1. Acquisitions by ESOP-Owned Corporations - The Competitive Advantage Ohio Employee Ownership Conference Ronald J. Gilbert President ESOP Services, Inc. Scottsville, VA 24590 Phone: (434) 286-3130 San Diego, CA 92124 (858) 292-4819 http://www.esopservices.com

2. ESOP Corporate Acquisitions Two key benefits –Seller of target company will receives favorable tax treatment due to either stock sale (versus asset sale) or IRS 1042 (ESOP) sale –Earnings of target company may become partially or 100% free of federal and most state income taxes, if buying company is an S Corporation (certain states do not mirror federal tax law on ESOP S Corporations) –Corporation receives tax deduction on ESOP debt principle and interest payments

3. Tax Benefits to Seller Note: This example illustration assumes a C corporation with no cost basis in assets under asset sale scenario and no cost basis under stock sale scenario

4. Making the Seller’s Tax Advantage Work for You Purchase target company at below fair value by “splitting” tax savings with seller –Seller should take into consideration Likelihood of permanent gain deferral (2010?) Requirement of having to reinvest in qualified replacement property (“QRP”) Enhances your position in a competitive bidding situation by getting more after tax proceeds to seller

5. Target Note 2 1 Stock Target ESOP Selling Stockholders Day 1 Transaction (1)Target forms Target ESOP (2)Selling stockholders sell all of their stock to the ESOP in exchange for a note

6. Acquirer Note 4 3 Loan Acquisition Subsidiary Target ESOP Day 2 Transaction (3)Acquirer forms Acquisition Subsidiary (4)Acquisition Subsidiary borrows money from Bank and/or Acquirer (5)Acquisition Subsidiary loans proceeds to Target who then loans the proceeds to the Target ESOP (6)Target ESOP uses loan proceeds to repay note due to selling stockholders (7) Target ESOP merges into Acquirer ESOP. Target merges with Acquisition Subsidiary and Target (now “Acquirer”) ESOP receives Acquirer stock in exchange for 100% of Target stock. Bank and / or Acquirer ESOP Selling Stockholders 6 Note Repaid 7 7 5 Loan Note Acquirer Stock Target Stock

7. Financing Options Bank financing secured by target company only (unlikely) Bank financing secured by target and acquiring company Capital injection or loan by acquiring company Limited guarantees by seller and/or owners Seller notes Mezzanine financing Combination or 2 or more

8. Synthetic Equity Seller or other mezzanine financing (subordinated debt) could include warrants, etc. Important to keep and retain existing management group of target company. Equity equivalents outside ESOP (i.e., incentive stock options, stock appreciation rights, etc.) can be provided to key management as part of their compensation package to create “golden handcuffs”

9. Contingent Purchase Price Contingent payments can be structured if seller thinks there is substantial upside Typically the contingencies are structured so the Target company (not the ESOP) will pay contingency May be possible to structure so payments will be taxed as long-term capital gain

10. Contingent Purchase Price (continued) Typical contingencies include Earn-out or Contingent Note Earn-out –If Target beats earnings projections (typically based on some derivation of EBITDA) seller receives percentage of excess over stated period of time (i.e., seller receives 50% of EBITDA that exceeds $1 million over 7 year period)

11. Contingent Purchase Price (continued) Contingent Note –Seller notes subject to risk of forfeiture if certain performance levels are not met –Can be structured so seller notes are reduced incrementally –For example $10 million contingent note payable if 5 year EBITDA average exceeds $15 million Reduced to $5 million if 5 year EBITDA average is between $10 million and $15 million Reduced to $0 if 5 year EBITDA average is less than $10 million

12. Real Life Success Stories Example A Target company seeks proposals Several bids all around $35 million After tax proceeds to seller would have been approximately $21 million 100% ESOP Owned S Corporation (“Acquirer”) negotiates to purchase business in 1042 sale

13. Real Life Success Stories Example A (continued) Acquirer negotiates to purchase Target for $27 million ($8 million below fair value) in 1042 sale Seller receives $27 million in “after tax” proceeds

14. Real Life Success Stories Example B Acquirer identifies target for strategic purchase Target price too high Acquirer, an S Corporation, does not have an ESOP Acquirer negotiates to purchase business in 1042 sale

15. Real Life Success Stories Example B (continued) $500,000 tax savings, combined with ESOP benefit to remaining employees motivates Target to sell ESOPs merge post transaction Acquirer (an S Corporation) operates Target as a C Corporation subsidiary Surviving company is 30% ESOP owned

16. Considerations Complex and costly transaction - cost/benefit analysis, seller sophistication –Important to work with experienced practitioners –Many people involved in transaction, including Target ESOP trustee, attorney and financial advisor, corporate counsel and financial advisors Acquirer ESOP trustee, attorney and financial advisor and corporate counsel and ESOP quarterback Bank counsel

17. Considerations (continued) Still needs to be sound business acquisition (don’t rely on tax savings to justify deal) Obtain signed letter of intent to specify terms and conditions as soon as possible (who will pay what costs and under what conditions) Legal and financial due diligence Coordination of other benefit plans (i.e. 401(k) plan, vesting schedule, match, etc.) Effect on repurchase obligation

18. Considerations (continued) Second class of stock issues related to synthetic equity and S corporation abuse issues (don’t do anything that would jeopardize tax status!!!)

19. ESOP-owned Corporations in an acquisition scenario can lead to unparalleled results Ronald J. Gilbert President ESOP Services, Inc. Scottsville, VA 24590 Phone: (434) 286-3130 San Diego, CA 92124 (858) 292-4819 http://www.esopservices.com