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The Art Of Seller Financing

ESOPs - Beyond The Basics

Presented by:

Kevin G. Long

Chang, Ruthenberg & Long PC

2033 Gateway Place, Suite 500

San Jose, CA 95110

(408) 467-3860

kgl@seethebenefits.com

James F. Higgins

Pilot Hill Advisors, LLC

55 Union Place, Suite 131

Summit, NJ 07901

(908) 897-0826

jhiggins@pilothilladvisors.com

Michael E. New

Evolve Bank & Trust

6070 Poplar Avenue, Suite 100

Memphis, TN 38119

(901) 624-2555

mnew@getevolved.com

"So I got this call from a very a very

good CPA firm we work with….."

Acme LLC Case Study

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• Which transaction structure used

• Cost of doing the deal

• Loan documentation and built in checks

and balances of ALL parties

• Transaction trustee vs. post deal fiduciary

concerns

• Need for quality independent counsel

• Contingency planning

Impacts On Transaction

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• Selling Shareholder

• Corporation

• Other creditors

• ESOP Trustee

• Management?

The Constituencies Affected

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• Longer terms for "inside" ESOP loans

• Cost – seller vs senior debt

• Cost – seller vs secondary financing

• Flexibility

• Known creditor

• Ease of "work outs"

• Board presence of creditor

• Subordination requirements – deal and

future

Corporation's Concerns

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• Lend to ESOP or company?

• Collateral

• Retain control over corporate risk?

• Comfort with senior lender, trustee,

management

• Compared to:

• holding back equity

• guaranteeing bank debt

• Mezzanine / portfolio / secondary

financing

Seller's Issues – Risk, Return, Control

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• Pricing / optimizing interest costs

• Mezzanine Debt? Really? Real?

• Post transaction board composition

• Involvement and monitoring

• Secondary stage refinancing – timing?

Trustee's Concerns

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• A seller taking a note must think like a bank

and investor

• A lender wants:

a) sustainable cash flow;

b) assets that can be liquidated to pay off

debt if necessary; and

c) flexibility to modify terms if necessary

• The better seller note structure would be

with the company? the ESOP?

Credit 101

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Pros And Cons Of Bank vs. Seller Financing

Bank

Financed

Seller

Financed

Cash at Closing

Ability to Diversify

Flexibility

Easier §1042 Fulfilment

Independent Oversight

Potential Warrant Upside

Interest Income for Seller

Faster Close and Lower Fees

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Step 1"Outside" Loan

Bank Company

Step 2"Inside"

Loan

ESOPSelling

Shareholders

Step 3Stock TransactionCash

Company Stock

Bank & Seller Financed Leveraged ESOP

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Step 1Seller Guarantee?

Seller note

Step 3Corp Guarantee?

Step 1Redemption to Corp

Company

ESOPSelling

Shareholders

Seller Financed Corporate Redemption ESOP

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Step 2ESOP Note

Third party beneficiary rights

Step 2Issue Stock to ESOP

Step 1Corp Note

Step 1"Day" Loan

Bank Company

Step 2"Inside"

Loan

ESOPSelling

Shareholders

Step 3Stock Transaction

Cash

Company Stock

"Day Loan" Resulting In Company Note

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Step 3Seller

Loan to Company

Step 4Day Loan Repayment

ESOP Note Swap Buy-Out: Step 1

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Corporate

Guaranty

Annual

Contributions

Stock Sale

7-Year

Notes

Company

ESOP Seller

Start with stock sale directly to ESOP for

subordinated 7 yr 6% notes, secured by corporate

guaranty, company pays notes via ESOP

contributions

ESOP Note Swap Buy-Out: Step 2

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Company assumes

and secures 7-year

notesAnnual

Contributions

Company

Seller

ESOP Gives

combined

note

ESOP

Annual Note

payments

ESOP assigns and company assumes the 7 yr notes in

exchange for the ESOP giving it a note for the combined

balances. Corporate guaranty extinguished in favor of direct

creditor relationship to sellers.

• Tax Treatment• Interest Income is taxed as ordinary income• Potential Capital Gain Taxation on Warrants• Capital Gains Treatment On Principal - non §1042

• Terms of Seller Financing• Collateral – Corporate – Direct or Guarantee• Return on Investment

• Cash Interest• Payment In Kind (deferred interest)• Warrant (equity kicker)

• Expected rate of return is commensurate with the perceived risk• Loan regs allow terms that would be commensurate from a third party

lender• Generally, leverage is a metric that is used to tier the seller financing• Seller financing positioned like senior debt risk should be paid a

return similar to a bank• 100% seller financed transactions may "tranche" seller notes based

on relative risk profiles• Maturity and Excess Cash Flow• Board Involvement• Financial Covenants

Seller Financing Considerations

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Senior

Debt

Subordinated Debt & Mezzanine

Equity

Corporate Capital Structure

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Risk

Increases

Risk

Increases

Req.

Return

5-

10%

10 -

24%

25 -

∞%

• Purchase agreements

• Redemption and issuance issues

• Loan Agreements

• Corporate and personal guarantees

(secured vs. not)

• Subordination agreements

• Contribution agreements

• Assignment of pledges

• Voting trusts

Transaction Documentation

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• May achieve same protection as direct loan

to corporation

• Very careful drafting required

• Third party beneficiary rights often

overlooked – equitable remedies

• Events of default can be tied to

performance of funding ESOP

Corporate Guarantees

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• The senior lender wants to have the strongest

position in getting repaid before others

• Seller financing always expressly subordinated to

a bank

• Bank will typically require the seller to:

• Wait for a period before receiving any principal

• Forego interest and principal payments if the

company is underperforming (i.e., a bank

financial covenant is violated)

• Agree to standstill on pursuing rights and

remedies if the company is in default on the

senior loan

Subordination Agreements

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• Typically require borrowers to have at least $5-10

million of historical annual EBITDA

• Are an additional "complicating factor" in getting a

transaction closed

• Are typically not as lenient if the company

underperforms

• May want to be involved in corporate governance

• Can be expensive

• Sellers will often prefer to remain with the company

post-transaction and would prefer to get the sub debt

return rather than provide it to a "stranger"; or prefer

it to third party leveraged 1042 portfolio – even at

capital gains rates on principal

What About 3rd Party Sub Debt Lenders?

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• Some assume that due to the risk profile of

a note, a seller is justified in expecting a

15% rate of return (like a third party)

• The return is a function of the amount

"invested" in the note and the subsequent

cash flows received

• Cash flows received:

• Cash interest income

• Principal both original as well as payment in

kind "PIK"

• Warrants

Seller Note Return "Mix"

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• PIK is interest that is compounded into the

note's principal rather than paid in cash

• (Reverse amortization?)

• A $10 million note with a 5% PIK interest

compounded annually would result in the

following principal balances over time

(assuming no principal payments)

PIK – Payment In Kind

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Beginning Balance PIK Interest Ending Balance

Year 1 $10,000,000 $500,000 $10,500,000

Year 2 $10,500,000 $525,000 $11,025,000

Year 3 $11,025,000 $551,250 $11,576,250

Year 4 $11,576,250 $578,813 $12,155,063

Year 5 $12,155,063 $607,753 $12,762,816

• Essentially a stock option issued in connection with a

financial instrument / transaction

• A contractual obligation of a company to sell a specific

number of shares to the warrant holder in the future at a pre-

established price

• Example: Jane owns a warrant that provides her the option

to purchase 100 shares of Acme Co. for $10 per share on or

prior to 12/31/17

• Scenario A: If on 12/31/17 the value of Acme stock is $30

per share, then Jane should exercise the warrant (pay $10

per share) and receive the stock

• Scenario B: If on 12/31/17 the value of Acme stock is $9

per share, Jane should do nothing and the warrant would

expire as worthless to her

Warrants Are

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• Essentially allow the holders to conduct a "cashless" exercise to trade

some of the warrants for cash. Example:

• Instead of writing a check for $1,000 to exercise the 100 warrants,

Jane instead forfeits 50 warrants to pay the exercise price in lieu of

cash

• Each warrant is worth $30-10=$20 and therefore 50 warrants would

be worth $1,000

• Warrant holders typically want to get cashed out rather than holding

company stock, so warrants typically have "put" features that requires

the company to cash out the warrant at a specific date

• If an ESOP owns all or a portion of the company, the ESOP's tax

benefits (i.e., 100% S Corp ESOP) provide a strong desire to avoid

additional share ownership outside of the ESOP

• In ESOP transactions, warrants are typically structured so that

company can buyout the warrant (a "call") before the holder proceeds

to exercise and take ownership of shares

• Beware IRC §409 (p): Too many warrants in too few hands may trip

the anti abuse test

Warrants (continued)

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• Creditor's rights in non ESOP scenarios

• Overall governance structure issues

• Seller's protections in ESOP deals:

• Compare guarantee agreements with

retaining stock

• Upside of warrants vs retaining stock

• Voting trust duration

• Desire of Sellers to sit on board until:

• Bank Loan is paid off?

• Their loan is paid off?

Degrees Of Control – Legal Or Effective?

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• Sale of 74% of stock to ESOP

• Senior debt for X% of transaction at Y%

interest

• Seller subordinated note for Z% of

transaction

• Board seat protected by cumulative voting

of 26%. Projected good return and

protection of ensured participation

• Industry gyrations required Trustee / seller

actions to restructure in subsequent year

So What About Acme And Mr. Big?

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