Redemption Approach to Leveraged ESOP · PDF fileRedemption Approach to Leveraged ESOP Transactions ... 5 Valuation & Financial Opinions Dispute Advisory ... Discounted Cash Flow Method

Valuation & Financial Opinions Dispute Advisory & Forensic Services

Redemption Approach to Leveraged ESOP Transactions

Scott D. Levine, CPA/ABV, CFA, ASA Managing Director Stout Risius Ross, Inc.

Peter H. Briggs Managing Director Shareholder Strategies, Inc.

Valuation & Financial Opinions Dispute Advisory & Forensic Services 2

CLASSIC LEVERAGED ESOP

BANK

Front-end Loan Principal + InterestPayments

COMPANY

Principal + InterestPayments

Interior Loan Contributions

Stock STOCK-ESOP HOLDERS

Cash


SELLER-FINANCED ESOPLoan Thru Company

COMPANY P+I

LoanShareholderDistributions Contributions

Loan

Stock STOCK-ESOP HOLDERS

Principal and InterestPayments Cash


Illustration Assume FMV of Company Stock is a total of $10,000,000 1,000,000 Shares Outstanding Purchase price equals FMV and is $10.00 per share ESOP purchases 100% of the stock for $10.0 million Purchase is entirely funded with debt Assume seller note for $10.0 million to the Company This seller note is 10 years, level principal, $1.0 million per year A back-to-back loan from the Company to the ESOP for $10.0 million The “Inside” loan from the Company to the ESOP is 15 years, level principal The 15-year ESOP loan provides cash flow savings to the Company by virtue of

the tax-deductibility of principal payments on the ESOP loan These tax savings result in a post-deal value of $1.5 million or $1.50 per share Note that the ESOP is the buyer. This would be required for the Section 1042 Tax-

Free Rollover


Recovery in Value as Debt Repaid After just one year, $1.0 million of seller debt should be

repaid. This alone should cause value (all else equal) to

recover to $2.5 million or $2.50 per share. This represents a 67% growth in the price per share in year 1.


DOL’s “Dollar for Dollar” Position

The DOL does not like the Post-Deal drop in Value They are troubled that the asset being purchased by

the ESOP is immediately less than the ESOP paid for it


Dole v. Farnum DOL files lawsuit in 1990 against independent ESOP Trustee 1985 ESOP transaction at Wardwell Braiding Machine Company ESOP purchased 80% of the Company, largely funded with debt from Fleet DOL alleges that Trustee paid more than Adequate Consideration because

the appraisal did not take into account the necessary future debt service to Fleet

Therefore, the ESOP loan was not an Exempt Loan Therefore, it was alleged to be a Prohibited Transaction Huge outcry among the business, labor and ESOP community DOL withdraws suit later that same year Note that ESOPs were specifically intended by Congress to be not only an employee benefit but also to be used as a tool of corporate finance. They were intended to borrow money. That is the whole point behind the exempt loan rules.


What Is The Typical ESOP Candidate?

A closely held corporation (C or S corporation) One or more owners nearing retirement Company needs tax favored capital In closely-held company, generally no (or limited) family

involvement in business History of profitability Comfort with the concept of employee ownership Stable employee population Successor management in place or in the wings Available corporate credit Focus on organic growth


REDEMPTION APPROACH

STOCK-HOLDERS

Sell Stock to Company Note Principal + InterestPayments

COMPANY

Principal + InterestPayments

Sells Treas. Stock to ESOP Contributionsand Distrib's

ESOP


Advantages of Redemption Approach

Avoids the Post-deal drop in value issue Reduces contribution levels to service ESOP debt and can

therefore avoid Section 404 problems (limits on Plan contributions)

Safer from a Fiduciary standpoint – ESOP might purchase its stock at a price that is somewhat lower than even the post-debt value


Disadvantages of Redemption Approach

Cannot elect tax-free Section 1042 rollover. ESOP must be the buyer in that case


Redemption Transaction Redemption Transaction Illustration

In U.S. DollarsLow High

Guideline Company Method 11,000$ 14,000$ Discounted Cash Flow Method 10,000 13,000

Concluded Enterprise Value 10,500$ 13,500$

Less: Interest-Bearing Debt (2,000) (2,000) Add: Cash and Cash Equivalents 1,000 1,000 Total Adjustments to Enterprise Value (1,000) (1,000)

Fair Market Value of Equity (Rounded) 9,500$ 12,500$

Redemption Price

ESOP Purchase

Indicated Range of Value

$10,000

$2,500


Post-Transaction Value Post-Transaction Fair Market Value of Common Stock

In U.S. DollarsPost-Transaction

Implied Enterprise Value (Rounded) 10,500$ 13,500$

Add: Cash and Cash Equivalents 1,000 1,000 Less: Existing Debt (2,000) (2,000) Less: Senior Subordinated Term (7,000) (7,000) Less: Subordinated Seller Notes (3,000) (3,000) Add: Present Value of ESOP Debt Tax Benefit 1,000 1,000 Total Adjustments to Enterprise Value (10,000) (10,000)

Marketable, Controlling-Interest Value of Equity 500$ 3,500$

Less: Discount for Limited Marketability 5.0% (25) (175)

Fair Market Value of Equity (Rounded) 500$ 3,300$

Divided by: Common Shares Outstanding 100.0 100.0

Estimated Post-Transaction Fair Market Value Per Share of Common Stock 5.00$ 33.00$

Per Share Strike Price of Warrants

Indicated Value

$10.00


What is a Warrant?

A warrant is a security similar to a stock option that entitles a holder to buy the underlying stock of the issuing company at a fixed exercise price for a specified period of time. A warrant is frequently attached to bonds allowing the issuer (ESOP company) to pay a lower interest rate and can also be used to enhance the yield of the bond.


Why Are Warrants Used in ESOP Transactions?

With less access to capital from more traditional financing sources seller financing is often used as an alternative form of capital to help finance an ESOP Transaction

Almost always utilized in highly leveraged deals The ESOP transaction creates significant leverage and a lower

interest rate combined with warrants reduces an ESOP company’s cash obligations post-transaction

Sellers will pay taxes at ordinary income levels for the interest earned on their seller notes but can pay the long-term capital gains tax rate on the appreciation of warrants.


Overview of Seller Debt and Warrant Position

$3 million of seller debt Interest rate of 5% and warrant equal to 20% of stock

post-transaction Targeted IRR – 15%


IRR Calculation

In U.S. Dollars

12/31/2013 12/31/2014 12/31/2015 12/31/2016 12/31/2017 12/31/2018 12/31/2019 12/31/2020 12/31/2021

Initial Outlay (3,000)$ 0$ 0$ 0$ 0$ 0$ 0$ 0$ 0$

Interest Payments [a] 0 150 150 150 150 120 90 60 30 Principal Payments 0 0 0 0 600 600 600 600 600

Payment for Warrants 0 0 0 0 0 0 0 0 3,400

Total Debt Cash Flows (3,000)$ 150$ 150$ 150$ 750$ 720$ 690$ 660$ 4,030$

Internal Rate of Return 15.0%

[a] Based on cash interest of 5.00% per annum. Interest calculation is based on annual payments.

Calculation of IRR of Subordinated Term Notes

For the Year Ending


Items for ESOP Team to Consider Regarding Warrant Position Cash flow considerations (interest rate v. warrant position) Strike price for warrant What is a reasonable IRR? What is reasonable ownership dilution (also consider other equity

holders)?


Questions?


Contact Information

Scott D. Levine, CPA/ABV, CFA, ASA Managing Director

Stout Risius Ross, Inc. 8180 Greensboro Drive, Suite 600

McLean, VA 22102 (703) 848-4944

[email protected]

Peter H. Briggs Managing Director

Shareholder Strategies, Inc. P.O. Box 158

Charlottesville, VA 22902 (434) 984-0474

[email protected]

Documents

Redemption Approach to Leveraged ESOP · PDF fileRedemption Approach to Leveraged ESOP Transactions ... 5 Valuation & Financial Opinions Dispute Advisory ... Discounted Cash Flow Method