Employee Ownership: A Business Retention Strategy. April 8, Paul Karch

Transcription

1 Employee Ownership: A Business Retention Strategy Paul Karch pkarch@whlaw.com

2 What is an ESOP? Employee Stock Ownership Plan Retirement plan protected by ERISA Similar to profit sharing or 401(k) match Two differences: Primarily invested in company stock Can borrow money to buy stock Flexible tax-advantaged tool for many corporate finance transactions 2

3 Regulatory and Legal Frameworks ERISA IRS and DOL Corporate Finance Trustee fiduciary duties 3

4 Contemplating the Exit Third Party Family ESOP 4

5 Third Party Sale Third Party Owner pays capital gain tax Buyer pays with after-tax earnings Owner likely loses control Corporate identity? Fate of employees? 5

6 Family Sale Family Owner pays tax Buyer pays with aftertax earnings Family retains control Business retains identity Retain employees 6

7 ESOP Sale ESOP ADVANTAGES TO SELLER Liquidity may be tax free Retain control Eliminate corporate taxes Employees own part of business and do not pay taxes until retirement Pass rest of business and estate assets to children and charity without estate taxes 7

8 ESOP Transaction Tax Deferred Reinvestment 8

9 C Corporation Deduction for Company receives tax deduction for providing shareholder liquidity In other words, tax savings pay 40% of debt Principal 9

10 Allocation of Stock Participant Accounts ESOP Trust Stock Year

11 S Corporation Before the ESOP Assume: $5 million taxable income 40% tax rate (fed & state) Requires $2,000,000 tax distribution $2,000,000 S dividend distributions Shareholders pay tax $2,000,000 11

12 S Corporation After the ESOP Assume: $5 million taxable income 40% tax rate (fed & state) ESOP owns 50% $1,000,000 $1,000,000 Tax savings pay 100% of debt 12

13 Common Objections If it sounds too good to be true, it probably is. Answer: This time it is true. Congress intentionally set up benefits to encourage employers to provide retirement benefits and align shareholder and employee interests. ESOPs are favored by both parties. I don t want to lose control. Answer: Owner can retain control as trustee and vote all of the shares in the ESOP on most issues. I don t want to disclose everything to employees. Answer: Only disclosure required to employee is standard retirement plan statement shares and value in participant s account. 13

14 Who is Typical ESOP Candidate - Technical? A closely held corporation (C or S Corporation) One or more owners nearing retirement Gradual exits allow owner to receive cash Rapid exits often necessitate a seller note (from company) History of profitability ($1,000,000+ after-tax) Stable earnings history fosters better enterprise valuation. Value sold to ESOP of $2 million or more to justify the fees (at least $50,000; but other transactions are not fee) Most ESOP transactions are for businesses worth $10 - $75 million Minimum 35 employees (a rough guideline) S corporations need a good employee base due to IRS anti-abuse rules C corporations can have fewer, but broad ownership spreads the repurchase liability 14

15 Who is Typical ESOP Candidate? Comfort with the concept of broadbased employee ownership Successor management in place or in the wings Available corporate credit 15

16 Additional Players in Transaction Trustee (internal or external) Administrator Trustee financial advisor/valuation company Trustee counsel 16

17 ESOP Transaction Process: Building Value Communication Administration Seller Investment & Planning Documents Comprehensive Design Financing Preliminary Design Trustee & Valuation Comprehensive Financial Analysis 17

18 Transaction Timeline ESOP Transaction Feasibility Study Due Diligence Financing Preliminary Value Negotiate Transaction Closing Third Party Transaction Seek Offers Due Diligence Financing Negotiate Price Negotiate Transaction Closing 18

19 ESOP Uses in Private Companies Exit succession strategy while providing continuity of management and control Partial or complete liquidity for inactive shareholders Create a market for closely held stock Acquisition strategy Reward, retain and attract employees Create tax efficient employee-owned company 19

20 ESOP Advantages in Debt Financing Sub-S ESOP yields more cash flow so higher leverage Add back non-cash compensation expense Employee commitment But... Mandatory distributions in mature ESOP (repurchase equity) Complexity adds to transaction costs 20

21 ESOPs Improve Business Performance Increased productivity and profitability Increased resilience and likelihood of survival Increased equity return Greater employee commitment, identification, Higher motivation Greater levels of engagement When employees feel like owners 21

22 ESOPs Are Good for Employees Equity opportunity Average pay same or higher Greater employment stability Increased organizational commitment Other retirement plans generally same or better 22

23 Questions? Paul Karch