STEP BY STEP PROCESS FOR

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STEP BY STEP PROCESS FOR SELLING YOUR BUSINESS TO
YOUR EMPLOYEES
Financing an ESOP Acquisition Akron, OH April 21,
2006
Kurt W. NicholsVice President ESOP Financial
Services 312 904-5059 kurt.nichols_at_abnamro.com
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• MECHANICS OF ESOP FINANCING
• UNIQUE FINANCIAL CHARACTERISTICS
• SOURCES OF ESOP FINANCING
• PREPARING TO SHOP FOR ESOP FINANCING
• WHAT TO LOOK FOR IN YOUR LENDER
• IRS CIRCULAR 230 DISCLOSURE

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• MECHANICS OF ESOP FINANCING

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MECHANICS OF ESOP FINANCING
Tax Deduction of Principal Interest

• Structure
• The Company creates an ESOP Trust
• The Company borrows funds and re-lends the
  proceeds (inside loan) to
  the ESOP
• The ESOP uses the funds to purchase shares
  from existing shareholders. The shares are held
  in a suspense or contra equity account
• The Company services the new debt by making tax
  deductible contributions to the ESOP. In turn,
  the ESOP repays the inside loan to the Company
  and the Company repays the debt to the lender
• As the Company makes ESOP contributions, and the
  inside loan is repaid, shares are released from
  the suspense account and allocated to the
  employee accounts

Leveraged ESOP Purchase of Existing Stock
Repayment of ESOP Financing
Lender
Note Repayment
Dividends Contributions
Company
ESOP Trust
Note Repayment
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MECHANICS OF ESOP FINANCING
Tax Deduction of Principal Interest

• ESOP Tax Savings

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MECHANICS OF ESOP FINANCING

• Deferral of Capital Gains for Selling Shareholders

• C-Corp Transactions
• Shareholders selling at least 30 of their stock
  to an ESOP will be able to defer capital gains
  tax indefinitely
• Properly structured, the sellers proceeds may
  eventually be transferred to the sellers estate
  with a tax-basis that is stepped-up to the sale
  price, effectively eliminating forever the
  deferred tax associated with the original sale of
  the stock

Seller Defers Capital Gains Tax 1042 Rollover
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MECHANICS OF ESOP FINANCING

• An ESOP is a tax exempt entity. In 1998, ESOPs
  were allowed to own stock in S-Corporations
• If the ESOP owns 100 of the common stock, the
  Company can elect S-Corporation tax status and
  avoid paying federal income tax completely
• By reducing its debt balances (all other things
  being equal), a Company is able to generate
  additional value for its equity holders

Tax Exempt S-Corp ESOP
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• UNIQUE FINANCIAL CHARACTERISTICS

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UNIQUE FINANCIAL CHARACTERISTICS
Negative Net Worth

• ESOP Accounting
• Value of shares purchased by the ESOP creates a
  contra-equity item
• May create negative net worth
• Accounting anomaly
• Standard bank measure of leverage, liabilities /
  equity, is not applicable
• Need a lender experienced in ESOP financing

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UNIQUE FINANCIAL CHARACTERISTICS
Highly Leveraged Cash Flow

• Redefine leverage
• Debt / EBITDA E
• E ESOP benefit expense

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UNIQUE FINANCIAL CHARACTERISTICS
Highly Leveraged Cash Flow

• E ESOP Benefit Expense
• Tax deductible
• Can be up to 25 of qualified payroll
• Effectively a non-cash expense
• ESOP uses the benefit, contributed by the
  company, to repay the inside loan from the
  company

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UNIQUE FINANCIAL CHARACTERISTICS
Highly Leveraged Cash Flow

• Greater cash flow available to service debt
• EBITDA E

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• SOURCES OF ESOP FINANCING

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SOURCES OF ESOP FINANCING
What Do Lenders Look For In Companies?
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SOURCES OF ESOP FINANCING

• Asset Based Lenders
• Cash Flow Senior Lenders
• Subordinated Lenders (Institutional)
• Seller Paper
• Equity
• Institutional
• Employee-Based

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SOURCES OF ESOP FINANCING
Commercial Loans vs. Asset Based Loans
Commercial Loans

• Typically are less leveraged
• Due to bank comfort level, company has limited
  reporting requirements
• Lowest spread/pricing
• Secured by assets but limited monitoring

Asset Based Loans

• Due to higher leverage and or lack of earnings -
  banks very focused on asset values/borrowing base
• Asset values need to be greater than loan needs
• Daily A/R reporting
• Weekly inventory reporting
• Lock-box mechanism
• More expensive

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Asset Based Loans
SOURCES OF ESOP FINANCING
Underwriting Criteria
Asset Values

• Current Assets
• A/R x 80
• Inventory x 50
• Fixed Assets
• Equipment (OLV) x 80
• Real Estate x 75

Security Interest
First Lien on All Assets
Floats Based on LIBOR with Spread of 175 to 325
Pricing
Maturity
Three to Five Years
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What if Debt Needs Exceed Loan Value of
Collateral?
SOURCES OF ESOP FINANCING

• Asset Based with an Air Ball
• Cash Flow Senior
• Institutional Mezzanine Debt
• Seller Debt
• Equity

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Asset Based with an Air Ball
SOURCES OF ESOP FINANCING
Underwriting Criteria
Asset Values and Short-Term Earnings Outlook
Security Interest
Same as Asset Based
Pricing
Floats but Spread 50 to 150 Points Higher than
Asset Based
Maturity
Air Ball Portion Amortized Over Two Years
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Cash Flow Senior Loan
SOURCES OF ESOP FINANCING
Underwriting Criteria
Enterprise Value (i.e. Multiple of EBITDA) Not
Asset Value
Security Interest
First Lien on All Assets
Pricing
Floats Based on LIBOR with Spread of 300 to 375
Maturity
Five Years
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Institutional Mezzanine/Subordinated Debt
SOURCES OF ESOP FINANCING
Underwriting Criteria
Earnings/Enterprise Value
Security Interest
Earnings/Enterprise Value
Pricing
Fixed Interest Rate 11 to 13 Yield
Enhancement PIK Interest and/or Warrants
Maturity
Six to Seven Years
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Seller Notes
SOURCES OF ESOP FINANCING
Underwriting Criteria
None
Security Interest
None
Pricing
Varies but Typically Fixed at a Relatively Low
Rate
Maturity
After All Other Debt
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Equity Capital
SOURCES OF ESOP FINANCING

• Institutional Equity
• Pricing 20 30
• Board Rights
• Exit Rights
• Typically a Mezzanine or Private Equity Fund
• Employee Based Equity
• Existing ESOP
• 401K/Pension/Profit Sharing Assets
• Hard Dollars from Management

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Current Market Conditions
SOURCES OF ESOP FINANCING

• Strong Supply of Capital
• Traditional Senior Lenders are lending again
• Hedge Funds, Insurance Companies, Mutual Funds,
  Institutional Mezzanine Funds All Chasing
  Yield
• Private Equity
• Rising Rates Yet Lower Spreads
• Increased Leverage

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• PREPARING TO SHOP FOR ESOP FINANCING

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PREPARING TO SHOP FOR ESOP FINANCING

What to Present to Your Potential Lender

• 3-5 years of historical financial statements
• 5-7 year financial forecast with assumptions
• Feasibility study or summary of ESOP facts
• Collateral support
• A/R aging
• Inventory breakdown
• Fixed asset schedules
• Description of business and market forecast
• Outline of management

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• WHAT TO LOOK FOR IN YOUR LENDER

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WHAT TO LOOK FOR IN YOUR LENDER

• ESOP Experience
• How many ESOP transactions completed?
• Does the decision maker understand ESOP
  financing?
• The vast majority of lenders have either a credit
  committee or a credit officer that makes the
  decision whether or not to lend
• Commitment to the ESOP community
• Member of The ESOP Association
• Current with critical issues affecting ESOPs
• Understand current ESOP market dynamics
• Commitment to your type of transaction
• Structure (asset based/cash flow)
• Size (small business, middle market, large
  corporate)
• Industry (service, specialized, manufacturing,
  construction)

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• IRS CIRCULAR 230 DISCLOUSRE

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IRS CIRCULAR 230 DISCLOSURE

• To ensure compliance with requirements imposed by
  the IRS, we inform you that any tax advice
  contained in this communication was not intended
  nor written to be used, and cannot be used, for
  the purpose of (i) avoiding penalties under the
  Internal Revenue Code (ii) avoiding penalties
  under applicable state or local tax law or (iii)
  promoting, marketing, or recommending to another
  party any transaction or matters addressed by
  this written advice. All parties should seek tax
  advice based on that party's particular
  circumstances from an independent tax advisor.