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ESOP Feasibility Presented at the 20 th Annual Ohio Employee Ownership Conference April 21, 2006.

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Presentation on theme: "ESOP Feasibility Presented at the 20 th Annual Ohio Employee Ownership Conference April 21, 2006."— Presentation transcript:

1 ESOP Feasibility Presented at the 20 th Annual Ohio Employee Ownership Conference April 21, 2006

2 2 ESOP Feasibility - Overview  Thinking about an ESOP?  ESOP Considerations  ESOP Feasibility Issues  Q & A

3 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 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 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 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 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 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 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 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 11 CONTACT John C. O’Brien Director Duff & Phelps, LLC 311 S. Wacker Drive Chicago, IL 60606 Phone: (312) 697-4545 e-mail:

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