Business Succession: The ESOP ModelPETER E. JONES, PARTNER, ESOP PLUS®: SCHATZ BROWN GLASSMAN LLP

PJONES@ESOPPLUS.COM OR 614.344.7604

What Are We Going to Discuss Today?1. Why Business Succession Planning2. The Key Elements of Business Succession Planning3. How an ESOP Can Transfer Ownership of the Business in a

Tax Efficient Manner

Some StatisticsSUCCESSION TSUNAMI – 70% IN 10 YEARS

70%

30%

Closely-Held Businesses -4.6mm

Transition in the next10 Years

Not Transitioning

HISTORICALLY FEW SURVIVE TO NEXT GENERATION

15%5%

80%

Closely-Held Businesses -4.6mm

2nd Generation

3rd Generation

Terminate Operation

More Statistics

With20%

Without80%

Business Succession Plan

With

Without

Worst Case Scenario• Business Ceases Operations• Family loses investment• Employees lose jobs• Communities lose tax base• Quality of Life and Services Suffer• Domino Effect

Business Succession Planning is

Strategic planning for the future of the business and the owner

Business Succession: The Bridge to the FutureA complete business succession plan addresses three important components:• Ownership Transfer

• Management Succession

• Legacy Planning

Ownership Transfer: Who Buys The Company?

Third Party5%

Internal95%

Businesses Sold

Third Party

Internal

Internal Transactions• Buy-Sell among Partners• Family Succession • Management Buyout• ESOP

Typical Internal Management BuyoutCompany Borrows Money

Company loan to

Managers

Management Pays

Shareholder

Company Distributes

Cash to Management

Management Pays

Company to Repay Loan

1. Company Borrows Cash

2. Company Loans Money to Management

3. Management pays Shareholder – Cash plus Note

4. Company distributes profits after tax to Management.

5. Management repays Company Loan and Shareholder Note.

6. Company pays Loan.

7. No deduction for principal loan payments.

An ESOP TransactionCompany Borrows Money

Company loan to ESOP

ESOP Pays Shareholder

Company contributes

Cash to ESOP

ESOP Pays Company to Repay Loan

1. Company Borrows Cash

2. Company Loans Money to ESOP

3. ESOP pays Shareholder – Cash plus Note

4. Company contributes cash to ESOP pre-tax – Deductible compensation expense.

5. ESOP repays Company Loan and Shareholder Note.

6. Company pays Loan.

7. Cleansed through an ESOP – receive deduction for principal loan payments.

Business Succession: The ESOP Model

Ownership Transfer – in an ESOP, the owner transfers shares to a trust that holds the shares for the benefit of the employees

Management Succession – the ESOP serves either as an incentive and reward for current successor management to grow the business or lures future successor management with an opportunity to receive the benefit of growing the business

Legacy Planning – an ESOP can be a tax efficient legacy plan and can always serve to preserve the independence of the business

What is an ESOP?

• A qualified retirement plan• Invests primarily in Employer Securities• Broad-based equity ownership• A Business Model

Must satisfy the requirements of the Internal Revenue Code and the Employee Retirement Income Security Act (“ERISA”) of 1974

An ESOP is the only retirement plan that is allowed to borrow money to purchase company stock

Employee Stock Ownership Plan

Establishing an ESOPCompany Board of Directors establishes Trust (“ESOT”)

Methods for ESOT to get stock• Company contributes stock or cash to ESOT; if cash, ESOT purchases stock

from existing shareholder(s) (non-leveraged)• Company loans money to ESOT, ESOT purchases stock from existing

shareholder(s) (leveraged)• Existing shareholder(s) sell stock to ESOT in exchange for a promissory note

(leveraged)

Benefits of an ESOP1. Tax Benefits to Company, Shareholders, and Participants

2. ESOP’s tax-advantage can finance growth

3. An ESOP provides employees with a stake in the profitability of the company

4. Retirement Benefit to Employees/Management Incentive

Tax Benefits

Shareholder may be able to defer gains on sale of C corporation stock to ESOP via 1042

Company contributions to ESOP are tax-deductible

C corporation can deduct dividends paid on ESOP owned stock, whether used to repay money borrowed to purchase stock or otherwise

S corporation can obtain partial or full “exemption” from U.S. and most state income tax

Participants defer taxes on benefits until distribution

For the Company, the Shareholder and the Participant

Business GrowthESOP companies see average yearly improvement in Return on Assets of +2.7%

ESOP companies increased sales per employee between 2.3%-3.4% as compared to pre-ESOP

S Corp ESOP benefit – a snapshot from 2008

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S Corp ESOP Peer

Jobs + 1.9% - 2.8%

Wages +5.9% + 3.2%

Revenues +15.1% - 3.4%

Retirement Contr. + 18.6% + 2.8%

Employee Stake Drives GrowthAs beneficial owners through the ESOP Trust, employees benefit from the capital growth of the Company

Over recent 10-year period, ESOPs have 25% higher job growth than comparable non-ESOP companies

Employee-owners were 4x less likely to be laid off during the recent recession

Source: NCEO’s The State of Broad Based Employee Ownerships Plans, 2013

Retirement BenefitESOP retirement benefit is contributed by the Company only

Employees at ESOP companies have, on average, 2.5x greater retirement accounts than non-ESOP retirement plans

ESOPs more likely to offer a second defined contribution plan than other retirement plans (401(k) elective deferral plan + ESOP = KSOP)

ESOP companies contribute, on average, 75% more to their ESOPs than other companies contribute to their primary defined contribution plan

Management IncentiveUnder ESOP, Management

1. “Own” all or part of the employer; and2. Participate in the growth and success of the employer

Management can be incentivized further with nonqualified equity-based compensation (phantom stock, stock appreciation rights, stock options)

Who Manages an ESOP Company?• The Board of Directors provide vision and direction

• Appointed Management manage day to day operations

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Sole Proprietor ESOP Participant Public Co. Stock

• Put up own money• Owns everything• Manages everything• Controls everything• Impacts the business• Receives the carrot

and stick of ownership

• Company money• Beneficial interest• Direct Trustee on

some issues• Manager likely a

Participant• Impacts the business• Receives the carrot

only

• Put up own money• Own shares• Vote under state law• No participation in

management or control

• No impact on business

• Receives the carrot and stick

Participant Rights•Receive Summary Plan Description and Access to Plan Documents

•Receive Annual Account Statements

•At a minimum, permitted to direct the Trustee on the following (if state law requires shareholder approval):• Corporate merger• Recapitalization• Reclassification• Liquidation or dissolution• Sale of substantially all of the assets

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Other Key Features of ESOPs1. Diversification

2. Stock Distributions

3. Repurchase Obligation

Diversification• Participants age 55 and older who have participated in the Plan for

10 years must be permitted to “diversify” 25% of the balance credited to his account (6 year period)

• After the first five years of the diversification period, may diversity up to 50% (only in year 6)

• Three investment options to be provided

• Alternatives to Investment Options: distribute the stock/cash to the Participant, permit transfer to 401(k) plan with three investment options

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Distributions• Right to demand company stock unless

• Plan sponsor is an S Corp• Articles of incorporation or by-laws restrict ownership to

employees or trust • Put Option

• Unless stock publicly traded, may require repurchase by Company

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Repurchase Obligation• If the Company stock is not readily tradable on an established

market, the Company has an obligation to purchase stock distributed to Participants.

• Two 60 day put option periods must be provided to participants who have received a distribution of Company Stock

How Does the ESOP Process Start?• Engage Trustee who in turn engages Independent Appraiser

o Company can engage preliminary appraiser but creates conflict if it later works for Trustee

• Trustee makes an offer to purchase shares of “Target” Company based on Fair Market Value determination of Independent Appraiser

• Sellers determine whether to proceed with deal based on offer

A Word About Fair Market Value• Generally, a sale or exchange of property between a plan and party

in interest is a prohibited transaction• Statutory exemption for acquisition or sale by ESOP if price is not

less favorable to the plan than “adequate consideration” and no commission is charged to the Plan.

• FMV is the price at which an asset would change hands between a willing buyer and a willing seller with neither under threat or compulsion

• ESOP Buyer is a financial buyer not a strategic buyer

Advantages of Leveraged ESOPLEVERAGED ESOP

•Seller can obtain deferral of capital gain taxation under 1042 to be discussed

•ESOP principal is tax-deductible

•S Corp advantage – no income tax to the Company

LBO MANAGEMENT BUYOUT

•No deferral of capital gain

•Only interest expense of loan deductible

•S corp Distributions to Management to repay loan are taxed

Potential Downsides to an ESOPDOWNSIDE

If selling shareholder elects Sec. 1042 tax benefits, he and his family are excluded from participation in the ESOP

Tax benefits may improve debt-service but repurchase obligation can drain cash

ESOP can pay only fair market value for stock and may not pay strategic premium

Ownership culture requires effort – mere fact of profit based incentives does not create the ownership culture effect

RESOLUTION

Synthetic equity in the form of Phantom Stock to family members in the business in amounts to replace 1042 stock

Proper planning and plan design can address repurchase obligation

Tax benefits can offset perceived loss in value

The effort to develop a culture is rewarding and pays off with greater profits

Legacy PlanningStockholder’s estate may consist almost entirely of illiquid privately-held company stock

An ESOP can

1. Create shareholder liquidity;

2. Diversify shareholder’s wealth;

3. Create estate liquidity;

4. Permit equalization of inheritances; and

5. Maximize gifts to family members

Section 1042 and the EstateUnder Section 1042, a selling shareholder (SS) that sells stock to an ESOP may defer capital gains if the following requirements are met:

1. ESOP owns 30% or more of the issued and outstanding stock of the Company or 30% of the total value of all outstanding stock of the Company;

2. Within 1 year of the close of the sale, the SS (i) makes Election and (ii) purchases Qualified Replacement Property (QRP);

3. Gain is deferred until disposition of the QRP

Qualified Replacement Property is any security issued by domestic operating company which: 1. Did not have passive investment income in excess of 25% of gross receipts of the

corporation; and2. Is not Company stock

Estate Planning ExamplePost-transaction, the equity value of the Company reduces due to transaction indebtedness on books of Company, and thereby benefits sellers that retain company stock by providing excellent gift and estate planning opportunities.

For example: Mr. Big sells 55% controlling interest in C-Corporation to ESOP for $5.5mm (assuming $10mm equity value on control basis). Mr. Big retains 45% of C-Corporation and gifts that stock to his two sons. Even assuming pre-transaction equity value, that 45% is a non-control interest and thereby permits application of discounts for (1) lack of control (inverse of control premium – let’s say 25%) and (2) lack of marketability (anywhere from 35 to 50%). In brief, that 45% is now likely worth somewhere around $2.025mm on a good day.

Ideal ESOP CandidatesBusiness with consistent annual profits (including Owner Compensation) of $700K or more

15+ employees

Solid management

Non-highly leveraged balance sheet

ESOP Plus®: An IntroductionESOP Plus®: Schatz Brown Glassman LLP is a boutique law firm focusing on business succession for middle market companies with niche expertise in employee stock ownership plans (ESOPs).

Founded in 2011, the attorneys at ESOP Plus combined their collective experience, including several attorneys with more than 30 years experience in the field, to provide the most comprehensive ESOP services available.

Services:

Succession Transactions Regulatory Compliance Mergers & Acquisitions

Plan Design Executive Compensation Corporate Restructuring

Fiduciary Advisory Employee Benefit Plans Corporate Finance

Litigation Audit Defense Legacy Planning

Peter E. JonesPeter E. Jones represents ESOP companies from the initial transaction to maturity and beyond. At ESOP Plus®, Peter structures ESOP transactions, designs ESOP plans, and advises ESOP companies with their continuing regulatory compliance as they begin their journey into employee ownership. Peter also develops executive compensation plans to attract and retain successor management and aids selling business owners with legacy planning.

Peter is a graduate of Bradley University (B.A.) and was the valedictorian at Capital University Law School (J.D.) when he graduated in 2007. He is admitted to the bar of Ohio as well as the U.S. Court of Appeals for the Sixth Circuit, the U.S. District Courts for the Northern and Southern Districts of Ohio and the U.S. Bankruptcy Court for the Southern District of Ohio.

He is a professional member of the ESOP Association and National Center for Employee Ownership and an adjunct professor at the Moritz College of Law at The Ohio State University.