ESOP Feasibility Presented at the 20 th Annual Ohio Employee Ownership Conference April 21, 2006.
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ESOP Feasibility Presented at the 20 th Annual Ohio Employee Ownership Conference April 21, 2006
2 ESOP Feasibility - Overview Thinking about an ESOP? ESOP Considerations ESOP Feasibility Issues Q & A
3 THINKING ABOUT AN ESOP? Goals & Objectives Shareholder Liquidity / Diversification –Can sell a portion or all equity to an ESOP Tax benefits (1042 for seller) Employee ownership culture –Sharing wealth creation capability –Employee Retirement plan –Alignment of financial interests between owner & employees Continuing legacy of business Strategic reasons –“Friendly”, “patient” shareholder –Improve company cash flows / liquidity (temporarily), if benefit substitution occurs Other?
4 THINKING ABOUT AN ESOP? Characteristics of ESOP Candidates Closely held U.S. based company Ownership Tax benefits available to individual owners rather than corporate owners Corporate owners do not receive tax benefits on sale, but an ESOP can provide significant tax benefits to the company post-transaction that can facilitate an attractive transaction price Company can be a C-corp or and S-corp Currently section 1042 is only available to individuals owning stock of C-corps More than 25 employees Companies with small payroll bases may encounter 415 limitation problems Profitable As most of the company benefits are the result of tax savings, the company needs to be profitable to enjoy these benefits Debt capacity Since ESOPs are usually a specialized form of a leveraged buyout, the assets and/or cash flows of the business need to support the transaction debt.
5 THINKING ABOUT AN ESOP? Characteristics of ESOP Candidates (continued) Owners interested in a liquidity event An ESOP can provide total or partial liquidity to the owner(s) ESOP can be formed and provide liquidity for a minority or controlling interest For the owner to receive the tax benefits of a section 1042 rollover, the ESOP has to end up owning more than 30% of the company on a post-transaction basis Owners that are interested in diversifying their net worth currently trapped in the business A minority sale to an ESOP now does not preclude a sale to a third party later Owners that are interested in beginning a succession plan can transition ownership to the employees over time Sharing the wealth creation potential
6 ESOP CONSIDERATIONS Business Considerations Strength of management team esp. if owner(s) totally cashing out Capital constraints Operating the business with debt increases financial risk Market position / growth constraints while servicing debt? Culture Open environment Communication Helping employees understand what it means for them. Who will participate? In sale? In ESOP? Post transaction incentive plans for key employees
7 ESOP CONSIDERATIONS Other Considerations Governance & Disclosure ESOP, not individual employees own shares Trustee – Internal vs. external Trustees are not usually active in day to day company operations Sharing of Information with employees Minimum disclosure - employees need to receive a statement annually showing their account value, do not have to share company financials Repurchase Liability While initial ESOP contributions are cashless, ultimately the vested and allocated shares have to be repurchased from departing employees, which is a cash out flow of the business. Repurchases can become a problem when capital is constrained and large blocks of stock are put, but… ….Repurchase payments can be managed with proper planning In most cases, no cash payments until after loan is repaid ESOPs own stock – STOCK VALUES GO UP AND DOWN
8 ESOP FEASIBILITY Feasibility Study Understanding your goals & objectives To sell at what price? Fair market value vs. strategic value ESOP is akin to a financial buyer Control vs. minority Typical valuation methods Comparable companies, DCF, M&A transactions Ultimately the purchase price based upon active negotiations with the ESOP trustee (who represents the buyer) and their advisors, and the seller and his/her advisors ESOP cannot pay more than fair market value!
9 ESOP FEASIBILITY Feasibility Study (continued) Tax Benefits To selling shareholder(s) – 1042 election? Need to sell at least 30% to make 1042 election Stock must have been purchased to be eligible for 1042 1042 not yet available to S Corp shareholders To company Contributions are deductible C-corp. vs. S-corp. post-transaction 100% owned ESOP S-corp. creates a tax free entity!
10 ESOP FEASIBILITY Feasibility Study (continued) Sizing the Transaction Your Goals & Objectives Total or partial liquidity Dilution Value Borrowing capacity (for leveraged ESOPs) Collateral base Ability to service debt w/o over-stressing the company, esp. for companies not used to operating with debt ESOP provides greater borrowing capacity…with the right lender Need of Mezzanine or Seller financing? Identifying 415 Limitation Issues
11 CONTACT John C. O’Brien Director Duff & Phelps, LLC 311 S. Wacker Drive Chicago, IL 60606 Phone: (312) 697-4545 e-mail: firstname.lastname@example.org