Exiting Gracefully:
Options for Transitioning Ownership
Corey Rosen
National Center for Employee Ownership
Moderated by: Diane Stoneman, Director of Consulting and Training,
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Our Agenda Today
• Three options for transitioning
ownership
• Discuss each option in detail
• Pros and cons
• Questions
Featured Presenter
Corey Rosen
National Center for Employee Ownership
(NCEO)
Laying out the Options
1: Sell to Employees Directly
2: Selling to Third Party
3: Use an ESOP to Buy Out Owner
Option 1: Sell to Employees Directly
• Employees come up with cash out of
after-tax dollars
• Employer loans $$ at reasonable rates
• Owner takes a note to finance sale
• Employees forego bonuses to pay loan
• Owner gets capital gains if stock is sold.
If assets are sold, company may have
capital gain as well.
Reducing Costs to Employees
• Sale price reduced by leasing tangible or
intangible assets (e.g.: intellectual property,
company’s name). Paid for in pre-tax corporate
dollars, owner pays income tax.
• Owner agrees to compensation agreement
and/or non-compete agreement in return for
taxable consideration as part of sale price.
• Part of sale price structured as earn-out. Not
deductible; if properly structured, may be
capital gain to seller.
Option 2: Selling to Third Party
• Hard to find these days
• Synergistic buyers pay a premium
• Financial buyers pay a multiple of future
free cash flow
• Both may require an earn-out of some
kind and have various other financing
contingencies
What to Look For in Outside Buyer
• Financial strength: do they have cash or
ability to borrow money? If they are
financing payment, is there collateral?
• Record of successful acquisitions
• Acceptable plans for future of business
and employees
• Reasonable requirements for what the
seller will subsequently do
• Acceptable time frame
Option 3: ESOP to Buy Out Owner
How An ESOP Buys Out an Owner
• Company sets up employee benefit trust
• Contributes cash to buy shares or
• Borrows money through plan to buy
shares
• Employees do not buy the stock
• Contributions tax deductible, even when
used to repay a loan (principal and
interest), up to 25% of eligible pay
How Much Will ESOP Pay?
• Price not be higher than fair market
value on a financial basis as
determined by independent appraisal.
• Negotiations over sale terms can only
be to produce a better price than that
set by the appraiser.
• ESOP cannot pay synergistic value.
• Minority ownership sales are valued at
less per share than control sales.
Elements of Valuation
• Most important is multiple of future free
cash flow or discounted future cash
flow over an number of years.
• Comparable company sale data and, if
applicable, public company comparison
data will be factored in.
• Asset value usually least important
factor, but valuable non-performing
assets may add to value.
Benefits to Seller
• If ESOP owns 30% or more after sale in C
corp., seller can defer tax on sale gain if
reinvested in stocks and bonds. If not,
sale qualifies as capital gain.
• If company is an S corporation, deferral
not possible, but capital gains deferral is
not available, but other tax benefits are.
• ESOP buys some stock now, some later.
• Sale accomplished in pre-tax dollars.
Rules for Owners in Section 1042
• Stock held for at least 3 yrs.
• Only privately held C corps. qualify.
• 30% rule: ESOP must own 30% of
stock after transaction; synthetic equity
(options) considered outstanding stock.
• Direct family members, sellers, and
25% owners can’t get allocation of
shares in ESOP subject to deferral of
taxation. Can if the seller opts not to
take deferral.
Eligible Investments
• Sellers have 12 months after sale to
reinvest in “qualified replacement
property” (QRP).
• QRP must be securities of domestic
operating companies not making more
than 25% of income from passive
investment (mutual funds, gov’t bonds).
• Gain on sale of any QRP is taxed using
original basis of company stock with
ESOP.
Sales in a S Corporation
• The tax deferral is not available.
• ESOP profits not subject to federal,
and usually state, income tax.
• Subject to anti-abuse rules, seller,
25% owners, and family members can
get ESOP allocations.
• Distributions made to other owners
must be made pro-rata to ESOP, but
can be used to buy additional shares.
Funding Options
•
Banks loan money to company which loans to
ESOP, which uses cash to buy owner’s shares.
•
Sellers finance transaction with note, can get tax
deferral on what they reinvest in first 12 months.
•
Company contributes cash to buy shares that year
OR build cash reserve to make larger purchase
later on.
•
In limited circumstances, some portion of funds in
existing defined contribution plans may be used to
help fund the ESOP (fiduciary issues arise.)
Key Points to Remember
• Company, not employees, fund plan.
• Acquisition of shares is nonproductive expense, company must
have earnings to absorb it.
• ESOPs only way a company can use
pre-tax dollars to buy out an owner.
Leveraged ESOPs
• Plan can borrow money to buy existing
shares or new shares to fund growth.
• Company contributes cash to ESOP to
repay loan and takes a tax deduction.
• Shares into a “suspense account;” as
they are paid for get released to
employee accounts.
Contribution Limits
• Generally, 25% of compensation of
employees covered by plan.
• If ESOP loan, in a C corp., interest
payments and dividends don’t count
toward limit; in S corp., they do.
• Not more than 100% of pay or $49,000
(in 2009) can be added to an
employee’s account each year from all
defined contribution plans.
Participation, Vesting, and Allocation
• Employees have individual accounts.
• Company contributes cash to buy stock,
contributes stock, or plan borrows to buy
shares.
• Accounts subject to vesting not more
than 6 yrs.
• Generally, full-time employees with
1,000 hours/yr must be included in plan.
• Allocations can be based on relative pay
or more level formula. No discretionary
or merit based.
Distribution
• Employees get distributions not later
than one year after death disability, or
retirement, or
• Five years after the end of plan year for
other terminations.
• Paid out in installments up to 5 yrs.
• Employees with 10 years in plan who
are 55 or older can diversify part of their
stock accounts.
Paying for Distribution
• Company must assure employees get
fair market value for stock, but can put
cash into the plan to do this.
• Employees have a put right for shares
distributed to them.
• Distributions are taxed same way that
other distributions from defined
contribution plans are taxed.
Governance Issues
• Limited employee voting rights
• Plans governed by a trustee appointed
by the board
• ESOP committee to assist in process
Costs Issues
• First yr costs typically $40,000 and up.
• Ongoing costs as low as $15,000 or so,
depending on size of the company,
changes in the law, and other factors.
• ESOPs more expensive than other
plans, but much less expensive than
selling a business in other ways.
S Corporation Issues
• ESOP’s share of taxable income not
subject to federal and, usually, state
income taxes. 100% S ESOPs pay no
federal and, often state income tax.
• ESOP is one shareholder.
• Sales to ESOP not qualify for tax deferral.
• Contributions limits can be lower because
interest, as well as principal payments on
the loan count towards the limits.
Equity to Employees Outside ESOP
• Employees can individually be
granted equity rights
• Stock options
• Phantom stock and stock
appreciation rights
• Restricted stock
• Bonus shares
Further Resources
• Selling to an ESOP (NCEO, $25 to
members; $35 to non-members)
• Introductory consultation on equity
compensation available from NCEO;
contact Corey crosen@nceo.org
• NCEO web site: www.nceo.org
Upcoming 2009 Webinars
May 27 Two Perspectives on Succession
Paul Silvis, Founder, Restek Corp;
Michael Foley, CEO, Reflexite Corp
June 17 The Story of Transforming an American Icon
Robert F. Pasin, President and CEO, Radio Flyer
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