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Vermont Bar Association
Seminar Materials
Employee Ownership:
A Technical Introduction
December 6, 2017
Trader Duke's Hotel (Formerly DoubleTree)
So. Burlington, VT
Speakers:
Tabitha Croscut, Esq., Devine Millimet
Chuck Coyne, Empire Valuation
Bill Cherry, Switchback Brewing Company
Mark Saunders, Esq., Dunkiel Saunders
Matt Cropp, VT Employee Ownership Center
Elias Gardner, The New School of Montpelier
EMPLOYEE OWNERSHIP: A TECHNICAL INTRODUCTION
SEMINAR PRESENTED BY THE VERMONT BAR ASSOCIATION AND THE VERMONT SOCIETY OF CPAS
DEC. 6, 2017
Chuck Coyne
Managing Director
Empire Valuation Consultants
860.233.6552
Tabitha Croscut
Devine Millimet & Branch
603.695.8542
What is an ESOP?
“Employee Stock Ownership Plan”
Qualified retirement plan for Employees
Regulated by US DOL and IRS
Company-funded benefit — no employee contributions
ESOP is a shareholder only
Tax-efficient and controlled means of selling stock
Maintain employee jobs
Decision making over day-to-day maintained
Flexible in transaction structure (e.g. minority sales)
2
Applicable in almost all industries — service, manufacturing, professional (engineering and architects)
ESOP Existence…
3
Why Do Business Owners Use ESOPs?
Legacy
Employee concern (family)
Control / maintain day-to-day
• Drive ownership behavior
• Tax efficient ownership transition to employees
• Diversification / Liquidity
• Avoid / Reduce Income Tax (Seller & Company)
• Additional retirement plan for employees
• Increase employee productivity / employee incentive
• Value / purchase price certainty
4
Corporate Structure Pre-ESOP
Non-ESOP Shareholders
Shareholders
Management Team
hires and oversees
elect
Board of Directors
appoints and oversees
President and CEO
hires and oversees
Employees
5
Corporate Structure After ESOP
ESOP Participants
ESOP eligibility
requirements are met
Shareholders
Management Team
hires and oversees
elect
appoints and oversees
hires and oversees
Board of Directors
President and CEO
ESOP Trustee
are represented
by selects
Employees
Non-ESOP Shareholders
6
The ESOP Trustee
Who?
Internal versus External/Independent
The ESOP trustee will represent the plan interests
What?
Trustee duties:
• Determining annual/transaction share value
• Voting company stock owned by the ESOP (e.g. annual director vote)
7
ESOP Valuation
8
“Fair Market Value”
The price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well informed about the asset and the market for such asset.
9
Proposed DOL Regulations
Adequate Consideration = Fair Market Value
Determined in Good Faith
As of the Date of the Transaction
Reflected in Written Documentation of Value
10
Valuation Approaches
• Market Approach – Guideline Publicly Traded Company Method – Guideline Merged and Acquired Company Method
• Income Approach
– Discounted Future Net Cash Flows *Vetting management projections
– Historical Based Cash Flows
• Asset-Based Approach
11
Levels of Relative Value
Minority Interest Discount
Premium For Control
Lack of Marketability Discount
Controlling Interest Value
Marketable Minority Interest Value As-IF-Freely-Traded Value
Nonmarketable Minority Interest Value
Synergistic (Strategic) Value
Acquisition Premium
12
ESOP Valuation Adjustments
Normalization Adjustments to Cash Flows Owner/Officer Compensation Related Party adjustments (i.e. facility rent)
Control Premiums versus Control Cash Flows
(DOL Issue “control in fact”)
Minority Interest Discount Discount for Lack of Marketability
13
Engaging the ESOP Valuation Advisors
ESOP Trustee hires a third-party, independent appraiser as their financial advisor
Appraiser should be experienced in the industry and in valuing stock for ESOP purposes
ESOP stock must be re-appraised annually
14
15
“C” Corporation ESOP Transaction
Bank
Note & Collateral
$$ Cash
No
te &
Ple
dge
of
Sto
ck
Corporation
ESOP
Shareholders
$$ Cash
% Company Stock
16
ESOP Loan Repayment
Corporation
Bank and/or Shareholders
ESOP
Release of Shares Pledged as Collateral and Share Allocations
to Individual ESOP Accounts
Loan Payments ($$$)
Loan
Payments
($$$)
Contributions or
Dividends ($$$) Contributions or
Dividends ($$$)
Contributions or Dividends ($$$)
Loan Payments ($$$)
Loan Payments
($$$)
17
“S” Corporation ESOP Transaction [100%]
Company
ESOP
Company
Stock
Cash &
Sub. Note
w/Warrants
Shareholder
Cash
Bank $$ Cash
Note & Collateral
Cash & Sub. Note
Stock Stock
Note & Pledge
of Stock
18
Steps in an ESOP Transaction
Identify the various objectives FIRST. Preliminary Appraisal (Sell-Side Financial Advisor)
Feasibility/Transaction Analysis (Sell-Side Financial Advisor)
Financing (Bank?) Retain Team of ESOP Transaction Providers
Company ESOP Legal Advisor ESOP Trustee ESOP Financial Advisor - Valuation ESOP Legal Advisor ESOP Plan Administrator Investment Advisor / Estate Planning
ESOP Plan Design / Legal Documentation Closing *Accounting firm involved from feasibility through/after closing.
19
Ongoing ESOP Items Post-Transaction
Annual appraisal update
Annual recordkeeping and administration
Annual Audit for large plans
Repurchase obligations [update every 3-5 years]
Routine Communications training and education
Legal compliance
20
21
ESOP TAX ADVANTAGES
Significant ESOP Tax Preferences - Company
S Corporation & C Corporation: Deduction of principal on ESOP loan repayment
Limitations differ for S Corp versus C Corp
Deduction of dividends paid on ESOP shares
S Corporation: ESOP non-recognition of corporate income “S” Corporation income attributed to shareholders (pass
through entity)
ESOP as a tax exempt S Corp shareholder pays no taxes on its share of corporate income
22
Signification Tax Implication – Seller
Tax Treatment on Seller Promissory Note:
Interest earned will be taxed at Ordinary Income rates
Principal will be either:
1. Taxed at capital gains tax rates on an installment basis
(Note: If note exceeds $5mm, taxes are due at closing!)
-or-
2. Deferred using QRP investment (C corp)- 1042
23
IRC § 1042 Rollover Requirements for Capital Gains Tax Deferral
Must be a C corporation
Minimum of 3-year holding period
“Best” stock (voting)
ESOP must own 30% of company immediately following the sale
Reinvest in Qualified Replacement Property (QRP)
15-month reinvestment window of proceeds (3 months before and 12 months after the sale)
24
Qualified Replacement Property (“QRP”)
Eligible* Common Stock
Convertible Bonds
Corporate Fixed Rate Bonds
Corporate Floating Rate Notes (FRN)
Not Eligible
Municipal Bonds
U.S. Government Bonds
Mutual Funds
Foreign Securities
REITs
Bank CDs
*Eligible issuer must have:
– Securities of a corporation that is incorporated in the U.S.
– More than 50% of its assets used in the active conduct of a trade or business
– No more than 25% of its gross income from passive sources
25
Disadvantages of § 1042 Rollover
Exclusion from allocations of 1042 stock in the ESOP Who?
• Taxpayer electing 1042
• Family members (brothers and sisters, spouses, ancestors and lineal descendants (children and grandchildren)
• 25-percent shareholder(s) [within 1-year prior to sale] – Includes (i) shares allocated to ESOP account and (ii) shares owned by
spouses, parents, children and grandchildren (but not brothers and sisters)
How Long? • Ten years after the later of (i) the date of the § 1042
transaction, or (ii) the date of the final allocation of the 1042 stock.
26
ESOP Operations as a Retirement Plan
27
ESOP Operations: Participation & Allocations
Who can Participate in the ESOP?
1,000 hours and age 21 (outside limit)
Who can receive an “allocation” in the ESOP?
Employed on last day of PY/FY AND 1,000 hours
Allocation Formula
• In proportion to annual compensation [see next slide]
• Also points formula optional (not safe harbor)
28
Share Allocation Example
29
Shares purchased by ESOP = 150,000 shares
Allocation period = 25 years
W-2 Pay Allocation Percentage
Shares Allocated in 1st Year
Employee #1 $20,000 18% 1,080
Employee #2 $40,000 36% 2,160
Employee #3 $50,000 46% 2,760
$110,000 100% 6,000.00
ESOP Operations: Vesting & Distributions
What does an employee get if they terminate? 1. Vesting
• 3 year cliff (0%, 0%, 100%) • 6 year graded (0%, 20%, 20%, 20%, 20%, 20%) • Non-vested shares are forfeited
2. Timing of Distributions i- Year after death, disability or Normal Retirement Age ii- Sixth year after “other” termination 3. Form of Distribution
• Cash or Company Stock (immediately redeemed) • Lump Sum or 5-year annual installments
30
MANCHESTER | CONCORD | PORTSMOUTH | BOSTON
100 % ESOP Owned in 2017
31
THE SWITCHBACK BREWING STORY
TABITHA CROSCUT, ESQ.
Tabitha is a shareholder and chair of the ESOP team at Devine, Millimet, with a national practice focused on Employee Stock Ownership Plans (ESOPs) as succession and employee compensation strategies. In addition to counseling clients regarding transactional, compliance and fiduciary issues with respect to their ESOPs, she has represented companies, sellers and internal and external trustees in ESOP transactions ranging from under a million dollars to over four hundred million dollars. She is a frequent speaker at ESOP conferences nationwide and presents regularly on how ESOPs can be an effective exit or transition planning tool for owners of closely held businesses. Tabitha serves as a director and former President of the Vermont Employee Ownership Center (VEOC), is an active member of The ESOP Association and the National Center for Employee Ownership (NCEO), and serves on the Board of Trustees for the Employee Ownership Foundation. Visit our website at: TheESOPTeam.com.
www.TheESOPTeam.com
603.695.8542
Vermont office:
77 College St., Suite 2D
Burlington, VT 05401
Massachusetts office:
2 Oliver St.
Boston, MA 02109
New Hampshire office:
111 Amherst Street
Manchester, NH 03101
CHUCK COYNE, EMPIRE VALUATION CONSULTANTS For over 25 years Chuck has provided business valuations of privately
held companies in various industries. He has prepared valuations for
estate and gift tax, employee stock ownership plans (ESOPs), family
business succession, bankruptcy and reorganizations, fairness opinions,
marital dissolution, shareholder and partnership disputes, allocation of
purchase price among acquired assets and goodwill impairment testing,
and mergers, acquisitions, and divestitures.
Chuck specializes in transactional consulting services including;
assistance in business succession planning, mergers and acquisitions,
ESOP feasibility and transaction structuring, ESOP transaction
quarterbacking, assistance in obtaining financing, and other valuation
related consulting services. Chuck has assisted companies with revenues
of less than a million dollars to over half a billion dollars.
Chuck received his MBA with a concentration in Finance and Accounting
from University of Hartford. He holds a Senior Accredited Appraiser
(“ASA”) designation from the American Society of Appraisers. He serves
as a member of the Valuation Advisory Committee of The ESOP
Association and is a member of the National Center for Employee
Ownership (NCEO).
860.233.6552
61 South Main Street Suite 201 West Hartford, CT 06107
Selling a Small Businessto a Worker Co-op
Mark Saunders, Dunkiel SaundersElias Gardner, New School of Montpelier
Matt Cropp, Vermont Employee Ownership Center
www.veocorgwww.veoc.org
What is a Cooperative?
“A co-operative is an autonomous association of persons united voluntarily to meet their common economic, social, and cultural needs and aspirations through a jointly-owned and democratically-controlled enterprise.”
www.veocorgwww.veoc.org
In Other Words...
A co-op is a legal business that is equitably ownedand democratically controlled by its members for their common good, the good of the community, and to accomplish a shared goal or purpose.
Any surplus (usually called “profit” in private firms) is distributed among members in proportion to their use of the business (purchases, labor, or supply), as a discount on purchases, or is reinvested in the enterprise for the mutual benefit of members.
www.veocorgwww.veoc.org
Cooperative Principles
1. Voluntary & Open Membership
2. Democratic Member Control
3. Member Economic Participation
4. Autonomy & Independence
5. Education, Training & Information
6. Co-operation among Co-operatives
7. Concern for Community
www.veocorgwww.veoc.org
Worker Co-ops: Nuts & Bolts
• In a worker cooperative, membership is limited to those who work in the business.
• There are 300-400 nationally, 18 identified in Vermont at last count. Can have a traditional management structure or operate as a collective.
• Bylaws define how long someone must work for the co-op before being eligible to apply for membership.
• Each worker-owner buys a single voting share, which entitles them to a share of profit (“surplus”) and a vote for the board of directors and other shareholder matters.
www.veocorgwww.veoc.org
Worker Co-ops: Nuts & Bolts (cont.)
• Value of voting shares not directly tied to market value; priced to balance “skin in the game” with affordability.
• Distribution of workers’ share of surplus is based on a measure of labor (hours worked and/or W-2 income).
• Profits retained by the co-op in the name of members are taxed at individual level, accumulate in internal capital accounts. At least 20% must be distributed in cash.
www.veocorgwww.veoc.org
Entity Option 1:Worker Co-op Corporation
• Governed by Title 11, Chapter 8 of Vermont Statutes Annotated
• Any corporation may elect to be governed as a worker cooperative
• Articles of incorporation establish qualification of members
www.veocorgwww.veoc.org
Worker Co-op Corporation (cont.)
• Class of voting stock designated as membership shares
• One share for each member
• Membership must constitute at least 50.1% of the regular, full and part-time work force
www.veocorgwww.veoc.org
Worker Co-op Corporation (cont.)
• Net earnings or losses apportioned and distributed as articles or bylaws specify
• Net earnings declared as patronage allocations apportioned among members in accordance with ratio of each member’s patronage bears to total patronage by all members
• Internal capital account cooperative – entire net book value is reflected in internal capital accounts – each member and a collective account
www.veocorgwww.veoc.org
Entity Option 2:Limited Liability Company (LLC)
• Governed by Title 11, Chapter 25 of Vermont Statutes Annotated
• Governance documents are articles of organization and an operating agreement
• Pass-through entity like a partnership, but with limited liability
• Flexibility in management and financial structure
• Can separate financial rights from governance rights
www.veocorgwww.veoc.org
Entity Option 3:Mutual Benefit Enterprise
• Governed by Title 11C of Vermont Statutes Annotated
• Known in other states as limited cooperative associations
• Governance documents are articles of organization and bylaws (“organic rules”)
• Combines traditional cooperative values with modern financing mechanisms
www.veocorgwww.veoc.org
Mutual Benefit Enterprise (cont.)
• Membership consists of patron members and investor members
• Default rule is that each patron member has one vote, but voting power can be allocated based on patronage or equity
• Each investor member has one vote unless the organic rules provide otherwise
• All profits and losses allocated to patron members, unless the organic rules provide otherwise
• Organic rules may not reduce allocation to patron members to less than 50% of profits
www.veocorgwww.veoc.org
Assessing Feasibility
• Is the business saleable and financeable (adequate debt capacity & collateral, valuation in range of seller’s needs/hopes, etc).
• Are employees interested and excited about thepossibility of cooperative ownership?
• Is the employee group capable of taking on the roles played by the present owner?
• Is the seller interested in continuing with the company and/or consulting for a transitional period?
www.veocorgwww.veoc.org
Worker Co-op Conversion Steps
• Interested employees form a working group to explore the potential.
• Determine if the conversion is viable.
o Develop business plan (including cash flow).
o Determine what management roles would need to be filled upon owner exit.
o Ascertain potential gaps in expertise after transition.
• Learn to work and make decisions democratically.
• Determine co-operative structure (create bylaws).
www.veocorgwww.veoc.org
Worker Co-op Financing
Challenges:
• Voting shares usually constitute small % of price.
• Often the limited wealth of employee group means that significant outside financing is needed.
• Conventional lenders often unfamiliar with the details of the model.
• For co-ops with more than a handful of members, personal guarantees can become unwieldy, which can leave an uncollateralized gap.
www.veocorgwww.veoc.org
Worker Co-op Financing (cont.)
Capital Sources:
• Member shares
• Seller note
• Institutional debt and equity (traditional
financial institutions, CDFIs, VEDA, VEOC’s revolving loan fund)
• Community raise
• Members’ friends and family: loans or equity
• VSBO offering (Milk Money, VSECU’s Co-op Capital Fund )
www.veocorgwww.veoc.org
The Conversion Transaction
• Owner and employees agree on price and structure of transaction:
• valuation
• terms
• Owner’s role in co-op:
• member (employment contract?)
• advisor, friend
• non-compete agreement
• Arranging financing
• Closing
www.veocorgwww.veoc.org
Case Study:The New School of Montpelier
Selling Founder:
Susan Kimmerly
Discussion with:
Elias Gardner, current worker-owner and
board member.
www.veocorgwww.veoc.org
Contact
Dunkiel Saunders
www.dunkielsaunders.com
New School of Montpelier
www.nsmvt.org
Vermont Employee Ownership Center
www.veoc.org
Mark Saunders, [email protected]
Elias Gardner, [email protected]
Matt Cropp, [email protected]
www.veocorgwww.veoc.org
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