ESOPs for Wholesalers and Distributors

0:00
good morning and welcome to the web esop seminar on esops for wholesalers and distributors
0:05
my name is john menke and i’m president of menken associates today’s seminar will be in a question
0:10
and answer format i’ll ask a series of questions regarding how esops can be used by wholesalers and
0:16
distributors to accomplish various goals and objectives and rick rose will provide the answers based on his knowledge and
0:21
experience in designing these stops for for dozens of wholesalers and distributors rick is a managing director of menken
0:28
associates and he’s been a member of our firm for over 20 years my way of background mental associates
0:34
is the oldest firm in the country specializing in issac our firm was founded in 1974 and 2005 marks our 31st anniversary
0:42
of designing and installing esops over the past 30 years we’ve created more than 2000 esops more than
0:49
any other firm in the country we also administer about 800 esops also more than any other firm in the country
0:56
we have six offices throughout the united states and we’ve installed esops in all 50 states
1:02
let me begin by defining what an esop is and he stopped as many things to many people
1:07
to the existing shareholders it’s a buyer of stock that simultaneously offers tax savings to the seller
1:13
and an early succession plan for both majority and minority shareholders to the company esop is a technique of
1:20
corporate finance that enables a company to finance growth and expansion and or shareholder redemptions with tax deductible dollars
1:27
while simultaneously providing a highly effective employee and senate plan to the employees an esop is a
1:33
company-funded retirement plan that offers them an incentive and a reward that’s usually unmatched by any
1:39
other type of retirement plan it’s important to note that an esop consists of both a plan and a trust
1:46
and that the trust is the direct owner of company stock not the employees typically the company owners are
1:52
designated as the plan’s trustee employees will receive annual statements reflecting their account balance in the
1:58
esop however they’re not entitled to company financial statements nor do they have voting rights
2:03
except with respect to certain special issues therefore voting control does not have to change
2:09
when an esop is implemented even when these south owns a majority of the stock now i’d like to ask rick the first
2:15
question why is it that esops are popular with owners of privately owned businesses
2:21
over the past 30 years esops have been increasingly popular among privately held wholesaling
2:27
companies and distributorships because they offer a number of tax and financial advantages
2:32
that are not available under other alternatives the most frequent use for an esop
2:37
for example is to create partial or total liquidity for existing shareholders further it’s
2:44
not always easy to find a buyer for a wholesaling business esops are uniquely designed
2:50
to accomplish this objective in the great majority of cases the primary purpose of the esop is to
2:56
create an in-house market for existing shareholders the advantage their nissa brings to the
3:02
table is that it enables the company to repurchase shares from existing shareholders
3:07
using tax deductible rather than after tax funds in the case of a regular c
3:14
corporation congress has provided a special tax incentive to encourage companies to use esops for
3:20
shareholder liquidity if the esop acquires 30 percent or more
3:25
of the stock of a privately held company the tax on the gain will either be deferred or tax free
3:33
provided that the selling shareholders reinvest the proceeds in qualified replacement property in the
3:39
case of an s corporation there is also the advantage of using an esop to create shareholder liquidity
3:46
rather than utilizing a stock redemption the advantage of selling to the esop is
3:52
that any amount of stock sold to the esop will qualify for the favorable capital gains tax rate
3:58
which under the current tax code is only 15 at the federal level in the case of a
4:04
stock redemption the redemption has to be substantially disproportionate in order for the redemption to be taxed
4:10
at these lower capital gains rates rather than at ordinary income tax rates
4:16
a second reason why both cns corporations have been increasingly popular
4:22
is that an esop can help a company to substantially reduce or even eliminate
4:27
the payment of federal and state income taxes on the earnings of the company we’ll
4:32
discuss the techniques for doing this a little bit later in the session a third advantage of using an esop
4:39
is that it allows you to continue to control your company just as you do today unlike a sailor
4:45
merger you can create shareholder liquidity for yourself and for other shareholders
4:50
and still retain control even if you sell a majority of the stock to the esop the next
4:57
advantage is that the funds that the esop borrows in order to buy out the shareholders can be repaid entirely
5:04
with tax deductible dollars that’s to say the company will be able to deduct not only the loan interest
5:11
but also the loan principle and this is unique to esops in so many words the loan is being
5:18
subsidized by uncle sam and your state last but not least when
5:23
properly implemented and communicated an esop can have a dramatic effect in increasing employee productivity
5:30
and efficiency this in turn can result in increased profitability and an increase in the overall valuation
5:37
of the company since distributorships even the most successful ones
5:42
operate at modest profit margins the slightest increase in productivity and efficiency
5:48
can create major increases in the overall profit picture as a result of the various tax and
5:55
financial benefits that esops have to offer there are now over eleven thousand esops
6:00
currently in existence and these esops cover over 10 million participants over one thousand
6:08
of these esop companies are wholesalers it’s estimated that the total value of all esop assets
6:15
now exceed 500 billion dollars now i’d like to talk about how eastops
6:20
can be used by owners of wholesaling firms and distributing firms in particular rick what are the common ownership
6:26
problems that are faced by owners of these firms the common ownership problems faced by
6:32
owners of wholesaling and distribution firms are the same problems faced by all owners of
6:37
privately held firms namely lack of liquidity lack of diversification
6:43
and a need for a business succession plan fortunately the esop is one of the tools
6:49
that can provide an answer to all three of these problems it provides liquidity and diversification
6:55
for the existing owners and it also provides for an orderly business succession strategy
7:03
as a liquidity tool the esop offers a number of advantages v-stop creates an in-house market
7:10
whereby owners can sell their shares whenever they want to unlike a sale or a
7:15
merger an esop allows the owners to sell a portion of their shares rather than selling the entire company
7:22
thus the owners can sell their shares over a period of years rather than selling
7:27
all at once the esop creates an in-house market no outside party need be involved
7:35
there therefore is a certainty to the outcome and also the costs of arranging a sale
7:42
to an esop are a fraction of the cost that would be incurred in a sale to a third party
7:48
as a tool for investment diversification a sale to an esop allows you to diversify
7:53
whatever amount you wish to liquidate and to invest in other investments such as cash
7:59
fixed income securities equities or even a beach house the mix of investment selections is
8:05
entirely up to you as a tool for business succession
8:11
the esop is probably the least stressful method of ownership transfer due to the fact that it doesn’t
8:17
involve an outside buyer with an esop it’s easy there is certainty
8:22
of the outcome and there is less likelihood of employee layoffs and or changes in management in fact an
8:30
esop purchase can also be combined with a management buyout so that the management team can acquire
8:36
significant equity in the company over and above their esop positions
8:41
and esop provides for a gradual change of ownership to the employees in the meantime
8:47
the existing owners still retain the right to sell the entire company at a later date if they desire to and
8:54
still retain control of the company in the meantime rick it’s easy to see that esops offer a
9:00
number of financial and tax advantages not offered by other alternatives but why is it that esops are especially
9:06
popular with wholesaling firms and distribution firms well east hops are especially popular
9:12
with distributorships because they are service businesses where the success and profitability of the firm
9:18
depends heavily on the productivity of the employees another reason for esop’s popularity is
9:25
because these businesses tend to be locally owned and locally operated and the third reason for the large
9:32
number of wholesalers implementing esops is because esops can be a very
9:38
useful tool in helping a company attract and hire high quality people again good employees
9:45
are much more inclined to accept a job offer from a company that provides the opportunity for stock
9:50
ownership than from a company that doesn’t esops work so well among distribution firms
9:56
because good management recognizes that their employees are in fact their most valuable asset in the
10:03
absence of an esop or a similar type of program there’s always the risk that the key employees might walk out the door
10:10
and start up a competitor company and lastly it’s hard to find a buyer for many small
10:16
and medium-sized distributor ships for all these reasons i think that esops
10:21
are an especially good fit for wholesaling firms rick given that these stocks are in general a
10:27
good fit for distribution firms are there any situations where nest is not a good fit for a distribution firm
10:33
yeah sure there are a few situations where an esop may not work well one situation would be where the firm is
10:40
too small to have an esop as you know we’ve done esop for companies with as few as ten employees
10:46
and as many as ten thousand however it’s usually not economical to install
10:52
and maintain an esop if the esop has fewer than ten employees in addition if the
10:59
company is an s corporation and has 10 or fewer employees it can often be difficult to comply with
11:06
the so-called anti-abuse provisions if the very small company cannot comply with these provisions
11:13
then it will either have to become a c corporation or forego becoming any sub also if a
11:21
business is new or not yet profitable it may make sense to wait a bit in order
11:27
for an esop to be most effective the company does need to be profitable and
11:32
paying taxes ethops are generally used for four principal purposes to create liquidity
11:39
and diversification for sellers to increase employee productivity to increase company cash flow
11:45
and to provide for business diversification let’s start by discussing how esops are
11:51
used to create liquidity and diversification for sellers rick how are you soft transactions
11:56
typically structured to create liquidity and diversification for owners of distribution firms
12:02
well pretty much the same way as they’re structured for any type of firm how the east office structure depends
12:07
upon the goals and objectives of the current shareholders esops can be extremely flexible
12:14
in how they are structured for shareholder liquidity purposes in general there are three basic esop
12:20
transactions the first is what i call a pre-funded esop
12:25
a pre-funded esop is one where the company makes contributions to the plan in cash this cash is accumulated to be
12:33
used at some later date to purchase stock from the shareholders presumably
12:38
at a higher price than today’s value many companies start out by using a
12:43
pre-funded esop as a way to generate current tax deductions and as a way to accumulate cash in the
12:50
plan because the current shareholders are not yet willing to start selling their shares
12:56
under current code provisions a company is allowed to make tax deductible contributions
13:01
each year in an amount up to 25 percent of eligible payroll thus for example
13:08
if the company’s payroll is a million dollars it could make tax deductible contributions
13:14
of up to two hundred and fifty thousand dollars per year thus if the company contributed the
13:19
maximum each year for a period of four years the esop will accumulate a piggy bank of at least one
13:25
million dollars plus interest dividends and hopefully some securities gains
13:32
many times the company is already spending these funds in a 401k match or in profit sharing
13:38
contributions which do not have the flexibility to invest in company stock the second transaction
13:46
is the gradual esop with a gradual esop the distributor makes discretionary
13:53
contributions each year up to the 25 percent of payroll amount and uses these contributions to purchase
14:00
shares from the existing shareholders on a year by year basis
14:05
this approach offers lots of flexibility the selling shareholders may be selling
14:11
a small percentage of their stock from year to year each sale to the esop will qualify for favorable capital gains
14:18
treatment in the case of a c-corporation once the e-shop has acquired a minimum threshold
14:24
of 30 percent or more of the outstanding stock the sellers then can elect to defer
14:32
indefinitely or even avoid paying the capital gains tax provided certain conditions are met
14:40
a third way that an esop can be structured is by using leverage by leverage i simply mean an
14:46
esop that is borrowing money a leveraged dsop structure is used where the shareholders want to cash out more
14:52
quickly or in the case of the c corporation want to immediately qualify for the tax free
14:59
rollover or tax deferral as i mentioned a little while ago in order to qualify for the
15:05
tax deferral or tax free sale the sap must acquire at least 30 percent of the outstanding
15:12
shares unless the plan has been pre-funded the stock will usually have to borrow from a
15:18
bank or other lender in order to have enough funds to purchase thirty percent
15:23
of the stock most of our clients who use leverage right away sell between thirty percent and fifty
15:30
percent and how is the plan leveraged does the plan bother money or does the company borrow the money
15:36
well good question let me explain by giving a specific example let’s assume we have a company with
15:42
annual sales of 10 million dollars a payroll of one million dollars pre-tax
15:48
profits of six hundred thousand dollars and a fair market value of three million
15:54
dollars and let’s further assume that the esop wants to purchase thirty percent of the
16:00
outstanding stock for a price of nine hundred thousand dollars the way this works is the bank lends
16:07
nine hundred thousand dollars to the company and the company then lends the same nine
16:13
hundred thousand dollars to its esop the stop then purchases
16:18
thirty percent of the outstanding stock from the company’s shareholders for nine hundred thousand dollars
16:24
of cash at the end of the year the company makes a tax-deductible cash
16:30
contribution to the esop in an amount up to two hundred and fifty thousand dollars
16:36
plus interest the esop then uses that contribution to repay interest and principal on the
16:43
company loan the company in turn repays the bank loan
16:49
the sellers wind up saving anywhere from 135 000 to 180 000
16:55
in federal and state taxes depending upon the state they live in
17:01
of course these structures can be combined if useful and necessary case four combines the pre-funding and
17:09
leveraging ideas of case two and three that we’ve already discussed
17:14
in this slide you’ll note that the company pre-funded the esop for two years
17:19
accumulating about four hundred thousand dollars of cash meanwhile the company grew from a fair
17:25
market value of three million to three point three three million dollars at the end of its third year
17:32
in order to reach the thirty percent threshold the esop now needs to own one million dollars of
17:38
stock since four hundred thousand dollars has already been accumulated
17:44
the required bank loan need only be six hundred thousand dollars this is three hundred thousand dollars
17:50
less than would have been required if no pre-funding had occurred therefore the required loan is reduced
17:56
by 33 percent and the annual debt service is reduced by over eighty one thousand dollars
18:03
per year similarly case five combines year by year
18:08
purchases with a tax deferred sale in year four as shown by this slide at the end of the
18:15
first year the stock would purchase three percent at the end of the second year the esop would hold seven percent of the
18:21
outstanding stock at the end of the third year it would now hold 12 percent
18:26
each of these sales would be taxed at capital gains rates however the sale in year four would
18:32
result in the esop owning 30 percent thus the seller would be able
18:38
to elect the tax-free rollover with respect to the stock sold during that fourth year
18:45
case six illustrates how an esop can be structured to accomplish a 100 percent esop buyout of a
18:51
distributorship in most cases it’s hard to obtain the financing to accomplish a 100 percent
18:57
esop buyout in one fell swoop accordingly a 100 percent esau buyout is
19:03
usually structured over two stages in the first stage the esop might be leveraged in an amount
19:10
sufficient to buy say 50 percent of the outstanding stock then after this loan has been paid down
19:17
the esop could be re-leveraged in year 4 to buy the remaining 50 percent rick
19:23
what if there’s more than just one shareholder of the company what if there’s a majority shareholder and one or more minority shareholders
19:30
can any stop offer to buy out the majority shareholder without also making the same offer to minority shareholders
19:36
uh yes in most cases shareholders agree amongst themselves whether the esop will be used to
19:42
purchase part or all of the stock of a shareholder or part of all the stock of one or more
19:48
shareholders or a combination of the two however if for some reason the shareholders can’t agree
19:54
then typically the esop will buy stock from all the shareholders on a pro rata basis you mentioned
20:01
earlier that in the case of a c corporation there’s a special provision of the code that allows the selling shareholders to receive their proceeds
20:08
on a tax-deferred or tax-free basis can you tell us a little more about how this works
20:14
yes under section 1042 of the code if an esop acquires 30 percent or more
20:19
of the stock of a privately held c corporation the capital gains tax on
20:25
the amount of gain will be deferred provided that the seller reinvests the money in qualified replacement property
20:33
within 12 months from the date of sale this tax deferral will continue as long as the seller holds the
20:40
qualified replacement property if the seller holds the property until his death
20:46
then it will receive a step up in basis and the capital gains tax will be
20:51
completely avoided this type of transaction is typically referred to
20:56
as a tax free rollover qualified replacement property consists
21:03
of stocks or bonds of american corporations the corporations may be bigger little
21:09
public or private and they must be american the seller cannot invest in a mutual
21:14
fund or in government securities unless he is willing to pay a capital gains tax
21:21
most sellers who elect the tax deferral wind up investing the proceeds in a diversified portfolio
21:27
of corporate stocks and corporate bonds a seller can only sell part or all of
21:32
his replacement securities later on to the extent that he does so however
21:37
you’ll have to pay the capital gains tax that was previously deferred as well as a gain on any subsequent
21:44
appreciation as well rick is there any way to avoid being locked into these replacement
21:50
securities and having to hold them till till death there is a way to unlock the lock up
21:56
that was the way around this problem is to purchase long-term esop floating rate bonds
22:03
and then margin out 80 to 90 percent of the proceeds for example assume that the seller
22:10
receives thousand dollars from the sale of stock to the esop
22:15
he or she could then purchase nine hundred thousand dollars worth of these long-term esop bonds this purchase satisfies the
22:23
requirement that the seller must purchase qualified replacement securities
22:29
then the seller could then margin out let’s say seven hundred and twenty thousand dollars of the proceeds
22:35
and invest these funds as he or she sees fit this unlocks the lockup rick you
22:41
mentioned earlier that the tax-free roller provisions do not apply to shareholders of s-corporations
22:47
are there any tax advantages that apply to s-corporations that do not apply to c-corporations
22:54
uh yes john there are as you know in the case of an s corporation all the earnings of the corporation are
23:00
taxed at the shareholder level rather than the corporate level as you also know
23:05
the esop is a tax-exempt entity thus to the extent that the stock of an
23:11
s-corporation is owned by an esop part of the corporation’s earnings will be exempt from income tax
23:18
in the case of an s-corporation that is 100 percent owned by an esop there will be no income tax
23:27
there are only two disadvantages to s corporation esops the principal disadvantage is that there
23:32
is no tax free rollover available to the sellers in other words they must pay their capital gains tax on
23:40
the sale and an s corporation must cover a broadly based group
23:46
of employees with less than 15 employees it’s tough for an s corporation to pass
23:52
the broadly based test rick and due to the fact that in the case of s corporation esops the tax benefits
23:59
accrue more for the benefit of the company itself rather than for the benefit of the selling shareholders are you top
24:05
transactions structured differently for s corporations than for c corporations
24:10
basically the transaction structures are the same with c corporations or s corporation
24:16
esops these stops are structured as pre-funded esops some of them are structured as
24:21
gradual esops where these stops purchase shares year by year and some of them are structured
24:26
as leverage dsops however because of the fact that the company will be 100 percent
24:32
tax exempt if the esop is the sole stockholder we have seen many more 100 percent esop
24:38
buyouts of s corporations than we have seen in the case of c corporations almost all esops with
24:46
100 ownership switched to s-corporation status also because of the difficulty of
24:53
securing 100 percent bank financing for a buyout many of these transactions have been
24:58
structured with a hundred percent seller financing here’s an example of
25:04
how leveraged esops are typically structured for s corporations in this example
25:09
the owner sam is the sole owner and pays himself a salary of two hundred thousand dollars
25:15
a year let’s assume there are twenty other employees that have a total compensation of eight
25:21
hundred thousand dollars so that sam’s compensation is twenty percent of total payroll furthermore the company
25:28
will say has a value of four million dollars case seven
25:34
shows how the transaction will be financed using seller financing in this case sam becomes the seller and
25:41
banker himself by taking back an installment note from the esop
25:46
sam will receive installment payments over the term of the note as he receives the principal you’ll have
25:52
to pay capital gains tax on the portion of the principal payment that represents gain
25:58
and he will also pay ordinary income tax on the interest portion but the important thing to point
26:04
out is that the esop now owns 100 percent of the company therefore the
26:09
company no longer pays any income taxes assuming a pre-tax
26:14
profit of eight hundred thousand dollars this would result in tax savings of over three hundred thousand dollars
26:20
that otherwise would have to be paid each and every year in taxes that same three hundred
26:27
thousand dollars can be used instead to pay for a large portion of the installment payments
26:32
paid to sam each year on his installment note the next slide illustrates two points
26:38
with respect to leveraged esops first it illustrates how the debt is repaid
26:44
in the case of an s corporation the debt is repaid by having the company make tax-deductible contributions to the esop
26:51
which the stop then uses to make note payments to sam in the case of an s corporation
26:58
the debt can also be repaid by using the s corporation distributions that are paid to the esop and then used
27:05
to make note payments to sam debt is repaid the same way in c corporations except that c corporations
27:13
are not allowed to make s-corporation cash distributions to shareholders
27:18
instead c corporations are allowed to pay so-called deductible dividends to the
27:25
esop over and above tax deductible contributions
27:30
normally c corporations do not pay dividends because these dividends are not tax deductible
27:36
but in the case of an esop and if used to repay you stop debt the dividends are indeed tax deductible
27:44
the second point of this slide is to illustrate how stock is allocated in the case of a leveraged esop in the
27:51
case of a gradual lease op the stock is allocated on a year-by-year basis
27:57
as and when shares are purchased but in the case of a leveraged dsop the stock is allocated to participants
28:04
as the note payments are made to the bank or other lender thus if the estop purchases 100
28:11
of the outstanding stock all of the stock is initially held by the esop
28:16
in a suspense account then each year as the company makes contributions to the plan
28:23
in order to pay down the note to the seller the exact same dollar amount is released
28:28
from the suspense account the block of stock that is released from the suspense account each year
28:34
is then allocated among the accounts of the participants in proportion to covered compensation
28:41
the transaction may also be financed with a bank loan rather than with a seller note thus if
28:48
sam wants to receive cash right away for his stock then external bank financing would be
28:54
required in order to put the four million dollars into sam’s pocket right away thus case number eight is the
29:01
same as case number seven with the exception that a bank is now involved
29:06
the concept however is exactly the same these top owns 100 percent of the company therefore the company no longer pays
29:13
income taxes and the lender is being repaid with pre-tax dollars because the company is now exempt from
29:20
paying any taxes whether the e-stop is bank financed or seller financed
29:26
the results will be the same in either case first the company’s earnings will no longer be subject to income tax
29:34
and second sam will receive four million dollars and will pay capital gains tax on his
29:40
gain thirdly since sam’s compensation constituted twenty percent of the total covered
29:47
compensation sam will be allocated twenty percent of the stock within the esop
29:53
and he will be able to cash that out later when he leaves the company you should
29:59
note that this is a benefit that does not apply in the case of the c corp where the seller has sold stock to
30:05
the esop and elected the tax-free rollover treatment under that scenario there is a special
30:12
rule that prohibits the selling shareholder and related parties from receiving any
30:17
allocation of the stock that was sold in the tax free rollover transaction
30:22
and lastly since the earnings of the company are no longer subject to income taxation
30:27
the company no longer has to make distributions to the shareholders to enable them to pay their income tax
30:33
each year instead these funds can now be used to repay debt after the debts repaid these funds
30:40
can be accumulated in the company and used to make acquisitions or to otherwise fund growth
30:46
and expansion so far we’ve talked about esops being used to create liquidity and
30:52
diversification for the shareholders a second use of estops is to create increased
30:57
employee productivity sometimes the primary purpose for adopting an esop is
31:02
to create a direct link between employee productivity and their retirement benefits it’s
31:07
simply common sense that people work best when they work for themselves as they say no one ever washes a rental
31:13
car the concept of an esop is to have employees think and act like owners correct the obvious question
31:19
then arises the use ops in fact increased employee productivity
31:25
numerous studies conducted over the last 17 years have all concluded that esop’s increased
31:30
company performance for example one of the early studies found that employee absenteeism
31:37
went down by 66 percent and employee turnover by over 50 percent after implementing an
31:45
esop more recently there were two harvard business review studies that found that
31:51
sales growth in esop companies was significantly higher than in comparable
31:56
non-esop companies more importantly two independent studies one by
32:02
northwestern university’s kellogg school of management and one by hewitt associates both found
32:09
that esop companies had a higher return on assets and a higher return on shareholder equity than comparable
32:15
non-esop companies rick what is the impact of increased employee productivity on profitability and on the overall
32:22
value of a company is the impact relatively nominal or is it significant
32:28
the impact can be quite significant this slide illustrates for example a two
32:33
percent increase in productivity that can literally result in a fifty percent increase
32:38
in profitability in this case we assume that a company had 10 million in revenues
32:44
and a pre-tax profit of four hundred thousand dollars as indicated if the sales force can
32:49
increase revenues by two percent but hold expenses constant the pre-tax profit increases by fifty
32:57
percent and another way that profitability could be increased by fifty percent
33:03
would be if the employees are able to reduce expenses by two percent while holding revenues
33:08
constant of course the employees can both increase revenues by two percent
33:14
and reduce expenses by two percent then the company would literally experience a one hundred percent increase in
33:22
profitability a third use of these stocks is to increase corporate cash flow
33:29
this can be accomplished by simply having the company contribute newly issued stock or treasury stock to the esop on a year by year basis
33:36
result is to reduce corporate taxes and increase cash flow while simultaneously providing a
33:41
retirement benefit for the company’s employees rick what are the pros and cons
33:47
of using an esop to increase company cash flow as you just mentioned the main advantage
33:52
is to increase cash flow and the net worth of the wholesaler the disadvantage is
33:59
that new shares of stock must be issued to the esop that will create ownership dilution to
34:05
original shareholders actually there is no dilution if the contribution to the esop
34:12
is in lieu of cash bonuses or cash contributions to profit sharing or 401k
34:18
for example if the company contributes three hundred thousand dollars worth of stock to the esop
34:24
in lieu of a three hundred thousand dollar 401k matching contribution or a three hundred
34:30
thousand dollar profit sharing contribution the company has in effect received
34:35
three hundred thousand dollars of cash in exchange for three hundred thousand dollars of stock
34:42
if the company puts this money to good work the value of the company will increase for the benefit of all of its
34:48
shareholders but if the company does not spend the money wisely then there indeed will be
34:54
ownership dilution of the shareholders equity a fourth use of these stops is to create
35:00
a succession plan for the existing shareholders in my view an esop transaction is the
35:06
least stressful and most efficient means of transferring ownership to the next generation for three primary reasons
35:12
first it utilizes pre-tax cash flow rather than after tax cash flow second it’s usually done in stages and
35:19
therefore involves less leverage and third it usually involves no change in management control at the offset
35:25
in most cases there’s only a gradual change in management control over a long period of time rick what’s
35:31
your view of the esop as a tool for business succession in the area of business succession and
35:38
transition an esop on its own is usually not the sole answer to one’s objective
35:44
many owners wish to reward their key employees as well as certain family members
35:50
in addition to the esop participants stock sales can be made directly to the
35:55
key group of employees and stock grants can be made to family members
36:00
in many if not most cases we recommend creating a separate non-qualified management stock bonus
36:07
plan to run alongside with the esop that is created specifically for the key employees who
36:14
will be responsible for the long-term growth and succession of the business rick
36:20
we’ve talked about various advantages of an esop what are the disadvantages of an esop well john there’s several potential
36:26
pitfalls or disadvantages of an esop it depends on the facts and the circumstances however in most cases
36:33
the alleged disadvantages are more perceived than real one potential disadvantage of
36:40
a sale to an asap versus a sale to a third party is that a sale to an esop depends on obtaining
36:47
the necessary financing if the transaction is financed with a bank loan
36:52
the company must have the sufficient cash flow to service the loan and sufficient assets to collateralize
36:58
the loan if the company doesn’t have enough collateral the seller may have to give a
37:03
personal guarantee or he may have to pledge a portion of the qualified replacement securities
37:09
on the other hand a seller can always self-finance the sale in whole or in part
37:14
if sufficient bank financing is not available the debt incurred to finance the
37:20
transaction will have an impact on the balance sheet the company’s net worth
37:26
will be reduced this is no different than in the case of a stock redemption
37:31
or a management buyout and in most cases has little or no impact
37:36
on the company’s operations this adverse impact tends to affect construction companies
37:42
more than let’s say wholesalers or distributors in fact the impact on wholesalers is
37:47
typically very minimal shareholder dilution is another potential esop disadvantage
37:55
shareholder dilution comes about only if the esop is funded with newly issued shares
38:00
of company stock since most esops are funded with cash which is used to purchase shares of
38:06
existing stock rather than newly issued or treasury stock dilution seldom comes into play
38:14
even if the esop is funded with newly issued shares the dilution is usually not that significant as illustrated by this slide
38:23
in fact if the cash flow savings are put to good use the dilution becomes an advantage rather
38:28
than a disadvantage to the extent that it enables the shareholders to own a smaller piece
38:33
of a bigger pie a common misperception is
38:39
that an e-stop results in loss of control this is not at all true with an esop the
38:46
board of directors appoints the controlling shareholders as the esop plan committee and esop
38:52
trustee thus those controlling the company before the esop was put in continued to
38:57
do so after the esop the planned committee directs the voting of all
39:04
the esop shares on all ordinary issues such as annual election to the board of
39:09
directors thus there is never any loss of control
39:15
the only exception is that the participants in the plan are allowed to vote on certain
39:20
special issues the special issues that participants are allowed to vote on include merger
39:27
consolidation recapitalization liquidation or sale of substantially
39:33
all of the corporate assets but even on those special issues the participants are only allowed to
39:39
vote with respect to those shares that have been actually allocated to their accounts
39:45
all unallocated shares are still voted by the trustee also participants do not vote upon any
39:52
proposed sale of the stock to a third party since this is a fiduciary decision not a
39:57
decision that requires a shareholder vote it’s important to note that having an
40:03
esop does not take away any of the other shareholder liquidity options the controlling shareholder can
40:09
still sell his remaining non-esop shares to a third party and the planned committee can still
40:14
elect to sell all of these top shares to a third party another misperception
40:21
is that having an esop will require the company to disclose confidential financial information again
40:29
this is not at all true the only disclosures that are required are that the participants must be
40:35
furnished with an annual benefit statement which discloses their total account balance their percentage vested
40:42
and the per share value of the stock having an esop does not expose the
40:48
trustees to any greater degree of fiduciary liability than they would have as trustees of a pension
40:54
or profit sharing plan in fact the fiduciary liability is somewhat less
41:00
since the trustees of an esop are exempt from the normal requirements to earn a fair rate of return to
41:06
diversify the investments and to provide investment liquidity
41:12
yet another misperception is that having an esop creates a repurchase liability
41:17
for the stock that is acquired by the esop the fact of the matter is all stock ultimately will need to be
41:24
repurchased whether you have an esop or not that is why stock has value
41:29
the difference is that with an esop the repurchase of such stock will be spread out over
41:34
the lives of all the planned participants and will be made with tax deductible dollars
41:40
whereas in the case of a stock redemption the repurchase will come due all at once upon the death of retirement
41:46
of the owner and will be made with after tax dollars lastly it should be noted that selling
41:53
to an aesop unlike a merger or sale to a third party is not an irreversible decision if you later
42:01
change your mind the esop can be terminated and all of the shares can be distributed and repurchased
42:07
in the alternative the esop can be frozen and the shares can be gradually repurchased as employees die
42:14
and retire thanks rick menken associates is a specialist in
42:19
employee stock ownership plan design installation administration and valuation enkin associates
42:25
has been designing esop since 1974 and we offer a full spectrum of esop services the design and installation
42:34
services provided by minkin associates include preparation of the formal business appraisal of the company
42:40
financial consulting regarding the transaction drafting all the legal documents irs approval of
42:46
the plan documents preparation of the employee communication booklets
42:51
and conducting powerpoint presentations for the employees and then assistance setting up the
42:56
accounting and administration systems required for the plan on an annual basis minkin associates
43:03
also provides annual record-keeping services including the preparation of individual employee benefits statements
43:09
an additional service that is required annually is the update of the stock appraisal in order to report to the employees the value of their retirement
43:16
plan as well as to establish a value should the esa buy a second or third block of stock
43:22
it’s critical to use an esop firm that’s a specialist in this area with an experienced firm fully stop
43:28
services will be provided at less cost to the client and there will be fewer errors incurred in the in
43:34
the process lincoln associates have designed over 2 000 esop since our inception in 1974 and we are the
43:41
nation’s number one firm in esop activity lincoln associates is
43:46
headquartered in san francisco california with offices in los angeles portland chicago atlanta
43:52
and wilmington delaware our appraisers are located throughout the country as
43:58
well but how do you know if your business is an appropriate candidate for an esop
44:04
take a few minutes to complete the confidential feasibility questionnaire form that’s on our website at
44:11
www.lenke.com fax or email this information back to our home office and we’ll then give you a call to discuss our findings
44:17
and the feasibility of an e-stop to accomplish your objectives again if you’d like to have us perform a
44:22
free preliminary analysis just give us a call at 800-347-8357
44:30
or you can complete the questionnaire form by clicking on the button at the top of the screen
44:36
thank you for viewing our esop seminar and again we look forward to talking with you at your earliest convenience
44:55
you