The ESOP Association California Western States 2017 Annual Conference October 11 13, 2017 Paradise Point, San Diego Issues Associated with Second-Stage ESOP Transactions Michael Harden Senior Managing Director Ed Dainko Chief Executive Officer HUB Construction Specialties Reminder Please fill out a session evaluation form and drop it off at the table outside of this room Your feedback on topics and presenters is important and will be used to develop subsequent CAWS and TEA programs Take a moment to silence your cell phone Remember to get your CPE sheet stamped before and after each session for CPE credit 1
Agenda What is a Second Stage Transaction? Key Second Stage Transaction Structuring Issues Redemption Versus Sale to ESOP? Transaction Financing Internal Loan Structuring Considerations Fiduciary & Valuation Considerations Other Topics, MIP & Repurchase Liability Case Study Discussion Q & A Second Stage ESOP Transaction: What is it? TOPIC ASSUMES: There is an already established ESOP that owns a portion of Company stock The ESOP previously completed at least one purchase and sale transaction ESOP has existed for a few years or longer ESOP might be minority owner or own a majority, but not 100%. o If minority ESOP, owner may have only sold minority, thus keeping control, or o Company might not have been able to handle the full debt load or o Not sure if ESOP was right for the Company (at the time of first Transaction) 2
Typical Reasons for a Second Stage ESOP Transaction Retirement, death or disability of founder Part of a process (creeping to 100%) Moving from minority to majority or moving from majority to 100% in previously unplanned transaction Mature ESOP in need of new shares of stock Achieve key tax benefits common in second stage transactions 100% ESOP owned S-Corp. avoids paying federal income taxes and most all state income taxes Simply increasing ESOP ownership under an S-Corp. (if not going to 100%) increases the tax benefits to the ESOP owners Can allow for selling shareholders to elect IRC 1042 tax treatment if company is a C- Corp. Can facilitate a C-Corp. to S-Corp. election, especially in 100% ESOP transactions Key Second Stage Transaction Structuring Issues To 1042 or not to 1042 Status of existing ESOP as a benefit plan No internal loan, fully allocated? Do we need a new internal loan? Existing internal loan appears adequate? Keep in place? Existing internal loan too benefit rich? Stretch-It-Out? Three basic structures Full sale to ESOP of non-esop shares Hybrid, partial sale to ESOP, partial redemption Full redemption of non-esop shares Dilutive impact considerations Post-Transaction drop in value Price protection Current and future benefit considerations Financing the transaction Management incentive plan Fiduciary & valuation concerns 3
Redemption or Sale or Combination? $25 Million Transaction Examples Full Sale of All Stock to the ESOP Company Cash $25mm (term $10mm & bridge $15mm) Repay Bridge Loan $15mm Lender(s) Sellers Cash $25mm Promissory Note Internal Loan $25mm ESOP TRUST/ Employee Benefit Plan 4
Full Sale of Stock to the ESOP Selling shareholders able to elect 1042 treatment if C-Corp Provides new shares to the ESOP, can address have, have not issues, if they exist Selling shareholders able to elect 1042 treatment if C-Corp Significant post transaction drop in value issues Will price protection be needed? Dilutive to long-tenured participants in the existing ESOP Communications challenges May over benefit recent and new employees New inside loan plus may need to renegotiate any existing inside loan(s)? Full Redemption in a Partial ESOP Company Cash $10mm Debt Lender(s) Sellers ESOP TRUST/ Employee Benefit Plan 5
Full Redemption in a Partial ESOP Simpler transaction ESOP is not buying stock While fiduciary not making a buy decision, fiduciary typically makes a fairness determination No post transaction stock price decline Significant reduction in outstanding shares can lead to rapid stock price growth over time vis-à-vis status quo or full sale to the ESOP scenarios Typically does not have an additional/new inside loan although existing internal loans may need to be stretched out for benefit plan purposes No new stock to the ESOP at the time of transaction Might exacerbate a have and have-not problem Advantages current employees Company can make defined yearly contributions of cash and/or stock Selling shareholders can not elect 1042 treatment Hybrid: Partial Sale, Partial Redemption Company Cash $10mm Debt $10mm Lender(s) Sellers Cash $10mm Promissory Note Internal Loan $10mm ESOP TRUST/ Employee Benefit Plan 6
Partial Redemption and Partial Sale Flexibility to create the right balance between transaction stakeholders Able to elect a portion of the sale as 1042 treatment Re-loads some shares into the ESOP for targeted benefit level purposes Post transaction drop in value and its impact on ESOP participants and other equity stakeholders can be better managed and balanced Transaction Financing 7
Typical Second Stage Transaction Capital Structure $25 Million Example Continued 2 nd Stage Transaction Capital Structure has LBO characteristics and similarities Equity Existing ESOP equity, i.e. 30% ESOP fully allocated Warrants Additional purchased equity, i.e. 401(k) plan asset transfer & buy Mezzanine Capital Seller debt, with warrants if applicable Third party mezzanine Senior Debt New facility is common Leave spare capacity for business & repurchase liability purposes Representative Return 20% and Higher 10% 16% (all in) 3% 9%* * High end of pricing range representative of a blended/ unitranche facility versus strictly senior debt Capital Structure High Return Requirements Low Equity Mezzanine Capital Senior Debt Up to 4.0x Up to 3.0x Seller Debt with Warrants When analyzing a second stage transaction with seller notes and warrants one should ensure that the internal rate of return ( IRR ) to the seller does not exceed what is reasonable and appropriate given prevailing capital market costs for debt financing with similar risk characteristics IRR typically between 10% - 16% includes interest rate on the seller note and expected return characteristics of the warrant Coupon interest rate in this structure typically in a 3% - 8% range Depends on overall credit profile of the seller debt, factoring in the equity level behind and the senior debt level ahead of the seller debt in the capital structure Overall warrant dilution in the structure a result of the warrant component of the seller financing to drive the all-in seller note return A higher coupon on the financing results in lower warrant dilution, a lower coupon on the financing results in a higher warrant dilution 8
Purchased Warrants Transaction Equity In certain, less common, ESOP transactions, warrants are purchased directly by investors as a form of equity transaction financing Typically the current shareholder group along with potentially board of director members and executive management team members Provides the company (and ESOP) with access to equity financing that would otherwise not be available Can provide continuity of some, or new, direct equity exposure for the investors along with the rewards and risks of such an investment Offers some protection to the ESOP on the down side as warrant equity is effectively subordinate to ESOP equity based on the strike price of the warrants Can offer management team members more equity exposure to the company but with capital gain tax, versus ordinary income, characteristics Warrant dilution is a direct function of the targeted amount of dollars invested to purchase a set amount of warrants Third Party Mezzanine Debt Mezzanine debt is cash borrowed from a third party investor in excess of the amount that can be borrowed from a senior lender (bank) based upon the company s cash flow and collateral Used to increase cash at closing proceeds to sellers beyond what the bank will lend Utilized where seller requires more cash at closing than available from senior debt Typical annual rates of return are 12%-16% with cash pay interest of 8%-12% and either or both of PIK interest or warrants to make up total return Smaller size companies and deals realize higher rates Higher leverage profile realize higher rates May also have governance or other terms Generally most appropriate for higher growth companies 9
Internal Loan Structuring Considerations Internal Loan Structuring Considerations Tax Considerations Historically was main structuring consideration The amount of 1042 tax treatment in a transaction is a key determinant of the internal loan size The shorter the internal loan the larger the tax deductions and the valuation asset commonly referred to as NPV of ESOP tax benefits. However, the shorter the internal loan, the higher the amount employee benefit value allocated on an annual basis However, the ESOP Inside Loan is pre-payable without penalty regardless of term. Tax considerations still at play, especially with interest in C-Corp. and 1042 structures Employee Benefit Considerations More recent focus, especially with popularity of S-Corp. structures The longer the internal loan the lower the amount of annual employee benefit value earned (and expensed) 10
Internal Loan Structuring Considerations Structuring is an interplay of benefit levels and tax considerations Benefit level targeting may include 401k match levels if transaction includes a redirection of company 401k match contribution A target range of annual benefit as a percentage of annual compensation established by a company 5% to 15% of annual, eligible compensation is common with many company s targeting much higher levels and even up to the statutory 25% maximum (mainly due accelerated contributions for tax planning) Length of internal loans, while always facts and circumstances based Shorter time frames of 10-20 years, for example, more common with minority ESOPs or companies with a large payroll base relative to corporate value Longer time frames of 15-30 years, or on occasion longer, are more common in 100% ESOP ownership transactions or companies with a small payroll base relative to corporate value Internal Loan Stretch-Outs Stretch-Outs of existing ESOP internal loan(s) often take place in conjunction with the second stage transaction Main purpose is to re-establish benefit levels within desired corporate goals in recognition of the prospective, post-transaction structure and/or if the existing benefit level is deemed too high Also common to consolidate, and stretch-out, any existing internal loans with the prospective, second stage transaction internal loan (if there is a sale to the ESOP) into one internal loan, i.e. a consolidation What is an ESOP internal loan Stretch-Out Transaction The term of the ESOP loan is extended beyond the contractual and expected term of the note, i.e. an ESOP loan with a 5 year remaining payment schedule is extended for another 10 years and now has 15 years of remaining payments 11
Why Does the Internal Loan Stretch-Out and Modified Release of Share Schedule Matter? If you have an original 15 year internal loan and stretch the loan after 7 years so the entire term is now 25 years, you will release about 55% percent less shares per year Original loan for 1,500,000 shares released 100,000 shares per year based on mortgage style level principle plus interest payments 800,000 shares in suspense remaining at end of Year 7 Stretched for an additional 10 years for 18 years remaining New, modified loan releases 1/18 of 800,000 shares, or 44,444 shares per annum, a significant decrease from current rate of 100,000 shares If the current benefit level was releasing 25% of eligible compensation, this stretched loan releases value at 11% of eligible compensation Fiduciary & Valuation Considerations 12
Fiduciary Concerns about Second Stage Transaction Structures ESOP Fiduciaries focus on key fiduciary duties in evaluating and negotiating complex transaction structures: Prudence ( Is this wise to do on behalf of ESOP participants given the risk/reward profile? ) Fairness/Primary Benefit ( Do the ESOP participants benefit from the transaction? Are the relative structure benefits fairly allocated among the transaction players?) Prohibited Transactions ( What are the transactions between the ESOP and parties in interest and are these transactions exempted under the prohibited transaction rules? ) Valuation/Adequate consideration ( Am I paying no more than fair market value both directly and indirectly for stock acquired on behalf of the ESOP in light of all the related transactions? ) Indirect risk ( Do I have fiduciary obligations with respect to transactions where I am not a direct party?) Governance ( if ESOP is paying for control, is it getting control ) Often look to valuation and legal advisors for advice and formal opinions Valuation Concerns about Second Stage Transaction Structures Need to assess and evaluate all of the components of a complex transaction structure, including: Controlling interest vs. minority interest valuation issues Warrants MIP synthetic equity Employment contracts for management including compensation, perks and performance bonus arrangements Governance rights Board of Directors composition and compensation post-transaction Fair value of straight debt Terms of ESOP loan from Company to ESOP Post-transaction drop in value, price protection 13
Post-Transaction Drop in Value, Price Protection Significant internal loan transaction debt (resulting from sale of shares to ESOP by shareholders and/or company) often causes a large, per share post-transaction share price drop, impacting account values and thus distributions and diversification How to address post-transaction stock price drop? Increased future benefit levels? So-called floor or price protection Who is protected? Retirees, deceased, disabled, diversifications, everyone? How long to offer? Until participant s account value is equal to or greater than what it would have been under the status quo scenario or certain time period? Who pays, company or ESOP? Price protection methodologies Fair market value exclusive of internal loan transaction debt Floor price, transaction price or fair market value, whichever is higher Parties to Price Protection Negotiations Board of Directors Have fiduciary duty to all shareholders ESOP Trustee Has fiduciary duty to all participants and beneficiaries ERISA standard to not overpay Balance fairness to terminating participants (protection receivers) against ongoing participants (effectively, the protection payors) 14
Case Study Discussion Galatic Enterprises-2 nd Stage Galatic Enterprises Extended Smith Family 2/3rds, ESOP 1/3 ownership C-Corporation Transaction Value - $40 million Smith family stake Existing ESOP fully allocated, has many long tenured employees, annual discretionary contribution around 5% of compensation Goal is to achieve a 100% S-Corp. owned ESOP at end of transaction 15
Galatic Transaction Challenges Different Smith family members have different interests with respect to transaction consideration Some want cash Some want fixed income seller notes Some would prefer to hold their equity Most want a 1042 eligible sale Company is concerned about potential post-transaction drop in value impact on ESOP participants Company and management would like to implement a long-term incentive management program in conjunction with the transaction Galatic Transaction Solution A hybrid, partial sale to the ESOP, partial redemption transaction $20 million ESOP purchase of Smith family stock 25 year internal loan with a custom, front loaded amortization schedule $20 million corporate redemption of Smith family stock $40 million transaction value financed via $20 million of funded, senior bank debt $14 million of Smith family subordinated, seller notes $6 million equity warrant purchase by certain Smith family members 10% fully-diluted management SARs plan implemented Half of the SARs plan (5%) time vested Half of the SARs plan (5%) performance vested 16
Galatic Enterprises 2 nd Stage Transaction Company Cash $20mm Debt $20mm Lender(s) Sellers Cash $20mm Promissory Note 25 year term Internal Loan $20mm ESOP TRUST/ Employee Benefit Plan Galatic Transaction Balance Smith family transaction consideration balanced between Cash at close Fixed income (i.e. seller debt) financing Equity exposure with warrant purchase 1042 availability for cash sale to ESOP, installment tax treatment for seller debt in redemption transaction Company and ESOP considerations New, long-term internal loan reloads the ESOP for current and future participants Long-tenured employee account balances helped by front loaded amortization schedule and S-Corp. structure, 2- to 4-year expected account balance recovery SARs program to reward and incentivize management to work towards posttransaction debt reduction and stakeholder value creation 17
Other Topics Management Incentive Plans A careful review of existing management incentive plans is typically undertaken in a second stage transaction. It is common to either modify or terminate such plans in the transaction for purposes of tailoring a revised or new management incentive plan for the prospective transaction structure. Factors which lead to this include: Post-transaction drop in value issues can impair the value of existing management incentive plans (most common issue) IRC 409(p) analysis might require existing plan modifications Existing management incentive plan could be prospectively too rich in a full redemption transaction Opportunity to implement a plan if one is not in place and/or existing arrangements are deemed inadequate 18
Repurchase Liability Detailed repurchase liability studies and analysis are required for a successful second stage transaction As the ESOP is relatively seasoned in a second stage transaction, unlike a new ESOP implementation, there is often current and ongoing repurchase liability use of cash flow needs by the company Use of cash flow for repurchase liability needs to be planned for in the transaction modeling and is almost always part of senior debt fixed charge covenant compliance calculations The expected cost of price protection measures, if any, is derived from repurchase liability analysis Reminder Please fill out a session evaluation form and drop it off at the table outside of this room. Your feedback on topics and presenters is important and will be used to develop subsequent TEA programs. Remember to get your CPE sheet stamped before and after each session for CPE credit. 19
Q & A 20