Is an ESOP right for you, and your Company? Presented by ESOP Services, Inc. © ESOP Services Inc. 2019

What if the shareholders could… Sell some, or all shares, at fair market value Pay no capital gains tax Preserve company legacy and independence Incentivize leadership with equity or equity based incentives Provide a meaningful retirement plan with value based on growth of company Focus everyone on same objective: to grow shareholder value Position the company to avoid paying additional federal and state income taxes *Most states mirror federal law

Agenda Why transition with ESOPs? What is an ESOP ? Transaction design Tax advantages The ESOP’s impact on cash flow What does an ESOP mean to Corporate governance Leadership and management How do you set up an ESOP? Process and Team Next Steps

Why ESOPs? Liquidity in part or whole Converting shares into cash at a fair market value, enabling the business owner(s) to diversify their portfolios Perpetuation Selling shareholders stay involved, if desired Maximum tax efficiency Shareholders, company, employees Broadened ownership Employees incentivized to “think like owners” Strategic planning Achieve shareholder and corporate objectives

An ESOP is a transition alternative Answers the question, “What are my alternatives for business perpetuation and creating liquidity?” Sale to third party Merger Sale to management Corporate stock redemption Initial public offering Gift or other transfer to heirs Wind up business and liquidate Leveraged recapitalization Sale to Employee Stock Ownership Trust (potentially tax deferred with “tax-free” dollars)

Over a 100 Studies ESOP Companies are: More productive More profitable Have higher survival rates Resources esopservices.com esopassociation.org nceo.org esopinfo.org

Direct Shareholders (if < 100%) Ownership – Transfer 1%-100% of the company Post-sale Prior to sale Direct Shareholders (if < 100%) Company Shareholder 1 Shareholder 2 Shareholder 3 Company ESOP Participant Employee Stock Ownership Plan Eligible employees become ESOP participants

What is an ESOP? It is a retirement plan Designed to hold primarily stock of the sponsoring company The company, selling shareholders, and employee participants may receive various tax benefits The US government has given the company tax breaks for funding ESOP The plan is regulated by the government (IRS and DOL)

An ESOP is a: Buyer Think of the ESOP as a shareholder, or any other sophisticated buyer Can borrow to buy stock Wants a good deal Benefit plan Established for the benefit of the participants, governed by ERISA Has a trustee, appointed by the board Tool of corporate finance Liquidity plan and benefit plan often largely funded with tax savings

Leveraged ESOPs Most ESOPs are leveraged The ESOP receives a loan to purchase a block of stock This stock is held in trust and released into employee accounts at a rate corresponding to debt amortization

Financing Alternatives ESOPs typically acquire a block of stock with leverage (“debt”) funded by one or a combination of: Bank(s) Excess company cash Private equity group (PEG) Selling shareholder(s) Combination of the above (typical) Management investment (rare) Broad-based employee investment (rare)

Leveraged ESOP (bank and seller debt) (2) loan to ESOP Leveraged ESOP (bank and seller debt) (1) Bank lends to company (2) Company lends to ESOP (3) ESOP buys stock from existing shareholders with cash and a promissory note (4) Shares are held in suspense account (5) Company makes annual tax-deductible contributions to ESOP to repay seller and bank debt (6) Shares are released from suspense account and allocated each year as ESOP repays loans (7) The ESOP then repays sellers and company. Company makes periodic payments to bank. (8) Employees receive stock or cash when they retire or leave (vesting applies) Bank Company (7) Periodic Payments 1) ESOP Term Loan from Bank (7) Repay ESOP Loan (5) Contributions Selling Shareholder(s) (3) ESOP pays cash and (4) Suspense ESOP Trust (3) ESOP issues promissory note 6) Allocated shares (3) Shares move to suspense 6) Allocated Shares Participant Account 6) Allocated Shares (7) Payments on promissory note Participant Account Participant Account (8) Retirement $$ $$$

How is stock price determined? By law the ESOP may not pay more than fair market value as determined by an independent valuation firm and trustee Company’s stock price will be determined upon purchase (and at least annually thereafter) by the ESOP’s trustee, based on an independent valuation firm’s determination of fair market value ESOP trustee Expertise in ESOP trustee services Appointed to act on behalf of ESOP participants Independent valuation firm Independent and experienced in valuation Utilize expertise, experience, industry standards, and guidelines provided by IRS

Valuation Approaches Market approach Income approach Asset approach Standard ESOP discounts Marketability 5-10% Minority 10-15%

An ESOP offers significant Tax advantages to the sellers, the Company, and the employees Tax-deferred sale - C corporation stock [IRC 1042] Tax-deductible C corporation dividends [IRC § 404(k)] Tax-deductible principal repayment [IRC 404(a)(9)] Tax-free S corporation income [IRC 409(p) and 512(a)] Contributions may be reimbursable under federal government contracts Participants are not taxed until distribution

IRC 1042 Tax Deferred Sale Seller Proceeds Illustration Asset Sale Stock Sale (non-ESOP) Stock Sale ESOP with IRC 1042 Sale Price $10,000,000 Less: Basis assumed $0 Gain on Stock Sale Ordinary Tax On Gain (21% Fed, 5% State)* 26% 2,600,000 Capital Gain Tax Rate (20% Fed, 5% State)* 25% 1,850,000 2,500,000 After Tax Sale Proceeds $5,550,000 $7,500,000 Paige This example is for illustrative purposes only. Additional taxes may apply.

C corporation IRC 1042 “Tax-Free” rollover Seller must have owned stock for at least three years prior to sale: Cannot have acquired the stock in a compensatory stock option plan, or any other section 83 transaction, nor from a qualified retirement plan Seller, certain related individuals, and greater-than-25% owners generally cannot participate in ESOP allocations 10% excise tax applies if ESOP disposes of stock within three years, except for normal benefit distribution Above rules do not apply if company does not allow for the “tax-free” rollover

Qualified Replacement Property General Guidelines* Eligible** Common stock Convertible bonds Corporate fixed rate bonds Corporate “Floating Rate Notes” Not Eligible Municipal bonds U.S. government bonds Mutual funds Foreign securities REITs Bank CDs * QRP must be evaluated by an experienced investment advisor to ensure compliance guidelines are met. * *Eligible issuer must have: More than 50% of its assets used in the active conduct of a trade or business No more than 25% of its gross income from passive sources

The ESOP’s impact on Cash Flow Tax Deductible Contributions Tax Deductible Dividends when used to repay debt Tax-Free S corporation Income Government reimbursable Lender repayment Repurchase obligation Implementation and ongoing costs

Advantages Disadvantages Company Substantial tax savings Increased cash flow Pre-tax dollars repay debt Tax-free income, S Corp ESOP stockholder not subject to federal and most state income tax Stockholders Liquidity in part or whole IRC 1042 “tax-free” rollover Selling shareholders can remain involved (if desired) Leadership Minimal disruption Flexible alternatives to motivate key performance typical Employees Share in equity growth Research shows ESOP companies more likely to have other retirement-oriented benefit plans Proven motivator Retains key employees Requires debt to purchase larger blocks of stock Seller can finance with larger block of stock Repurchase obligation Planning for funding options important Complexity Experienced advisors essential

How does an ESOP impact ... Corporate governance Current owners who aren’t selling Leadership going forward?

Corporate Governance ESOP Company Nomination Committee ESOP Nomination Committee Nominates Board of Directors for Trustee to Vote ESOP Committee (Optional) Board appoints Board appoints Board of Directors Audit Committee Board appoints/removes Trustee Trustee(s) Manages Day to Day Operations of the ESOP Compensation Committee Company Other Committees ESOP Sponsor * Trustee elects Directors from nominating committee’s slate

Current Owners (Who are not Selling) The opportunity to have each employee focused on the same goal, growing shareholder value The ESOP is one shareholder

Leadership and Management Can be structured with minimal or no impact on current incentive and benefit plans Participate in the ESOP Shares typically awarded based on individual payroll as a percent of the total Trustees normally approve equity based incentives for key management, over and above your participation in the ESOP

Synthetic equity Generates value in relation to value of stock for key employees Units issued by board of directors Can be performance based Typically vesting applies Other Incentives Existing plan(s) Cash bonus, based on exceeding projections Stock options Deferred comp

Is an ESOP right for your Company? The answer: it depends… On shareholder goals and objectives Estate planning, personal financial needs, time table, control Company’s strategic plan Projected growth, successor management, cash flow, employee benefits levels, ownership culture Current economic considerations Valuation, transaction financing, tax implications, current legislative environment Paige

The process Phase I Decision Package Phase II Implementation Phase III No fee Confidential Preliminary Analysis Preliminary range of valuation Financial Analysis Feasibility study, creating a “decision package” Phase I Decision Package Independent transaction valuation Plan and trust, and transaction documents Financing, Bank and / or Seller Employee Communications Phase II Implementation Employee education Repurchase Obligation Planning Annual administration and valuation Phase III Ongoing Paige 27

Phase I: Feasibility Study Solidify and modify goals and objectives Advisors confirm tax implications Preliminary value range provided by appraiser Funding discussions Transaction design(s) – viability confirmed by tax, legal and accounting teams Review of all related documents, plans, buy-sell In-depth financial analysis and modeling

Financial Analysis & Modeling Based on projections Relying on preliminary value range Assesses cash flow, include repurchase obligation Assesses compliance limitations Payroll size and growth projection IRC § 415 limitation, 409(p), etc. Models shareholder positioning over lifecycle of ESOP Estimates tax savings changed asses to assesses

Financial Analysis & Modeling (continued) Coordinating ESOP with existing plans, benefit levels, and executive compensation programs Identifies show stoppers “C” or “S” corporation? IRC 1042 Models funding sources Illustrates impact of plan design This is an iterative process!

ESOP Team Corporate advisory team: CPA, corporate counsel, financial advisor(s), etc. Supporting and advising as needed ESOP consultant Prepares feasibility study, a decision package to ascertain viability, and “quarterbacks” implementation Independent appraiser Determines fair-market value Trustee(s) Acts on behalf of the ESOP and purchases stock ESOP counsel / Corporate Counsel Drafts plan, trust and transaction documents Advises trustee(s) and other fiduciaries Banks Providing funds to facilitate transaction Third party plan administrator Provides annual record keeping and compliance testing

Next Steps Learn more www.esopservices.com References Selected upon request Partial list at www.esopservices.com/reference.html Call or email with questions! ESOP Videos (esopinfo.org) Feasibility Study

ESOP Services, Inc. www.esopservices.com Paige Ryan Founded in 1984, ESOP Services, Inc. responds to the needs of business owners to understand and analyze the ESOP’s impact on the company, shareholders, and employees, focusing on the financial aspects of cash flow, tax savings, shareholder liquidity, and employee benefits. We specialize in all aspects of Employee Stock Ownership Plans for both private and public companies throughout the United States and internationally. Our unique approach emphasizes the financial aspects of ESOPs, while coordinating the many diverse elements necessary to successfully establish an ESOP. Paige Ryan San Diego, CA 92142 858-292-4819 paige@esopservices.com Ron Gilbert Scottsville, VA 24590 434-286-3130 esop@esopservices.com 33