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ADVANCED ESOP STRATEGIES:

OPTIONS AND ALTERNATIVES

Presented by

Welcome to

www.menke.com

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Today’s Agenda

Introduction

Basic ESOP Transactions

Advanced ESOP Transactions

Tax Considerations

Financing Considerations

Incentive Plans for Key Employees

Q&A

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Introduction

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What is an ESOP?

• Similar to a Profit Sharing Plan:• Tax deductible contributions for employer

• Retirement savings for employees

• Also an M&A opportunity • ESOP invests in sponsor’s stock

• ESOP participates in earnings and growth of the

sponsor

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Some Familiar ESOP Companies

196 of S&P 900

have ESOPs

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Why Use an ESOP?

• Liquidity for shareholders

• Diversify owner’s asset allocation

• Real business succession strategy

• Increase company cash flow

• Enhance employee productivity

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Basic ESOP Transactions

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The Company Incorporated (TCI)

Owners: John 75%

Pat 25%

Sales $ 10,000,000

Payroll $ 1,000,000

Pre–tax Profit $ 600,000

Net Worth (Book Value) $ 2,000,000

Fair Market Value $ 3,000,000

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Case I – Gradual ESOP

John wants to cash out on a

gradual basis, starting with a 5% sale

0

10

20

30

40

50

60

70

80

90

100

1 2 3 4 5 6 7 8 9 10 11

Year

ES

OP

Ow

ne

rsh

ip %

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Case I – Gradual ESOP

TCI

JOHN

$ 0 – $

250,000

$ 0 – $

250,000

TCI Stock

ESOP

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Case II –Prefund

Annual

contributions to

build up cash for a

future sale

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Case II – Prefund

ESOP accumulates $400,000 for future purchase of stock.

TCI takes annual deductions for contributions

TCI ESOP

ESOPTCI

$ 250,000

$ 150,000

Year 1

Year 2

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• John wants to cash out more quickly

• TCI’s bank is willing to extend financing

• Potential for tax deferral on John’s sale

Case III – Leveraged C Corp ESOP

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$

900,000

$ 900,000

ESOPTCI

Bank

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30% of TCI

Stock

$

900,000


JOHN

ESOP

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• The ESOP uses that contribution to repay interest and principal on the company loan.

• TCI makes a deductible cash contribution to the ESOP.– Up to $250,000 (1/4 of payroll) plus interest.

• TCI repays the bank loan.

ESOP

TCI

Bank

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Case IV – Combine Cases II &III

AnnualDebt

ServiceRequiredbank loan

Prefunding– – –

annual

Company’sFair

MarketValueYear

1 $ 3,000,000 $ 900,000 $ 250,000 $ 250,000 $ 900,000 $ 243,000

2 N/A N/A 150,000 400,000 N/A N/A

3 $ 3,333,333 $ 1,000,000 N/A $ 400,000 $ 600,000 $ 162,000

30% of FMVTax–deferredsales proceeds

To seller

Prefunding– – –

cumulative

Results:1. John receives additional $ 100,000 in tax–deferred rollover funds.2. The required loan is reduced by 33% ($600,000 rather than $900,000) and

the Company’s first-year principal + interest debt service is reduced by $81,000 pretax.

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Case V – Combine Cases I and III

Year

% Sale --

Annual

% Sale --

Cumulative

Taxable or

Tax Deferred S or C

1 3 % 3 % Capital-gains S or C



4 18 % 30 % Tax Deferred C

Capital-gains sales followed by a tax-free rolloversale

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Case VI – Two–Stage ESOP Buyout

1 $3,000 $1,500 (50%) $1,500 $450

2 3,200 1,200 420

3 3,500 900 390

4 3,800 $1,900 (50%) 2,500 550

5 4,100 2,200 530

6 4,400 1,900 490

7 4,800 1,600 460

8 5,200 1,300 430

9 5,600 1,000 400

10 6,000 700 370

DebtService

LoanBalance

SaleProceeds

MarketValueYear

($ thousands)

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Tax-free Rollovers

Tax–FreeESOP

Gross Purchase Price

Net to Seller

Less Tax

$ 225,000 = 33% More CapitalSeller’s Extra Cash

TaxableSale at 25%*

$ 900,000

$ 900,000

$

900,000–0–

$

675,000

($ 225,000)

* 20% Federal Tax, plus 5% State tax

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ESOP must acquire 30% or more of the stock of a

privately–held C corporation

Seller must have a holding period of at least 3 years

Seller must reinvest the proceeds within 12 months

Funds must be reinvested in “Qualified Replacement

Property”

Tax deferral continues as long as seller holds QRP

Basis in QRP carries over from basis in stock sold

Seller may not receive ESOP allocation of sold shares

Tax-Free Rollover

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Stocks, Bonds or Notes issued by U.S.

Corporations, Public or Private

Can invest in Brother/Sister of the ESOP

Company, but not a Subsidiary

Option to create diversified portfolio

Qualified Replacement Property

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Unlocking the QRP Lockup

$ 900,000

From Saleof StockTo ESOP

NetUnrestricted

ProceedsTo Seller

$ 720,000Margin

LoanProceeds

$ 900,000QRPBond

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CORPORATION ESOP

The S

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Benefits of S Corp ESOPs

ESOP’s share of S corp. earnings is exempt from unrelated business income tax (UBIT).

Taxation is delayed until distributions are made to ESOP beneficiaries.

Thus, a 100% ESOP-owned S corp. does not pay Federal income taxes.

However, an S corp. ESOP must meet “broadly based” test.

Selling Shareholders participate in ESOP allocation

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S Corp. ESOPs

Tom, age 50, owns 100% of “S, Inc.”, an S corp.

Tom’s compensation is $210,000/year

S, Inc. employs 20 other employees with total compensation of $840,000/year

Annual pretax earnings are $800,000

The fair market value of S, Inc. is $4MM

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Leveraged S Corp. ESOP (Seller Financed)

NOTE FOR $4 MM

STOCK 100%

ESOPTOM

STEP 1

S, INC.

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ESOP

NOTE PAYMENTS

TOM

STEP 2

* Stock is allocated to participants as a note payments are made

ESOP*TOM

S, INC.CONTRIBUTIONS

DISTRIBUTIONS

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Seller Note Options

• Conventional Seller Note• 10 to 15 year term with prepayment provisions

• 6% to 8% interest rate

• Fully Priced Seller Note• 10 to 15 year term with prepayment provisions

• IRR of 13%, based on comparable mezzanine loan rates

• 6% to 8% current-pay interest

• Warrants for 10% - 20% ownership to make up the difference

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Leveraged S Corp. ESOP

END RESULTS:

• S, Inc. no longer pays income tax, as its sole shareholder is tax-exempt

• Tom receives $ 4MM and, on the gain, paysonly capital gains tax (not ordinary income tax)

• Tom is allocated 20% of ESOP stock (which he will be able to cash out when he leaves Company)

• Since Company avoids making distributions to fund S corp. shareholders’ income tax, additional Company funds are available to repay debt and increase Company value

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Advanced ESOP Transactions

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Advanced ESOP Transaction Overview

Section 1042 Transaction and Floating Rate Notes

Combination Redemption / ESOP buyout

Stock warrants

Case Study: 100% Leveraged 1042 ESOP Transaction

Asset Purchase by ESOP-Owned Company

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Section 1042 Transaction and Floating Rate Notes

Company

Seller

ESOP

2 $

1

$

QRP=

FRN

3

10%$

90%$

4

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Seller Financing and Floating Rate Notes

Seller

ESOP

1

Stock

FRN10%$

90%$

Seller

Note

2

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Redemption and ESOP Purchase Combo

• More flexibility with purchase price

• More flexibility on seller note terms of collateral

• Helps manage company’s repurchase obligation

• Seller note has higher interest rate (mezzanine debt)

• Disadvantage: 1042 probably not available

• Disadvantage: state solvency laws

Company

Note

ESOP

Seller

5%95%

Cash

Cash

$

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Redemption and ESOP Purchase

Seller

ESOPCompany

Shares

Note

SharesNote

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Stock Warrants

Seller

Company

StockPromissary Note w/

warrants or deferred

interest

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Stock Warrants

Gives the holder a right to purchase company stock at a specified price at a future date

Almost identical to an option

Used in Seller-financed transactions

Issued in lieu of a higher interest rate on the seller note

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Stock Warrants

Example: 15% total IRR with 8% cash pay = 7% of note balance (per year compounded) would represent a predetermined number of warrants (a certain ownership %) in the Company to enable sellers to acquire shares in the future at a pre-determined price

Sellers often have right to put warrants to Company for cash once all transaction debt has been repaid

Company may request a “call” feature

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Case Study: 100% ESOP Transaction

ABC Corp Lenders

(Bank & Mezz Firm)

ESOP Shareholders

1042 Deferral

Step 1 – Outside Financing: (1) $12MM

bank term loan, (2) $13MM bridge loan

from bank, (3) $10MM Mezzanine Debt

Step 5 – Repay Bridge Loan ($13MM)

Step 3 – ESOP pays $35MM)

cash for 100% of ABC Stock

Step 2 – $35MM

Loan to ESOP

(“Inside Loan”)

Net Cash before 1042 Deferral:

$22MM and Approx. $18.5MM

after 1042 deferral

Step 6 – Invest in Qualified

Replacement Securities

(approx. $3.5MM)

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Case Study: 100% ESOP Transaction

• Receive a total of $35MM for the sale of ABC Corp stock:

• $22MM cash (from $12MM senior debt loans and $10MM mezzanine financing)

• $13MM subordinated seller notes

• Sellers may elect to defer (possibly permanently) capital gains taxes on entire sale by investing in qualified replacement securities (e.g. Floating Rate Notes or “FRNs”)

• If 1042 Deferral is elected, Capital gains tax savings up to $7MM (assumes $35.0MM price, stock basis of $0 and 20% federal long-term capital gains tax rates)

SELLERS

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Asset purchase by ESOP-owned Company

• Objective• Due to pending liabilities, Company wants to

purchase assets rather than stock, or• Seller wants to sell assets in exchange for cash, a

seller note, and an earn-out provision

• Application• Can be used either by an S or C corp• Cannot be used in a 1042 transaction

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Asset purchase by ESOP-owned Company

Steps in the transaction1. Management forms a Newco with

paid-in capital of $10,0002. Newco establishes an ESOP3. ESOP purchases all of the

outstanding stock of Newco in exchange for a promissory note in the amount of $10,000 payable over a term of 10 or 15 years.

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Steps in the transaction (ctd.)4. Newco borrows say, $10 million from

a bank, secured by the assets to be purchased

5. Newco purchases the assets from company X in exchange for $10 million of cash, a promissory note of, say, $5 million, and an earn-out of up to $5 million if earnings over the next 5 years exceeds projections

Asset purchase by ESOP-owned Firm

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C corp remains as C corp• Taxable sale

• Pay current federal capital gains tax• Seller participates in ESOP

• Tax-free rollover sale • No current tax on sale of stock• If QRP sold later, capital gains tax may be higher• If QRP never sold, estate gets a step-up in basis• Seller, seller’s family, and 25% shareholders (and

their families) are excluded from ESOP participation

C corporation tax strategies

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C corporation tax strategies

C corp makes an S election• Advantages

• ESOP tax shield • S corp distributions can be used to pay debt

• Disadvantages• Must adopt calendar year• Built-in-gains tax• One class of stock• Switch from LIFO to FIFO & LIFO recapture• Loss of NOL carryovers• Anti-abuse provisions-§409(p)

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• If ESOP acquires less than 100%• Advantage of remaining a C corp

• Continued availability of §1042

• Advantage of switching to S status• ESOP tax shield• S corp distributions can be used to pay bank debt and/or

seller note

• If ESOP acquires 100%• No advantage in remaining a C corp

C Corp Second Stage Transactions

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S corporation tax strategies

S corp remains an S corp• Advantages

• Seller taxes are low if stock basis was high• Sellers and their family members participate in

allocations• S corp distributions can be used to repay ESOP loan• ESOP tax shield on S corp distributions enables faster

pay down of ESOP loan

• Disadvantages• 1042 election not available to sellers

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S corporation tax strategies

S corp election ended before year end• Advantages

• Sellers can elect 1042

• Disadvantages• Short period accounting & tax returns• Sellers and family members cannot participate in

ESOP• Corporation will be subject to income taxation &

liable for income tax on AR• 5 year wait to switch back to S corp• ESOP will not have access to S corp distributions to

help repay loan amount• Corporation must use accrual method of

accounting

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• Borrow if:• Want to lock in capital gains rate• Want to lock in current value• Seller plans to elect 1042 and need to purchase QRP

• Do not borrow if:• Company is in a cyclical industry• Borrowing will use up company’s line of credit• Borrowing will otherwise jeopardize company’s financial

security• Personal guarantees are a concern


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Alternatives to borrowing – Seller Notes• Seller can lock in current valuation• Seller can be more flexible than a bank• Seller can still lock in capital gains rate, provided that

seller elects out of installment sale treatment• Seller can still qualify for 1042 treatment by buying

Floating Rate Notes (“FRNs”)


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• To lend or not to lend?• Advantages:

• Seller can earn interest at the same rate that a bank would charge

• Seller may charge a mezzanine rate of interest in certain cases

• Seller may receive warrants in certain cases• May or may not be worth more than deferred

interest• But warrants may qualify for capital gains

treatment


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• If there is a prior bank loan, seller note will be subordinate to bank loan

• C corp dividends and S corp distributions on both allocated shares and unallocated shares can be used to repay an ESOP loan

• But dividends and distributions paid on a prior block of stock cannot be used to make loan payments on a loan used to acquire a second block of stock

Second Stage Transactions


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Incentive Plans for Key Employees

• Key employees receive a relatively small percentage of the ESOP shares

• Banks and some large suppliers may require that key employees have skin in the game

• Available tools• Deferred Compensation • Phantom Stock Plans• Stock Appreciation Rights (SARs)• Stock Options• Stock Purchase Plans• Management Stock Bonus Plans

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Menke’s Total ESOP Servicing

RECORD

KEEPING

SERVICES

EMPLOYEE

COMMUNICATIONS

FINANCING

SERVICES

VALUATION

SERVICES

DESIGN &INSTALLATION

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Complete Feasibility

Questionnaire

Analyze ESOP Feasibility

Propose Alternative ESOP

Structures

Engage Menke & Associates, Inc.

Close Transaction

Menke’s ESOP Process

Confidential

ESOP

Questionnaire

255 California Street, 10th FloorSan Francisco, CA 94111

Phone: 415-362-5200Fax: 415-398-2260

For a free ESOP analysis, mail or fax this information to:

Over 2,500 ESOPs ESTABLISHED SINCE 1974

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To determine if ESOP is feasible

call or email Michael Pasahow or Chuck Bachman

(415) 362-5200

[email protected]

[email protected]

For additional information and articles

go to: www.menke.com

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Questions and

Answers

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Thank You For Attending

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