Employee Stock Ownership Plans ESOPs 101 2 0 1 5 B T A I N C. Presented by: Daniel M. Zugell Senior Vice President TURN-KEY SERVICES Full Service ESOP Implementation Services Preliminary Analysis Feasibility Studies Valuation Consulting Plan and Transaction Design Financing Repurchase Liability Studies Employee Communications Post Transactional Services WHAT IF YOUR CLIENTS WERE ABLE TO: TEAM APPROACH Company Repurchase CPA Obligation Corporate Employees Counsel Sell all or a portion of their company to a ready and willing buyer at full Fair Market Value Retain Control, Salary and Benefits Indefinitely Defer all capital gains taxes Leave behind a completely Tax-Exempt company to the next generation Stock Valuation Estate Planning ERISA Counsel TPA Trustee Banker Plan Design Insurance Investments BUSINESS TRANSITION ADVISORS Providing services in all 50 states Drawing on over 100 years of combined team experience In the last 5 years BTA has worked with: 17,600 employees 704 stockholders Market values of over $2.8 BILLION DOLLARS! WHAT IS AN ESOP? Employee Stock Ownership Plan A tax qualified defined contribution employee retirement plan Overseen by the IRS and the Department of Labor Qualified Plan under IRC Sections 401(a) and 4975(e)(7) Allows employees to become beneficial owners of the stock in their Company 1
ESOP STATISTICS USES OF ESOPS Modern ESOPs came into being with passage of ERISA-1974 Almost 9,000 ESOP companies in America today 14.7 million participants Almost 1 trillion in assets held This includes large and small companies Business owner exit strategy/next generation transfer Liquidity/diversification for closely held stock Partner buy out Desire for employee owned culture Divorces/immediate cash needs Enhanced employee benefits/handcuffs ESOP COMPANY EXAMPLES ESOP TRANSITION OPTION Lockheed Martin Winco Microsoft Macy's General Mills National Fuel Gas Co. Northern Trust Publix Gardener s Supply King Arthur Flour Most likely the greatest net after-tax proceeds to selling shareholder Immediate buyer at full fair market value No outside third party owner interests involved Smooth transition to family or key mgmt. The most tax-advantaged method of transition APPLICATION OF ESOPS Misconception: ESOP s are used for very narrow purposes and have narrow applications Reality: Very flexible tool to accomplish a broad range of goals with wide applications to business liquidity and succession COMPARING OPTIONS All traditional sale methods use after-tax dollars ESOP s utilize pre-tax dollars 2
$10,000,000 VALUE STEP 3 Management Buy-Out/ Corporate Redemption ESOP $16,666,000 Earnings Required - $6,666,000 Corporate Tax $10,000,000 - $2,920,000 Capital Gains Tax $7,080,000 Net to Seller $10,000,000 Earnings Required $10,000,000 Deduction - $0 Corporate Tax - $0 Capital Gains Tax $10,000,000 Net to Seller Lender Company ESOP Trust STOCK $9,586,000 Taxes Paid $0 Taxes Paid (C Corp) Assuming 40% Combined Federal & State Tax Rate Assuming 29.2% Avg. Combined Federal & State Capital Gains Tax Rate IRC 1042 Selling Shareholder STEP 1 STEP 4 ADOPTS Lender Company ESOP Trust Company ESOP Trust STOCK Selling Shareholder STEP 2 STEP 5 Lender Company ESOP Trust BENEFICIAL Lender Company ESOP Trust OWNERSHIP STOCK EMPLOYEES Employees Selling Shareholder 3
Lender STEP 6 Death, Disability, Retirement, Termination, Diversification Company ESOP Trust INTEREST STOCK EMPLOYEES Sinking Fund Employees Selling Shareholder 100% S CORP ESOP Pays no Federal or State corporate income tax to the extent ESOP owned Taxation is passed through to shareholders in proportion to ownership An ESOP is tax exempt, therefore no tax is paid on percentage owned by the ESOP Corp does not have to distribute income Exempt from prohibited transaction rules IRC 1042 TAXATION OF S CORPORATIONS Before ESOP The Company Selling shareholder may elect to indefinitely defer all capital gains on sale proceeds regardless of basis Similar to real estate provision IRC 1031 and life insurance IRC 1035 The Shareholder CPA Prepares Form K-1 K-1 Goes to the Owner Files 1040 Pays Tax IRC 1042 Seller must reinvest sale proceeds into Qualified Replacement Property (QRP) (U.S. stocks and bonds) within 12 months QRP requirements are set at a relatively low bar Special ESOP financial vehicles are available to facilitate deferral and access to cash TAXATION OF S CORPORATIONS After Sale to ESOP The Company ESOP Shareholder CPA Prepares Form K-1 K-1 Goes to the Owner Files 5500 Pays NO Tax Note: No distributions needed, cash stays in the company 4
TAXATION PRE VS POST ESOP Pre-ESOP Post-ESOP (100% S Corp Sale) Company Value 10,000,000 Company Value 10,000,000 Taxable Income 2,000,000 Taxable Income 2,000,000 Taxable Income 15 Years 30,000,000 Taxable Income 15 Years 30,000,000 Taxes (40% Fed/State) (12,000,000) Taxes (40% Fed/State) (0) After Tax Cash Flow $18,000,000 After Tax Cash Flow $30,000,000 HOW DO WE FINANCE THE BUYOUT? Bank financing Seller financing Combination of bank and seller financing Significant incentives for seller ESOP tax savings = $12,000,000 Tax savings usually cover the entire stock sale CORPORATE GOVERNANCE FINANCING STRUCTURE VENTURE CAPITAL ESOP is a passive shareholder Employees are not shareholders and do not gain Statutory Minority Shareholder Rights Lend 2-3X E B I T D A 40 60% O F T H E E Q U I T Y NO CHANGE IN CONTROL FINANCING STRUCTURE Current Owner Votes Appoints Board of Directors Directed Trustee F R O M P R I V A T E E Q U I T Y - E X P E N S I V E 12-14% MEZZANINE FINANCING 20 30% 5
FINANCING STRUCTURE V. C. C A N B E E V E N M O R E E X P E N S I V E 20% + VENTURE CAPITAL MEZZANINE FINANCING 20 30% BTA RECOMMENDED STRUCTURE Market Rate of Interest IS what the secondary lenders (mezzanine/venture capital) would have charged to lend the same money in the same subordinated position The interest rate can be adjusted to suit the sellers goals, company cash flow and maintain payment flexibility FINANCING STRUCTURE SELLER S MARKET INTEREST V. C. C A N B E E V E N M O R E E X P E N S I V E 20% + F R O M P R I V A T E E Q U I T Y - E X P E N S I V E 12-14% VENTURE CAPITAL MEZZANINE FINANCING 20 3 0% 20 3 0% B L E N D E D M A R K E T R A T E 14-15% SELLER NOTE 6 0 40% T O T A L E Q U I T Y L E N D 2-3 X E B I T D A 3-5% 40 6 0% T O T A L E Q U I T Y L E N D 2-3 X E B I T D A 3-5% 40 6 0% T O T A L E Q U I T Y BTA RECOMMENDED STRUCTURE BTA RECOMMENDED STRUCTURE Instead of going to the market for all the financing, we recommend the seller take a note for everything above senior debt The Seller is entitled to a Market Rate of Interest Market Rate of Interest is NOT what the senior lender (bank) is charging B L E N D E D M A R K E T R A T E S E L L E R T O A C C E P T L E N D 2-3 X E B I T D A 3-5% 14-15% 3-5% SELLER NOTE 6 0 40% T O T A L E Q U I T Y 40 6 0% T O T A L E Q U I T Y 6
FINANCING STRUCTURE Why will the seller accept the senior debt interest rate? Facilitate the transaction Protect company s viability Maximize current cash flow Maximize flexibility Reduce income taxation Warrants or equity sweeteners (PIK) WARRANTS: EXAMPLE Assumed pre-esop value of $20,000,000 with $19,000,000 of new ESOP debt, the post-esop value is approximately $1,000,000 Warrant exercise price post-esop stock value With 35% of future equity value in warrants, the seller s total exercise price would be approximately $350,000 (35% x $1,000,000) WARRANTS WARRANTS: EXAMPLE Right to purchase company stock at a future date at a fixed price Exercise price is Post Transaction stock value Must be valued by qualified valuator Gives the Seller a 2nd bite of the apple Warrants can be given or gifted to management or family members If the Company only pays off its debt and doesn t grow at all, the value should return to $20,000,000 The value of the seller s warrants for 35% of the company equity would be worth approximately $7,000,000 WARRANTS: EXERCISE PRICE Post ESOP transaction equity value low Value post-sale is the pre-sale value less ESOP debt Warrants exercisable at post transaction value Warrants are deeply subordinated, not exercisable until debt is repaid Warrants are, in effect, exercised after debt is repaid and value is back to its inherent value plus growth WARRANTS: EXAMPLE The exercise price of $350,000 would yield a profit to the seller of approximately $6,650,000 Warrants value is taxed as capital gains, not ordinary income Warrant value is in addition to the original $20,000,000 sales proceeds and interest on the seller note Upside of warrants value is not capped 7
ESTATE PLANNING OPPORTUNITIES Warrants may be worth very little at the time of issuance Can be transferred to the next generation with little or No Estate or Gift Tax Seller s subordinated note is subject to significant discounting for estate and gift tax purposes Use of GRATs, GRUTs CRTs or IDITs around the note, may reduce the value to near zero for estate and gift tax purposes POSSIBLE OUTCOME SUMMARY Company Value $20,000,000 Down Payment (Bank) 8,000,000 Seller Note - Principal 12,000,000 Seller Note - Interest 2,924,000 Warrants (30%) * 8,064,000 Approx. Total Sales Proceeds $31,000,000 *Assumes company value grows at 3% annually over 10 years POSSIBLE OUTCOME SUMMARY PLANNING NEEDS Owners sold stock for Fair Market Value Deferred/avoided capital gains tax on stock sale proceeds Cash down-payment (bank loan or corp. cash) Seller notes for the Mezzanine & V.C. portion Long term interest income on seller notes POSSIBLE OUTCOME SUMMARY 25-40% of future equity value in warrants Retain control indefinitely Salary/Healthcare/Phone/Clubs/Car/Board Fees ESOP Participation Estate planning/charitable gift/transfer benefits Company s profits become income tax-free ASSET MANAGEMENT Mandatory reinvestment of sale proceeds into U.S. Securities within 12 mos. to maintain IRC 1042 tax deferral SELLER NOTE 401(k) takeover while re-structuring qualified plans to include ESOP EE rollovers from ESOP to IRAs Estate Planning/FLP/Gifting ANK DEBT NQDC/Equalization for ineligible family Sinking fund to pre-finance mandatory buy back of participant shares 8
INSURANCE Life insurance on seller who also guaranteed loan; death benefit SELLER assigned to lender for duration of loan NOTE Potential institutional grade life insurance to pre-finance mandatory buy back of exiting participant shares Buy-Sell financing ANK for death DEBTand disability on non-esop shares Estate tax neutralization policies CORPORATE COUNSEL Retain client with ESOP Lose client if sold SELLER Corporate restructuring NOTE Draft purchase agreements, loan docs, AAA notes, warrants, board resolutions, adoption agreements etc. Review agreements/documents ANK DEBT pre-pared by ERISA/Trustee/Bank counsel Seller estate planning, revised wills, trusts etc. BANKING Retail Banking Retain/strengthen SELLER retail client with ESOP Lose retail client (checking, NOTE bus. services) if sold Lose EE deposit accts and loans to EEs Commercial Lending Significant lending SEN opportunity IOR of ESOP purchase price ANK DEBT Lose existing loans/locs if sold Lose future loans if sold VALUATION Gain client with ESOP Lose client if sold SELLER NOTE Potentially one and done with outright sale Annual valuation required with ESOPs Partnership opportunities w/ other valuation firms ANK DEBT Potential conflicts (company vs. ESOP) Varying levels of ESOP experience ACCOUNTING Retain corporate client with ESOP SELLER Gain ESOP as a client NOTE Lose client if sold Significant balance sheet and cash flow forecasting and accounting work associated with ESOP install ANK DEBT Tax analysis of AAA, Retained Earnings, B.I.G. tax etc. relating to restructuring/esop install ESOP CANDIDATE PROFILE Owner wishing to cash out all or portion of business Payroll of $1,000,000 or greater Strong succession management $5,000,000 or more business value 20 + Employees 9
RECENT TRANSACTIONS C O N S T R U C T I O N R E T A I L S U P E R M A R K E T M A N U F A C T U R I N G S T O R E S $ 1 1 0, 0 0 0, 0 0 0 $ 5 2, 5 0 0, 0 0 0 $ 6 2, 0 0 0, 0 0 0 $ 8, 0 0 0, 0 0 0 C O N S U L T I N G T E C H N O L O G Y O I L F I E L D S E R V I C E S E L E C T R I C A L & C I V I L C O N T R A C T O R $ 2 7, 2 0 0, 0 0 0 $ 1 5, 5 0 0, 0 0 0 $ 1 2, 2 5 0, 0 0 0 $ 5 6, 0 0 0, 0 0 0 rfarmer@bta.us.com (208) 761-3612 dzugell@bta.us.com (724) 766-3998 ashapiro@bta.us.com (614) 619-9286 RECENT TRANSACTIONS P E T F O O D P H A R M A C E U T I C A L G R A I N & F L O U R E N V I R O N M E N T A L I N D U S T R Y C O M P A N Y P R O D U C T S C O N S U L T I N G $ 6 0, 0 0 0, 0 0 0 $ 1 2 5, 0 0 0, 0 0 0 $ 5 8, 0 0 0, 0 0 0 $ 2 0, 5 0 0, 0 0 0 Daniel M. Zugell Senior Vice President Email dzugell@bta.us.com F I N A N C I A L I N D U S T R Y P A Y M E N T P R O C E S S I N G E N E R G Y R E S E L L E R C O M M U N I C A T I O N I N D U S T R Y Phone (724) 766-3998 $ 1 4, 0 0 0, 0 0 0 $ 3 5, 0 0 0, 0 0 0 $ 2 9 6, 0 0 0, 0 0 0 $ 4 0, 0 0 0, 0 0 0 Website www.esopguy.com NEXT STEPS 1. Complimentary client ESOP 101 2. Complimentary ESOP financial review (3 years of income statements, balance sheets and fact finder) 3. Preliminary Valuation/Preliminary Analysis 4. Feasibility Study 5. Implementation 10