Webinar Slides: Private Equity Firms - The Role of ESOPs in Your Deals


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Original air date:
Oct. 24, 2013
View a recording at http://www.mhmcpa.com

Employee stock ownership plans (ESOPs) can be an effective option for private equity firms seeking to exit a portfolio company position, as well as offering opportunities for investment and/or acquisition strategies while improving tax advantages.

This course from Mayer Hoffman McCann P.C. will cover purchasing a company that is partially or wholly owned by a qualified ESOP, selling all or part of a portfolio company to a qualified ESOP, and providing mezzanine capital in a third-party’s qualified ESOP transaction.

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Webinar Slides: Private Equity Firms - The Role of ESOPs in Your Deals

  1. 1. Executive Education Series: The Role of ESOPs in Private Equity Firms Presenters: Hal Hunt and Cindy Dwyer – MHM Shareholders Brooks Myhran – Managing Director, Verit Advisors Mark Welker – Partner, Husch Blackwell October 24, 2013 Co-presenters from:
  2. 2. Before We Get Started…  To view this webinar in full screen mode, click on view options in the upper right hand corner.  Click the Support tab for technical assistance.  If you have a question during the presentation, please use the Q&A feature at the bottom of your screen. #MHMwebinar 2
  3. 3. CPE Credit  This webinar is eligible for CPE credit. To receive credit, you will need to answer periodic polling questions throughout the webinar.  External participants will receive their CPE certificate via email immediately following the webinar. #MHMwebinar 3
  4. 4. Today’s Presenters Hal Hunt, CPA Shareholder 913.234.1012 | hhunt@cbiz.com Hal leads MHM’s Employee Benefit Plan (EBP) Audit Practice. With over 25 years of diverse experience with EBP accounting, auditing and compliance issues, he is also a member of the firm’s Professional Standards Group as EBP subject matter expert. As the EBP National Practice Leader, Hal is responsible for providing internal training, along with providing technical support to engagement teams, serving as engagement quality reviewer and developing resource tools for our EBP audit professionals. He served on the AICPA’s Employee Benefit Plan Audit Quality Center (EBPAQC) Executive Committee and is currently a member of the EBPAQC ESOP Task Force. Cindy Dwyer Shareholder 913.234.1022 | cdwyer@cbiz.com Cindy is the President of MHM Retirement Plan Solutions and a Shareholder of Mayer Hoffman McCann P.C. She supervises staff, oversees technical research, and provides quality control services. She has previously served as the national Chairperson of the American Institute of Certified Public Accountants Employee Benefits Technical Resource Panel (TRP) and has recently been reappointed as a member of the TRP. Additionally, Cindy has been a recurring speaker at the American Institute of Certified Public Accountants National Conference on Employee Benefit Plans. Cindy is also a committee member and current chair of the Employee Benefits Institute sponsored by UMKC School of Law. #MHMwebinar 4
  5. 5. Today’s Presenters Brooks Myhran Managing Director, Verit Advisors 612.766.4055 | brooks@verit.com Brooks has more than 25 years of investment banking experience executing mergers and acquisitions, going-private transactions, and recapitalizations, as well as extensive valuation experience providing a wide range of sophisticated financial advisory services, including all manner of fairness opinions, solvency opinions, and ESOP and non-ESOP appraisals and related valuation consulting. Mr. Myhran has broad industry experience with particular expertise in the consumer products, education, ethanol, financial services, household products, plastics, specialty retail, transportation, and travel-services industries. Mark D. Welker Partner, Husch Blackwell 816.983.8148 | mark.welker@huschblackwell.com Chair of the firm's Tax & Benefits Department, Mark is considered clients’ go-to advisor on any important benefit or compensation matter. He focuses on all benefit and compensation matters, including the creation and operation of employee retirement plans, deferred and equity executive compensation, employee stock ownership plans, and health and welfare plans. Mark is highly regarded for his strategies and management of fiduciary and tax disputes. #MHMwebinar 5
  6. 6. Disclaimer The information in this Executive Education Series course is a brief summary and may not include all the details relevant to your situation. Please contact your MHM service provider to further discuss the impact on your financial statements. #MHMwebinar 6
  7. 7. Today’s Agenda 1 Intersection of Private Equity and ESOPs 2 ESOP Overview 3 Private Equity as a Buyer, Seller and Investor 4 Key ESOP Considerations for Private Equity 5 Case Studies 6 Summary #MHMwebinar 7
  9. 9. Where Private Equity and ESOPs May Intersect As a Buyer Purchase of a company that has an ESOP in place As a Seller Sale of a portfolio company to an ESOP As an Investor Provide capital to a company implementing an ESOP or to an existing ESOP company in need of financing There are a number of interesting and unique strategies for private equity firms that may involve ESOPs. #MHMwebinar 9
  11. 11. What is an ESOP? Transition Alternative Liquidity Tax Advantages Employee Benefit Plan #MHMwebinar ESOPs, which can and do pay fair market value, often compare favorably to more traditional transition alternatives such as private equity, a strategic sale, or a dividend recap, depending on transaction objectives and current market dynamics. An ESOP is an innovative liquidity tool that provides tremendous flexibility for shareholders. An ESOP provides distinct tax incentives to businesses and their owners. An ESOP provides an incentive for employees to grow the company’s value because they share in company stock appreciation. 11
  12. 12. How Does an ESOP Work? (1) Company sets up an ESOP Trust. (2) Company makes annual tax-deductible contributions in cash or stock to the ESOP. (3) Cash is used to buy stock from current shareholders. (4) Shares are allocated to the accounts of eligible employees within the ESOP based on salary. (4) ESOP holds stock for employees and annually notifies them of how much they own and how much the stock is worth. (4) Employees receive stock or cash after they retire or leave the company, a vesting schedule applies. #MHMwebinar 12
  13. 13. How Does an ESOP Work?  The ESOP receives a loan and uses the proceeds to purchase stock from current shareholders.  These shares are held in trust and are released into employee accounts at a rate corresponding to debt amortization. #MHMwebinar 13
  14. 14. How Does an ESOP Work? 1) 2) 3) 4) 5) 6) Lender lends to company. Company lends to ESOP. ESOP buys stock from existing shareholders. Company makes annual tax-deductible contributions to ESOP. The ESOP then repays company and company repays lender -- although those two amortization schedules are usually different, so the repayments won’t be the same dollar amount. Employees receive stock or cash when they retire or leave (vesting schedule). #MHMwebinar 14
  15. 15. ESOP Lenders    Owner/Selling Shareholder  Take back a note in exchange for shares  Taxed on principal upon receipt at capital gains and interest as ordinary income (if installment sale treatment is elected)  Advantage: Entitled to higher interest rate; subordinated to bonding company and bank  Disadvantage: 1042 Tax Free Roll over requires proceeds to be reinvested within 12 months Bank  Loan is to the company which makes a loan to ESOP  Typically 7 years  Assessment of company credit  Advantage: Selling shareholder ends up with cash up front  Disadvantage: Lenders look to collateralize short fall with proceeds, Bank will not subordinate to bonding company The Company  Cash rich company can make loan to the ESOP  Advantage; Company repays itself with market rate of interest #MHMwebinar 15
  16. 16. ESOP Overview Approximately 11,000 ESOPs in the U.S., covering 10.3 million employees (10% of the private sector workforce) across a wide spectrum of industries   About half of ESOP companies are majority-owned by the ESOP At least 70% of ESOP companies are or were leveraged, meaning they used borrowed funds to acquire the employer securities held by the ESOP Total assets owned by U.S. ESOPs is estimated to be $870 billion   ESOP TIMELINE  Employee Retirement Income Security Act of 1974 (ERISA) 1950’s  ESOP concept developed #MHMwebinar  ~4,000 ESOPs by 1980 1970’s  ~1,600 ESOPs by 1975 Source: The ESOP Association  ESOPs become eligible to hold shares of S-Corporations Jan. 1998  2001: Clarification and definition of abusive SCorp ESOP structures – 409 (p) 1990’s  ESOPs used as a hostile takeover defense – selling or contributing equity to an ESOP Today  ~8,000 ESOPs by 1990   3,700 S-Corp ESOPs 57% of S-Corp ESOPs are majority owned 16
  17. 17. Where ESOPs Work Well Company Characteristics         Strong cash flow and debt capacity Labor is a significant contributor to company value Company currently pays meaningful income taxes (e.g., service businesses with few or no available deductions) Strong and experienced management team Significant employee ownership is operationally beneficial through culture and best practices Little or no presence of aggressive strategic acquirers or an initial public offering alternative Modest but reliable growth prospects Failed M&A process #MHMwebinar 17
  18. 18. Where ESOPs Work Well Seller Characteristics  Confidentiality, certainty to close, and abbreviated process length are highly valued  Diversification and some liquidity at closing is sought but ongoing operating and governance influence is desirable  Desire to sell business today and retain the opportunity to participate in significant future equity appreciation Over the decades ESOPs have been in place, certain characteristics , including both industry and company dynamics, have contributed to ESOPs being a superior transaction alternative. #MHMwebinar 18
  19. 19. Special ESOP Tax Incentives S-Corporation ESOPs  Company     ESOP is a tax-exempt shareholder of an S-Corp. 100% ESOP-owned S-Corps pay no federal income taxes ESOP counts as one shareholder Per IRC 409(p), there are anti-abuse provisions to ensure the company cannot dilute the ESOP’s claim below 50% via warrants or other forms of synthetic equity while paying no federal income taxes C-Corporation ESOPs  Company    Tax shield (i.e., deductibility of principal and interest) up to 25% of payroll Dividends are tax-deductible (to the extent they are used to repay the ESOP / “inside” loan) Selling Shareholder    Tax-free rollover (IRC Section 1042) At least 30% of company equity must be sold to the ESOP Sale proceeds are subject to certain reinvestment restrictions #MHMwebinar 19
  20. 20. ESOP vs. Private Equity Valuation Methodologies Market Approaches Transaction Structure Income Approaches Guideline Public Company Precedent Transaction Discounted Cash Flow (DCF) Leveraged Buyout (LBO) ESOP Yes Limited Yes No Private Equity Yes Yes Limited Yes In our experience, both ESOP trustees and private equity funds rely upon public-company and transaction comparables for valuation purposes (to a lesser extent for ESOPs). Their use of income approaches, however, varies. ESOP trustees employ DCF analyses that rely upon management growth forecasts and ascribe considerable weight to their implications; private equity does so to a limited extent. Conversely, ESOP trustees do not consider LBO models, whereas private equity relies on this methodology extensively. Implications:  ESOP valuations are competitive with other alternatives.  Private equity values are frequently constrained by their LBO models’ comparatively high IRR targets (as well as the vicissitudes of the credit markets). #MHMwebinar 20
  21. 21. Valuation Multiples of Verit’s Recent ESOP Transactions Project Name Industry Total Enterprise Value / EBITDA Multiple Oregon Packaged Food & Meats 10.0x Colt Consumer Products 9.4x Carly Transportation 9.2x Black Swan Heavy Electric 8.1x Spike Office Furniture & Supplies 7.7x Shared Values Plastics & Packaging 7.6x Timberwolf Construction & Engineering 7.0x Echo Government Contractor 5.6x Razorback Metal Manufacturing 4.5x Average: Median: #MHMwebinar 7.7x 7.7x 21
  22. 22. Traditional ESOP and M&A Deal Terms Comparisons Traditional M&A Deal Terms* Traditional ESOP Deal Terms Trust Factor/Due Diligence Third party sale; more complex contract, generally forensic due diligence Unless seeking third party junior capital, “forensic due diligence” is not a requirement and highly unusual Transaction Form Buyer preference to purchase assets, or 338 (H) 10 election ESOP can only buy stock, cannot buy assets Typically based on working capital or earnings targets Generally not part of ESOP transaction Earn-outs Median earn-out can exceed 15% of purchase price Earn-outs are not generally part of an ESOP transaction Escrow/Holdbacks Ranges from 5% to 30% and is dynamic for specific companies and specific times Varies from transaction to transaction; generally an ESOP has either no or significantly fewer holdbacks Basket Average is +/-1% of transaction value About the same as an M&A deal Indemnification Cap Average is +/-15% of transaction value About the same as an M&A deal 18 months to 36 months Generally 18 months Purchase Price Adjustment Survival Period * Deal terms are subject to market conditions and change over time ESOP trustees typically rely heavily on extensive representations and warranties, so the due diligence process is generally simpler than other corporate finance alternatives. #MHMwebinar 22
  23. 23. ESOP vs. Traditional M&A Timeline to Close  An efficient ESOP transaction can be completed in approximately three months  ESOP transaction can provide greater certainty of closure and shorter process  M&A transaction requires more steps, third-party due diligence, and a less certain outcome  In M&A process, there is risk that the potential acquirer may delay or change the terms Months 1 ESOP Transaction Due Diligence, Valuation and Design Feasibility 2 Negotiate with Trustee, Credit Underwriting and Legal Documentation begins 3 4 5-8 8-12 Final Documentation, Implementation, and Closing Close M&A Transaction Due Diligence and Offering Memorandum Preparation Contact Potential Acquirers Receive Initial Indications and Hold Management Presentations Data Room, Due Diligence and Final Offers Negotiations and Final Due Diligence Closing Close #MHMwebinar 23
  24. 24. ESOP Transaction Process Initial interest  Owner or management learns about ESOPs  Education period Conduct feasibility / alternatives analysis  ESOP financial advisor or investment banker prepares debt feasibility analysis  ESOP advisory team presents feasible transaction structures  Desired structure selected  ESOP appraiser presents preliminary valuation  Prepare transaction description Form ESOP trustee team  Interview and select trustee and ESOP advisors Secure financing arrangements  Advisor prepares confidential memorandum, pursues funding sources, and initiates process to raise senior, mezzanine, and/or junior capital Negotiate with trustee  Client and advisor present transaction structure to the ESOP trustee team  Client and its advisors negotiate transaction terms with trustee and its advisory team Manage investor due diligence  ESOP advisory team manages due diligence for all transaction parties Manage documentation and closing #MHMwebinar 24
  25. 25. ESOP Transaction Timeline #MHMwebinar 25
  26. 26. How an ESOP Works - 100% ESOP Transaction Overview Cash and Seller Financing 2 Cash Lender(s) — Senior — Mezzanine — Other 1 Portco Debt (“Outside Loan”) Private Equity Firm Stock Sale / Redemption Promissory Note (“Inside Loan”) 3 Stock Sale ESOP TRUST*/ Employee Benefit Plan *The ESOP Trustee is represented by independent legal and financial advisors Transaction Steps:  Portco borrows money from lender(s) (“outside loan”).  Portco exchanges debt-raise proceeds with private equity firm (i.e., the seller), along with other types of consideration (e.g., seller notes with warrants), for Portco stock.  Portco issues shares of stock to a newly formed ESOP (i.e., the buyer) in exchange for a promissory note; the ESOP will pay for the shares over time by retiring the note with cash contributions treated as an employee benefit from the company (typically 20 years). #MHMwebinar 26
  29. 29. Private Equity as a Buyer – Why?         ESOP-controlled companies offer many of the same opportunities for improvement as traditional privately-held businesses Succession planning for founder who has stayed involved since the formation of the original ESOP Roll-up opportunities Professionalization of organization Access to capital for shareholder liquidity and growth capital Shift in industry dynamics challenges firm’s competitiveness on a stand-alone basis Opportunity for employees to have asset diversification Could keep partial ESOP in place #MHMwebinar 29
  30. 30. Private Equity as a Buyer – How?  Fundamentally the same process as traditional M&A; however, an ESOP is a different kind of seller     Earn-outs are unusual Fewer seller representations and warranties in many cases Primarily cash deals Partial ESOP companies may be interesting from two points of view   Take out the ESOP Take out the non-ESOP shareholders #MHMwebinar 30
  31. 31. Valuation Observations Over Time 16 Value Once transaction debt is repaid (and cash begins to accumulate), absent a robust strategy to grow share value, ESOP companies can see diminishing IRR. Equity Value 14 12 Enterprise Value 10 8 6 4 2 0 ESOP Creation Time Equity Value Enterprise Value While a privately held business may have selected an ESOP for its original transaction, such companies may see their enterprise value grow more slowly over time due to the impact of leverage, ESOP repurchase liability and a lack of proactive strategies to grow value (e.g., operational engineering, strategic acquisitions, brand development). The impact of these realities may be substantial and can offer a unique buying opportunity for private equity. #MHMwebinar 31
  33. 33. Private Equity as a Seller – Why?      Traditional M&A process has been unsuccessful Portfolio company is neither “star” nor “dog” Management team has significant equity stake and a clear, wellarticulated vision for the future Certainty and timeliness of close at fair market value highly desirable; all cash at close less important ESOP valuations are competitive with other transaction alternatives #MHMwebinar 33
  34. 34. Private Equity as a Seller – How?     ESOP pays fair market value Portfolio company borrows senior and subordinated debt on a tax-advantaged basis Additional, unique capital sources (e.g., 401(k) raise, direct investment by management/others) may be accessed “Gap” financing provided by seller (which offers opportunity to participate in future upside via warrants) at mezzanine-like returns #MHMwebinar 34
  35. 35. Why an ESOP Exit Strategy Makes Sense  An ESOP transaction can provide competitive price, terms and conditions; ESOPs offer greater confidentiality and a higher certainty of close relative to non-ESOP sale alternatives  Cash from the ESOP “buyer” comes at close and/or over time  Selling shareholders’ consideration can range from all cash at close to virtually no cash at close; overall consideration is generally captured through the following:  Cash at close: Dependent on company’s debt capacity and other factors  Seller notes: Annual interest payment (taxed as ordinary income) plus return of principal (capital gains); rollover of management equity provides unique economic opportunity for key leaders  Warrants: Participation in future equity upside with an all-in yield comparable to prevailing market terms; capital gains treatment is often claimed for warrants  Warrants often appreciate over post-close (debt-reduced) value and therefore appreciate as debt is repaid and returns from tax exempt status are realized An ESOP transaction provides selling shareholders liquidity at full, fair market value, and also allows for participation in future equity upside. At close and over time, an ESOP can enhance overall value derived from a portfolio company. #MHMwebinar 35
  36. 36. Sale to an ESOP – Relevant Portfolio Company Characteristics        Previous attempt to sell via conventional M&A process was unsuccessful History of non-recurring/extraordinary events Partial leveraged ESOP buyout as an alternative to traditional dividend recapitalization Portfolio company is held by a fund with 4-5 years remaining on its term Modest growth prospects in mature industry with highly compensated employees Existing portfolio company culture consistent with employee ownership Strong management team in place poised to generate growth, but the growth has not yet been realized Portfolio Company Liquidity Alternatives: Strategic Buyer IPO ESOP Dividend Recap #MHMwebinar Financial Buyer 36
  37. 37. Professional Advisors to the “Seller” Private Equity Fund Advisor: Scope: #MHMwebinar Investment Banker  Negotiate price, terms, and conditions on behalf of seller  Overall transaction support and structuring  Provide capital placement, if applicable ESOP Administration and Communication  Provide detail on plan design  Provide guidance on communications  Provide detail on plan requirements and compliance  Provide repurchase liability and 409(p) analysis Legal Counsel  Assist with transaction structure  Draft ESOP Plan and related ESOP transaction documents  Can be the same law firm as company counsel; often a special ESOP firm assists company counsel for the transaction 37
  38. 38. Professional Advisors to the “Buyer” ESOP Trustee Advisor: Scope: #MHMwebinar Legal Counsel Financial Advisor  Review ESOP Plan and related transaction documents for the Trustee  Provide independent valuation to the Trustee  Ongoing annual valuation update 38
  40. 40. Private Equity as an Investor – Why?     Mature ESOP company requires capital to pursue growth opportunities 100% ESOP transaction requires incremental financing between senior debt and seller notes Large non-ESOP owner desires an exit but does not want to sell the entire business Successful ESOP companies may have significant claims on cash flow for repurchase obligation, which may reduce overall debt capacity to achieve strategic opportunities #MHMwebinar 40
  41. 41. Private Equity as an Investor – How?    Invest as minority equity shareholder, sometimes with partial or full control Invest as a source of subordinated debt (with warrants) Flexibility with ownership structure (S-Corp, C-Corp, and LLC) #MHMwebinar 41
  42. 42. Private Equity as Owner of an S-Corporation A drop-down LLC structure can be utilized to achieve the benefits of a passthrough structure while avoiding complexities of seller note and warrant/derivative structures. ESOP Private Equity Firm Portco S-Corporation Portco LLC (or Partnership) Minority or majority common or preferred equity* * This could take the form of member units or partnership interests Common equity ownership Lenders  Typically, operating assets and liabilities of Portco S-Corp are contributed to Portco LLC in exchange for common equity ownership.  Employees remain at Portco S-Corp level and provide all or virtually all services required for Portco LLC to operate, in exchange for which Portco S-Corp is paid a fee. #MHMwebinar 42
  44. 44. Perceived Challenges Regarding ESOPs Valuation:  An ESOP sponsored by a privately held company cannot pay more than adequate consideration for employer securities purchased by the ESOP,  The ESOP trustee is required by law to have an independent appraisal performed to determine the fair market value of any non-public company stock acquired by the plan. #MHMwebinar 44
  45. 45. Perceived Challenges Regarding ESOPs Financing:  Many large commercial lenders and non-bank financial institutions are active in the leveraged ESOP marketplace  Certain subordinated debt/mezzanine funds find ESOPs especially attractive credit candidates  There are numerous other sources of financing for ESOP transactions, including management rollovers, 401(k) raises, sale of warrants, “friend and family” raises, and others  ESOP companies frequently secure incremental debt financing due to tax advantages   Underwriters view fixed-charge coverage ratio as key credit metric, which is an advantage for ESOP borrowers Competitive debt capital market conditions will further drive 2013 transaction activity  “Borrower-friendly” terms and market conditions  Larger lender hold levels  Strong access to capital for middle-market companies and sponsors #MHMwebinar 45
  46. 46. Perceived Challenges Regarding ESOPs Seller Financing:  Seller financing includes warrants that can offer the selling private equity firm up to 49% of fully diluted future value  Expected all-in returns on seller financing are benchmarked against prevailing mezzanine market IRRs  Seller note can be structured to accommodate a subsequent sale to a thirdparty investor; such sales generally require a layer of equity, which can be achieved through:   401(k) raise   Management rollover Time, as the post-closing company deleverages and compounds its earnings growth via tax shield Warrant strike prices can be set at pre-transaction or post-transaction value and vary with transaction design  Warrants benefit from company not paying income tax #MHMwebinar 46
  47. 47. Perceived Challenges Regarding ESOPs Tax Issues:  Tax treatment on retained seller note  Transaction proceeds are capital gains – interest income is ordinary income    S-Corporation shareholder laws do not apply to synthetic equity holders 409(p) disqualified person issues   Installment sale is common, but prepayment of tax is an option Ownership of warrants on stock in an S-Corporation   Warrants are usually claimed as capital gains Disqualified persons cannot hold synthetic equity in excess of 49% of fully diluted equity Distribution of pro rata pieces of notes and warrants to LPs  Note and warrant holders are not subject to S-Corporation limitations #MHMwebinar 47
  48. 48. Perceived Challenges Regarding ESOPs Management Conflict of Interest:  Management less able to influence buyer (i.e., the ESOP) than in traditional M&A exit  Management more incentivized to consummate a transaction than in other exits #MHMwebinar 48
  49. 49. Perceived Challenges Regarding ESOPs Dividend Recap:  The dividend recap does not effect a sale of the company’s equity, whereas an ESOP can partially or completely monetize the private equity firm’s investment  An ESOP provides tax savings not available for a straight dividend recap – allows for faster deleveraging in an ESOP-owned company #MHMwebinar 49
  50. 50. Perceived Challenges Regarding ESOPs Trustee Fiduciary Objectives:  Trustee does not have an affirmative obligation to shop the company  The trustee does, however, have an obligation to consider bona fide offers from prospective buyers Each private equity fund has its own unique characteristics and rules – ESOP transactions can be structured to accommodate such constraints. #MHMwebinar 50
  51. 51. CASE STUDIES
  52. 52. Case Study – Project “Shared Values” Situation Quasi-private equity investors controlled a leading manufacturer and distributor of pressure-sensitive labels and other materials with revenues in excess of $100 million Challenge The company, already moderately leveraged and in need of continued access to capital to support growth, had a track record of non-recurring events and exposure to certain environmental liability issues Evaluate liquidity alternatives by benchmarking traditional M&A valuation and ESOP alternatives Execution of a 100% ESOP-owned S-Corporation at a 45% premium to the established M&A valuation Project Solution ESOP Sale Economics Cash at close ▪ 7-year seller note (a ) Total ▪ Projected Year-7 Economics $ $ 3,250 24,250 27,500 ▪ Cash at close Seller note principal ▪ Seller note interest ▪ Warrants Total $ 24,250 12,125 ▪ $ Observations:  Superior returns relative to M&A alternative if warrants provide the projected value  Continued equity participation in future earnings growth via warrants or SARS 3,250 29,866 69,491 (a) 6% coupon for years 1-3 and 8% for years 4-7 with warrants for 30% of the company’s fully diluted equity  Excellent legacy for company and its leadership team  Employees participate in generous retirement tied to company performance and stock appreciation #MHMwebinar 52
  53. 53. Case Study – Project “Maple Leaf” A private equity firm was the majority shareholder of a service provider and manufacturer of equipment for niche projects in the timber, construction, and oil and gas industries with revenues in excess of $150 million and EBITDA of $25 million The company suffered two significant quality-of-earnings events (loss of a contract that contributed 30% of gross profit and a significant asset impairment) while the private equity owner was assessing its transaction options Explore the sale of the company to management and an S-Corp ESOP as an alternative to the traditional M&A process that had been initiated by the fund Situation Challenge Project Solution Develop an ESOP "stalking horse" bid to compete with the traditional M&A process M&A Buyer / Initial Offer ▪ Valuation ▪ Tax escrow 15,000 ▪ Indemnification baskets 25,000 $ 166,000 M&A Buyer / Benefit of Final Offer Dual Track ESOP Offer $ 208,000 $ 190,000 14.5% 5,000 5,000 66.7% 15,000 15,000 40.0% Observations:  ESOP provided a stalking horse to optimize price, terms, and conditions from M&A process  Greater certainty of close relative to M&A buyer  ESOP was able to deliver a firm and fully financed and negotiated stock purchase agreement within 60 days  #MHMwebinar expenses paid by private equity firm ESOP team 53
  54. 54. Case Study – Project “Beat the 2013 Tax Increase” Situation Owners of company were motivated to sell. Several traditional M&A attempts had failed. By the Spring of 2012, they want to be assured of a 2012 closing Challenge Sellers want all cash. Project Solution Structure a realistic ESOP transaction that could be closed during 2012. Sales price of $170 million; closed December 2012; financing as follows: (1) first and second senior secured loans: $130 million, (2) first subordinated loan from an investor: $15 million (3) second subordinated loan (seller note): $25 million No warrants were issued. First subordinated interest: 17.5% cash. Second subordinated interest: 13% cash/4% PIK, with ratio changing to more cash and less PIK through year 6, and rate increasing to 18% starting in year 7. #MHMwebinar 54
  55. 55. Case Study – Project “Breeze” Situation Challenge Project Solution A private equity firm was 70-percent shareholder of a national leading niche business-to-business service company with EBITDA of less than $10 million – which had been acquired from another private equity fund The company had a colorful history, including numerous "non-recurring" events, contributing to inconsistent sales and earnings results Advise the company and management on the formation, valuation, structure, and financing of an ESOP transaction Execution of a management-led ESOP MBO at a purchase price equal to 8.0x EBITDA with 100% cash at closing for the private equity firm Type of Capital EBITDA Multiple Sources / Comments Senior debt 4.00x Cash flow loan, raised at one turn above market at the time; ESOP tax shield, strong relationships, and management investment / strength contributed to this above-market commitment Mezzanine 1.50x Mezzanine provider had a prior relationship with management, familiarity with the ESOP tax shield, and an understanding of the improved debt service provided by the structure Seller debt - While common in many ESOP transactions, there was no seller financing in this transaction Management rolled most of its equity; in addition, former corporate executives invested on a pari passu basis All in, 401(k) investments in employer securities represented less than 35% of total plan assets "Friends and family" 1.25x Equity raise from 401(k) 1.25x Purchase price 8.00x Observations:  Transaction was completed in less than 90 days  #MHMwebinar Private equity firm was looking for full and fair price and all cash at close…and got it 55
  56. 56. SUMMARY
  57. 57. Summary: Review of Each of the Three Categories Seller Buyer Investor  Large minority shareholder wants to stay  Private equity majority owner wants to sell  Private equity firm wants to divest a subsidiary of a newly acquired company  Carve out of subsidiary/division using an ESOP  Terminate existing ESOP     Maintain partial ESOP Acquisition financing potential Growth capital potential Take-out of minority, non-ESOP shareholder potential  Investor able to negotiate typical covenants, including covenants related to activities of the company In select niche situations an ESOP can be a superior corporate finance alternative for private equity investors. #MHMwebinar 57
  58. 58. Questions? #MHMwebinar 58
  59. 59. If You Enjoyed This Webinar…  Join us for these related EES courses:   Nov. 14 and 19: Employee Benefit Plan Accounting Issues Update Accounting & Management Issues of Employee Stock Ownership Plans (recorded on 5/23/13)  ESOPs for the Construction Industry (recorded on 6/18/13)  Read these related publications:   MHM Messenger 11-13: FASB Proposal Affects Employee Benefit Plans Employee Stock Ownership Plan Primer #MHMwebinar 59
  60. 60. Connect with Mayer Hoffman McCann linkedin.com/company/ mayer-hoffman-mccann-p.c. @mhm_pc youtube.com/ mayerhoffmanmccann slideshare.net/mhmpc gplus.to/mhmpc facebook.com/mhmpc blog.mhmcpa.com #MHMwebinar 60