Session Slides

Exiting Gracefully:
Options for Transitioning Ownership
Corey Rosen
National Center for Employee Ownership
Moderated by: Diane Stoneman, Director of Consulting and Training,
Winning Workplaces
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Our Agenda Today
• Three options for transitioning
• Discuss each option in detail
• Pros and cons
• Questions
Featured Presenter
Corey Rosen
National Center for Employee Ownership
Laying out the Options
1: Sell to Employees Directly
2: Selling to Third Party
3: Use an ESOP to Buy Out Owner
Option 1: Sell to Employees Directly
• Employees come up with cash out of
after-tax dollars
• Employer loans $$ at reasonable rates
• Owner takes a note to finance sale
• Employees forego bonuses to pay loan
• Owner gets capital gains if stock is sold.
If assets are sold, company may have
capital gain as well.
Reducing Costs to Employees
• Sale price reduced by leasing tangible or
intangible assets (e.g.: intellectual property,
company’s name). Paid for in pre-tax corporate
dollars, owner pays income tax.
• Owner agrees to compensation agreement
and/or non-compete agreement in return for
taxable consideration as part of sale price.
• Part of sale price structured as earn-out. Not
deductible; if properly structured, may be
capital gain to seller.
Option 2: Selling to Third Party
• Hard to find these days
• Synergistic buyers pay a premium
• Financial buyers pay a multiple of future
free cash flow
• Both may require an earn-out of some
kind and have various other financing
What to Look For in Outside Buyer
• Financial strength: do they have cash or
ability to borrow money? If they are
financing payment, is there collateral?
• Record of successful acquisitions
• Acceptable plans for future of business
and employees
• Reasonable requirements for what the
seller will subsequently do
• Acceptable time frame
Option 3: ESOP to Buy Out Owner
How An ESOP Buys Out an Owner
• Company sets up employee benefit trust
• Contributes cash to buy shares or
• Borrows money through plan to buy
• Employees do not buy the stock
• Contributions tax deductible, even when
used to repay a loan (principal and
interest), up to 25% of eligible pay
How Much Will ESOP Pay?
• Price not be higher than fair market
value on a financial basis as
determined by independent appraisal.
• Negotiations over sale terms can only
be to produce a better price than that
set by the appraiser.
• ESOP cannot pay synergistic value.
• Minority ownership sales are valued at
less per share than control sales.
Elements of Valuation
• Most important is multiple of future free
cash flow or discounted future cash
flow over an number of years.
• Comparable company sale data and, if
applicable, public company comparison
data will be factored in.
• Asset value usually least important
factor, but valuable non-performing
assets may add to value.
Benefits to Seller
• If ESOP owns 30% or more after sale in C
corp., seller can defer tax on sale gain if
reinvested in stocks and bonds. If not,
sale qualifies as capital gain.
• If company is an S corporation, deferral
not possible, but capital gains deferral is
not available, but other tax benefits are.
• ESOP buys some stock now, some later.
• Sale accomplished in pre-tax dollars.
Rules for Owners in Section 1042
• Stock held for at least 3 yrs.
• Only privately held C corps. qualify.
• 30% rule: ESOP must own 30% of
stock after transaction; synthetic equity
(options) considered outstanding stock.
• Direct family members, sellers, and
25% owners can’t get allocation of
shares in ESOP subject to deferral of
taxation. Can if the seller opts not to
take deferral.
Eligible Investments
• Sellers have 12 months after sale to
reinvest in “qualified replacement
property” (QRP).
• QRP must be securities of domestic
operating companies not making more
than 25% of income from passive
investment (mutual funds, gov’t bonds).
• Gain on sale of any QRP is taxed using
original basis of company stock with
Sales in a S Corporation
• The tax deferral is not available.
• ESOP profits not subject to federal,
and usually state, income tax.
• Subject to anti-abuse rules, seller,
25% owners, and family members can
get ESOP allocations.
• Distributions made to other owners
must be made pro-rata to ESOP, but
can be used to buy additional shares.
Funding Options
Banks loan money to company which loans to
ESOP, which uses cash to buy owner’s shares.
Sellers finance transaction with note, can get tax
deferral on what they reinvest in first 12 months.
Company contributes cash to buy shares that year
OR build cash reserve to make larger purchase
later on.
In limited circumstances, some portion of funds in
existing defined contribution plans may be used to
help fund the ESOP (fiduciary issues arise.)
Key Points to Remember
• Company, not employees, fund plan.
• Acquisition of shares is nonproductive expense, company must
have earnings to absorb it.
• ESOPs only way a company can use
pre-tax dollars to buy out an owner.
Leveraged ESOPs
• Plan can borrow money to buy existing
shares or new shares to fund growth.
• Company contributes cash to ESOP to
repay loan and takes a tax deduction.
• Shares into a “suspense account;” as
they are paid for get released to
employee accounts.
Contribution Limits
• Generally, 25% of compensation of
employees covered by plan.
• If ESOP loan, in a C corp., interest
payments and dividends don’t count
toward limit; in S corp., they do.
• Not more than 100% of pay or $49,000
(in 2009) can be added to an
employee’s account each year from all
defined contribution plans.
Participation, Vesting, and Allocation
• Employees have individual accounts.
• Company contributes cash to buy stock,
contributes stock, or plan borrows to buy
• Accounts subject to vesting not more
than 6 yrs.
• Generally, full-time employees with
1,000 hours/yr must be included in plan.
• Allocations can be based on relative pay
or more level formula. No discretionary
or merit based.
• Employees get distributions not later
than one year after death disability, or
retirement, or
• Five years after the end of plan year for
other terminations.
• Paid out in installments up to 5 yrs.
• Employees with 10 years in plan who
are 55 or older can diversify part of their
stock accounts.
Paying for Distribution
• Company must assure employees get
fair market value for stock, but can put
cash into the plan to do this.
• Employees have a put right for shares
distributed to them.
• Distributions are taxed same way that
other distributions from defined
contribution plans are taxed.
Governance Issues
• Limited employee voting rights
• Plans governed by a trustee appointed
by the board
• ESOP committee to assist in process
Costs Issues
• First yr costs typically $40,000 and up.
• Ongoing costs as low as $15,000 or so,
depending on size of the company,
changes in the law, and other factors.
• ESOPs more expensive than other
plans, but much less expensive than
selling a business in other ways.
S Corporation Issues
• ESOP’s share of taxable income not
subject to federal and, usually, state
income taxes. 100% S ESOPs pay no
federal and, often state income tax.
• ESOP is one shareholder.
• Sales to ESOP not qualify for tax deferral.
• Contributions limits can be lower because
interest, as well as principal payments on
the loan count towards the limits.
Equity to Employees Outside ESOP
• Employees can individually be
granted equity rights
• Stock options
• Phantom stock and stock
appreciation rights
• Restricted stock
• Bonus shares
Further Resources
• Selling to an ESOP (NCEO, $25 to
members; $35 to non-members)
• Introductory consultation on equity
compensation available from NCEO;
contact Corey [email protected]
• NCEO web site:
Upcoming 2009 Webinars
May 27 Two Perspectives on Succession
Paul Silvis, Founder, Restek Corp;
Michael Foley, CEO, Reflexite Corp
June 17 The Story of Transforming an American Icon
Robert F. Pasin, President and CEO, Radio Flyer
Thank You!

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