ESOPs for Banks and Thrifts

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in the chat section and you can type those in as we’re going and then we’ll
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get now to hello this is John Menke president Menke and Associates, Inc and
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welcome to all of you through our webinar presentation on ESOPs for
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banks and thrifts before we begin if anyone is having the problems viewing
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the presentation just give us a call at four one five three six two fifty two hundred and ask for Jeannie Klug um
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again four one five three six two fifty two hundred also before we began when
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they cover a few logistics this webinar program is being presented in broadcast
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mode which means that we can hear you you can hear us but we can’t hear you so
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as we’re going through our presentation if you have questions you can submit
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written questions by using the chat function on your screen you can type in a question either where it says
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questions or in the chat section and you can type those in as we’re going and
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then we’ll get to those questions at the end of presentation we reserved about 15
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minutes for question and answers at the end of them at the end of the webinar
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and then if you have additional questions or we don’t get to all of them
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today you can call us or email us afterwards and we will get back to you you know in a day or so
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now today’s presenters will be myself and Victor alum and the presentation
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will be more or less than a question-and-answer format I’ll ask Victor a series of questions
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regarding how he thoughts can be used by banks and thrifts and and or by their but by some of their clients to
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accomplish various goals and objectives and Victor will provide the answers
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based on his knowledge and experience in designing research for numerous banks and thrifts Victor Allan is an ERISA
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attorney and he’s been a senior counsel with our friends for over 17 years by
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way of a quick background Menken associates is the oldest firm in the country specializing in Aesop’s our firm
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was founded in 1974 and this year marks our 35th anniversary of designing and
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installing shops over the past 35 years we’ve created more than 2,500 Aesop’s
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more than any other firm in the country we also administer over 800 Aesop’s and
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we have eight offices around the country and we’ve installed these tops in all 50
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states so let me begin by first defining what
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an esop is and he stopped as many things to many people to the existing
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shareholders of a company it’s a buyer of stock that simultaneously that offers
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tax savings to the seller and an orderly succession plan for both majority and
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minority shareholders to the company itself the ESOP is a tool or technique
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of corporate finance that enables the company to finance growth and expansion and/or shareholder redemptions with
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tax-deductible dollars while also simultaneously providing a highly effective employee incentive plan and to
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the employees these off is a company funded incentive plan and/or retirement
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plan that offers incentives and also reward a retirement benefit if you will
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that’s usually unmatched by any other type of retirement plan it’s important to know and note that an
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esop consists of both the plan and a trust and the trust is the owner of the
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stock not the employees so the certificate is actually made out stock
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certificate in the name of the employee stock ownership trust and typically the
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company owners and managers are designated as the plan trustees employees then receive annual statements
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reflecting the their account balances in the ESOP however they’re not entitled to receive company panel statements in
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order they have voting rights except with respect to certain special issues therefore voting control does not have
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to change when an esop was implemented even even when these stopped owns the majority of the stock now I’ll turn it
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back to Victor for the first question why is it in general that Aesop’s are popular with owners of privately held
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firms thanks John are we looking at slide 6 we see that probably one of the
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biggest reasons these offs are so popular and privately held companies is because of a unique factor that they
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bring to the table which is the ability to create a partial or even a total
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liquidity for existing shareholders one of the primary ways that this occurs is
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that the ESOP creates what’s referred to as an in-house market Esau becomes the
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buyer of the stock held by existing shareholders and key to that is the tax
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advantages specifically in the case of a C corporation there is an ability for
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the shareholders to sell their stock to the ESOP and under the special tax
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provision provided esau acquires at least 30% or more of the company stock the tax on the gain would be deferred
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provided that the selling shareholder reinvests the proceeds is something
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called qualified replacement property now in the case of S corporations is
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also an advantage of using an esop to create that shareholder liquidity the primary advantage there is the
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shareholder is going to be entitled to to pay capital gains tax on a sale of
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those shares of the ESOP of course currently the capital gains rate is only at 15% which is substantially lower than
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ordinary income tax rates the second reason that Aesop’s are still popular
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with privately held companies is that the ESOP can help the company reduce the
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payment of federal and state income taxes on the earnings of the company we’ll talk more about that in just a
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little bit another highly advantageous use of an esop is the idea of control
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now unlike selling your stock in a sale to a third party and unrelated party an
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esop provides the opportunity to create shareholder liquidity for yourself as
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the owner and the other shareholders and yet still stay in control and continue to run the business the way you have in
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the past this is even true in the case of an esop that acquires a majority interest of the company stock fourth
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advantage of using an esop is that in the case of it will call and discuss a leveraged ISA the monies that the ESOP
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borrows in order to buyout existing shareholders well those monies can be paid back with tax-deductible dollars
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and this is to say that the company is able to the tough not only the interest but can also in a case well in the case
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of a stock redemption the company gets to do those deduct the interest but in the case of an esop what’s so unique is
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the principal payments will also be paid back with pre-tax dollars now last and
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certainly not least if you properly implement and communicate an esop there
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can be a dramatic effect on increasing employee productivity and this course
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results in increased profitability as well as an overall increasing value of
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the company if we look over at slide 7 as a result of these these various tax
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and financial benefits that an esop brings to the table there are actually now in excess of eleven thousand four
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hundred e-stops currently in existence those Aesop’s cover 13 estimated
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thirteen and a half or more million participants and the value if you look
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at it from that perspective the ESOP assets is in excess of nine hundred
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billion dollars well now I’d like to talk about how a Sox can be used by
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owners of banks and thrifts but before talking about how you software used by
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banks and thrifts however we need to distinguish between publicly held banks and thrifts
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pardon me and banks and trips that are thinly traded or are just privately held
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Aesop’s are used in publicly held banks and thrifts the same way that Aesop’s
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are used by other types of public companies that’s to say in case of a public company these ops are seldom used to create a
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market for the existing shareholders because it becomes public than it already has a market for its stock so in
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the case of public companies Aesop’s are usually used to facilitate the existing public market for the
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common stock or as an employee incentive and benefit plan in the case of thinly
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traded companies or privately held companies on the other hand then these
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are primarily used to solve ownership problems the Victor what are the typical
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ownership problems that are faced by owners of thinly traded or privately owned banks and thrifts
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well let’s get into that and look at these these vitamins that are referred to on on slide eight let me also remind
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our audience that we would appreciate questions that you have feel free as we go through that this part and the other
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parts of the presentation to type in those questions and we’ll get back to those well-drawn the typical ownership
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problems that you see with privately held banks and thrifts and it’s similar to the problems that are faced by by all
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owners of privately held companies and that’s the lack of liquidity the lack of diversification and of course the need
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for a succession plan and currently there’s also of course the need for capital adequate
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fortunately stops are one tools that can provide an answer to all four of these these problems it can
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provide liquidity and diversification for existing owners it can provide for an orderly business succession strategy
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and it can help increase the value of the business by increasing in the case
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of banks and thrifts the net worth and the lending capacity
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on slide 10 is a liquidity tool you’ll see that Aesop’s offer a number of advantages the ESOP creates this
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in-house market whereby existing owners can sell their shares when they see fit
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to do so now unlike a sale or a merger these op allows the owners to sell part
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of their shares or they could even consider selling all of it at one time in a sense the owners can sell their
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shares over a period of time rather than to having to sell it all at once which is typically going to be the case if an
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outside buyer comes in now since these stops create this in-house market there’s no outside party involved and
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there is what we refer to as a certainty of the outcome but also it goes without
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saying the costs of arranging a sale of stock to the ESOP well that’s going to be a fraction of what costs are incurred
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when you bring a third party in to a sale of the entire business as a tool
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for investment diversification Aesop’s will allow you as shareholders to
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diversify whatever amount of stock you wish to liquidate and invest in other investments cash fixing some income
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securities or equities the mix of these investment selections well that’s entirely up to the seller
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Victor it’s easy to see that he stops offer a number a number of financial and
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tax advantages not offered by other alternatives but why is it that e software especially popular and suitable
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for banks and thrifts you know I think there’s a couple of really specific reasons John for that the the first that
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just jumps out is that in the case of privately held banks and thrifts they’re going to have a greater than
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maybe ordinary need to provide shareholder liquidity unlike a lot of privately held companies banks and
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thrifts are thinly traded and they’re privately held businesses but instead of
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having just a few founders they’re going to have dozens and dozens oftentimes of shareholders and this is because the
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banks from the thrifts have a number a certain amount of a paid in capital requirement in order to obtain their
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Charter this usually results in the stock being sold to a relatively large
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number of shareholders because of the fact that there are a relatively large
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number of shareholders in privately held banks or thrifts there’s a continuing
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need to have this in-house market for those shareholders who are leaving the business or they can’t wait until the
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company is eventually sold or even before it goes public they need a liquidity event much sooner an esop is
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particularly useful in this regard since it enables the bank or the thrift to
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repurchase the shares from a retiring or departing scare older or perhaps the deceased shareholder in their estate at
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any time it enables the company to do this again with tax-deductible dollars
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rather than using after-tax dollars now this in turn enables the bank or the
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thrift to pay back any debt that gets encouraged much faster as a result the
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capital then of the company will be restored much faster than it would be if
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this debt was being paid back with after-tax dollars now the second reason
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why Aesop’s are particularly popular in privately held banks and thrifts is because the ESOP can very readily be
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used increase the net capital of the bank of the thrift without the need for a public
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offering now this gets accomplished by simply having the board of directors of the bank authorized a deductible
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contribution to the ESOP in the form of newly issued stock of the company the
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result of the stock contributions is that there’s an increase in the company’s net worth in the amount equal
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to the tax savings now contributions of newly issued stock it’s going to cause a
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short-term dilution existing shareholders will then notice that there
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are now a larger number of shares outstanding however the long-term results are beneficial since any
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increase in the company’s net worth the case of a bank or a thrift is going to enable the the entity to increase its
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lending volume by a multiple of the net worth inquiries now I probably say the
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third reason banks and thrifts utilize Aesop’s is that they they truly can be a successful tool in helping the entity
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attract and retain high quality high value employees and in key employees and
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many companies and banks and thrifts in particular they really are going to be inclined to look for a company where
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they can as we say have a piece of the the action as a participant in stock
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ownership they’re going to find that in an esop company I guess I’d say lastly
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the reason we hear that banks and thrift companies where he stops are real
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popular is that they really feel again that the full group of employees feel that this is a valuable asset to a
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portion of their their retirement benefits so I guess probably all together John
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those reasons tell me why I think there’s a good fit for Aesop’s in in
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banks and thrifts probably even in some cases a higher percentage of success for an esop and a
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bank or thrift and maybe other industry well given that Aesop’s are in general a good fit for banks and through
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are there any situations where and he thought the not a good fit for a bank or a thrift well there certainly will be
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some in a few situations where this just doesn’t doesn’t fit properly one
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situation for example is the company via the bank or any arc is just too small you know we we’ve done II soft John and
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companies that have had as few a number is 10 and as many as 10,000 employees
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but the fact is economically speaking to install and to maintain an esop if the
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company has less than 10 employees it’s going to be a little hard to justify that in the case of a bank or a thrift
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if there are an S corporation and if they have a small number of employees there can be some difficulty complying
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with a a relatively new requirement under the law the Internal Revenue Code there’s a provision referred to as the
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anti-abuse requirements and that those rules are set forth in Code section 409
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P if the company can’t comply with these provisions and we’ll talk more detail
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about 4 and IP later well then they’re going to either have to forgo becoming an esop or they may even have to convert
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to being a C corporation now the concern about having too few employees it
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typically isn’t any relevant for a bank and a thrift mean the operation of those entities usually requires employees of
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more than 10 or 20 now another situation where you socks are going to be a little problematic in terms of fitting in is
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where the other bank is new and it’s not yet profitable and those tax deductions
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and all those advantages we talked about you really need to be a profitable entity paying taxed for any stock to
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work well we’re good
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we want to create liquidity and diversification for sellers owners the
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bank’s number two to increase employee productivity number three to increase
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company cash flow and that worth number four to provide for business diversification so we’re going to
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discuss each of these uses in more detail now let’s start by discussing how
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you socks are used to create liquidity and diversification for for sellers
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Victor power ESOP transactions typically structured so as to create liquidity and
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diversification for shareholders of privately owned banks and thrifts well
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in many ways they’re similar to the way we structure an esop for other for other
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types of firms and when the ESOP gets the structure depends on the goals and
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the objectives of the current shareholders Aesop’s can be extremely flexible in how we structure them
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depending on the liquidity purposes in general there are three basic ways that we were table structures
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I’m slide 16 and I call this one the pre-funded eSAB in this case the esop is
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established by the bank and the the entity makes two tax deductible
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contributions to the plan and that cash accumulates in the ESOP and it’s used
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later to purchase stock excuse me from the sheriff excuse me from the shareholders
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a lot of companies do start out by pre-funding an esop as a way to first get that current tax deduction
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accumulate that cash and the plan and let’s say there could be a situation with current shareholders they aren’t
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ready to start selling their stock there isn’t this liquidity need at least in the first year or two of the Aesop’s
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installment well then under this current structure the company gets the the tax
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deductions under Code section 404 as long as the contributions don’t exceed
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25% of what’s called eligible payroll so for example assume the company has
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eligible payroll of 5 million it could start making tax deductible contributions to the ISA of up to a
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million 1.25 million per year now if the
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company contributed the maximum amount each year let’s say they set up the ESOP and for 4 years they can call it and
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since the a piggy bank we just accumulate these cash contributions well there could be 5
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million dollars of contributions over say a period of four years and then
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don’t forget that that cash and ESOP is also generating or earnings that are added to the ESOP participants accounts
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many times the company is already making contributions to its 401k maybe in the
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form of a match or profit-sharing contributions see the big difference is that that cash built up in an esop under
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this pre funded structure that cash is earmarked to invest in Company stock
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on slide 18 we show that the second common way an esop can be structured is
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as we’ll refer to at a gradual ESOP purchase now in this case the company
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sets up the ESOP it makes the discretionary contributions each year perhaps up to the maximum amount but
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then currently uses those contributions to purchase shares from existing
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shareholders on a year-by-year basis so again this is one of the nice ways about the ISA is that it provides the
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flexibility and again for banks and thrifts that have numerous shareholders
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with perhaps your year liquidity issues a gradually saw purchase tends to be
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used a lot by banks and thrifts I mean again think of the discretionary the the
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discretion you have because we have the company’s contributions they can be made up to the maximum deductible amount they
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do not have to be and we also don’t have to use all the cash every single year that’s contributed to buy stock there
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can be this sort of flexibility to buy only a small percentage or large or
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percentage and then of course don’t forget that unlike stock Redemption each
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and every one of those sales by shareholders to the ESOP will qualify for favorable capital gains treatment in
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the case of a c-corporation remember we mentioned this earlier we’ll talk a little more about it won’t the
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ESOP acquires 30% of the outstanding stock well then those gradual sales of
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shares by the sellers they will enable the shareholder to elect to defer indefinitely the taxation on the capital
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gains our slide 19 we show the third classical way to the nice op is
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structured and that is referred to as a leveraged esata leveraged structure we use that where shareholders want to cash
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out more quickly or in the case of the C corporation as we mentioned there’s this 30% B soft threshold ownership
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requirement well that typically means we’re going to need to borrow the money how the ESOP become leveraged so that we
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can get up to that 30% threshold typically unless the plan has been pre
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funded it’s going to really take a nice awful bit of time to get right to 30% without
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being leveraged okay but if it is leveraged I was the plan typically structure those out the leverage
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structures in the plan to borrow the money or does the or does the company the bank borrow the money well let me
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let me give you an example to explain that here on slide 20 let’s assume that
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we have a bank with annual revenues of 50 million eligible payrolls 5,000,000
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pre-tax profits of the entity 3 million and let’s assume that for each saw
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purposes there’s an evaluation of 15 million dollars now let’s assume that
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the ESOP wants to purchase 30% of the outstanding stock and price there based
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on our numbers 4.5 million the way this will work is that there’s going to be typically an outside lender it will be
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perhaps a correspondent bank they will lend to the ESOP entity bank or company
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the four and a half million dollars the bank then takes that money and it loans
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it in we call it one inside loan to the ESOP now these saw has the cash the sale
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sorry the loan proceeds and it turns around and buys to the 30% of the stock from the shareholders pays the
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shareholder for the four and a half million dollars on slide 23 you’ll see that what happens then at the end of
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that year the bank or the thrift then we’ll make these tax deductible
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contributions into the ESOP up to the maximum deductible amount we’re going to
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assume it there they’re contributing the maximum is that’s the 1.5 million plus interest the ESOP then gets that cash
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well it borrowed money from the company the bank the lender they’re the thrift
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so it’s going to go ahead and pay that loan back the company the bank that has
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also borrowed its money from an outside lender then turns around now we can also
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assume that the seller is qualify for the tax deferral provisions they’re
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going to wind up saving anywhere from 675 thousand and nine 100,000 and federal and state taxes
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depending of course on the state income tax rate now these structures they
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aren’t fixed and they can be combined if you look at on slide 24 sorry it’s 525 I
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mistake case case 4 for example in this case we’re combining the concept of a
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pre funded ESOP and a leveraged ESOP in this particular slide for example you’ll
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see that the company is set up he thought they pre funded it for two years in the trust the stop is accumulated two
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and a half million dollars of cash but the company is also grown it’s fair market value has grown from fifteen
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million in our original example up to 16 16 million 16 point 65 million at the
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end of the third year so now again if it’s a c-corporation and we want that tax deferred structure we got to get up
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to 30% that threshold amount so in this case the es off will need to borrow more money to buy 30% of company’s
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outstanding stock since we already have the 2.5 million pre-funded that’s going to require a
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leveraged ESOP alone from a third party in the amount of the two million 495
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which is effectively less than you know two million lesson we would have been
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required if we didn’t do any priest funding so in the sense using this
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combined structure we end up reducing the amount of the loan that we originally would have needed had we done
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the 30 percent transaction all at once in one leverage structure take a look on
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slide 26 if you look at our case 5 in this case we combined the idea of a
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year-by-year purchase with again a tax deferred sale in year 4 what you’re
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seeing in this slide is at the end of the first year through the current contribution the ESOP is purchase 3% at
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the end of the second year it purchases additional stock it’s up to 7% well the
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time you get to the third year the ESOP through this gradual year by year sale is holding 12% of
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suck remember that those sales that have occurred have occurred with the shareholders electing to the tax at the
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capital gains rates now here we are in year four and we say again we want the
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ESOP to buy 30% the seller really want the tax deferral treatment in year four
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well in that case then we have to have the ESOP purchase enough shares to get
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us up to 30% all in year four on slide 27 in case case number six we actually
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show and illustrate how the ESOP can be accomplished doing a hundred percent buyout now these types of transactions
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will be a bit rare for banks and thrifts we wanted to show you that it can be done but there are some problems
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financing a hundred percent ESOP buyout of one fell swoop is is not the easiest
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thing to do accordingly 100 percent buyouts usually are going to be done in two stages so
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for example it’s pretty common for the ESOP to be leveraged and the first sort
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of big big Tron’s as we call it might be up to say 49 and even 50 percent of the
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outstanding stock then as the debt gets paid down on that first block the plan goes ahead and purchases the remaining
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stock a victory as I mentioned earlier in the case of most privately held banks
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and thrifts there’s usually a goal for the largest number of shareholders as opposed to a lot of privately held
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companies with just one or two three or four however there may be two or three
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shareholders in a bank that had the controlling interest so in these
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situations can an esop offer to buy stock run say the controlling shareholder or shareholders without also
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making an offer to the the other shareholders well in most cases the
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shareholders are going to agree among themselves with respect to sail to the ESOP who’s going to sell and who’s not
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going to sell now there there could be some very specific reasons why
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shareholders won’t necessarily see eye to eye on these things in that case it’s not
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uncommon at all for the Esau purchase to occur from all the shareholders on a
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pro-rated basis I will say that first and foremost you’re going to look to
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things like any existing shareholder agreements there might even be to the state law requirements John that would
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need to be considered that would delineate who these ops going to buy from if it’s going to buy from some but
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not all the shareholders oK we’ve mentioned in a couple of the slides earlier that in the case of a
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c-corporation there is the special tax deferral tax rollover provision that
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allows the selling shareholders to receive their proceeds on a tax deferred
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tax-free face basis so can you tell us a little more about how this works
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absolutely the Code section for this is section 1042 and the way it works is if
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the ESOP acquires 30% or more of stock of remember it’s got to be a c-corporation entity well then the
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capital gains the selling shareholder shareholders would ordinarily pay well
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it’s going to be deferred now there’s a provision the sear holder the seller has to get the proceeds well they have to
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reinvest I should say a like amount of the money that they’re getting in
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connection with the ESOP sale in something called qualified replacement property and they have a time limit on
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that within twelve months of the sale that reinvestment has to occur now the
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tax deferral is going to continue as long as the seller holds this qualified
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replacement property if the seller holds the property until death well then guess
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what there’s going to be a step-up in the basis and the capital gains tax is completely avoided now you’ll hear this
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type of transaction referred to as a tax-free rollover this qualified replacement property I’ve
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been mentioning it does have some limitations it consists of stocks and bonds of us domestically issued stock
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and domestic corporations the corporations don’t have to be big they can be big small public organs in
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private they do have to be US companies the seller can’t invest in a mutual fund
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for example or government securities those things will qualify as proper
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qualified replacement property and they’re then going to have to pay the capital gains tax what you do see with
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most sellers that elect tax deferral treatment is they end up investing the proceeds in a diversified portfolio
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borrow those corporate bonds and stocks now the idea is that the seller isn’t
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isn’t prohibited they could always choose to sell a portion of their replacement securities maybe later run
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to the extent they do that however they’re going to trigger the capital gains tax that was previously deferred
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and then of course any subsequent appreciation well that sounds like
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you’re locked in to these qualified replacement securities forever so is
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there any way to avoid that not being locked into those investments until death you know there there is there’s a
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it really is a relatively simple way to address this problem is concerned if the
33:56
if the seller who sold the stock to the ESOP purchases something referred to as
34:03
a long-term East op bond or bonds see that bonds going to represent the
34:09
qualified replacement property so there’s your problem they’re locked into that bond but here’s the fun part the
34:15
seller can then margin or take a loan out against the bond for as much as
34:21
maybe 75 80 maybe even if 90 percent of the value of the bond so for example
34:28
let’s look at a seller who’s received this 4.5 million proceeds from the sale
34:34
of their stock to the ESOP well that seller could then do is purchase the bond long-term esau bonds the 4.5
34:42
million boners purchased and they satisfy the requirement they are now holding qualified replacement securities
34:48
and they go and they do this margin up to stay 3.6 million of the face value of
34:55
the bond therefore giving themselves a bit more freedom with respect to how
35:01
they use those proceeds ok let’s turn to another topic the this
35:07
tax-free rollover provision only applies to 3 corporations not to S corporations
35:12
so are there I’m going to hand them tax advantages that apply to F’s corporation
35:19
that don’t apply to C corporation before you answer that actually I have another
35:24
question – the provision of the tax code even allow a bank to operate as an
35:30
escort well we do the last question and that’s clear now thankfully that as a
35:36
result of a piece of legislation from 1996 the jobs Protection Act it’s clear
35:44
that banks and thrifts can operate as S corporations there is a provision of the
35:49
bank or the thrift the bank of the
35:54
thrift doesn’t use what’s called the reserve method of accounting for bad
36:00
debts described in this code section 585 so as long as if the bank is currently
36:07
using the reserve instead of accounting for bad debts well then it could automatically switch from that method
36:13
and they would then be eligible as an entity to elect to be taxed as a subchapter S corporation let me look at
36:20
your go back to your first question I mean there are there are major advantages that still apply the sponsor
36:27
of an esop where you’re an ass versus C now remember how S corporations work all
36:32
the earnings of the corporation are taxed at the shareholder level not at the corporate level an esop don’t forget
36:39
is a tax-exempt entity so what ends up happening then is to the extent that the ESOP own stock of the S corporation the
36:46
part of the Corporations earnings attributable to that ESOP percent
36:51
ownership exempt from income tax take it one step further if the ISA owns a
36:58
hundred percent of the S corporation stock we’ll then none of the
37:03
Corporations earnings are subject to income taxes the other thing that’s very
37:09
beneficial is that the e-stop share of the S corporation earnings is exempt
37:16
from the unrelated business income tax that normally is affects non tax-exempt
37:24
shareholders of S corporations now there are two specifically disadvantage
37:30
disadvantages of these sots and S corporations I mean the one we already talked about is there’s no tax free
37:36
rollover availability to a shareholder of an S who sells to the ISA they gotta
37:41
pay the capital gains tax the second is this relatively new concern we’re in a
37:47
small S corporation ISA you’ve got to be able to cover what’s called the
37:52
broadly-based test well that’s that 409 Code section 409 P test I told you about
37:59
let me tell you about that a little bit what they’re saying there is if there is disqualified persons the term we’ll get
38:06
into in a second and if they own more than 50% of what’s called the gained own
38:12
shares well that’s a problem because the ESOP share of the earnings will then be
38:18
subject to the unrelated business income tax and this group of individuals or
38:24
could just be one individual that are called disqualified person or persons well they’re going to be subject to some
38:31
excise tax well and view the fact that in the case of S corporation Aesop’s the
38:38
tax benefit accrues more to the benefit of the company itself calm yourself if
38:44
earnings can become partially or totally typed event so that accrues to the company fellow than to the benefit of at
38:52
least directly to the selling shareholders so if you all had our there our ESOP transaction structured
38:59
differently for escorts for sequence well you know like say basically this
39:05
a new structure is used if it’s an asterisk and and by that I mean whether
39:10
it’s a C or an S we’re going to have pre funded e Sox now some are any structured to have this gradually soft purchase of
39:17
stock that we talked about and some are going to be structured to be leveraged right away take a look on slide 34
39:25
here’s an example of how leveraged ESOP certificate ruptured for S corporations
39:32
in this case our shareholder Larry owns 20% of stock he pays himself a salary of
39:38
200,000 a year he’s got 40 employees and the total compensation for that group a
39:44
million six now you look at what liquor he’s got he has a percentage of comp he’s got 12.5% and let’s further assume
39:53
that the stock Larry holds has a value of four million in case number seven on
39:59
slide 35 it shows that the transaction will be financed with what we call
40:04
seller financing in this case Larry he’s going to become the bank or himself he’s going to sell the stock and he’s opted
40:10
to take back installment note he will then receive installment payments over the term of the note he’s going to pay
40:17
his principal and he receives the principal he’s going to pay the capital gains tax on that portion that he
40:24
receives and of course he’s going to pay ordinary income tax on the interest portion in our next slide we illustrate
40:32
two points with respect to leverage these up first it shows how the debt gets repaid now in
40:38
the case of an S corporation the debt is repaid by having a company make those tax deductible contributions we talked
40:44
about earlier those get made to the east-southeast stop uses those to make payments on Larry’s note but in the case
40:51
of an S corporation the debt can also be repaid and typically is by using S
40:58
corporation distributions that are paid to the ESOP which then come into the
41:03
ESOP as earnings the es off uses that cash to pay down Larry’s note as well
41:10
the debt can be repaid and is repaid in the case of a seep corporation kind of the same way it
41:17
c-corporations remember they’re different from s’s they’re not going to get S corporation distributions
41:23
dividends however in the case of the C corporation Esau are available and I’ll
41:29
tell you why they’re uniquely available there’s a Code section section 404 K
41:34
that says in certain cases Corp dividends that are paid to an esop and a
41:40
C corporation can be deductible I know that sounds kind of strange ordinarily C
41:46
corporations pay dividends to shareholders well those aren’t tax deductible but in this special case if
41:52
certain conditions are met the e-stop receives the dividend it uses the dividend to pay on the each Saab debt
41:59
those dividends are deductible to company the second point of this slide is to show how the stock visa buys is
42:08
allocated among the participants accounts in a leveraged structure now when the gradual structure we talked
42:14
earlier company makes a contribution ESOP gets the cash Usopp buys the stock stock is divvied up divided allocated as
42:22
we say on a year-by-year basis to the participants accounts but you see what happens when the plan is leveraged the
42:29
stock is going to be purchased by the ESOP and it gets allocated to the participants accounts as the note
42:35
payments are made now if the isaw purchases a block of stock and it’s all leveraged all the stock is purchased
42:42
initially by the ESOP it goes into what we call a suspense account still owned by the trust it’s just that it hasn’t
42:49
been allocated among the participants account then what happens is year by
42:54
year as the company makes the contributions or the distributions or the C corporation dividends into the
43:00
ESOP the payments are made by the to this seller if the sellers taken back a
43:05
promissory note or paid by the ESOP to the lender who lent the ESOP the money
43:12
and then what happens is in a proportionate amount these shares get released from the ESOP suspense account
43:19
they get allocated to the accounts of participants now the shares that get released from
43:24
the suspense account happens again each plan year allocated among the participants accounts most commonly
43:31
the format for doing that is based on the proportionate compensation of on
43:36
slide 37 we show that there’s another alternative for structuring a leveraged ISA and that’s to have the transactions
43:44
in answer the third party loan instead of the seller note so if you take a look there we’re going to say that Larry
43:50
wants says he wants all this cash right away and therefore this external financing that the the bank or the
43:58
thrift would get needs to come in in order for the ESOP to be able to turn to
44:04
Larry and say here’s your four million dollars I’ll buy your stock so in case eight on our slide we see that it’s
44:12
basically the same with the exception that instead of Larry so I guess I’d say
44:19
John that whether the esop is bank financed or seller financed the results are pretty much the same we’ve got a
44:24
seller he wants and he’s going to receive four million dollars he sold the ESOP again in case of an S he’s going to
44:30
pay the capital gains tax since Larry’s compensation go back to that number I gave you we assume that he has 12.5% of
44:40
the compensation um he he’s going to receive twelve point percent of the
44:47
allocation of the stock and he’ll be able to cash out later when he leaves
44:53
the company now be aware that this benefit that does not apply in the case
44:59
of C corporation and where the seller has sold a stock to the ESOP and he’s elected tax deferral treatment the
45:06
benefit of the tax deferral treatment under the Code section 1042 in the related section says well if you’re
45:13
going to sell Larry as a shareholder to the ESOP and you’re going to get to know is to furro of capital gains tax well
45:20
then there’s a trade-off and the trade-off is the shares that are in the ESOP cannot be allocated to Larry as the
45:27
selling shareholder or anybody or certain parties that are related to him
45:33
that again are rules that come hand-in-hand with conducting a tax-free rollover transaction okay thank you
45:40
Victor so we’ve now covered how we sought to are used to create liquidity and
45:46
diversification for shareholders the sacrum used to be soft and the critic
45:53
employee productivity often times one of the primary purposes as you know for any
46:00
sauces is not creating a market to the shareholder but just to create employed
46:06
Senate plan and to create a direct link giving the employees productivity and
46:11
their karmic benefits which is something that a traditional profit sharing plan
46:17
says it doesn’t do and it’s just common sense that people work best when they
46:22
work for themselves as I said no one ever washes a rental car so the concept
46:29
of any stop is to have employees think and act like owners in the picture the
46:35
question then arises of how does it work out at practice three stops in fact
46:41
increase employee productivity well the good news is that Aesop’s didn’t come
46:46
along yesterday they’ve been around for a number of years and there are studies he studies over the last 17 years they
46:54
really have concluded that in Aesop’s to increase the company’s performance one
47:00
of the early studies found that employee absenteeism when down by 66% employee
47:07
turnover goes down in companies that had implemented Aesop’s more recently the
47:14
Harvard Business Review studies well they found that the sales growth in isaw
47:19
Companies was significantly higher than when you compare that to a similar company where there’s no ESOP most
47:27
importantly there were two studies done one by Northwestern University’s Kellogg School of Management and one by the
47:34
Hewitt Associates consulting firm well both of those studies found that Aesop’s companies had a higher return on assets
47:43
and a higher return on the shareholders equity and when you compare those
47:48
businesses to comparable non e soft companies
47:54
what is the impact employees are more productive what’s the impact on the
48:00
overall value of the company what’s the magnitude is it plays a more productive
48:06
productive what impact does that have on the valuation well I mean it can be
48:12
significant if you look at slide 43 there’s an illustration there so let’s
48:20
place for example there’s a 2% increase in productivity well and that can result
48:25
in a 50% increase in profitability let’s assume here the company has a has ten
48:32
million dollars in revenues pre-tax profits of $400,000 as we’ve shown a
48:39
slide if that sales force can increase revenues by two percent but hold the
48:45
expenses constant will the pre-tax profits increase by 50 percent
48:51
another way that profitability could be increased by 50 percent would be if the
48:57
employees are able to reduce the expenses by 2 percent while holding revenues constant of course if you can
49:05
get the employees to both increase the revenues and expenses can be kept in
49:10
check well mathematically you could be talking about increasing the company a
49:16
hundred percent in terms of its profitability okay let’s move on to the third use of these thoughts which is to
49:22
increase corporate cash flow and net worth as you mentioned earlier this can
49:27
be accomplished by simply having the company contributes newly issued stock or Treasury stock we stock on a
49:35
year-by-year basis and then the result is to reduce corporate taxes and
49:42
increase cash flow multi-multi Nestle providing a retirement benefit for the
49:48
employees so what are the pros and cons of using these soft in this way to increase company cash flow well as you
49:57
mentioned I mean the principal advantage of using an esop to increase the cash flow the company’s cash flow and the net
50:04
worth we know will be increased disadvantage you’re talking about
50:10
issuing new shares and that’s going to create dilution to the existing shareholders
50:17
you know if you think about it there in a sense the dial there’s no dilution if the contribution to the esop is in lieu
50:24
of cash bonuses cash contributions would be made to another retirement plan a
50:30
company’s 401k or the profit sharing on this slide for example we illustrate and
50:36
here’s a banker thrift they contribute $300,000 worth of company stock to the ESOP but that’s in lieu of the 300,000
50:44
that they’re putting in to fund the 401k match or maybe a profit sharing contribution the bank the thrift in what
50:53
they’ve done in effect is they’ve received $300,000 of cash in exchange for the $300,000 stock contribution you
51:02
know its net worth and increases by 300,000 similarly the bank or the thrift
51:07
currently makes no contributions to a qualified plan – if that’s the case they
51:12
now make these contributions worth 300,000 of company stock to the ESOP again from a cash flow perspective net
51:20
worth we still increased it by a hundred and thirty-two thousand dollars so if
51:26
you think about it given the severity of the current recession an esop can be used to generate the tax refund of prior
51:35
taxes paid for example if the bank or the thrift already anticipates that it’s
51:41
going to have a loss for 2009 let’s say it contributes the $300,000 worth of
51:47
company stock to the ISA thereby increasing its current loss by an additional three hundred thousand it
51:53
could then carry this loss back to any of the prior five years and receive a
51:59
tax refund assuming the bank was profitable and paid taxes during those prior years the fourth use of an esop is
52:06
to create a succession plan for existing shareholders in my view any stock
52:12
transaction is truly the least stressful and most efficient means of doing it to
52:19
transfer ownership to the generation after the number of reasons
52:25
first as we’ve noted it utilizes pre-tax cash flow rather than after-tax cash
52:31
flow to do this secondly it’s usually done in stages and therefore involves
52:38
less leverage which is important these days and third it usually involves no
52:44
change in management control at the outset in most cases there’s only a gradual change of management control
52:51
over a long period of time how do you view the ESOP as a business succession to lifteth well I mean from a
52:59
transition standpoint an esop on its own usually is not going to be the single
53:05
answer to the objective the objectives of Sheila’s would typically have two or three or four pieces to them I mean for
53:12
example many owners they want to reward the key employees in addition to an esop
53:17
it’s going to be broadly benefiting the rank-and-file but there is a way to do
53:22
that there’s an alternative whereby their stock sold to the ESOP and then
53:27
there’s also stock that’s awarded to or maybe even sold directly to key employees they sent those key employees
53:35
have available funds they’re going to purchase that stock but there’s also another way in which ESOP stand side by
53:41
side with a compensation a stock compensation program for key employees
53:47
we refer to those as non qualified stock options or or management stock bonus
53:53
plans and those things are created specifically for the key employees who
53:58
are going to be responsible for the long term growth and the succession of the business okay we’ve talked about the
54:05
various advantages of a nice top of what about the disadvantages so what do you
54:12
think those are the disadvantages of an esop I guess I’d say it depends on the
54:18
facts in the circumstances but there there can be some disadvantages I mean in most cases the the disadvantages they
54:26
really far more perceived than they are real you have to look look at the case specifically objective the objectives of
54:33
Sheila’s would typically have two or three or four pieces to them I mean for example many owners they want to reward
54:39
the key employees in addition to an esop it’s going to be broadly benefiting the
54:45
rank-and-file but there is a way to do that there there’s an alternative whereby their stock sold to the ESOP and
54:52
then there’s also stock that’s awarded to or maybe even sold directly to key
54:57
employees they sent those key employees have available funds they’re going to purchase that stock but there’s also
55:04
another way in which ESOP stands side by side with a compensation a stop
55:09
compensation program for key employees we refer to those as non-qualified stock
55:15
options or or management stock bonus plans and those things are created
55:21
specifically for the key employees who are going to be responsible for the long term growth and the succession of the
55:28
business okay we’ve talked about the various advantages of an esop of what
55:34
about the disadvantages so what do you think are the disadvantages of any stock
55:41
I guess I’d say it depends on the facts in the circumstances but there can be some disadvantages in most cases the the
55:50
disadvantages they really far more perceive than they are real you have to look look at the case specifically one
55:57
case where there is a disadvantage in the sale of an esop or sales and II saw by a bank or a thrift is the necessity
56:06
to secure the regulatory approval for the transaction in certain cases under
56:12
the Bank Holding act if the ESOP acquires 25 percent or more of the stock
56:17
of a closely held bank or a bank holding company or if 10 percent or more of a
56:24
publicly traded bank or bank holding company there’s a requirement it will be
56:30
deemed I should say to be a bank holding company and it must secure approval from
56:36
from the Federal Reserve before acquiring this amount of stock now the
56:41
same rules apply in the case of a federally chartered thrift and federally
56:46
chartered thrift holding company except the approval must be secured in this
56:52
case from the office of Thrift Supervision similar rules apply to state
56:57
chartered thrift institutions but the state requirements they’re not always the same as the federal requirements in
57:04
the case of an ISA approval will always be given since the Aesop’s ownership is
57:11
never to create a monopoly or restraint of trade fundamentally the concerns that these these requirements are there to
57:18
guard against so it’s not that there’s a real prohibition it’s just that the
57:24
disadvantage is it takes time to satisfy those requirements of the regulations you’re going to need some lead time 90
57:30
days 120 days in a case of federally registered thrift institutions there’s
57:38
also a reg that requires the thrift to notify the office of Thrift Supervision
57:44
if the South acquires 10% or more of the outstanding stock this office of Thrift
57:50
Supervision excuse me they can disallow the transaction if they believe this
57:56
transaction will impair the thrift financial ability under the change of
58:01
control provisions of the specific act called the chain engine bank control act
58:08
you’ve got to get the approval – it must be secured if the ESOP acquires from
58:15
five percent up to twenty four point nine percent of the stock of a bank a
58:20
bank holding company or a thrift institution again in the case of an esop
58:26
the approval will be given because the ESI ops ownership is not going to do
58:31
what those regulations are intended to guard against which is create some further monopoly or restraining probably
58:38
say that another disadvantage of the knee stop versus a sale to a third party
58:44
is that it you know the sale to the ESOP depends on the ability of bank or the
58:50
thrift to obtain the necessary financing if the transaction is financed through the third party loan excuse me well the
58:56
bank of the thrift must have the ability to obtain the necessary third party funds based on their sufficient cash
59:03
flow because they have to service the debt another alternative of course is to have the bank itself act as the lender
59:10
in other words don’t involve another lender to the other bank of the drift they do it themselves again there’s some
59:17
Federal Reserve Act requirements that will allow the bank to do that arm
59:22
however in the case of thrifts they are not permitted to lend to their pony
59:28
socks but don’t forget that even a thrift there’s another source of fine
59:33
dancing which is the seller can finance the transaction himself or herself
59:39
probably the the other disadvantage of a nice off sale is that the debt that’s
59:44
incurred to finance the transaction well that certainly is going to reduce the bank’s net worth if the bank’s net worth
59:51
is gradually diminished so I should say it’s greatly diminished the banks
59:56
lending capacity can be reduced and that problem can be avoided it’s generally
1:00:03
advisable that the stock of the bank or the thrift if it’s purchased gradually in other words you’re not over
1:00:10
leveraging the transaction well then in that case the concerns about network usually are diminished in fact this
1:00:18
disadvantage can usually be completely avoided if the bank or the thrift is
1:00:24
owned by a holding company see in this case the esop is adopted by the holding
1:00:30
company and the financing gets obtained by the holding company not by the operating bank the subsidiary in this
1:00:37
case the net worth the net worth and the lending capacity of the bank or the
1:00:44
thrift subsidiary won’t be affected there is one exception however in the
1:00:50
case of a bank holding company that owns only one bank so it’s only got the one subsidiary that and if that bank has
1:00:58
assets of less than 150 million and the
1:01:03
other 30 soft owns 25 for more for 25 percent or more of the stock holding company sorry the stock of a holding
1:01:10
company well then the holding company’s debt it’s going to count against the bank’s capital unless of course the the
1:01:18
holding company’s debt complies with certain requirements in these
1:01:23
requirements include for example the requirement that the acquisition indebtedness must be less than 75% of
1:01:31
the purchase price of the stock and that the ratio of gross capital to assets
1:01:36
must be at least 7 percent during the first 12 months after the acquisition
1:01:42
and the requirement there’s also a requirement the ratio of debt to equity in the
1:01:49
holding company must be projected to decline 30 percent or less within twelve
1:01:56
months of the acquisition now we’ve already talked a little bit about the idea of shareholder dilution
1:02:02
and that certainly is another concern in the case of an esop transaction the
1:02:09
dilution comes about only if the e-stop is funded with newly issued shares again
1:02:14
remember we mentioned that if the ESOP is funded with newly issued shares there’s going to be an increase in the
1:02:20
bank’s net worth and it’s lending capacity I mean I’d probably say that the the dilution becomes an advantage rather
1:02:27
than a disadvantage to the extent that it enables the shareholders to own a
1:02:33
smaller piece of a bigger pie
1:02:39
the thing is the common misconception is that an esop is also a problem because
1:02:44
of the loss of control and you know that just isn’t true in the case of a closely held company the Board of Directors
1:02:50
remember they run the company and they appoint oftentimes the controlling
1:02:56
shareholder the founders as the officers and the directors of the company and
1:03:01
they’re also going to be identified as the Aesop’s fiduciaries in the case of a
1:03:09
privately held company this ISA fiduciary in our document structure the plan committee well they’re going to
1:03:15
direct that the voting of the shares in isaw on all ordinary issues that’s done
1:03:21
by that group for example the annual election of the shareholders will be voted in a sense controlled by the same
1:03:29
group so there really isn’t any loss of control now remember that there is this
1:03:35
is an employee stock ownership plan we’re not trying to dilute the the
1:03:41
interest and the benefits of the employees but the fact is under the law the only exception is that participants
1:03:47
in the plan they are going to be entitled to direct the trustee to vote the shares that are in their account
1:03:53
what we call these special issues these issues for example in the case of a
1:03:59
corporate merger or consolidation a reclassification a liquidation a sale of
1:04:05
substantially all the assets and what I call organizational type issues well if
1:04:10
those types of issues come up then the participants are going to be entitled to following a full disclosure of the
1:04:17
action that’s being presented they’re going to get the benefit of being able to vote the shares that they want in
1:04:25
their account allocated their account in the manner they see fit now again there’s going to be unallocated shares
1:04:31
in the case of a leveraged ESOP well the soft fiduciary is going to be able to control those and vote those remember
1:04:39
there are certain cases where the participants again these special unique circumstances where they vote but
1:04:45
generally the participants also just because the trusts own stock they don’t vote on any proposed sale the stock
1:04:53
a third party see that’s a tender issue that’s the fiduciary decision investment decision and the participants don’t vote
1:05:00
on that nor is there any sort of a shareholder vote classically in a tender
1:05:05
offer to sell all the shares it’s important also to note that you know
1:05:11
having an esop isn’t going to take away any of the other shareholder liquidity options and so you put the ESOP in place
1:05:18
at own stock existing shares they can still sell their stock to others Nonnie
1:05:23
Safa shareholders there in the company I mean the existing shareholders then sell
1:05:30
say the remaining stock they could sell the remaining stock to a third party
1:05:36
you’re going to have to have the ESOP fiduciary make a decision as to whether or not they want to sell their stock to
1:05:42
a third party I mean I think that the biggest misconception is that somehow having an esop will require the company
1:05:49
to also disclose financial information again see this isn’t true the ESOP the
1:05:54
infra digital participants don’t own stock the trust owns the stock well shareholders of companies are not
1:06:01
entitled to to ordinarily have all financial information the company exposed to them there are disclosures
1:06:08
that are required you know to the trustee as the shareholder those are
1:06:14
subject to to state law requirements but as to the individual participants the only disclosures that are required is
1:06:21
that they’re furnished with their annual benefit statements they have to obviously know what their their account
1:06:26
balances are from year to year their vested percentage and the value of the stock in their account
1:06:32
so you see having an esop you know it doesn’t expose the the Esau fiduciaries
1:06:38
the trustees to any greater risk of fiduciary liability that’s always a common question that comes up when you
1:06:45
consider some of the concerns by an ISA but to see the fact is most companies already have a profit sharing plan or a
1:06:52
401k they have to do sharing liability as to those plans as well I mean in some
1:06:58
ways the ESOP fiduciary liability is less because the trustees of an esop
1:07:03
there’s a there’s a normal requirement in profit sharing plans that the trustees if they’re going to invest that
1:07:10
money on behalf of the participants they have a high standard of care to live up to by way of diversifying those
1:07:17
investments in an attempt to provide maximum investment liquidity for the
1:07:23
assets of the trust well if I’m a trustee of an esop guess what I actually am exempt from that normal
1:07:30
requirement if I decide to prudently invest the assets of an esop in company
1:07:36
stock I’m actually given a presumption that that is a an appropriate thing to
1:07:41
do and even though there’s no diversity and diversification of those investments
1:07:47
the law says that’s Lenise op is supposed to do the other conception or misconception
1:07:54
that comes up a concerned about Aesop’s is oh my goodness crushing repurchased liability because
1:07:59
of the ESOP it was never there before well that’s not true at all remember and shareholders in closely held companies
1:08:06
that are holding stock well that’s a call on the company’s capital as well those shareholders are going to have a
1:08:12
right if not under a shareholder agreement under a contractual agreement to say they get the right to be
1:08:18
repurchased as well so the difference of course is that in an esop the repurchase
1:08:24
obligation it’s going to be spread out over the lives of all the participants remember the trust owns the stock
1:08:30
allocated the participants accounts and in the case of you know for example in a
1:08:37
stock redemption will boom the repurchase is going to occur all at once upon the death of the retirement of an
1:08:44
owner and usually without an esop you’d be doing that with after-tax dollars in
1:08:50
the case of an esop it’s going to be a gradual purchase of those shares as the
1:08:55
individual participants leave the plant I finally John what I would say is it’s
1:09:02
got to be pointed out that selling to an esop unlike a merger or sale to a third
1:09:09
party it’s not an irreversible decision and you sold the stock to the ESOP could
1:09:15
the company decide for good business reasons that it wants to terminate the plan absolutely that is a right that
1:09:21
still resides with the board of directors of the company now you can terminate the ESOP and if
1:09:28
there are shares and there they’re going to be distributed and repurchase it’s also possible that if there is sort
1:09:33
of a decision to put the ESOP on hold little plan can be frozen and in that case through some some appropriate steps
1:09:41
the stock gets repurchased over it over time as the employees die I retire and leave the company all right I guess
1:09:48
finally you know some states are going to prohibit banks and thrifts from
1:09:54
repurchasing their own shares if this restriction applies then the
1:09:59
ESOP can only be terminated if all the shares held by the ESOP are purchased by
1:10:05
a third-party buyer Thank You Victor I think that covers the formal
1:10:11
presentation that we planned for today and the next slide this is an overview
1:10:19
or the services that our firm maintain associates provide and more specifically
1:10:25
on the next slide we provide more or less one-stop shopping we do provide the
1:10:33
design and installation services we provide the business appraisal that’s
1:10:39
needed the financial consulting we draft all the legal documents we secure IRS
1:10:45
approval we prepare the employee communications booklets and summary plan descriptions we hold PowerPoint
1:10:51
presentations with them to explain how the plan works and then we yes last but
1:10:58
not least we provide and prepare the ongoing annual administration
1:11:04
requirements employee benefit statements and 5500 fires
1:11:09
and then on an ongoing basis we update the appraisals and we apply provide the
1:11:18
annual record-keeping services that’s required by the IRS from the department
1:11:23
labor we believe of course that if you’re conflating a nice outfit it’s essential
1:11:30
to use a firm that’s that specializes in this and has a long experience in doing
1:11:36
it with an experienced firm you’re going to get all the services needed at a less
1:11:44
cost than if you have to use a whole bunch of service providers and there’s
1:11:51
probably far fewer errors and again we take pride in the fact that we’ve done
1:11:58
over 2,500 Aesop’s over the last thirty five years and we’re the most active
1:12:03
firm in that regard if you’re interested we have offices in San Francisco Los
1:12:09
Angeles Las Vegas Chicago Atlanta Chesapeake City Maryland and Wilmington Delaware in Naples Florida and our
1:12:18
appraisers are located throughout the country as well in all the major regions
1:12:24
so if you’re interested in any software you have a client one of your bank
1:12:30
clients if interested them how do you know the business is an appropriate candidate for an esop we’ve covered a
1:12:36
lot of pros and cons but ultimately you have to determine on a case-by-case basis the VSOP really fit is it really
1:12:44
feasible so if you’re interested in finding that out or your clients are
1:12:49
just the way to proceed I think is to take few minutes and complete our
1:12:55
confidentiality or confidential feasibility questionnaire form that’s on
1:13:00
our website at wwlp.com the fax or email
1:13:07
this back to our home office and then we’ll review it and preach are give your
1:13:12
call discuss our findings and the feasibility so again just fill out the
1:13:18
free feasibility analysis form or you
1:13:24
can just give us a call directly at 803 for 78357 again thanks for attending
1:13:31
have a good day