Nevada Society of Certified Public Accountants
3rd Annual Southwest Tax Conference
December 7, 2011
Employee Stock Ownership
An Introduction to ESOPS
John A. Kober
Morgan, Lewis & Bockius LLP
1717 Main Street, Suite 3200
Dallas, TX 75201-7347
214-466-4105
John R. Maxfield
Holland & Hart LLP
555 17th Street, Suite 3200
Denver, CO 80202
303-295-8341
Outline
• Identify when ESOP opportunities are the
right business transition solution
• Educate attorneys and CPAs
• Starts with goals of the current owners
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Selected Uses of an ESOP
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Provide business continuity
A tax-advantaged corporate finance tool
Build a stronger corporate culture
Provide liquidity for existing shareholders (without necessarily
relinquishing control)
Create a charitable giving tool
Part of a poison pill, restructuring or acquisition strategy
Asset diversification for the existing shareholders
An estate planning tool for the existing shareholders
Spread ownership among most employees
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“Partial” ESOP As Alternative to Taxable
Recapitalization/Redemption and IPO
Taxable Recapitalization/
Redemption
IPO
ESOP
Company
Company
Company
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Stable Company
Privately Held
Shareholders Desire Liquidity
No Current Need for Capital for
Growth
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Steady Growth Company
Often Closely Held (may be a
professional Service Company)
Shareholders Desire Liquidity
Strong Ongoing Management Team
Perpetuation of Culture
No Current Need for Capital for Growth
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Steady or High Growth Company
Significant Use for Growth Capital
Desires Significant Capital Markets
Access
Sophisticated Operational and
Financial Management
Transaction
Transaction
Transaction
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Provides Partial Liquidity
Shareholder Group Retains
Control
Dividend Tax Rate
Debt/Private Equity/Sale Lease
Back Real Estate
Tax Inefficient for Company
Dilution Only if Private
Equity/Mezzanine Investor Involved
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Provides Partial Liquidity
Shareholder Group Can Retain Control
Financial Buyer Valuation Metrics
Tax Incentives Enhance Transaction
Economics
Estate Planning Benefits
Family/Succession Planning Benefits
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Creation of Liquid Market in Company
Shares Depending on Public Float
Achieve Public Fair Market Valuation
Access to Growth Capital
Diversification of Shareholder Base
Regulatory and Compliance
Requirements
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Sample ESOP Transaction
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2.
3.
4.
An ESOP Trust is formed
Bank lends money to the Company
Company lends money to the ESOP Trust
Stock is purchased from the Shareholder by the ESOP Trust at the current fair value of the shares
purchased. ESOP holds stock for employees and periodically notifies employees how much they own
and how much it is worth
5. Company makes tax deductible contributions to the ESOP which the ESOP uses to repay the company
for the stock it purchased.
6. Company makes annual payments on the debt to the Bank until debt is retired
7. Employees receive credit for the stock that has been “paid for” and separation from service (i.e.
retirement, termination) employees receive stock or cash in an amount equal to their vested account
balance which is directly impacted by the change in the fair value of the stock at the time of separation
stock
Existing
Shareholder(s)
1
4
ESOP Trust
Loan $$
Employees
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$$
3
Company
$$ or stock
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2
6 Payment $$
Bank
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ESOP Financing:
Where Does the Money Come From?
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Most ESOP transactions are leveraged
– Externally through independent sources of financing
– Internally using cash on the company’s books
– Using seller financing
– These can work independently or in combination
Financing categories
– Senior bank financing is the least expensive “slice”
– Cash flow loans
– Asset-based loans
– Subordinated (“Mezzanine”) debt can get quite expensive
– Seller financing can be structured as either senior or subordinated
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How much of each category depends on the situation
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Ideal Candidate Attributes
• Closely held corporation (C or S)
• Profitable with strong and steadily increasing cash flow
• Corporate culture suited to employee ownership
• Owners seek liquidity and/or diversification
• Company has borrowing capacity
• Strong ongoing management bench
• Substantial payroll
• Stable employee base
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The ESOP Owned S Corporation
• After 1998, ESOPs may own stock in S corporations
– Earnings of an S corporation are taxable to the
shareholders based on their ratable shareholdings
– ESOP ownership is attributed to the Trustee (not the
participants) – treated as a single shareholder
– ESOP Trustee is exempt from income tax under IRC Section
501(c)
– To the extent of the ESOP’s ownership, corporate earnings
are tax free
• Must meet the S corporation ownership rules and
there are anti-abuse rules to follow
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The ESOP Owned S Corporation
Tax Reporting for 100% ESOP Owned S Corporation
Company
Taxable Income
Shareholder ESOP Trust
Tax Liability
$0
State & Federal
Government
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Advisors
Trustee
Owners/
Shareholders
Company
ESOP
ESOP
Consultant
Lender
CPA
Attorney
Estate/Family
Planning Advisor
CPA
Attorney
Investment
Advisor
Attorney
Valuation
Company
Third Party
Administrator
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Sample ESOP Implementation
• Interview and retain advisors
– Preliminary evaluation and design (including feasibility study)
– Legal
– Trustee
– Valuation firm
• Financing
• Legal and financial due diligence
• ESOP and NQ plan design
• Negotiations
• Corporate revisions
• Documentation
• Closing
• Communication
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The Ownership Culture Reward
• Ownership proven to impact company performance
– 70 percent report revenue increase
– 64 percent report profitability increase
– Default rate on bank debt is two thirds the rate of non-ESOP
companies
– 60 percent of ESOP companies report productivity increases
– 80 percent of ESOP companies indicate the ESOP is a major benefit
in recruiting new employees
– Retirement plan contributions are double the amount of non-ESOP
companies
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Other Benefits to Company
• Cultural maintenance or enhancement
• Keep current management in place
• Current owner(s) stay involved and possibly
maintain control
• Effective deductibility of both principal and
interest repayment
• 100% ESOP-owned S Corps can effectively
become tax exempt business
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Benefits to Selling Shareholder(s)
• Liquidity and diversification
• Tax deferral opportunity (C Corp only)
• Owners may retain control
• Can be used for estate planning
– including potential for enhanced liquidity, date of death
basis step-up in “QRP” and/or reduced value for gifting
purposes due to leverage incurred (can apply to
company shares, seller notes and warrants)
• Enhanced charitable giving opportunities
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ESOP trustee has fiduciary
responsibility
Board owes duty of care &
loyalty to shareholders
Shareholders
ESOP participants have beneficial
ownership interest
BOD
Officers
Shareholders & trustee
vote for Board
How a Typical ESOP
Company is Organized
Mgmt
Employees
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Corporate Governance – Is This Important from Tax Standpoint
Independent
Capital Gains Treatment
Tax Abuses
Directors
Redemption – True Sale
1042 ESOP Purcahse
Entity
 Corporation
 LLC
 Partnership
Leverage
Debt
Equity
Seller
Contractual
Rights
Family
Assets
S–
CorporatiVs.
CCorporations
Trustee
of ESOP
S-Corporation
 Corp
 Individual
Synthetic Equity
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Potential Barriers to a
Successful Transaction
• Selling shareholders goals:
– Looking for a strategic valuation or has an unrealistic
expectation for the company’s value
– Wants to concentrate ownership in the hands of a few
individuals
– Requires best practices for corporate governance which is
a change for some family owned businesses
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Potential Barriers to a
Successful Transaction
• Company characteristics:
– Startup or early growth phases of life cycle
– Successor management is inadequate or nonexistent
• Must be able to understand complex ESOPs issues
– Company has no additional debt capacity
– Too few employees
– Transaction due diligence and costs may be too high – cannot cut
corners!
– May complicate subsequent company sale
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Sample ESOP Transaction - Take 2
20% Shares
2
80%
Shares
Shareholder
notes 5-10
years at 3.53%
interest plus
warrants
1A ESOP Loan
15 -25
Year Note
1A
1B
Share Redemption
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Sale to the ESOP
Cash
1B
SARs for key
management
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What Happens to Contribution
1. Company makes
annual contributions or
dividends to the ESOP
The Company
2. Trustee uses
contributions to repay
the ESOP loan
ESOP Trust
Unallocated
Account
Participant Accounts
3. As loan is repaid, stock
is allocated
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ESOP Care and Feeding
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Annual valuation
Plan document maintenance
Participant communication
Corporate formalities
Can be difficult to eliminate
– Terminate
– Heightened fiduciary standards if ESOP is seller
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Variations on Leveraged ESOP
• Selling shareholder finances
• ESOP borrows directly from lender
• Company redeems all (or most) stock from
shareholder, then sells to ESOP (or contributes
over time in contributory ESOP)
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Summary of the Meeting with
the Senate Finance Committee
Tax
Valuations
ESOP Leverage
Tax Abuses
Enhancements
Tax Revenues
Types of
Transactions
Senate
Family
Finance
Committee
Assets
S–
Corporations
Vs.
Jobs
Creation
Community
Advisors
Wins
Success of Company
C-Corporations
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Administrative Conference of the United States
• Reconstituted in 2010
• Independent Federal Agency
• Designed to Study Administrative Processes of the Federal
Government
• Recommend Specific Proposals to Improve Procedures
• Appointees
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Questions?
5267751
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