Employee Stock Ownership Plans ESOPs 101

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1 Employee Stock Ownership Plans ESOPs 101 BTA INC 2013

2 Complete 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

3 Team Approach Insurance Investments * Plan Design ERISA Counsel * Banker Estate Planning Trustee* Leader Team Leader Stock Valuation* TPA* Employee Communication Corporate Counsel Repurchase Obligation Company CPA * *Outside service provider

4 Providing services in all 50 states Drawing on 75 years of combined team experience In the last 5 years BTA has worked with: Over 8,100 employees 455 stockholders Market values of over $1.76 BILLION DOLLARS!

5 What is an ESOP? Employee Stock Ownership Plan A tax qualified defined contribution employee retirement plan Qualifies under IRC Section 401(a) and Section 4975(e)(7) Overseen by the IRS and the Department of Labor

6 ESOP Statistics Modern ESOPs came into being with passage of ERISA ,000 ESOP companies in America today Almost 1 trillion in assets held This includes large and small companies 21% of all U.S. private sector workers own company stock 72% of The ESOP Association s members have less than 250 employees

7 Unique Features Since Congress believes having employees accumulate retirement income is beneficial to society, it provides 3 major tax incentives to ESOP s: 1. Stock sold to ESOPs can qualify to defer/avoid capital gains tax 2. Company can receive dollar for dollar deduction for stock sold to the ESOP 3. Company can become State & Federal income tax free

8 Unique Features Must invest primarily in employer stock Can use borrowed funds (leverage) No employee contributions generally allowed Contributions can vary year to year, unless borrowed funds are used

9 Uses of ESOPs 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 Mergers & acquisitions

10 Owner Transition Concerns Minimize personal and corporate taxes Leave corporation with proper working capital and manageable, if any, debt Asset liquidity and diversification Convert business to retirement income Preserve family/community legacy Exit with the most after-tax dollars possible

11 Comparing Options All traditional sale methods use after-tax dollars ESOP s utilize pre-tax dollars

12 Comparing Options $10,000,000 Business Value Management Buy-Out/ Corporate Redemption $16,666,000 Earnings Required $6,666,000 Corporate Tax $2,920,000 Capital Gains Tax $7,080,000 Net to Seller $0 Tax Savings ESOP $10,000,000 Earnings Required $10,000,000 Deduction $4,000,000 Corp. Tax Savings $10,000,000 Net to Seller Approx. $10mm Tax Savings Assuming 40% Combined Federal & State Tax Rate Assuming 29.2% Avg. Combined Federal & State Capital Gains Tax Rate

13 How an ESOP Works: Step 1

14 How an ESOP Works: Step 2 LENDER LOAN COMPANY LOAN ESOP TRUST

15 How an ESOP Works: Step 3 LENDER LOAN COMPANY LOAN ESOP TRUST CASH STOCK IRC 1042 (C Corp) CASH SELLING SHAREHOLDER

16 How an ESOP Works: Step 4 LENDER LOAN PAYMENT COMPANY LOAN PAYMENT ESOP TRUST CASH CASH STOCK SELLING SHAREHOLDER

17 How an ESOP Works: Step 5 LENDER LOAN PAYMENT COMPANY LOAN PAYMENT ESOP TRUST CASH EMPLOYEES BENEFICIAL OWNERSHIP CASH STOCK SELLING SHAREHOLDER

18 How an ESOP Works: Step 6 LOAN LOAN LENDER PAYMENT COMPANY PAYMENT ESOP TRUST CASH CASH INTEREST CASH SINKING FUND DEATH DISABILITY RETIREMENT TERMINATION DIVERSIFICATION EMPLOYEES STOCK SELLING SHAREHOLDER

19 IRC 1042 Tax Deferral 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 Financial products specifically made to facilitate liquidity of IRC 1042 assets

20 Qualified Replacement Property (QRP) Eligible Ineligible Common Stock Municipal Bonds Preferred Stock US Govt. Bonds Convertible Bonds Mutual Funds Corporate Fixed Rate Bonds Foreign Securities Corporate Floating Rate Notes REITs, Bank CDs Note: Eligible issuer must have 50% of its assets used in the active conduct of trade or business and no more than 25% of its gross income from passive sources

21 Leveraged QRP Strategy Proceeds From Sale (1042) CASH Portfolio Floating Rate Notes Balance Income with Interest QRP can be margined to 90% Margin Account Liquid Cash New Home Car Boat Stocks Bonds

22 100% S Corporation 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

23 Taxation of S Corporations: Before ESOP The Company CPA Prepares Form K-1 K-1 Goes to the Owner The Shareholder Files 1040 Pays Tax

24 Taxation of S Corporations: After Sale to ESOP The Company CPA Prepares Form K-1 K-1 Goes to the Owner ESOP The Shareholder Files 5500 Pays NO Tax Note: Cash can stay in the company

25 Corporate Governance If you control the Board of Directors, you control the company Shareholders Elect the Board of Directors Board of Directors appoints the Officers Officers responsible for day-to-day operations

26 Control: Unchanged In An ESOP: Current Owner Votes Board of Directors Appoints Directed Trustee

27 ESOP Employee Interest The directed trustee votes the stock on behalf of the employees The employees only have a beneficial interest in the ESOP trust Employees advise trustee only on mergers, sale, recapitalization or liquidation Employees are not shareholders and do not have Statutory Minority Shareholder Rights

28 Qualitative Benefits Golden handcuffs for key people Reduced turnover Reduced worker comp claims Greater productivity Greater profitability Greater commitment to the company Better work environment

29 Summary of Tax Benefits Deferral and/or avoidance of capital gains taxes on the sale of stock Deduction of the full Fair Market Value of the stock purchased by the ESOP Possibility of becoming tax free as a 100% S Corporation ESOP

30 How Do We Finance the Buy Out? Bank financing Seller financing Combination of bank and seller financing Significant incentives for seller

31 Financing Structure: Need to Finance 100% L E N D 2-3 X E B I T D A S E N I O R B A N K D E B T 40 60% O F T H E E Q U I T Y

32 Financing Structure: Need to Finance 100% 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% M E Z Z A N I N E F I N A N C I N G 20 30% S E N I O R B A N K D E B T

33 Financing Structure: Need to Finance 100% V. C. C A N B E E V E N M O R E E X P E N S I V E 2 0 % + V E N T U R E C A P I TA L 20 30% M E Z Z A N I N E F I N A N C I N G 20 30% S E N I O R B A N K D E B T 40 60% 100%

34 BTA Recommended Structure The Seller is entitled to a Market Rate of Interest Instead of going to the market for all the financing, we recommend the seller take a note for everything above senior debt The interest rate can be adjusted to suit the sellers goals, company cash flow and maintain payment flexibility

35 BTA Recommended Financing Structure B L E N D E D R A T E 14-15% S E L L E R T O A C C E P T S E L L E R N O T E 3-5% L E N D 2-3 X E B I T D A S E N I O R B A N K D E B T 40 60% T O T A L E Q U I T Y

36 Why will the seller accept 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)

37 Seller Financing: Warrants 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 2 nd bite of the apple Warrants can be given or gifted to management or family members

38 Seller Financing: Warrants Since the Seller is willing to accept a lower rate of interest on the seller note portion, warrants are issued to make up the difference for the lower interest rate Warrants issued can be 25-35% of the total equity of the company

39 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

40 Summary Owner sold stock for FMV Received some cash (bank loan or co.) Note for the mezz. & V.C. Piece Long term interest income Deferred or avoided capital gains tax Control retained Salary, perks & benefits 25%-35% of company in warrants Estate planning benefits Company is tax free

41 ESOP Steps 1. Initial complimentary review of Fact Finder and three years financials 2. Preliminary analysis & preliminary valuation 3. Feasibility study 4. ESOP implementation

42 Win-Win-Win For Everyone Business owners Employees Corporations More advantageous than any other single vehicle