outflow upon exercise o Most applicable when options are in the money, i.e., the exercise price is less than current FMV 12

14 Valuation Methodology, Cont. Black-Scholes-Merton Option Pricing Formula o Used for valuing SARs o The difference between the expected share price and the expected cost if the option is exercised. o Factors: o Current price o Exercise or strike price o Risk-free rate o Implied volatility o Expiration date o Expected dividend yield o Most applicable for options that are out of the money, i.e., the exercise price is greater than current FMV. For securities that will be in the money, i.e., the exercise price is below the current FMV, before maturity. 13

15 Valuation Overview The Trustee engages a valuation expert to analyze the impact of executive compensation on share dilution of the ESOP. o What are the benchmarks for each incentive plan? o Incentives that vest on achieving performance goals o Dilution relates to future appreciation o Incentives that vest on the passage of time o Dilution is immediate The exercise or strike prices for the exec comp plans are typically based upon the posttransaction ESOP values 14

16 Valuation & the Impact on Cash Flow Cash must be available to fund operations, growth, and pay for debt obligations in addition to performance incentives. Trustee must evaluate vesting and redemption schedules to analyze the timing and size of future awards. Cash typically funds management incentive plan obligations; therefore trustees must recognize the timing of these awards and their impact on cash flow available for operational expansion, as well as repurchase obligations. 15

17 Compensation & the Impact on Value All shares of stock owned by the ESOP, whether held as unallocated suspense shares or as allocated shares, must be netted against the total equity value. An analysis of the impact of exercising options should be conducted to compare the economic dilution vs. the projected increase in company value. In theory, any dilution should not negatively impact the sponsoring company s total value, and therefore an increase in dilution does not have to mean a decrease in value. Dilution Value 16

18 Case study 1: SARs gone bad Assume the following: o Company created a management incentive plan (MIP) when the ESOP acquired 100% of company o MIP provides for two types of SARs: (1) SARs that vest upon the passage of time, and (2) SARs that vest on achievement of projected EBIDTA (performance SARs) o Company missed the EBIDTA targets in the first two years and is not likely to achieve those targets in future Questions: o Are participants dissatisfied with the performance SARs? o Can Company s Board change the terms of the MIP by establishing new, more realistic performance goals? o Is Trustee approval required for any such changes? 17

19 Case study #2: Attracting new executives Assume: o An ESOP in which all shares are allocated o Company hired new CEO two years ago o Company expects to hire several new senior executives in next 1-3 years o Company requires a very competitive compensation package to attract senior execs Questions: o What long term incentive plans can they offer that will be in alignment with the ESOP? 18

20 Questions? Joni Andrioff, Partner Steptoe & Johnson LLP (202) Neil M. Brozen, CPA Managing Director Bankers Trust Company of South Dakota (612) Erin Durand Hollis, ASA, CDBV Director Valuation Marshall & Stevens Incorporated (312) ext

21 20 Appendix

22 Integrate Compensation in the Business Strategy Equity-based Compensation Vest/pay vs. Vest/hold Evergreen pools Dry powder reserve Impact on Stakeholders Relative ownership Relative return rates Equity Claims Equity Allocation Strategic Advisory Valuation Strategic Planning Leadership Team: Is succession planning aligned with strategic planning? Promote from within Recruit key executive talent (market cost, equity participation) 21

23 Mix of Pay Intended Outcome? 22

24 Annual Incentive Performance Measures Measure 2010 Survey 2005 Survey Sales/revenue 34% 31% Earnings per share 26% 29% Operating income 25% 28% EBIT or EBITDA 25% 19% Cash Flow 26% 19% Net income 24% 24% Cost control/reduction 17% - Working Capital 4% - Source: Towers Watson 2010 Survey 23