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MBBI ESOPs in a M & A World. October 9, 2012. Tim Regnitz Vice President SES Advisors www.sesadvisors.com. Ken Serwinski CEO Prairie Capital Advisors, Inc. www.prairiecap.com. What is an ESOP?. ESOP Transaction Basics. There Are a Few ESOP Quirks. The Money in Motion… at Closing.

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mbbi esops in a m a world
MBBIESOPs in a M & A World

October 9, 2012

Tim Regnitz

Vice President

SES Advisors

www.sesadvisors.com

Ken Serwinski

CEO

Prairie Capital Advisors, Inc.

www.prairiecap.com

private equity esops
Private Equity & ESOPs
  • Motivating factors
    • Many portfolio companies have strong cash flows and strong management teams, but lack a clear exit strategy
    • An IPO is often unlikely and the M&A market may not be as promising as anticipated at the time of investment
    • Untimely exit strategies can begin to weigh down the IRR of the fund
    • In the right situation, an ESOP can be the best possible exit strategy for the fund’s return, the company, the management team, and the employee base
  • Tax Exemption – 100% S-Corp ESOPs
    • A 100% S-corporation ESOP is exempt from federal income taxes
    • This tax exemption significantly increases a company’s cash flow, shortens payback period of the debt, and in turn, lowers the risk associated with the transaction and the company
    • Beyond the transaction debt, 100% S-corporation ESOPs continue to be tax exempt, with the potential of becoming a cash cow, making it more competitive in its markets
    • The ESOP company has more money to invest in organic or acquisition growth
private equity esops1
Private Equity & ESOPs
  • Look inside your portfolio...
    • A company that consistently generates quality cash flows
    • A company whose growth rates are not as robust as projected at the time of investment
    • Companies who have been to market one or more times and have been unable to find an appropriate third-party buyer
    • Capable and seasoned management team interested in the buyout and running the business on their own
    • A company that pays a substantial amount of federal income taxes, which will see cash flows enhanced from the owner being 100% S-corporation ESOP
    • Additional cash flow can be used for several purposes including assistance in paying off transaction debt
  • Benefits to the Seller
    • An ESOP transaction offers the seller the opportunity to control the sale process to a “friendly” buyer and make a good return
    • The transaction is typically less risky as many of the players involved already have extensive knowledge of the company
    • The players involved in getting an ESOP transaction done are the sellers, company’s management team, company’s board of directors, the appointed ESOP trustee, and the appraiser
    • Typically, the board will be controlled by the private equity firm (seller) and will thus control approval of the deal
private equity esops2
Private Equity & ESOPs
  • Enhancing returns
    • The return resulting from the sale of an ESOP is often enhanced by a higher rate of return, which is paid on a seller note
    • The return is made up in two parts; cash interest payments and warrants/stock appreciation rights (SARs)
    • It is common for cash interest payments to be kept at a minimum, while the return generated from the warrants is maximized
    • This is done to create a tax efficient structure whereby cash interest payments are taxed as income while payment on the warrants are taxed as capital gains
    • Also, the warrants allow the seller to participate in the upside potential of the company that will no longer be paying federal income taxes
    • For private equity sellers, a high return from seller notes will not only provide a boost to the overall return on the investment, but will also make the ESOP an attractive option when other buyers exist
private equity esops3
Private Equity & ESOPs
  • Valuation requirements
    • ESOP purchases must be valued at no greater than fair market value of the company stock
    • Determining the value of the company will require an independent valuation firm
    • The appraiser’s valuation can be used to set the value of the transaction and to assure that an arm’s length negotiation has taken place
    • Often the appraiser is the only outsider involved in the ESOP process for which transaction insiders need to make a convincing argument to the appraiser for why a particular selling price is appropriate
    • Given the fair market value requirement, ESOP transactions usually do not exhibit the premiums seen in many IPOs or M&A transactions
    • When a portfolio company can generate a premium above fair market value, a leveraged ESOP is typically not appropriate as an exit strategy
    • However, warrants used in the financing of the deal can frequently make up a percentage of the premium that the ESOP transaction does not enjoy
conclusions
Conclusions
  • Private equity firms can use ESOPs as a viable, internal, ready-made exit strategy for a subset of their portfolio companies
  • IPOs and acquisitions will always be preferred outcomes, but they are not always viable or available at the desired price
  • ESOP transactions offer the private equity firm the opportunity to control the sale of their portfolio companies back to the employees who originally grew the company into a successful business
  • The tax efficiencies will offer enhanced cash flows, which will first assist in paying down transaction debt, and will then go towards growing the business
  • With management support and enthusiasm, the result can be a successful transaction for all parties involved