Chapter 6 ESOPs As a financial strategy &MLPs

Agenda Employee Stock Ownership Plans (ESOPs) Establish of ESOPs Implementation of ESOPs Advantages of ESOP Disadvantages of ESOP Types of ESOPs ESOPs as a financial strategy Uses of ESOPs Master Limited Partnerships (MLPs) Tax treatment of MLPs Types of MLPs

ESOP An employee stock ownership plan is a type of stock bonus plan which invest primarily in the securities of the sponsoring employer firm. Employee Stock Ownership Plan is an employee benefit plan which makes the employees of company owners of stock in that company

Definition: Defined contribution employee benefit pension plans designed to invest at least 50% of its assets in qualifying employer securities ESOPs may be Stock bonus plans Combined stock bonus plans and money purchase plans May also provide for employee contributions May represent portion of profit-sharing plan Employee Stock Ownership Plans (ESOPs)

ESOPs different from: Employee stock purchase plans Enable employees to buy company stock at discount Participation of all or most employees Shares sold at 85% or more of prevailing market price of shares Executive incentive programs Provided mainly to top management and other key employees Part of executive compensation packages Two types Incentive stock options Stock appreciation rights

Establish of ESOPs A company interested in establishing an Employee Stock Ownership Plan (ESOP) has a wide range of options in tailoring a plan that is best suited to its particular needs and goals. The first step in the process of establishing an ESOP is to develop an idea of the type of plan that will best serve the company's interests

Implementation of ESOPs For implementation of ESOPs the company creates a trust to which it makes annual contributions. These contributions are then allocated to the individual employee accounts within the trust. employees might join the plan and begin receiving allocations after completing a year of service with the company, where any year in which an employee works at least 1000 hours is counted as a year of service.

Advantages of ESOP Employee loyalty enhanced Liquidity and diversification for firm owner Minimizes dilution of control Establishes market value for privately held stock which could be used to value estate

Tax-free rollover is actually only a tax deferral until securities are sold Motivates employees because they feel they are getting "a piece of the rock“ A ESOP-owned corporation are 100% tax-exempt entity

Disadvantages of ESOP Dilution - The equity of the company is being diluted because of the issue of further equity shares of the company which ultimately leads to a negative effect on the Earning per Share. Fiduciary Liability -The plan committee members who administer the plan are deemed to be fiduciaries, and can be held liable if they knowingly participate in improper transactions.

substantially, the ESOP and/or the company may not have sufficient funds to repurchase stock, upon employees’ retirement. Stock Performance - If the value of the company does not increase, the employees may feel that the ESOP is less attractive than a profit sharing plan. In an extreme case, if the company fails, the employees willLiquidity. If the value of the stock appreciates lose their benefits to the extent that the ESOP is not diversified in other investments

Types of ESOPs Leveraged Recognized under ERISA in 1974 Leveraged ESOP operation ESOP fund or trust borrows funds from financial institutions Lender transfers cash to ESOP trust in return for written obligation Sponsoring (employer) firm generally guarantees loan ESOP trust uses borrowed funds to purchase securities from sponsoring firm Sponsoring firm transfers stock to name of ESOP trust as portions of principal are repaid

Types of ESOPs Leveragable Recognized under ERISA Plan authorized but not required to borrow funds Nonleveraged The sponsoring employer contributes newly issued or treasury stock and/or cash to buy stock form existing owners. Contributions generally may equal up to 15% of covered payroll Recognized under ERISA Plan does not provide for borrowing of funds Essentially stock bonus plan

ESOPs as a financial strategy ESOPs may provide shareholders with increased value When the company's performance lags, employee shareholders are exposed to market losses in an investment that they cannot divest while employed by the firm. Tax credits ESOPs Provided by Tax Reduction Act of 1975; known as Tax Reduction Act ESOPs or TRASOPs In addition to regular investment credit in existence at that time, additional investment credit of 1% of qualified investment in plant and equipment could be earned by contribution of that amount to ESOP

ESOPs as a financial strategy In 1976, additional 0.5% credit added for companies that matched contributions of employees of same amount to TRASOP In 1983, basis for credit was changed from plant and equipment investments to 0.5% of covered payroll — plans called payroll-based ESOPs or PAYSOPs Recently, the Reconciliation Act of 2001, exempted employees' elective deferrals to their retirement plans from the calculation of total employer contribution to defined-contribution plans such as ESOPs and 401(k)s. In addition, the maximum contribution percentage was raised to 25% from 15% of total eligible pay

Uses of ESOPs Corporate restructuring activities Buy private companies (59% of leveraged ESOPs) Divestitures (37% of leveraged ESOPs) Rescue operations of failing companies Raising new capital Takeover defense to hostile tender offers

Master Limited Partnerships (MLPs) Business organizational forms in general Proprietorships and partnerships Most numerous Mostly small businesses Corporations Dominant in terms of total assets

MLPs Four advantages in raising large sums of money Limited liability for shareholders Unlimited life Ownership divided into many shares — limits risk exposure Shares freely tradable for liquidity, diversification, transferability of ownership MLPs — relatively new form of business organization

MLPs Master Limited Partnerships Type of limited partnerships whose interests are divided into units that are traded on organized exchanges First developed in oil and gas industry Some advantages Unit tradability similar to stock Limited liability (for limited partners) Continuity of life No double taxation of business earnings

Tax treatment of MLPs IRS focused on four characteristics to distinguish between corporations and MLPs Unlimited life Limited liability Centralized management Transferability

MLPs may have only two of four corporate characteristics to avoid being taxed as corporation — usually centralized management and transferability MLPs typically specify limited life of 100 years MLPs have limited liability for limited partners but unlimited liability for general partner or manager

General partner of MLPs General manager (partner) of MLPs has unlimited liability Virtually autocratic power Difficult to change general partner in absence of provable fraud Alignment of interests between general partner and public unit holders Management incentive fees Ownership of significant number of limited partnership units

Types of MLPs Roll-up MLPs Combine existing limited partnerships into one publicly traded partnership First type of MLPs organized; began in oil industry by Apache Petroleum Company in 1981 Provide liquidity for nontraded limited partnerships

Nature of roll-up Before roll-up, there are a number of limited partnerships in existence General partners enter into agreement to combine a number of previously sponsored limited partnerships; in return for their old shares, units in new MLP are issued After MLP has been formed, there is a general partner and units which are owned by limited partners; units may trade on stock exchange or over the counter

Roll-out (spin-off) MLPs Formed by a corporation's contribution of operating assets in exchange for general and limited partnership interests in MLP Sold on a yield comparison basis First roll-out MLP created by Transco Corp in 1983

Nature of roll-out Corporation holds a number of business segments Corporation places assets of one or more of its business segments into MLP Avoid double taxation of corporate dividends Establish a new value on undervalued assets MLP transfers MLP units to corporation which in turn distributes them to its shareholders Stockholder hold stock in corporation and own units in MLP Corporation could sell portion or all of units to outside public

Start-up MLPs Start-up (new issue, or acquisition) MLPs Formed by a partnership that is initially privately held but offers its interests to the public in order to finance internal growth Nature of start-up Existing entity transfers assets to MLP Management company may be involved that provides services to MLP and probably will be its general partner In return, management company receives certain percentage of cash flows of MLP General partner does not have to hold units in order to receive income