ESOPs for Government Contractors

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good morning and welcome to the esop web seminar for government contractors
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my name is john mendte and i’m the president of menken associates inc today’s seminar is in a question and
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answer format i’ll ask a series of questions regarding how esops can be used by government contractors to accomplish
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various goals and objectives and victor allen will provide the answers based on his knowledge and experience in
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designing these stops for dozens of government contractors victor is an erisa attorney and has been
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a senior counsel with minkin associates for almost 14 years
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our background lincoln associates is the oldest firm in the country specializing in esops our firm was
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founded in 1974 and 2005 marks our 31st anniversary of designing and installing esops
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over the past 30 years we’ve created more than 2 000 esops more than any other firm in the country
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we also administer about 800 esops also more than any other firm in the country and we have six offices throughout the
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united states and we’ve installed these stops in all 50 states let me begin by defining what an estop
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is to the existing shareholders and he stops a buyer of stock
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that simultaneously offers tax savings to the seller and an orderly succession plan for both
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majority and minority shareholders to the company the esop is a technique of corporate finance that enables a
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company to finance growth and expansion and or shareholder redemptions with tax deductible dollars
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while also providing a highly effective employee incentive plan to the employees an esop is a company
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funded retirement plan that offers them an incentive and a reward that is usually unmatched by any other type of
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retirement plan it’s important to note that an estop consists of both the plan and trust
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and that the trust is the direct owner of company stock not the employees typically the company owners are
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designated as the plan trustees employees will receive annual statements reflecting their account balances in the
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esop however they’re not entitled to company financial statements nor do they have voting rights except with respect to certain special
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issues therefore voting control does not have to change when an esop is implemented even when an
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esop owns a majority of the stock now i’d like to ask victor the first question why is it that esops are
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popular with owners of privately held businesses over the past 31 years esops have been increasingly
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popular among privately held firms because they offer a number of tax and financial advantages that are not
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available under other alternatives the most frequent use for an esop
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for example is to create partial or total liquidity for existing shareholders esops are
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uniquely designed to accomplish this objective in the great majority of cases the primary purpose of the esop
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is to create an in-house market for existing shareholders the advantage that an esop brings to the
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table is that it enables the company to repurchase shares from existing shareholders
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using tax-deductible contributions rather than after-tax funds in the case of a c corporation
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congress has provided a special tax incentive to encourage companies to use esops for
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shareholder liquidity under this special tax provision if the esop acquires
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30 or more of the stock of a privately held company the tax on the gain will be deferred
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provided that the selling shareholders reinvest the proceeds in qualified replacement property in the
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case of s corporations there is also an advantage to using an esop to create shareholder liquidity rather than
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utilizing a stock redemption the advantage of selling to an esop is that any amount of stocks
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sold to the esop will qualify for the favorable capital tax rate which
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under the current tax code is only 15 percent at the federal level
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in the case of a stock redemption redemption has to be substantially disproportionate
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in order for the redemption to be taxed at capital gains rates rather than ordinary income tax rates
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qualifying a stock redemption as a disproportionate redemption is often difficult in the case of a sole
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shareholder it is in fact impossible to achieve an esop on the other hand
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is very flexible and not limited by the rules that apply to stock redemptions now a
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second reason why esops have been increasingly popular is that whether the company is a c corporation
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or an s corporation an esop can help a company to substantially eliminate
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the payment of federal or state income taxes on the earnings of the company we’ll
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discuss the techniques for doing this in a little more detail later in this session the third advantage
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of using an esop is that in most cases you can continue to control your company just as you do now
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unlike a sale or merger you can create shareholder liquidity for yourself and
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for other shareholders of the company yet still retain control even after selling a majority of the
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outstanding stock to the esop a fourth advantage of using an esa
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is that the monies the esop borrows in order to buy out the existing shareholders can be repaid entirely with
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tax deductible dollars that is to say the company will be able to deduct not only the loan interest
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as can be done in the case of a stock redemption but also the loan principle
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this is unique to esop’s last but not least when properly implemented
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and communicated an esop can have a dramatic effect on increasing employee productivity this
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in turn can result in increased profitability and increase the overall valuation of
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the company now as a result of the various tax and financial benefits that esops
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have to offer there are now over 11 000 esops currently in existence and
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these esops cover over 10 million participants in fact it’s estimated that the total
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value of all esop assets now exceeds 500 billion dollars
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now i’d like to talk about how esops can be used by owners of government contractors victor what are the common ownership
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problems that are faced by owners of government contractors well the common
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ownership problems that are faced by owners of government contractors they are in general the same problems
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that are faced by all owners of privately held firms namely the lack of liquidity
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the lack of diversification and the need for a succession plan
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fortunately an esop is one of the tools that can provide an answer to all three of these problems
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it can provide liquidity and diversification for existing shareholders and it can also provide for an orderly
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business succession strategy as a liquidity tool the esop offers a
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number of advantages dsop creates an in-house market whereby existing owners can sell their shares as
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and when they see fit unlike a sale or a merger an esop allows
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the owners to sell part of their shares rather than needing to sell the entire company thus owners can sell
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their shares over a period of years rather than having to sell all at once
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since the esop creates an in-house market no outside party is involved and there is a
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certainty of the outcome also the cost of arranging a sale to an esop
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is a fraction of the cost that would be incurred in a sale to a third party
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now as a tool for investment diversification esop allows you to diversify whatever
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amount of stock you wish to liquidate and invest in other investments such as
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cash fixed income securities or equities the mix of investment selections is entirely up
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to you as a tool for business succession the esop is probably the least
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stressful method of ownership transfer due to the fact that it doesn’t involve an outside buyer
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with an esop there is certainty of the outcome and there is less likelihood of employee
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layoff and or changes in management in fact an esop purchase can also be combined
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with a management buyout so that management can also acquire significant equity in the company
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the particular advantage that an esop offers is that it can provide for the gradual change of
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ownership to the employees in the meantime the existing owners
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still retain the right to sell the entire company at a later date and still retain the right to control
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the company in the meantime victor it’s easy to see that he stops offer a number of financial
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taxes and is not offered by other alternatives but why is it that esops are especially popular with government
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contractors i think esops are especially popular with government contractors
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because these firms are by definition service businesses where the success and profitability of the firm
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depends largely on the productivity of the employees another reason why esops are so popular
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with government contractors is that as a general rule these types of firms
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prefer to be locally owned and operated a third reason why government contractors utilize esops is that the
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esop can be a very useful tool in helping a company attract and hire
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high quality employees again good employees are much more inclined to accept a job
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offer from a company that provides the opportunity for stock ownership than from a company that provides no
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such opportunity also esops are popular among government contractors because these types of firms
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fully recognize that their professional associates are in fact their most valuable asset in the absence
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of an esop or a similar type of program there’s always going to be that risk
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that the key employees will simply walk out the door and start up a competing business now
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another reason why esops are popular with government contractors is that many government contractors do
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work under something called cost plus contracts under cost plus contracts the contractor
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not only receives a predetermined fee for the work that it performs but it’s
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also reimbursed for certain internal costs above and beyond the set fee for example
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under the cost accounting standards board which we’ll refer to as the cas
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4 15 a government contractor under a cost plus contract is entitled
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to be reimbursed for something called deferred compensation benefits
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now in 2003 the cas 415 was specifically amended to make it
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clear that contributions to an esop qualify as deferred compensation benefits
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for purposes of the cas 415 standard thus for example if a cost
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plus government contractor adopts an esop and leverages its esop in order to buy
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stock from a shareholder the annual contributions that the company makes to a csop
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in order to service the esops debt will not only be tax deductible but will also be reimbursed in whole or
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in part depending on the circumstances whether the contributions will be fully reimbursable or only partly
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reimbursable will depend upon whether the company has already substantially used up
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the maximum amount allowed for deferred compensation under its existing contracts if the
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company has already utilized most of the maximum amount that is allowed for
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deferred compensation with for example contributions to other forms of deferred
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compensation well then only a small portion of the esop contributions will be reimbursable
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under the cas 415 standard now on the other hand if the company is
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utilized only a small portion of the maximum amount that’s allowed for deferred compensation
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with contributions to other forms of deferred compensation then all or most of the esop
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contribution will be reimbursable i’d say for all these foregoing reasons i think esops
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are an especially good fit for government contractors well victor given that he stops are
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generally a good fit for government contractors are there any situations where any stops not a good fit for government
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contractors yes there are a few situations where an esop
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won’t be a good fit one situation would be where the firm is simply too small to have an asop now
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john as you know we’ve done esops for companies with as few as 10 employees and as many as 10 000 employees however
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it is usually not economical to install or maintain an esop if the company has
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fewer than 10 employees in addition if the company is an s corporation and
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has 10 or fewer employees it can often be difficult to comply with the so-called
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anti-abuse provisions that are set forth in section 409 p of the internal revenue
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code if the company cannot comply with these provisions then it will either have to forego
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becoming an esop or convert to a c corporation status
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the second situation where an esop is not a good fit is where the company is relatively new
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and not yet profitable in order for the esop to be most effective the company needs to be profitable and
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paying taxes well these apps are generally used for four principal purposes
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to create liquidity and diversification for sellers to increase employee productivity to
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increase company cash flow and to provide for business diversification
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let’s start by discussing how eastops are used to create liquidity and diversification for sellers victor how restock
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transactions typically structured so as to create liquidity and diversification for owners of government
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contractors pretty much the same way as they are structured for any other type
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of firm how the esop is structured depends upon the goals and the objectives of the current
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shareholders esops can be extremely flexible in how they can be structured for
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shareholder liquidity purposes in general there are three basic ways an aesop can be structured
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the first is what i call a pre-funded esop a pre-funded esop is one where the esop
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is established and the company makes contributions to the planning cache which is accumulated to be used later to
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purchase stock from the company’s shareholders many companies start out by using a
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pre-funded esop as a way to generate current tax deductions and as a way to accumulate cash in the
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plan where for one reason or another the current shareholders are not yet willing
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to start selling their shares to the plan under the current internal revenue code
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provisions a company is allowed to make tax deductible contributions each year in an amount up to 25 percent
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of eligible payroll thus for example if the company’s eligible payroll is one
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million dollars it could make a tax deductible contribution of up to two hundred
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and fifty thousand dollars per annum thus if the company contributed the maximum
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amount each year for a period of say four years the plan would have accumulated a piggy bank of
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at least a million dollars in funds plus however much interest might be earned on these funds
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many times the company is already spending these funds in a 401k match or
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in profit sharing contributions which do not have the flexibility to invest in
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company stock now a second way that an esop can be structured
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is something referred to as a gradual esop gradual esop is one where the company makes
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discretionary contributions each year up to the maximum amount and then uses
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those contributions to purchase shares from the existing shareholders
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on a year by year basis the advantage of this approach is that it is highly flexible the
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company has complete discretion as to how much it can contribute to the plan each year
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the advantage to the selling shareholders is that they are only selling a small percentage of their
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stock from year to year however unlike a stock redemption each and every sale to the esop will qualify
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for favorable capital gains treatment in the case of a c corporation once the esop has acquired
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30 or more of the outstanding stock then the sellers can also elect to defer
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indefinitely the taxation of their capital gains provided that certain conditions are met
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the third way that an esop can be structured is a leveraged dsop a leveraged dsop
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structure is used where the shareholders want to cash out more quickly or in the case of a c corporation want
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to immediately qualify for the tax deferral of their capital gains
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taxes as i mentioned earlier in order to qualify for the tax deferral the esop must
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acquire at least 30 percent of the outstanding shares unless the plan has been pre-funded the
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esop will usually have to be leveraged in order to have enough funds to purchase 30 percent of the outstanding
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stock how is the plan leveraged does the plan borrow the money or does the company borrow the money
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good question let me explain this by giving a specific example let’s assume that we have a company with
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annual sales of 50 million dollars and an eligible payroll of 5 million
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pre-tax profits of 3 million and a fair market value of 15 million dollars
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now let’s further assume that the esop wants to purchase 30 percent of the outstanding stock for a price of
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4.5 million dollars the way this works is that the bank lends 4.5 million
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dollars to the company and the company lends the 4.5 million to the esop
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the esop then purchases 30 of the outstanding stock from the company’s shareholders
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for 4.5 million in cash at the end of the year the company then
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makes a tax-deductible cash contribution to the esop in an amount up to 1.25 million
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plus interest the esop then uses that contribution to repay the interest
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and the principal on the company loan the company then repays the bank loan
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assuming that our sellers qualify under the tax deferral provisions they will wind up
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saving anywhere from six hundred and seventy five thousand to nine hundred thousand
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in federal and state taxes depending upon the state income tax rate
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now of course these structures can be combined if useful and necessary
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case four for example combines the pre-funding and leveraging ideas of cases two and
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three in this slide for example you’ll note that the company pre-funded the esop for
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two years accumulating about two and a half million dollars of cash
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meanwhile the company grew from a fair market value of 15 million
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to 16.65 million at the end of the third year in order to
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achieve the 30 percent threshold the esop needs to own about five million dollars of company stock
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since 2.5 million is already accumulated the required bank loan now
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only needs to be two million four hundred and ninety five thousand dollars
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which is two million five thousand dollars less than what would have been required
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if no pre-funding had occurred therefore the required loan is reduced
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by 45 percent and the annual debt service well that’s going to be reduced by over two hundred
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and seventy two thousand dollars a year similarly in case five we combine
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a year by year purchase with a tax deferral sale in year four
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as shown by this slide by the end of the first year the esop would purchase
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three percent at the end of the second year the esop would hold seven percent and at the end of the
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third year it would hold twelve percent of the company’s outstanding stock each of these sales would be taxed at
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capital gains rates however the sale in year four would result in the esop owning
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30 percent thus the seller would be able to elect the tax-free rollover with respect to
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the stock sold to the esop in year four case six illustrates how an esop can be
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structured to accomplish a one hundred percent esop buyout
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in most cases this is not possible to obtain the financing to accomplish a one hundred percent esau buy out in
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one fell swoop accordingly a 100 percent esop buyout is usually structured as a two-stage
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esop purchase in the first stage for example the esop might be leveraged in an amount
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sufficient to buy fifty percent of the outstanding stock then after this loan has been paid down the
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plan could be re-leveraged in year four to buy the remaining fifty percent
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victor what if there’s more than just one shareholder of the company what if there’s a majority shareholder and one or more
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minority shareholders can use help offer to buy out the majority shareholder without also making the same offer to the minority
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shareholders well john in most cases the shareholders will readily agree among themselves
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as to whether the esop will be used to purchase all or part of the stock of a majority
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shareholder or part or all the stock of one or more the minority shareholders
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or it might even be a combination of the two however if for some reason the shareholders
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can’t agree among themselves then it is typically the case that the esop will buy stock from all the
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shareholders on a pro-rata basis you mentioned earlier that in the case
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of a c-corporation there’s a special provision of the code that allows selling shareholders to receive their proceeds on a tax-deferred
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or tax-free basis can you tell us a little more about how this works absolutely under section 1042 of
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the internal revenue code if an esop acquires 30 or more of the
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stock of a privately held c corporation the capital gains tax on the amount of
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gain will be deferred provided that the seller reinvests a like amount
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of money in qualified replacement property within 12 months from the date of the sale
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this tax deferral will continue as long as the seller continues to hold the qualified
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replacement property if the seller holds the property until death
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then it will receive a step up in basis and the capital gains tax will be
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completely avoided this type of transaction is typically referred to as a tax-free rollover
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qualified replacement property consists of stocks or bonds of american corporations
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corporations may be big or small private or public but they must be american the seller
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cannot invest in a mutual fund or in government securities unless he’s willing to pay
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capital gains tax most sellers who elect the tax deferral wind up investing the
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proceeds in a diversified portfolio of corporate stocks and corporate bonds now a seller can
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always sell part or all of his replacement securities later on to the extent that he does so however he
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will pay the capital gains tax that was previously deferred as well as a
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gain on any subsequent appreciation victor is there any way to avoid being
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locked into these replacement securities and having to hold the same securities until death
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yes there is a relatively simple way around this problem and that’s to purchase a
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long-term esop bond and then margin out 80 to 90 percent of the proceeds for
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example let’s assume that a seller receives 4.5 million dollars
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from the sale of stock to the esop he or she could then purchase 4.5 million dollars
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worth of long-term esau bonds and then this purchase would satisfy the
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requirement that the seller purchase qualified replacement securities now the
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seller could margin out let’s say 3.6 million of the proceeds
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and invest these funds as he or she sees fit victor you mentioned earlier
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that the tax free rollover provisions do not apply to shareholders of an s corporation but are there any tax advantages that
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apply to s-corporations that do not apply to c-corporations yes john there are as you know in the
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case of an s-corporation all the earnings of the corporation are taxed at the shareholder level
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rather than at the corporate level as you also know the esop is a tax-exempt entity thus to
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the extent that the stock of an s corporation is owned by an esop
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part of the corporation’s earnings will be exempt from income tax in the case of an s corporation that is
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100 owned by an esop none of the corporations earnings will be subject to
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income taxes the esop share of s corporation earnings is also exempt
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from the unrelated business income tax now there are only two disadvantages to
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s corporation esops the principal disadvantage is that there is no tax free rollover
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available to sellers when they sell their stock to the esop they must pay the capital gains
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tax on the sale a second disadvantage is that s corporation esops must cover a broadly
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based group of employees under this test if certain disqualified persons own more
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than 50 percent of what is called the deemed owned shares then the esop share of
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earnings will be subject to the unrelated business income tax and
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these disqualified persons will be subject to certain excise taxes
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victor and due to the fact that in the case of s-corporation e-stops the tax benefits accrue more for the
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benefit of the company itself rather than for the benefit of the selling shareholders are used
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transactions structured differently for s corporations than for c corporations basically all of the same
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transaction structures that are used by c corporation esops are used by s
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corporation esops as in the case of c corporations with s corporation esops
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some esops are structured as pre-funded esops some are structured as gradual esops
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where the esop purchases the shares from year to year and some will be structured as leverage d stops
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however because of the fact the company will be a hundred percent tax exempt
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if the esop is the sole shareholder we have seen many more hundred percent
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esau buyouts of s corporations than we have seen in the case of c
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corporations also because of the difficulty of securing 100
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bank financing for a buyout many of these transactions have been structured
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with 100 percent seller financing on this slide here’s an example of how
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leveraged esops are typically structured for s corporations in this example the owner
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let’s call him joe is the sole shareholder and pays himself a salary of two hundred thousand dollars a year
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there are twenty other employees that have a total compensation of eight hundred thousand dollars
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so that joe’s compensation is twenty percent of the total payroll finally let’s assume that the company
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has a value of four million dollars case seven shows how the transaction
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will be financed with seller financing in this case joe becomes the banker
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himself by taking back an installment note from the esop joe will receive installment payments
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over the term of the note as he receives the principal he will have to pay capital gains tax on the portion of the
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principal payment that represents gain and he will pay ordinary income tax on
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the interest portion but the important thing to point out is that the esop now owns one hundred
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percent of our company the company no longer has to pay any income taxes assuming a pre-tax
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profit for the company of eight hundred thousand dollars this would result in a tax savings of
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over three hundred thousand dollars that otherwise would have been paid each
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and every year in taxes that same three hundred thousand dollars can be used instead
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to pay for a large portion of the installment payments that will be paid to joe each year on
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his installment note now our next slide illustrates two points with respect to leveraged esops
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first it illustrates how the debt is repaid in the case of an s-corporation the debt is repaid by having the company
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make tax-deductible contributions to the esop which the esau then uses to make note
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payments to joe our seller in the case of an s corporation
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the debt can also be repaid by using the s corporation distributions that are paid
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to the esop and then used to make no payments to joe debt is repaid the same way in c
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corporations except that c corporations are not allowed to make
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s corporation distributions to shareholders instead there is a special code
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provision that allows c corporations to pay so called deductible dividends to the esop
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over and above the tax deductible contributions now normally c corporations won’t pay
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dividends because these dividends are not tax deductible however in the case of an esop if these
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deductible dividends are used to repay esop debt the dividends will be tax deductible
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the second point on this slide is to illustrate how stock is allocated in the case of a
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leveraged esop in the case of a gradual esop obviously the stock will be allocated on a year by
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year basis as and when the shares are purchased now in the case of a leveraged dsop
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the stock is allocated to participants as note payments are made thus if the esop
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purchases a hundred percent of the outstanding stock all of the stock is initially held by
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the esop in what’s called a suspense account now each year as the company makes
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contributions to the plan and the contributions are used to make note payments to the seller
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or to the bank lender if the bank is involved a pro rata portion of the shares will be
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released from the suspense account and allocated to the accounts of the
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participants the block of stock that is released from a suspense account each year
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is then allocated among the accounts of the participants in proportion to covered compensation
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now the other alternative for structuring a leveraged esop is to have a transaction financed with a
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bank loan rather than with a seller note so if joe wants to receive
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cash right away for his stock the external bank financing would be
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required in order to put 4 million dollars into joe’s pocket right away
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thus case 8 is the same as case 7 with the exception that the bank
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is now involved the concept however is exactly the same the esop owns 100 percent of the company
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therefore the company pays no taxes and the lender is being repaid with pre-tax dollars
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because the company is now exempt from paying any taxes
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now whether the esop is bank financed or seller financed the results will be the same in either
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case first the company’s earnings will no longer be subject to income tax
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second joe will receive four million dollars and will pay capital gains tax on this gain
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third since joe’s compensation constituted 20 percent of the total compensation of the
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company’s employees joe will be allocated 20 percent of the
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stock within the esa and he will be able to cash out later on
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when he leaves the company now you should note that this is a benefit that does not
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apply in the case of a c corporation where the seller has sold stock to the esop
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and elected tax-free rollover treatment in that case there is a special rule
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that prohibits the selling shareholder and related parties from receiving any allocation of the
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stock that was sold to the esop in a tax-free rollover transaction
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fourth since the earnings of the company are no longer subject to income taxation the company
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no longer has to make distributions to the shareholders to enable them to pay their income taxes
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instead these funds can now be used to repay debt
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after the debt is repaid these funds can be accumulated in the company and used to make acquisitions or to
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otherwise fund growth and expansion of the company well so far we’ve talked about esops
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being used to create liquidity and diversification for shareholders a second use of esops
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is to increase employee productivity sometimes the primary purpose for adopting an esop is
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to create a direct link between employee productivity and their retirement benefits it’s simply common sense that people
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work best when they work for themselves as they say no one ever washes a rental car
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the concept of an esop is to have employees think and act like owners victor the obvious question then arises
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do esops in fact increase employee productivity yes numerous studies conducted over the
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last 17 years have all concluded that esop’s increased company performance
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for example one of the early studies found that employee absenteeism went down by 66 percent
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and employee turnover also went down by 50 percent after implementing an esop
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more recently there were two harvard business review studies that found
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that sales growth in esop companies was significantly higher than incomparable non-esop companies
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more importantly two independent studies one by northwestern university’s
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kellogg’s school of management and one by hewitt associates both found
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that esop companies had a higher return on assets and a higher return on shareholders
37:36
equity than comparable non-esop companies victor what’s the impact of increased
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employee productivity on profitability and the overall value of the company is it relatively nominal or is it
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significant john the impact can be quite significant this slide illustrates for example a
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two percent increase in productivity can literally result in a fifty percent increase in
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profitability in this case we assume that the company had 10 million dollars in revenues and a
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pre-tax profit of four hundred thousand dollars as the slide indicates
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if the sales force can increase revenues by a mere two percent but hold expenses constant the pre-tax
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profit increases by fifty percent another way that profitability could be increased by
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fifty percent would be if the employees are able to reduce expenses by two percent while holding revenues
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constant now of course the employees can both increase revenues by two percent
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and reduce expenses by two percent then the company would literally experience a 100 percent increase
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in profitability the third use of an esop is to increase corporate cash flow this can be
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accomplished by simply having the company contribute newly issued stock or treasury stock to the esop
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on a year by year basis the result is to reduce corporate taxes and increase cash flow
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while simultaneously providing retirement benefit for the company’s employees victor what are the pros and cons of
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using an esop to increase corporate cash flow well john as you mentioned the principal advantage of using an esop
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to increase cash flow is that the company’s cash flow and net worth will be increased
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the potential disadvantage is that issuing new shares of stock to the esop it will
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create dilution to the existing shareholders actually there is no dilution if the
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contribution to the esop is in lieu of cash bonuses or cash contributions that would be made to
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another form of retirement plan as illustrated by this slide
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for example if the company contributes three hundred thousand dollars worth of stock to the esop
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in lieu of a three hundred thousand dollar 401 k matching contribution
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or a three hundred thousand dollar profit sharing plan contribution the company has in effect
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received three hundred thousand dollars of cash in exchange for three hundred thousand
40:20
worth of stock if the company puts this money to good work the value of the company will
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increase for the benefit of all of its shareholders if the company does not
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spend the money wisely then there will be a dilution of the shareholders equity
40:39
the fourth use of an e-stop is to create a succession plan for the existing shareholders
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in my view an esop transaction is the least stressful and most efficient means of transferring ownership to the
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next generation for three primary reasons first it utilizes pre-tax cash flow rather than after tax
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cash flow second it’s usually done in stages and therefore involves less leverage and third it usually involves no change
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in management control at the outset in most cases there’s only a gradual change in management control
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over a long period of time victor what what’s your view of the esop for the tool for business succession
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in the area of business succession and transition an esop on its own is usually not the
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sole answer to one’s objective for example many owners will wish to reward their key employees
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as well as certain family members in addition to the esau participants
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stock sales can be made directly to the key group of employees and stock grants can even be made to
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family members in many if not most cases we recommend creating a separate
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non-qualified management stock bonus plan that is created specifically for the key
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employees who will be responsible for the long-term growth and succession of
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the business victor we’ve talked about various advantages of an esop what are the
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disadvantages of an esop well john obviously there will be some disadvantages of an esop depending on
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the facts and circumstances however in most cases the alleged
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disadvantages they’re more perceived than real now one potential disadvantage of a sale
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to an esop versus a sale to a third party is that any sale to an esop will depend on the ability of the
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company to obtain the necessary financing if the transaction will be financed with
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a bank loan the company must have the ability to obtain the necessary bank loan
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based upon having sufficient cash flow to service the loan and sufficient assets to collateralize
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the loan if the company does not have sufficient collateral the seller may have to give a personal
42:58
guarantee or may have to pledge a portion of the qualified replacement securities
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now on the other hand a seller can always sell finance the sale in whole or in part if sufficient bank
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financing is not available another potential disadvantage of an esop
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sale is that the debt incurred to finance the transaction will reduce the company’s net worth this
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is no different than in the case of a stock redemption or a management buyout
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and in most cases has little or no impact on the company’s operations the only
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case where this does have an impact is in the case of construction companies
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that are required to obtain construction bonds if the company’s net worth
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is greatly diminished the company may have difficulty in obtaining the necessary bonding
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in general shareholders of construction companies should sell gradually over a period of years
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in order to avoid any sudden reduction in net worth
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shareholder dilution is another potentially soft disadvantage shareholder dilution comes about only if
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the esop is funded with newly issued shares of company stock since most esops are funded with
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cash which is then used to purchase shares from existing shareholders rather than newly issued
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stock dilution seldomly comes into play if the esop is funded with newly issued
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shares the dilution is usually not that significant as illustrated by this slide
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in fact if the cash flow savings are put to good use as we mentioned earlier the dilution
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becomes an advantage rather than a disadvantage to the extent that it enables the shareholders to own
44:58
a smaller piece of a bigger pie now there is a common
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misperception which is that an esop results in a loss of control this isn’t
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true at all in an esop the board of directors of the company appoints the controlling shareholder as
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the plan committee and trustee of the plan thus the controlling shareholder
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continues to vote the shares that he has sold to the plan as well as the shares that he still
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holds outside the plan the plan committee directs the voting of all the
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esop shares on all ordinary issues such as the annual election of the board of directors
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thus there really never is any loss of control
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now the only exception is that participants in the esau are allowed to vote on certain special
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issues the special issues that participants are allowed to vote upon include only merger
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a consolidation recapitalization liquidation or sale of substantially
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all of the corporations assets but even on these special issues however
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the participants are only allowed to vote with respect to the shares that have been actually allocated to their account
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in the case of a leveraged dsop all the unallocated shares are still
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voted by the trustee also participants do not vote upon
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any proposed sale of the stock to a third party since this is a fiduciary decision not a
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decision that requires a shareholder vote it is important to note that having an
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esop does not take away any of the other shareholder liquidity options
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the controlling shareholder can still sell his remaining non-esop shares to a third party and the
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plan committee could still elect to sell all of the esop shares to a third party
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now there is another misconception which is that esops will require the company to
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disclose confidential financial information again this is not true at all the only
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disclosures that are required are that the participants must be furnished with an annual benefit
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statement which discloses their total account balance their vested percentage in the account
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and the per share value of the stock in their account
47:39
having an esop does not expose the trustees to any greater degree of fiduciary
47:44
liability than they would have as trustees of a pension plan or profit sharing plan
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in fact the fiduciary liability is somewhat less since the trustees of an esop are exempt
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from the normal requirements to earn a fair rate of return or to diversify the investments and to provide
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investment liquidity another misconception is that having an esop creates a
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repurchased liability for the stock that is acquired by the esop the fact of
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the matter is all stock ultimately will need to be repurchased that is why the stock has value the
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difference is that in an esop the repurchase of such stock will be spread out over the lives of all
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the plan participants and will be made with tax deductible dollars
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whereas in the case of a stock redemption the repurchase will come due all at once upon the death or the
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retirement of the owner and will be made with after tax dollars
48:52
lastly it does need to be noted that selling to an esop unlike a merger or sale to a third party
48:59
is not an irreversible decision if you later change your mind the esop can be terminated and all of
49:07
the shares can be distributed and repurchased in the alternative the esop can be frozen and the shares
49:14
can be gradually repurchased as employees die and retire
49:20
thanks victor thinking associates is a specialist in employee stock ownership plan design
49:26
installation administration and valuation men can associates has been designing esop since 1974
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and we offer a full spectrum of esop services the design and installation services
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provided by minton associates include preparation of formal business appraisal of the company
49:45
financial consulting regarding the transaction drafting of all legal documents irs
49:51
approval of the planned documents preparation of the employee communications booklets
49:57
conducting powerpoint presentations for the employees and assistance in setting up the accounting and administration systems
50:04
required for the plan on an annual basis minkin associates also provides the annual record keeping
50:10
services including the preparation of individual employee benefit statements an additional service that is required
50:17
annually is the update of the stock appraisal in order to report to the employees the value of their retirement plan as
50:23
well as to establish the value should be stopped by a second or third block of stock
50:29
it’s critical to use an esop firm that’s a specialist in this area with an experienced firm fully services
50:36
will be provided at less cost to the client and there’ll be fewer errors incurred in the process
50:42
benton associates have designed over 2000 these stocks since our inception in 1974 and we are the
50:49
nation’s number one firm in esop activity princeton associates is headquartered in san francisco
50:55
california with offices in los angeles portland oregon chicago atlanta and wilmington delaware
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our appraisers are also located throughout the country but how do you know if your business is
51:09
an appropriate candidate for an esop just take a few minutes to complete the confidential feasibility questionnaire
51:16
form on our website at www.menke.com
51:21
fax or email this information back to our home office and we’ll then give you a call to discuss our findings and the feasibility
51:27
of an esop to accomplish your objectives again if you’d like to have us perform a free feasibility analysis
51:34
please give us a call at 800-347-8357 or you can complete the questionnaire
51:41
form by clicking on the button at the top of the screen thank you for viewing our
51:46
esop website seminar and again we look forward to talking with you at your earliest convenience
52:15
you