Employee Ownership: A Technical Introduction

Transcription

1 Vermont Bar Association Seminar Materials Employee Ownership: A Technical Introduction December 6, 2017 Trader Duke's Hotel (Formerly DoubleTree) So. Burlington, VT Speakers: Tabitha Croscut, Esq., Devine Millimet Chuck Coyne, Empire Valuation Bill Cherry, Switchback Brewing Company Mark Saunders, Esq., Dunkiel Saunders Matt Cropp, VT Employee Ownership Center Elias Gardner, The New School of Montpelier

2 EMPLOYEE OWNERSHIP: A TECHNICAL INTRODUCTION SEMINAR PRESENTED BY THE VERMONT BAR ASSOCIATION AND THE VERMONT SOCIETY OF CPAS DEC. 6, 2017 Chuck Coyne Managing Director Empire Valuation Consultants ccoyne@empireval.com Tabitha Croscut Devine Millimet & Branch tcroscut@devinemillimet.com

3 What is an ESOP? Employee Stock Ownership Plan Qualified retirement plan for Employees Regulated by US DOL and IRS Company-funded benefit no employee contributions ESOP is a shareholder only Tax-efficient and controlled means of selling stock Maintain employee jobs Decision making over day-to-day maintained Flexible in transaction structure (e.g. minority sales) 2

4 ESOP Existence Applicable in almost all industries service, manufacturing, professional (engineering and architects) 3

5 Why Do Business Owners Use ESOPs? Legacy Employee concern (family) Control / maintain day-to-day Drive ownership behavior Tax efficient ownership transition to employees Diversification / Liquidity Avoid / Reduce Income Tax (Seller & Company) Additional retirement plan for employees Increase employee productivity / employee incentive Value / purchase price certainty 4

6 Corporate Structure Pre-ESOP Shareholders Non-ESOP Shareholders elect Board of Directors President and CEO Management Team Employees appoints and oversees hires and oversees hires and oversees 5

7 Corporate Structure After ESOP ESOP Trustee Shareholders Non-ESOP Shareholders are represented by selects elect Board of Directors ESOP Participants President and CEO appoints and oversees ESOP eligibility requirements are met Management Team Employees hires and oversees hires and oversees 6

8 The ESOP Trustee Who? Internal versus External/Independent The ESOP trustee will represent the plan interests What? Trustee duties: Determining annual/transaction share value Voting company stock owned by the ESOP (e.g. annual director vote) 7

9 ESOP Valuation 8

10 Fair Market Value The price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well informed about the asset and the market for such asset. 9

11 Proposed DOL Regulations Adequate Consideration = Fair Market Value Determined in Good Faith As of the Date of the Transaction Reflected in Written Documentation of Value 10

12 Valuation Approaches Market Approach Guideline Publicly Traded Company Method Guideline Merged and Acquired Company Method Income Approach Discounted Future Net Cash Flows *Vetting management projections Historical Based Cash Flows Asset-Based Approach 11

13 Levels of Relative Value Synergistic (Strategic) Value Acquisition Premium Controlling Interest Value Premium For Control Minority Interest Discount Marketable Minority Interest Value As-IF-Freely-Traded Value Lack of Marketability Discount Nonmarketable Minority Interest Value 12

14 ESOP Valuation Adjustments Normalization Adjustments to Cash Flows Owner/Officer Compensation Related Party adjustments (i.e. facility rent) Control Premiums versus Control Cash Flows (DOL Issue control in fact ) Minority Interest Discount Discount for Lack of Marketability 13

15 Engaging the ESOP Valuation Advisors ESOP Trustee hires a third-party, independent appraiser as their financial advisor Appraiser should be experienced in the industry and in valuing stock for ESOP purposes ESOP stock must be re-appraised annually 14

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17 Note & Pledge of Stock C Corporation ESOP Transaction Corporation $$ Cash Note & Collateral Bank ESOP $$ Cash Shareholders % Company Stock 16

18 ESOP Loan Repayment Corporation Contributions or Contributions or or Dividends ($$$) ($$$) ESOP Loan Payments ($$$) Loan Payments ($$$) Bank and/or Shareholders Loan Payments ($$$) Loan Payments ($$$) Release of Shares Pledged as Collateral and Share Allocations to Individual ESOP Accounts 17

19 S Corporation ESOP Transaction [100%] Bank $$ Cash Cash Note & Collateral Company Shareholder Stock Cash & Sub. Note w/warrants Cash & Sub. Note Company Stock Stock ESOP Note & Pledge of Stock 18

20 Steps in an ESOP Transaction Identify the various objectives FIRST. Preliminary Appraisal (Sell-Side Financial Advisor) Feasibility/Transaction Analysis (Sell-Side Financial Advisor) Financing (Bank?) Retain Team of ESOP Transaction Providers Company ESOP Legal Advisor ESOP Trustee ESOP Financial Advisor - Valuation ESOP Legal Advisor ESOP Plan Administrator Investment Advisor / Estate Planning ESOP Plan Design / Legal Documentation Closing *Accounting firm involved from feasibility through/after closing. 19

21 Ongoing ESOP Items Post-Transaction Annual appraisal update Annual recordkeeping and administration Annual Audit for large plans Repurchase obligations [update every 3-5 years] Routine Communications training and education Legal compliance 20

22 ESOP TAX ADVANTAGES 21

23 Significant ESOP Tax Preferences - Company S Corporation & C Corporation: Deduction of principal on ESOP loan repayment Limitations differ for S Corp versus C Corp Deduction of dividends paid on ESOP shares S Corporation: ESOP non-recognition of corporate income S Corporation income attributed to shareholders (pass through entity) ESOP as a tax exempt S Corp shareholder pays no taxes on its share of corporate income 22

24 Signification Tax Implication Seller Tax Treatment on Seller Promissory Note: Interest earned will be taxed at Ordinary Income rates Principal will be either: 1. Taxed at capital gains tax rates on an installment basis (Note: If note exceeds $5mm, taxes are due at closing!) -or- 2. Deferred using QRP investment (C corp)

25 IRC 1042 Rollover Requirements for Capital Gains Tax Deferral Must be a C corporation Minimum of 3-year holding period Best stock (voting) ESOP must own 30% of company immediately following the sale Reinvest in Qualified Replacement Property (QRP) 15-month reinvestment window of proceeds (3 months before and 12 months after the sale) 24

26 Qualified Replacement Property ( QRP ) Eligible* Common Stock Convertible Bonds Corporate Fixed Rate Bonds Corporate Floating Rate Notes (FRN) *Eligible issuer must have: Not Eligible Municipal Bonds U.S. Government Bonds Mutual Funds Foreign Securities REITs Bank CDs Securities of a corporation that is incorporated in the U.S. More than 50% of its assets used in the active conduct of a trade or business No more than 25% of its gross income from passive sources 25

27 Disadvantages of 1042 Rollover Exclusion from allocations of 1042 stock in the ESOP Who? Taxpayer electing 1042 Family members (brothers and sisters, spouses, ancestors and lineal descendants (children and grandchildren) 25-percent shareholder(s) [within 1-year prior to sale] Includes (i) shares allocated to ESOP account and (ii) shares owned by spouses, parents, children and grandchildren (but not brothers and sisters) How Long? Ten years after the later of (i) the date of the 1042 transaction, or (ii) the date of the final allocation of the 1042 stock. 26

28 ESOP Operations as a Retirement Plan 27

29 ESOP Operations: Participation & Allocations Who can Participate in the ESOP? 1,000 hours and age 21 (outside limit) Who can receive an allocation in the ESOP? Employed on last day of PY/FY AND 1,000 hours Allocation Formula In proportion to annual compensation [see next slide] Also points formula optional (not safe harbor) 28

30 Share Allocation Example Shares purchased by ESOP = Allocation period = 150,000 shares 25 years W-2 Pay Allocation Percentage Shares Allocated in 1st Year Employee #1 $20,000 18% 1,080 Employee #2 $40,000 36% 2,160 Employee #3 $50,000 46% 2,760 $110, % 6,

31 ESOP Operations: Vesting & Distributions What does an employee get if they terminate? 1. Vesting 3 year cliff (0%, 0%, 100%) 6 year graded (0%, 20%, 20%, 20%, 20%, 20%) Non-vested shares are forfeited 2. Timing of Distributions i- Year after death, disability or Normal Retirement Age ii- Sixth year after other termination 3. Form of Distribution Cash or Company Stock (immediately redeemed) Lump Sum or 5-year annual installments 30

32 100 % ESOP Owned in 2017 MANCHESTER CONCORD PORTSMOUTH BOSTON 31

33 THE SWITCHBACK BREWING STORY

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40 TABITHA CROSCUT, ESQ Vermont office: 77 College St., Suite 2D Burlington, VT Massachusetts office: 2 Oliver St. Boston, MA New Hampshire office: 111 Amherst Street Manchester, NH Tabitha is a shareholder and chair of the ESOP team at Devine, Millimet, with a national practice focused on Employee Stock Ownership Plans (ESOPs) as succession and employee compensation strategies. In addition to counseling clients regarding transactional, compliance and fiduciary issues with respect to their ESOPs, she has represented companies, sellers and internal and external trustees in ESOP transactions ranging from under a million dollars to over four hundred million dollars. She is a frequent speaker at ESOP conferences nationwide and presents regularly on how ESOPs can be an effective exit or transition planning tool for owners of closely held businesses. Tabitha serves as a director and former President of the Vermont Employee Ownership Center (VEOC), is an active member of The ESOP Association and the National Center for Employee Ownership (NCEO), and serves on the Board of Trustees for the Employee Ownership Foundation. Visit our website at: TheESOPTeam.com.

41 CHUCK COYNE, EMPIRE VALUATION CONSULTANTS For over 25 years Chuck has provided business valuations of privately held companies in various industries. He has prepared valuations for estate and gift tax, employee stock ownership plans (ESOPs), family business succession, bankruptcy and reorganizations, fairness opinions, marital dissolution, shareholder and partnership disputes, allocation of purchase price among acquired assets and goodwill impairment testing, and mergers, acquisitions, and divestitures South Main Street Suite 201 West Hartford, CT Chuck specializes in transactional consulting services including; assistance in business succession planning, mergers and acquisitions, ESOP feasibility and transaction structuring, ESOP transaction quarterbacking, assistance in obtaining financing, and other valuation related consulting services. Chuck has assisted companies with revenues of less than a million dollars to over half a billion dollars. Chuck received his MBA with a concentration in Finance and Accounting from University of Hartford. He holds a Senior Accredited Appraiser ( ASA ) designation from the American Society of Appraisers. He serves as a member of the Valuation Advisory Committee of The ESOP Association and is a member of the National Center for Employee Ownership (NCEO).

42 Selling a Small Business to a Worker Co-op Mark Saunders, Dunkiel Saunders Elias Gardner, New School of Montpelier Matt Cropp, Vermont Employee Ownership Center

43 What is a Cooperative? A co-operative is an autonomous association of persons united voluntarily to meet their common economic, social, and cultural needs and aspirations through a jointly-owned and democraticallycontrolled enterprise.

44 In Other Words... A co-op is a legal business that is equitably owned and democratically controlled by its members for their common good, the good of the community, and to accomplish a shared goal or purpose. Any surplus (usually called profit in private firms) is distributed among members in proportion to their use of the business (purchases, labor, or supply), as a discount on purchases, or is reinvested in the enterprise for the mutual benefit of members.

45 Cooperative Principles 1. Voluntary & Open Membership 2. Democratic Member Control 3. Member Economic Participation 4. Autonomy & Independence 5. Education, Training & Information 6. Co-operation among Co-operatives 7. Concern for Community

46 Worker Co-ops: Nuts & Bolts In a worker cooperative, membership is limited to those who work in the business. Thereare nationally, 18 identified in Vermont at last count. Can have a traditional management structure or operate as a collective. Bylaws define how long someone must work for the co-op before being eligible to apply for membership. Each worker-owner buysa single voting share, which entitles them to a share of profit ( surplus ) and a vote fortheboardofdirectorsandothershareholder matters.

47 Worker Co-ops: Nuts & Bolts (cont.) Value of voting shares notdirectly tied to market value; priced to balance skin in the game with affordability. Distribution of workers share of surplus is based on a measure of labor (hours worked and/or W-2 income). Profits retained by the co-op in the name of members are taxed at individual level, accumulate in internal capital accounts. At least 20% must be distributed in cash.

48 Entity Option 1: Worker Co-op Corporation Governed by Title 11, Chapter 8 of Vermont Statutes Annotated Any corporation may elect to be governed as a worker cooperative Articles of incorporation establish qualification of members

49 Worker Co-op Corporation (cont.) Class of voting stock designated as membership shares One share for each member Membership must constitute at least 50.1% of the regular, full and part-time work force

50 Worker Co-op Corporation (cont.) Net earnings or losses apportioned and distributed as articles or bylaws specify Net earnings declared as patronage allocations apportioned among members in accordance with ratio of each member s patronage bears to total patronage by all members Internal capital account cooperative entire net book value is reflected in internal capital accounts each member and a collective account

51 Entity Option 2: Limited Liability Company (LLC) Governed by Title 11, Chapter 25 of Vermont Statutes Annotated Governance documents are articles of organization and an operating agreement Pass-through entity like a partnership, but with limited liability Flexibility in management and financial structure Can separate financial rights from governance rights

52 Entity Option 3: Mutual Benefit Enterprise Governed by Title 11C of Vermont Statutes Annotated Known in other states as limited cooperative associations Governance documents are articles of organization and bylaws ( organic rules ) Combines traditional cooperative values with modern financing mechanisms

53 Mutual Benefit Enterprise (cont.) Membership consists of patron members and investor members Default rule is that each patron member has one vote, but voting power can be allocated based on patronage or equity Each investor member has one vote unless the organic rules provide otherwise All profits and losses allocated to patron members, unless the organic rules provide otherwise Organic rules may not reduce allocation to patron members to less than 50% of profits

54 Assessing Feasibility Is the business saleable and financeable (adequate debt capacity & collateral, valuation in range of seller s needs/hopes, etc). Are employees interested and excited about the possibility of cooperative ownership? Is the employee group capable of taking on the roles played by the present owner? Is the seller interested in continuing with the company and/or consulting for a transitional period?

55 Worker Co-op Conversion Steps Interested employees form a working group to explore the potential. Determine if the conversion is viable. o Develop business plan (including cash flow). o Determine what management roles would need to be filled upon owner exit. o Ascertain potential gaps in expertise after transition. Learn to work and make decisions democratically. Determine co-operative structure (create bylaws).

56 Challenges: Worker Co-op Financing Voting shares usually constitute small % of price. Often the limited wealth of employee group means that significant outside financing is needed. Conventional lenders often unfamiliar with the details of the model. For co-ops with more than a handful of members, personal guarantees can become unwieldy, which can leave an uncollateralized gap.

57 Worker Co-op Financing (cont.) Capital Sources: Member shares Seller note Institutional debt and equity (traditional financial institutions, CDFIs, VEDA, VEOC s revolving loan fund) Community raise Members friends and family: loans or equity VSBO offering (Milk Money, VSECU s Co-op Capital Fund )

58 The Conversion Transaction Owner and employees agree on price and structure of transaction: valuation terms Owner s role in co-op: member (employment contract?) advisor, friend non-compete agreement Arranging financing Closing

59 Case Study: The New School of Montpelier Selling Founder: Susan Kimmerly Discussion with: Elias Gardner, current worker-owner and board member.

60 Contact Dunkiel Saunders New School of Montpelier Vermont Employee Ownership Center Mark Saunders, Elias Gardner, Matt Cropp,