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STEP BY STEP PROCESS FOR
SELLING YOUR BUSINESS TO YOUR EMPLOYEES
Financing an ESOP
Acquisition
Akron, OH
April 21, 2006
Kurt W. Nichols
Vice President
ESOP Financial Services
312 904-5059
kurt.nichols@abnamro.com
I.
MECHANICS OF ESOP FINANCING
II. UNIQUE FINANCIAL CHARACTERISTICS
III. SOURCES OF ESOP FINANCING
IV. PREPARING TO SHOP FOR ESOP FINANCING
V. WHAT TO LOOK FOR IN YOUR LENDER
VI. IRS CIRCULAR 230 DISCLOSURE
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MECHANICS OF ESOP FINANCING
MECHANICS OF ESOP FINANCING
Tax Deduction of Principal & Interest
Structure
Leveraged ESOP Purchase of Existing Stock
 The Company creates an ESOP Trust
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 The Company borrows funds and
re-lends the proceeds (“inside loan”) to
the ESOP
 The ESOP uses the funds to purchase
shares from existing shareholders. The
shares are held in a suspense or
“contra equity” account
Company
Loan
Lender
Inside Loan
Stock
ESOP
Trust
Shareholders
Cash
Repayment of ESOP Financing
 The Company services the new debt
by making tax deductible contributions
to the ESOP. In turn, the ESOP repays
the inside loan to the Company and the
Company repays the debt to the lender
 As the Company makes ESOP
contributions, and the inside loan is
repaid, shares are released from the
suspense account and allocated to the
employee accounts
Lender
Note Repayment
Company
Dividends & Contributions
Note Repayment
ESOP
Trust
MECHANICS OF ESOP FINANCING
Tax Deduction of Principal & Interest
• ESOP Tax Savings
(000’s omitted)
Operating Profit
ESOP Expense
(Principal Payment)
Pre-tax Income (EBIT)
TAXES (40%)
Cash Available
Debt Payment
Excess Cash after Debt
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NON-ESOP
$10,000
C-CORP ESOP
$10,000
$0
($4,000)
$10,000
($4,000)
$6,000
$4,000
$2,000
$6,000
($2,400)
$3,600
$0,000
$3,600
MECHANICS OF ESOP FINANCING
Deferral of Capital Gains for Selling Shareholders
C-Corp Transactions
Seller Defers Capital Gains Tax – 1042 Rollover
 Shareholders selling at least 30% of
their stock to an ESOP will be able to
defer capital gains tax indefinitely
 Properly structured, the seller’s
proceeds may eventually be transferred
to the seller’s estate with a tax-basis that
is “stepped-up” to the sale price,
effectively eliminating forever the
deferred tax associated with the original
sale of the stock
(000’s omitted)
ESOP
Transaction
Non-ESOP
Transaction
Sale Proceeds
$10,000
$10,000
Less: Capital
Gains Tax @ 15%
0
($1,500)
After-Tax
Proceeds
$10,000
$8,500
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MECHANICS OF ESOP FINANCING
Tax Exempt S-Corp ESOP
• An ESOP is a tax exempt entity. In 1998, ESOPs were allowed to own stock in
S-Corporations
• If the ESOP owns 100% of the common stock, the Company can elect SCorporation tax status and avoid paying federal income tax completely
• By reducing its debt balances (all other things being equal), a Company is able
to generate additional value for its equity holders
(000’s omitted)
YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5
Pre-tax Income (EBIT)
$10,000
$11,000
$12,000
$13,000 $14,000
Tax Savings @ 36%
$3,600
$3,960
$4,320
$4,680
Total Cash Savings to
Sub-S Election
5-Year Average Annual
Savings
$21,600
$4,320
$5,040
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UNIQUE FINANCIAL CHARACTERISTICS
UNIQUE FINANCIAL CHARACTERISTICS
Negative Net Worth
ESOP Accounting
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• Value of shares purchased by the ESOP creates a contra-equity item
• May create negative net worth
−Accounting anomaly
−Standard bank measure of leverage, liabilities / equity, is not applicable
−Need a lender experienced in ESOP financing
(000's omitted)
Pre-ESOP
ESOP
Post-ESOP
Assets
Liabilities
$5,000
$2,000
$0
$4,000
$5,000
$6,000
Equity (Net Worth)
$3,000
($4,000)
($1,000)
0.67
Negative
Negative
Leverage (Liabilities / Equity)
UNIQUE FINANCIAL CHARACTERISTICS
Highly Leveraged Cash Flow
(000's omitted)
Pre-ESOP
Post-ESOP
Senior Debt
$2,000
$6,000
EBITDA
$2,000
$2,000
Leverage (Debt / EBITDA)
1.00x
3.00x
• Redefine leverage
−Debt / EBITDA + “E”
* “E” = ESOP benefit
expense
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UNIQUE FINANCIAL CHARACTERISTICS
Highly Leveraged Cash Flow
“E” – ESOP Benefit Expense
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• Tax deductible
• Can be up to 25% of qualified payroll
• Effectively a non-cash expense
−ESOP uses the benefit, contributed by the company, to
repay the “inside loan” from the company
(000's omitted)
EBITDA
Plus: "E" - ESOP Benefit Expense
EBITDAE
$2,000
$750
$2,750
UNIQUE FINANCIAL CHARACTERISTICS
Highly Leveraged Cash Flow
Greater cash flow available to service debt
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• EBITDA + “E”
(000's omitted)
Pre-ESOP
Post-ESOP
Senior Debt
$2,000
$6,000
EBITDAE
$2,000
$2,750
1.00
2.18
Leverage (Debt / EBITDAE)
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SOURCES OF ESOP FINANCING
SOURCES OF ESOP FINANCING
What Do Lenders Look For In Companies?
Characteristics
Less Favorable
Tolerable
Best
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Industries
High Tech
Cyclical
Non-cyclical/ nontech based
Life Cycle
Start-ups
Profitable last two
years
Mature
Customer
Concentration
A few large
customers
Top five over 50%
No concentration over
5%
$0 - $5 million
$5 - $10 million
Over $10 million
Earnings
(in EBITDA)
Competition
No barriers to entry
Multiple competitors
Significant barriers to
entry and limited
competition
Senior Management
New
Combination of new
and long-term
Seasoned with equity
stakes
SOURCES OF ESOP FINANCING

Asset Based Lenders
•
Cash Flow Senior Lenders
•
Subordinated Lenders (Institutional)
•
Seller Paper
•
Equity
- Institutional
- Employee-Based
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SOURCES OF ESOP FINANCING
Commercial Loans vs. Asset Based Loans
Commercial Loans
• Typically are less leveraged
• Due to bank comfort level, company has limited reporting
requirements
• Lowest “spread”/pricing
• Secured by assets – but limited monitoring
Asset Based Loans
• Due to higher leverage and or lack of earnings - banks very focused on asset
values/borrowing base
• Asset values need to be greater than loan needs
• Daily A/R reporting
• Weekly inventory reporting
• Lock-box mechanism
• More expensive
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SOURCES OF ESOP FINANCING
Asset Based Loans
Underwriting Criteria
Asset Values
Current Assets

A/R x 80%

Inventory x 50%
Fixed Assets
Security Interest

Equipment (OLV) x 80%

Real Estate x 75%
First Lien on All Assets
Pricing
“Floats” Based on LIBOR with Spread
of 175 to 325
Maturity
Three to Five Years
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SOURCES OF ESOP FINANCING
What if Debt Needs Exceed Loan Value of Collateral?

Asset Based with an Air Ball
•
Cash Flow Senior
•
Institutional Mezzanine Debt
•
Seller Debt
•
Equity
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SOURCES OF ESOP FINANCING
Asset Based with an “Air Ball”
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Underwriting Criteria
Security Interest
Asset Values and Short-Term Earnings
Outlook
Same as Asset Based
Pricing
“Floats” but Spread 50 to 150 Points
Higher than Asset Based
Maturity
Air Ball Portion Amortized Over Two
Years
SOURCES OF ESOP FINANCING
Cash Flow Senior Loan
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Underwriting Criteria
Security Interest
Enterprise Value (i.e. Multiple of
EBITDA) Not Asset Value
First Lien on All Assets
Pricing
“Floats” Based on LIBOR with Spread
of 300 to 375
Maturity
Five Years
SOURCES OF ESOP FINANCING
Institutional Mezzanine/Subordinated Debt
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Underwriting Criteria
Earnings/Enterprise Value
Security Interest
Earnings/Enterprise Value
Pricing
Fixed Interest Rate: 11% to 13%
Yield Enhancement: PIK Interest
and/or Warrants
Maturity
Six to Seven Years
SOURCES OF ESOP FINANCING
Seller Notes
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Underwriting Criteria
None
Security Interest
None
Pricing
Varies but Typically Fixed at a
Relatively Low Rate
Maturity
After All Other Debt
SOURCES OF ESOP FINANCING
Equity Capital
Institutional Equity
•
Pricing: 20% – 30%
•
Board Rights
•
Exit Rights
•
Typically a Mezzanine or Private Equity Fund
Employee Based Equity
•
Existing ESOP
•
401K/Pension/Profit Sharing Assets
•
“Hard Dollars” from Management
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SOURCES OF ESOP FINANCING
Current Market Conditions
•
Strong Supply of Capital
- Traditional Senior Lenders are lending again
- Hedge Funds, Insurance Companies, Mutual Funds,
Institutional Mezzanine Funds – All “Chasing Yield”
- Private Equity
•
Rising Rates Yet Lower “Spreads”
•
Increased Leverage
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PREPARING TO SHOP FOR ESOP FINANCING
PREPARING TO SHOP FOR ESOP FINANCING
What to Present to Your Potential Lender
• 3-5 years of historical financial statements
• 5-7 year financial forecast with assumptions
• Feasibility study or summary of ESOP facts
• Collateral support
−A/R aging
−Inventory breakdown
−Fixed asset schedules
• Description of business and market forecast
• Outline of management
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WHAT TO LOOK FOR IN YOUR LENDER
WHAT TO LOOK FOR IN YOUR LENDER
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ESOP Experience
-
How many ESOP transactions completed?
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•
Does the decision maker understand ESOP financing?
-
The vast majority of lenders have either a credit committee or a credit
officer that makes the decision whether or not to lend
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Commitment to the ESOP community
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Member of The ESOP Association
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Current with critical issues affecting ESOP’s
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Understand current ESOP market dynamics
Commitment to your type of transaction
-
Structure (asset based/cash flow)
-
Size (small business, middle market, large corporate…)
-
Industry (service, specialized, manufacturing, construction…)
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IRS CIRCULAR 230 DISCLOUSRE
IRS CIRCULAR 230 DISCLOSURE
To ensure compliance with requirements imposed by the IRS, we
inform you that any tax advice contained in this communication
was not intended nor written to be used, and cannot be used, for
the purpose of: (i) avoiding penalties under the Internal Revenue
Code; (ii) avoiding penalties under applicable state or local tax
law; or (iii) promoting, marketing, or recommending to another
party any transaction or matters addressed by this written advice.
All parties should seek tax advice based on that party's particular
circumstances from an independent tax advisor.
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