The Essentials

1

• The Essentials
• of ESOPs
• A Lenders Perspective

2
Overview

• Describe the classic problem facing private
  business owners
• Explain the ESOP solution the lenders
  opportunity
• Illustrate a typical ESOP deal

3
Helping to Solve a Classic Problem Facing
Private Business Owners
How to create cash and liquidity for the
business theyve built
4
Typical Asset Allocation of Private Business
Owners
5
Client Net Worth Properly Diversified?
6
How to Create Liquidity The Usual Ways

• Sell to the Public
• Sell to a strategic or financial buyer
• Sell to Key Managers
• Sell to an ESOP

7
Why ESOP?

• To create cash for sale of part of the owners
  stock at fair value
• To indefinitely defer payment of capital gains
  taxes
• To finance deal with PRE-tax interest and
  principal
• To enable owners to sell shares while maintaining
  control of the shares

8
Typical Leveraged ESOP Transaction
XYZ
Selling Shareholders
ESOP
9
Repaying Loan Pre-Tax
XYZ

• XYZ makes a tax deductible contribution to the
  ESOP.

• ESOP uses the contribution to repay
• its loan from XYZ

ESOP

• XYZ repays bank

10
Case Study

• Review Loan Sizing
• Discuss collateral choices
• Accounting nuances for ESOPs SOP 93-6
• Value of tax perks

11
Balance Sheet(000)

• Line of Credit 950
• CP. LTD 200
• A/P 1,300
• Accrued Expenses 600
• Current Liabilities 3,050
• Long-term Debt 1,040
• Owners Equity 2,000
• Total Liabs Equity 6,090

• Cash 300
• A/R 1,000
• Inventory 1,590
• Prepaid Expenses 400
• Current Assets 3,290
• PPE 4,000
• Less Accum. Dep. 1,200
• PPE, Net 2,800
• Total Assets 6,090

12
Income Statement(000)
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Balance Sheet Capacity
Balance Effective Sheet Advance Asset
Amount Rate Availability Cash 300 0 - A/R 1,00
0 80 800 Inventory 1,590 60 954 Prepaid
Expenses 400 0 - Net PPE 2,800 50 1,400
Gross Balance Sheet Capacity 3,154 Less
Outstanding Debt (2009501,040) (2,190)
Net Balance Sheet Borrowing Capacity 964
14
Cash Flow Capacity(000)
15
Stand Alone Senior Debt Loan Sizing(000)

• Balance sheet borrowing capacity 964
• Cash flow borrowing capacity 1,716

16
Collateral Summary

• Maximum Stand Alone senior debt is the smaller
  of
• Balance sheet and cash flow borrowing capacity
• Capped by overall multiple of cash flow to senior
  debt
• Example company could borrow up to 964,000 on
  a senior stand alone basis for a 16
  transaction
• Example companys cash flow can support 1.8
  million
• Collateral shortfall for 1.8 million loan is
  approximately 836,000

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How do we get there from here?Collateral
Shortfalls

• Additional debt could be borrowed over and above
  the stand alone amount using one or more of the
  following approaches
• Limited personal guaranty
• Seller debt
• Mezzanine debt

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Limited Personal Guaranty

• Selling shareholder makes a limited guaranty for
  the uncollateralized portion of the loan
• Limited guarantee is secured by personal assets
• Typically, sale proceeds are used as collateral
  to support limited guaranty
• Limited guaranty typically ratchets down
  annually as company pays down principal and
  loan/value ratio decreases

19
Balance Sheet(000)

• Cash 300
• A/R 1,000
• Inventory 1,590
• Prepaid Expenses 400
• Current Assets 3,290
• PPE 4,000
• Less Accum. Dep. 1,200
• PPE, Net 2,800
• Total Assets 6,090

• Line of Credit 950
• CP. LTD 200
• A/P 1,300
• Accrued Expenses 600
• Current Liabilities 3,050
• Long-term Debt 1,040
• Owners Equity 2,000
• Total Liabs Equity 6,090

20
Post-ESOP Balance Sheet (SOP 93-6)

• Cash 300
• A/R 1,000
• Inventory 1,590
• Prepaid Expenses 400
• Current Assets 3,290
• PPE 4,000
• Less Accum. Dep. 1,200
• PPE, Net 2,800
• Total Assets 6,090

Line of Credit 950 CP. LTD 200 A/P 1,300 Accrue
d Expenses 600 Current
Liabilities 3,050 Long-term Debt 2,840 Owners
Equity 2,000 Unearned Shares (1,800) 200 Total
Liabs Equity 6,090
21
Post-ESOP Year 2

• Cash 300
• A/R 1,000
• Inventory 1,590
• Prepaid Expenses 400
• Current Assets 3,290
• PPE 4,000
• Less Accum. Dep. 1,200
• PPE, Net 2,800
• Total Assets 6,090

Line of Credit 950 CP. LTD 200 A/P 1,300 Accrue
d Expenses 600 Current
Liabilities 3,050 Long-term Debt 2,355 Owners
Equity 2,000 Unearned Shares (1,315) 685 Total
Liabs Equity 6,090
22
Important Ratios Considerations

• Ratios
• Fixed Charge Coverage Ratio (Cash flow Pmt)
• Debt-to-Equity Ratio
• Considerations
• Bonding
• Franchisor approvals
• Future borrowing needs
• Future share repurchases

23
Company Tax Benefit Using ESOP
Regular
ESOP
Gross Principal Payments 1,800,000 1,800,000 Val
ue of Principal Tax Deduction 0
(720,000) Net After-Tax Principal
Paid 1,800,000 1,080,000
Gross Interest Payments 378,000 280,800 Value of
Interest Tax Deduction (151,200) (112,320)
Net After-Tax Financing Cost 2,026,800 1,2
48,480 Net Cash Savings Using ESOP
778,320 62
24
Tax Savings on Sale to ESOP

• IRS allows for deferral of capital gains tax on
  certain ESOP transactions
• Our example owner may have saved as much as
  160,000 in taxes using ESOP
• Combined savings
• Company 778,000
• Seller 160,000

25
Requirements of Tax Deferred Sale

• Company has to be a C corporation at time of
  transaction
• S corporations still can do ESOPs, but no capital
  gains tax benefit
• ESOP must own at least 30
• Seller must reinvest the proceeds within 12
  months in Qualified Replacement Property

26
How Can We Work Together?
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How Can We Work Together?

• The Lender Identifies Profitable Business Owners
• Potential new source for term loan and L/Cs
• Good way to prospect for new clients
• SES Advisors
• Assess feasibility of the ESOP for your customer
  at no cost
• Complete transaction and maintain ESOP

28
Safe Assumptions about Business Owners

• Most owners do NOT have a detailed exit strategy
• Too busy running their company
• Too complex
• Im going to live forever
• Ill just sell it when I get sick of it
• They are not familiar with their alternatives
  especially the ESOP
• They HATE taxes more than anything else

29
Typical ESOP Company

• Cash flow north of 1 million
• Owner(s) looking for a way to sell some, but not
  necessarily all, of their stock
• Private and closely-held
• Debt capacity
• Value between 1 and 100 million
• Sales in excess of 5 million
• .did I say, profitable?

30
Questions for Your Customers

• Has your customer planned their business
  succession?
• Does your customer want to get some liquidity
  now, and not pay capital gains taxes?
• Is the owner seeking to retain control of the
  company?
• Is your customer sufficiently diversified away
  from the company?
• Is the company profitable?

31
The ESOP Process

• Bank discusses the ESOP concept with client
• Bank submits Feasibility Questionnaire to SES
• Bank and SES discuss findings with client
• SES Advisors is engaged to conduct feasibility
  analysis
• SES Advisors structures and quarterbacks
  transaction
• Bank finances transaction