ESOP Transaction
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ESOP Transaction

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The combination of corporate tax benefits, ownership control, improved debt repayment capabilities and legacy perpetuation persuaded Bret and Linda to hire SES Advisors to design an ESOP transaction that achieved their various objectives.

Bret and Linda were siblings and the second generation shareholders of a successful specialty manufacturing company located in southeastern Florida. Both were in their late 40s and actively engaged in the business. They were collectively responsible as primary drivers for the companys recent success in developing new product lines as well as penetrating several new markets. Both were acutely aware that that an overwhelming portion of their net worth and ultimately their retirement depended on the value of their companys stock. While the company experienced record revenue performance and profitability over the past several years, the business still remained volatile and subject to increasing competition. The companys outside accounting firm and its bankers frequently asked Bret and Linda about their financial end-game for the company: What will happen to the company when it is time for the two siblings to retire from the business? While Bret and Linda down-played the immediacy of preparing for an exit that seemed many years away, they were both in agreement on issues recently surfaced by Lindas personal financial advisor: their financial well-being hinged on one primary investment and, as a result, they each lacked a well-diversified portfolio of financial assets.

Diversification became a primary personal objective. However, achieving this objective would be far from easy. If an investor determines that he or she wishes to diversify away from a particular publicly traded security in their portfolio, selling the security for cash is a fairly straight-forward process involving a sale through their broker or investment advisor. This is not the case for shareholders of private companies. There are no public exchanges where you can conveniently sell private company stock. Faced with this predicament, Lindas personal financial advisor suggested that both siblings meet with SES Advisors to discuss the options available for selling their private company stock.

The consultants from SES Advisors spent considerable time with Bret and Linda with the objective of understanding their personal and corporate goals. Not surprisingly, a primary objective was achieving a fair value for their shares in the company. Since they were not ready to retire, they were seeking to sell only a portion of their shares and, as a result, they wanted to maintain full control of the company. The companys success was in part due to its ability to quickly and opportunistically invest in new equipment and operations. It was therefore important to maintain flexibility and borrowing capacity for future business opportunities. Finally, Bret and Linda had a paternalistic approach toward their employees and this aspect of the corporate culture fostered a productive and symbiotic relationship with their workforce. This was one of several characteristics of the company that they were seeking to perpetuate long after they stepped down from the business.

SES Advisors conducted additional due diligence on the company’s strategy, its business model, industry and financial profile and completed an analysis that included several options to address Bret and Linda’s financial diversification and other objectives:

Sale of the Company: This option arguably could possibly provide the highest value for Bret and Linda; however it was the least attractive alternative for several reasons. Bret and Linda both clearly wanted to reduce their financial dependency on the company; however, a critical objective was to cause no disruption in the management and control of the business. They desired to continue growing the companys success over the next several years and they were not yet ready to retire. They were proud of the companys culture and dedicated employees, and they were not in a position to jeopardize the continued success and legacy by way of a third-party acquirer. Finally, many of the would-be acquirers were competitors to the business, and Bret and Linda were unwilling to open their company and books due to the highly competitive nature of their business and the reality that many times corporate sale transactions fall apart.

Private Equity Investment: A private equity firm could make a minority interest investment that would essentially buy a portion of Bret and Lindas shares; however, the overall governance of the firm would need to be changed to allow the private equity firm to influence corporate decision making. Bret and Linda were dubious to take on private equity investors as partners because the private equity investment horizon was approximately five years. The private equity firms could force the company to forego profitable business opportunities in order to pay for the redemption of the private equity firms investment. Given that Bret and Linda had no desire to take the company public in an initial public offering, the block of shares that they were trying to sell in the immediate future would need to be cashed out again within a five to seven year period. Two stock transactions on the same block of shares within a five to seven year period seemed daunting and unattractive.

Management Buyout: Bret and Linda were fond of the idea of the companys management team acquiring a minority interest in the company by purchasing stock from Bret and Linda; however, none of the key managers had accumulated enough savings to provide any meaningful funding for a transaction. SES Advisors explained that a better means of providing stock benefits to management would include a long term equity incentive program whereby the company granted an equity interest in the company to the key managers. The cost of the equity would be paid for by the company; however, the key managers would be responsible for the income taxes associated with the benefit.

Employee Stock Ownership Plan: An ESOP is a retirement plan (similar to a profit sharing plan) that can be created by the company to acquire company stock from Bret and Linda. The qualified retirement plan status allows the company to deduct the cost of the entire ESOP stock purchase transaction for tax purposes over the life financing arranged to fund the ESOPs stock purchase. In essence, this allows the company to deduct both the interest expense and the principal payment of the ESOP loan.

Bret and Linda were pleased to learn that the shares acquired by the ESOP would benefit the companys employees; however, they were concerned about disclosing information such as financial data and compensation to the employees to which shareholders are normally entitled. This concern was addressed by the fact that the ESOP trust created by the company is the owner of the stock for the benefit of the employees and, since the employees are therefore not direct shareholders, they are not entitled to the same rights to sensitive information to which direct shareholders are entitled. Bret and Linda were further assured that the trustee of the ESOP would be selected by the companys Board of Directors.

Leveraged Stock Redemption: A fairly straight-forward liquidity transaction involves the company borrowing debt and using the proceeds to redeem some of the shares owned by Bret and Linda. This alternative achieves Bret and Lindas objective of diversifying their net worth; however, as compared to the ESOP alternative, the clear disadvantage is that the company would be required to repay the debt principal payments on an after-tax basis. Hence, if the leveraged stock redemption required that the company borrow $25 million to fund the transaction, the company would need to produce pre-tax profits of approximately $42 million to repay the debt principal over the five-year term of the loan.1 The leveraged redemption would maintain complete ownership with Bret and Linda, but it would be more costly to fund.

1 Assuming a 40% marginal federal/state income tax rate, $42 million of pre-tax profit will result in $25 million of net income available to pay the principal

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