Sr. Management Seminar Governance Structures Managing People Driving Stock Value Capital Needs of a Newly Leveraged ESOP Corporate Governance at an ESOP Company October 12, 2017 1
A Successful Sale to an ESOP. Done! 3 What Else Do You Need to Attend To? The Head Honcho 4 2
When the founder/owner/ceo sells to an ESOP and retires Who s large and in charge? 3
There s a Legal Framework for This 7 Corporate Ownership 8 4
So Who Owns the Stock in an ESOP? 9 So Who Owns the Stock in an ESOP? The ESOP Trustee! 10 5
Corporate Governance in an ESOP Company So, does the Trustee run the company? 11 Corporate Governance in an ESOP Company Then who does run the company? 12 6
The Role of the Trustee A fundamental role of the Trustee is to elect the company s Board of Directors. So, what does the Board do? 13 A Little History 14 7
Role of the Board at an ESOP Company Represents the shareholders Acts as their agent Oversees company operations Above all, attends to the long term sustainability of the company. 15 The Role of the Board A fundamental role of the board is to select and hire the CEO. The board appoints the company officers and sets their compensation. 16 8
The Role of the Board They only meet 4 days per year. So who s in charge the other 361 days? The Management Team! 17 So Who s in Charge at an ESOP company? Company Management ESOP Trustee Board of Directors 18 9
The Governance Collaboration While all three parties play a role in ESOP company corporate governance, the greatest responsibility falls to the Board of Directors. The Trustee is responsible for seeing that an effective board is in place (and monitoring to confirm that they remain effective). Thereafter, the Trustee is a relatively passive investor not its role to manage the business. The Board appoints management, sets their compensation, monitors management performance and, where performance is poor, must act to correct the situation. 19 So Back to our Opening Question When the founder/owner retires Who s going to run the show? 20 10
The Answer Begins with The Board of Directors must take charge of the transition! But (you say) we don t have a board. Most founder-run companies don t. So what do you do? 21 Building a Board of Directors 22 11
A Director s Job Description Knowledge Skills What does someone need to know to be a Director? What new knowledge would help your board? What skills are needed to be an effective director? What additional skills would enhance your board? Behavior How do want someone to act while being a Director? What attitudes, beliefs are needed to be successful? 23 Composing a Board Out of Individuals Constitution of the Board: Inside vs. outside directors Skill sets offered by each Collegiality and vigorous debate Personal Dynamics A Director is a Director, but Not all Directors are willing to be equal. Avoid dominance of personality 24 12
The Ideal Corporate Director Personal Style (the more the better): Team mentality Consensus builder Large picture thinking Ego control all are smarter than any Good listener Broad experience with a range of solutions More wisdom than knowledge 25 Practical Considerations Where will you find good candidates? Industry contacts Networking in the ESOP community? How will you select them? Resumes, references, interviews how do we do it? How do you decide? Who does it? What will be their obligations? How many meetings? Committee work? Travel?, etc. Term of office? How will you reimburse them? What s fair compensation? 26 13
Sr. Management Seminar Governance Structures Managing People Driving Stock Value Capital Needs of a Newly Leveraged ESOP Managing People In a Strong Employee Owned Company Jennifer Briggs 14
How is it different? Managing the individual in the job Leading participative teams Enabling the power of the many for planning and decisions organizational citizenship Why do it? The ESOP is the financial mechanism Leadership builds the EO environment Participative management Yields 8 11% more growth than expected (NCEO) 2.5X more revenue in engaged companies (Hay Group) 15
The Leader Mindset Do this Trusting and open develop open (book) culture Inclusive and interconnected Nourishes alignment and unification Values over rules Servant leader Leads the employee AND shareholder dynamic 16
Not this (limiting) Fear and control Silos Bureaucratic Authoritarian leadership Efficiency vs. effectiveness Not this Laisse Faire Autonomy with no alignment or unity Lack of systems of accountability and consequences Negative pluralistic subcultures 17
The Leader Mechanics & Methods Mechanics and Methods Check your vision purpose, mission, values Plan future, aspirational culture Develop managers Teach financial literacy Mentor business literacy 18
Mechanics and Methods Build community Integrative planning Committees Agile teams Values > norms Rights and Responsibilities EO companies are multidimensional considering the employee, the team and the shareholders at every step of the way 19
Sr. Management Seminar Governance Structures Managing People Driving Stock Value Capital Needs of a Newly Leveraged ESOP What Matters to Value? Learn the Business Drivers of value Threat of New Entry Products/Services Customers/Suppliers Geography Competitors Regulatory environment Bargaining Power of Buyers Substitute Products Degree of Rivalry Bargaining Power of Sellers 40 20
How Does Company Performance Effect Value? All else equal Factor Higher than Expected Lower than Expected Annual Performance Increase Decrease Long-term Prospects Increase Decrease Margins Increase Decrease Taxes Decrease Increase Free Cash Flow Capital Spending Decrease Increase Working Capital Decrease Increase Earnings Volatility Decrease Increase Risk Decrease Increase Discount Rate 41 But is All Else Equal? Not everything is in the company s control What has happened in the stock market? Where are similar companies priced? What is the pricing of industry transactions? Is the Company s performance/ outlook similar or different than others? Has the Company s risk changed? Duff & Phelps October 8, 2017 42 21
What Value is Measured? Let s distinguish enterprise value from equity (stock) value Enterprise Value is the value of Company s operations before considering debt, cash, or other assets/ liabilities Enterprise Value = Debt Equity Equity Value is the what remains of Enterprise Value for stockholders/ ESOP 43 How is Enterprise Value Determined? Mimic willing buyer/ seller concept Selected Public Companies M&A Multiples Enterprise Value Discounted Cash Flow 44 22
Review Outlook -- Discounted Cash Flow Analysis Analyze Historical Financial Performance Estimate Terminal Value Select Discount Rate Review Projected Income Statement and Balance Sheets Model Expected Free Cash Flows Discount Expected Free Cash Flows Understand Robustness of Projections Review Capital Spending Needs Compare Derived Enterprise Value to Other Analyses Evaluate Financial Forecasts Assess Working Capital Needs and Forecasts Adjust Accordingly 45 Where are Market Multiples? Which companies are driven by similar factors as the subject company Broad comparability Size Business lines/product mix Customers/Markets served Geography Financial performance Nature of competition Stage of business (e.g., mature, start-up) Degree of vertical or horizontal integration Factor 2 Factor 3 Factor 1 Refined Set 46 23
What Matters in Concluding a Value? Selected Public Companies Mechanics Valuation methods are initially performed independently Conclusions under each methodology should be consistent M&A Multiples Discounted Cash Flow Judgement Understanding the company s story matters to analytical choices. For example: How risky is the company? Are the opportunities real? Has management previously performed to projections? 47 Sr. Management Seminar Governance Structures Managing People Driving Stock Value Capital Needs of a Newly Leveraged ESOP 24
The recent strengthening in inflation data further raises the probability of another rate hike in December 49 49 J.P. Morgan expects the Fed to let $18bn of its balance sheet run off this year, followed by an additional $229bn of USTs and $166bn of mortgages in 2018 Tax reform, if revenue negative in early years, would increase these figures Following the extension of the debt ceiling suspension through December 8th, J.P. Morgan now estimates that Treasury s extraordinary measures will last into 2018 Hurricane relief spending and potential tax reform introduce uncertainty, but J.P. Morgan expects the new drop dead date to be sometime in the second quarter Range of 10 year U.S. Treasury yield forecasts 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% J.P. Morgan High Median Low Present 3.05% 3.00% 3.25% 3.35% 2.89% 2.48% 2.60% 2.75% 2.40% 2.45% 2.50% 2.55% 2.20% 2.00% 1.95% 1.90% 1.90% Present 4Q17 1Q18 2Q18 3Q18 Source: J.P. Morgan, Bloomberg as of 9/15/17 Spreads and structure remain borrower friendly amidst rising benchmark rates and increased regulatory requirements for banks 50 Increases in LIBOR (nearly 100 bps in the last 18 months) are driving up borrowing costs However, spreads have remained generally stable since 2014, with quarterly averages ranging from 176 bps to 215 bps 2Q17 50spread average reflected a modest 5 bps decline versus 1Q2017 A breakdown of revolvers by spread shows a decline in the number of higher priced deals since 2014, reflecting reduced M&A, a healthier economy, and greater competition. This decline has bottomed out in recent quarters All in borrowing costs (L + spread) Average LIBOR spread (Large MM) Revolver issuance by spread (#of deals) 7% 6% 5% 4% 3% 2% Avg. LIB Spread Large MM 3-month Libor 3Q15 2Q17 LIBOR: 33 bps 130 bps Spread 181 bps 188 bps All-in 204 bps 318 bps 2Q17 L + 188 bps 280bps 260bps 240bps 220bps 200bps 180bps 160bps 1Q14 L + 215 bps 2Q16 L + 176 bps 2Q17 L + 188 bps 200 150 100 < 100 bps 100-150 bps 150-200 bps 200-250 bps >= 250 bps 140bps 50 1% 120bps 0% 2007 2008 2009 2010 2011 2012 2013 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 100bps 2007 2008 2009 2010 2011 2012 2013 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 - Source: Thomson Reuters Source: Thomson Reuters Source: Thomson Reuters 25
Leverage tolerance has increased since the 2008/09 recession 51 The majority of transactions are getting done with 5 year tenors, with a more limited amount in the 3 4 year range Leverage tolerance has increased since 2008 2009 recession as economic conditions have improved and lenders have faced increased competition. 51 Average max debt / EBITDA covenant Average senior leverage tolerance Average total leverage tolerance 100% < 2.5x 2.5x - 3x > 3x 100% < 3x 3x - 3.5x 3.5x - 4x > 4x 3.40x 90% 90% 80% 80% 3.20x 70% 70% 60% 60% 3.00x 50% 50% 2.80x 40% 40% 30% 30% 2.60x 20% 20% 10% 10% 2.40x 0% 0% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2Q17 Source: Thomson Reuters Source: Thomson Reuters Source: Thomson Reuters Framework for cash flow prioritization A strong balance sheet to execute strategic priorities 52 Re-invest in business and pursue M&A to create value and generate growth Ensure that investments satisfy minimum risk-adjusted hurdle rate Prioritize deals with synergies Ensure that liquidity is adequate Hold liquidity as necessary to protect against downturns or take advantage of opportunities Liquidity issues more likely to lead to financial distress than leverage Maintain the right mix between cash and bank liquidity Optimize the capital structure If over-levered, de-lever to achieve an optimal capital structure Target a capital structure that is sustainable through-cycle Distribute excess cash to shareholders Ordinary dividends Share repurchases Special or variable dividends 26
Debt/equity mix depends on management/shareholder objectives and constraints 53 Capital structure objectives 1 2 3 Capital structure restraints 4 5 Shareholder return Cost of capital Business/risk industry Strategic flexibility Capital markets access Set strategic/capital structure goals to maximize shareholder value Higher leverage increases return required by investors to compensate for risk Management has to balance increased equity return with increased risk of high leverage Debt is cheaper than equity and interest is tax deductible Debt preserves control / is nondilutive Firm value increases with increased leverage until distress gets priced in Higher business / industry risk limits ability to leverage Cyclicality Sensitivity to economy Technology Regulation Product obsolescence Managements have different risk tolerances Management needs to: Consider leverage reduction to limit the potential for financial distress in a downturn Preserve flexibility to weather downturns Preserve liquidity Access to markets increases with higher credit rating Access to markets can be volatile The more flexibility a capital structure offers, the higher the cost of capital 54 Types of Capital Inside Equity Flexibility and Resources Senior Cash Flow Loan Second Lien Mezzanine Private Equity Seller Note Asset Based Loan Economic Cost 27
Characteristics of financing alternatives 55 Underwriting Criteria Asset Based Loan Cash Flow Senior Loan Second Lien Mezzanine Private Equity Seller Note Asset values Enterprise value (multiple of EBITDA); Enterprise value (unless special assets Enterprise value and earnings None strong stable cash flow are available Security Interest First lien on all assets First lien on all assets Secured but junior to first lien holders None None Pricing Floating based on LIBOR Floating based on LIBOR Floating based on LIBOR Fixed at 11% - 13% (9% current + 4% PIK) Yield enhanced with PIK interest and/or warrants (20%-25%) Typically fixed at a market rate Maturity 3-5 years 5-7 years 6-7 years 5-7 years Class A common or preferred Put at 5th year After all other debt Other Considerations Minimal amortization Annual amortization Annual amortization Prepayment penalties May have financial May have financial Appraisal based covenants (dependent covenants (dependent Equity dilution upon company size, etc.) upon company size, etc.) Minimal covenants Subordinated Management/investment fees Board and Committee governance Pro rata taxes Pro rata preemptive rights Consent rights for material transactions and changes to business Deeply subordinated Management fee Company s must balance their competing needs for capital 56 Aggregate Cash Flow Over Five Years $185 $350 $460 $275 $30 $200 $80 Capex Cash dividends Repurchase of Common Stock Total Obligations Cash Flow from Operations Cash and Investments 28