ABC’s of ESOPs
Presented by: Vernon P. Saper 616.752.2116 [email protected]
ESOP Overview
Liquidity Options for Business Owners
External Transaction Initial Public Offering (IPO). Sale of Company – Whole or Part.
Internal Transaction Management Buyout. Employee Stock Ownership Plan (ESOP).
1 What If A Business Owner Could …?
Sell part or all of their company stock at Fair Market Value.
Defer and potentially avoid paying capital gains tax when they sell.
Continue to lead their company even after selling.
Sell the company under circumstances that maintain confidentiality of their financial condition.
What If A Business Owner Could …?
Preserve their company's legacy and independence.
Reward their employees & management.
Work as much as they want after the sale.
Increase employee incentives and ultimately productivity.
Position their company to later become a 100% ESOP S-Corporation and therefore not pay federal or, in most states, state income taxes.
Growing Number of ESOPs
Over 9,774 ESOPs in United States covering over 11.2 million employees (1).
About 800 publicly traded companies and 2,500 financial institutions have ESOPs (1).
3,500 ESOP companies are majority-owned by the ESOP (1).
At least 75% of ESOP companies are or were leveraged (1).
At least 2,500 companies are 100% owned by ESOPs (2).
1 Source: NCEO – www.NCEO.org , August 2008 2 Source: The ESOP Association - www.esopassociation.org , October 2008
2 Growing Number of ESOPs
A 2000 study by Joseph Blasi and Douglas Kruse at Rutgers University found that ESOP companies grow 2.3% to 2.4% faster than would have been expected without an ESOP for sales, employment, and sales per employee.
Blasi-Kruse study also showed that productivity in ESOP companies is on average 4% higher.
The General Social Survey (GSS), a 2006 random sampling of working adults performed by the National Opinion Research Center (NORC) of the University of Chicago, showed 20.0% of all employees working in the private sector report owning stock in their companies, while 10.0% held stock options.
Growing Number of ESOPs
A 2007 University of Pennsylvania study showed the mean individual ownership stake among all ESOPs is $82,857.
Growing Number of ESOPs
Growth of Total ESOP Plan Assets Growth of ESOPs and Equivalent Plans
Number Number of Year Plan Assets Year of Plans Participants 2007 $928 billion 2007 9,774 11,200,000 2006 9,650 10,500,000 2006 $675 billion 2005 9,225 10,150,000 2004 9,115 10,030,000 2005 $600 billion 2003 8,875 9,600,000 2001 $400 billion 2002 8,450 9,300,000 2001 8,050 8,885,000 1998 $350 billion 2000 7,700 8,500,000 1995 $226 billion 1999 7,600 8,000,000 1993 9,225 7,500,000 1994 $184 billion 1990 8,080 5,000,000 1980 4,000 3,100,000 1990 $133 billion 1975 1,600 250,000
Source: A Statistical Profile of Employee Ownership, The National Center for Employee Ownership (NCEO), 2008
3 America’s Largest Majority Owned ESOPs Company State Business Employees Publix Supermarkets FL Supermarkets 142,000 Hy-Vee IA Supermarkets 51,000 SAIC CA R&D & computer systems 44,000 Price Chopper dba Golub Corp. NY Supermarkets 22,000 Tribune Co. IL Media 19,000 CH2M Hill, Inc. CO Engineering, construction 19,089 Lifetouch MN Photography studios 18,000 Nypro MA Plastics manufacturer 15,000 Houchens Industries KY Supermarkets 11,487 Parsons Corp. CA Engineering, construction 11,500 Amsted Industries IL Industrial manufacturer 9,233 Black & Veatch MO Engineering 8,500 WinCo Foods ID Supermarkets 8,100 W.L. Gore Associates DE Manufacturing (Gore-Tex) 8,000 Graybar Electric MO Electrical equipment wholesaler 8,000
Tharaldson Lodging ND Hotel management 7,000 Austin Industries TX Construction 6,000 MWH Americas CO Engineering 6,100 Davey Tree Expert Co. OH Tree service 6,000 Brookshire Brothers TX Supermarkets 5,800 Journal Communications WI Newspapers & communications 5,700 Performance Contracting Group KS Specialty contractor 5,700 HDR, Inc. NE Architecture & engineering 5,000 Schreiber Foods WI Cheese manufacturer 5,000 Guckenheimer Enterprises CA Food distribution 5,000
Source: America’s Largest Majority Employee-Owned Companies, The National Center for Employee Ownership (NCEO), 2008
What Matters? Key Considerations For A Successful ESOP Remember – there are always exceptions
Company Size and Strength Size: $10M minimum revenue with $1M EBITDA as a benchmark. Payroll Base: A large payroll base relative to the size of the transaction will allow the company to repay principal with tax deductible dollars. In general, you need payroll equal to 4x the required principal payment. Leveraged ESOPs require an unencumbered collateral base.
What Matters? Key Considerations For A Successful ESOP Remember – there are always exceptions
Management Team There must be strong successor management with a proven performance track record.
Management team must have experience operating business in leveraged environment.
In all likelihood key members of management will be asked to sign an employment agreement for up to 3 years.
4 What Matters? Key Considerations For A Successful ESOP Remember – there are always exceptions Employee Base
Generally a company with sizeable US operation versus foreign.
Generally non-union employees in plan.
Low turnover versus high turnover.
ESOP Mechanics
What is an ESOP?
Retirement Plan – An ESOP is a qualified retirement plan – like a profit sharing or 401(k) plan. Designed to invest primarily in employer stock.
Permitted to borrow funds to purchase employee stock.
Employees share in allocations based on relative compensation.
5 What is an ESOP?
Corporate Finance Tool - An ESOP can be used as a flexible financial tool that enables owners of privately-held businesses to extract wealth from their companies, tax deferred or potentially tax-free. Purchase stock from one or more shareholders.
Raise capital for employer.
Sell division or subsidiary to employers.
Refinance existing employer debt.
Explanation of Typical Leveraged ESOP Structure The following example demonstrates how a leveraged ESOP with a back to back transaction could be arranged: ♦ The Company would borrow money from a Lender. ♦ The Company would use the loan proceeds to make a loan to the ESOP (can be on same or different terms). ♦ The ESOP would use the loan proceeds to purchase shares in the Company from the Company or existing shareholders, who would then have the use of the loan proceeds; and ♦ The Company would make annual contributions to the ESOP sufficient to amortize the debt (both principal and interest). ♦ The Company is able to deduct the contributions to the ESOP.
The typical leveraged ESOP would look like this . . . Leveraged ESOP
Company Loan Company Bank Company Loan Payments
ESOP ESOP Loan Cash Initial Transaction Loan Payments Contributions Annual Transactions
Stock Stock Employees Shareholders ESOP Allocations For Cash
6 Key Points to Note
If a Company makes a $10,000,000 loan to an ESOP (“Loan #2”), the Company can take a $10,000,000 tax deduction for the cash contributed to the ESOP to pay on the loan. This would not be true in a conventional loan structure. If the Company is in a 34% tax bracket, a $10,000,000 tax deduction will yield tax benefits of $3,400,000.00, and thus the government pays $3,400,000.00 of the loan. The ESOP allows a Company to obtain financing for a leveraged buyout through a loan repaid with pre-tax dollars.
Allocations Example
Shares are gradually allocated to employees over the term of the internal ESOP loan… Employee Salary % Shares A 28,700 28.7% 287 B 25,700 25.7% 257 C 18,000 18.0% 180 D 15,000 15.0% 150 E 12,600 12.6% 126 Total $100,000 100.0% 1,000
Other allocation methods may be used, e.g., considering age and/or years of service.
Special ESOP Considerations
Voting Rights Private company, voting normally by trustee of plan, or Plan Committee. Plan participants may vote shares allocated to ESOP account on major corporate transactions such as merger, sale of all assets (but not sale of stock).
Diversification of Investments When participant is at least age 55 and at least 10 years in plan, may request diversification of 25% of stock for 5 years. Then may request diversification of 50% of stock.
7 Special ESOP Considerations
Distribution of Benefits Normally at retirement, death, disability or termination of employment. In some cases, may delay distribution until 5 years after of the termination. Participant may demand payment in employer stock unless S Corporation, or corporate bylaws restrict ownership to active employees. Participant receiving stock from private employer ESOP may elect to sell to company (or ESOP). Employer may pay for stock purchased from participant in cash, or over 5 years with interest.
Special ESOP Considerations
Repurchase Liability Since private employer must “make a market” for stock distributed to terminated employee, must recognize and plan for the future obligation. Repurchase liability would be avoided upon future sale of company, or public offering of stock. Fiduciary Issues Decisions concerning ESOP stock are made on behalf of the plan participants. Decisions must be made based on what is best for the plan participants, not the officers or management.
ESOP Tax Incentives
Deductibility of ESOP contributions.
Deductibility of dividends paid to ESOP.
ESOP “rollover” of gain on sale by shareholder.
No income tax on business profits to extent S corporation stock is owned by ESOP. 100% ESOP = elimination of all income tax on profits.
8 Summary of ESOP Benefits
Company - receives income tax deductions The cash to make principal payments on the acquisition debt is deductible. Increased productivity by employee participants. Avoid income tax – S corporations.
Employee - participates in stock allocation Added retirement savings. Financial benefits of ownership – power to affect own wealth. Usually no “out of pocket” cost to employee.
Summary of ESOP Benefits
Owner (Selling Shareholder) - receives cash tax- deferred (IRC 1042) Defer (or avoid) 15% federal capital gains tax and state income tax (only available if company is C corporation). Diversification / creation of market for shares. Retain control of Company. Succession strategy with certainty of outcome. Continued involvement in business.
Bank/Sources of Capital Increased cash flow for debt service.
Tax Benefits of the S Corporation ESOP
♦ Common Stock of the Company is held by an ESOP. ♦ An ESOP is a qualified plan in which earnings of the plan are not subject to income tax.
9 Tax Benefits of the S Corporation ESOP
♦ To the extent S Corporation ESOP owns stock of company, since it is a tax exempt entity, federal income tax is eliminated. ♦ If ESOP owns 100% of S Corporation, complete elimination of income tax on business profits.
Case Studies
Case Study #1 XYZ, Inc. is owned equally by Mary and Jack. They started the company 25 years ago with no money. XYZ now has $20 million in revenue and a bright future. Neither Mary nor Jack have family involved in the business and both are in their 50’s. They are not ready to retire and walk away, but they have competent management and they would like to diversify their personal wealth and spend more time away from the company.
Is an ESOP a possibility? What considerations are necessary to answer that question?
10 Case Study #2
ABC Company is owned by Linda. Her son Bill has worked in the Company for years and is now CEO. Linda has always thought Bill would own the company some day but he does not have independent wealth and simply cannot afford to buy the company or borrow the funds to do so. Linda has other children, none of whom are involved in the company. She would like to sell the company and retire but she wants to be sure Bill can continue as CEO and control the company. She also wants to share her estate equally among all three children.
Can an ESOP help? What considerations are important?
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