In this session you will learn about:

  • Pros and cons of using an ESOP as an exit channel
  • Company profile requirements to effectively use an ESOP
  • How a company's value is determined for an ESOP
  • How ESOPs are structured and financed
  • What financial information ESOPs have to provide to employees

About the Guest:

Jim Higgins is a co-founder and managing director of Pilot Hill Advisors and he specializes in designing, financing and executing internal buyout transactions for privately-held companies. Jim has advised more than 90 companies on management and ESOP buyouts that provide unique financial, tax, strategic and motivational benefits that are distinct from traditional third-party corporate sales.

Jim has held senior corporate finance and advisory positions for 25 years. His specialty in ESOP and MBO transactions began in 2001. Jim's prior employers include Bank of Boston, AT&T and Merck.

Jim received a Bachelor of Science in Finance from Boston College and a Master of Science in Management from Massachusetts Institute of Technology. He also holds Series 24, 63, 79 and 99 securities licenses.

Listen to the Webinar Here:





Read the Full Transcript Here:


Slide 1



Scott: Welcome Everyone! I’m Scott Yoder with Divestopedia. Today, we’ll be explaining a unique and tax efficient exit channel owners should become familiar with and compare alongside their alternative exit channel options - the Employee Stock Ownership Plan or an ESOP.


ESOPs aren’t widely used as only certain companies and ownership profiles are best suited for an ESOP but for those that do qualify, it can offer a powerful option for owners to accomplish their personal, business and financial objectives.


To explain and educate us on ESOPs, we have with us today James F. Higgins Jr. Jim is a Co-Founder and Managing Director of Pilot Hill Advisors. Jim specializes in designing, financing and executing internal buyout transactions for privately held companies. Jim has advised over 90 companies on the financial, tax and strategic aspects of management and ESOP buyouts.


Jim’s twenty six years of corporate finance experience include positions with Bank of America and Merck & Co., Inc. Jim received a Bachelor of Science in Finance from Boston College and a Master of Science in Management from MIT.


Slide 2


Scott: Thanks James, for presenting today. So I think a good place to start is by first providing our business owner audience a backdrop on how they could begin strategically thinking and planning to determine their optimal exit channel. And then also, discuss some of their typical options.


James: Thanks, Scott. So, I think from a big picture 30,000 foot view, what we’re talking about is looking at the fact that a lot of baby boomers who have been very successful at building a business over the past few decades are now facing a transition of their ownership. A lot of business owners, when they think about the process, they’re thinking about really only one thing. And that is, I think it’s very clear to be able to define and that is value or price. What are they going to get? When are they going to get it? That’s kind of the biggest objective that they’ve got.


But when they take a step back and look at all the different things that are going on their life and what their objectives are, many times, not always, but many times there are other issues that come into play or other objectives that comes into play. So what we do with the ESOP transaction is to try to address some of the objectives, many of the objectives quite frankly for some business owners. And the one thing we keep in mind here is that ESOP is not necessarily something that’s going to be applicable for every situation.


So, what we want to do in this presentation today is give an overview so people have a better idea. But the thing we’re trying to do is match up what the business objectives are of the business owner. What the business can actually do with what can be done with an ESOP.


Scott: Great. So, do you want to take us through some of the options that typically owners have for their exit.


James: Absolutely. There’s a bunch of different things that could be done, more are likely than others. The two key things that a business owner can typically do is find either a financial buyer or a strategic buyer; maybe a competitor or someone who wants to get in to the business that they’re in and buy them out.


All these different alternatives have pluses and minuses that are associated with them. And what we want to do is, again, try to match up what the business owner wants to do - namely, value the transferring of the ownership of the business to some of the key employees and other aspects that they may be interested in with, possibly in ESOP. We want to make sure that the business owners understand what they can and cannot do with an ESOP and try to get them to have what is going to be the optimal exit from their business.


Scott: Yeah, I mean, that’s a great process and that’s kind of one of the core values that we perform for owners in our engagements. So for those owners that maybe don’t have the certified exit planning advisor in their area, who do you suggest they call to kind of help them objectively vet the right exit channel for them as they start strategically thinking and planning for this?


James: Well, I think the keyword you just used there was objective. And in my experience, I find the people that work the best and provide the best guidance for the business owner are the people that are very familiar with their business - namely the CPA, maybe the corporate attorney for the company, or an independent board member in the extent that they have that. These people are knowledgeable about a lot of things that are going on outside the business in the broader finance world and can lend that to them and provide them with the guidance that they need. So that they are at least looking at the right things in evaluating what the right path should be going forward.


Scott: Right. so, somebody that has financial and market experience and kind of specializes in; or has some level or a decent level of transactional experience to help them vet each one of these channels and try to figure out where the owner fits in the best.


James: That’s right. Business owners are in the day-to-day operations of the business and they’re not very familiar with what’s going on and some of the other aspects of finance. And some of these folks that are their advisors can be people that could bring experience to the table which the business owner can leverage.


Scott: Yeah. They can bring the other disciplines that are needed to help the overall strategic planning and thinking, right?


James: That’s right.


Scott: Okay. So Jim, before we jump in to the details of an ESOP, can you first provide us an overview of what an ESOP is?


James: Absolutely.


Scott: In 30,000 point of view?


James: Yup. Here we go. The ESOP is the Employee Stock Ownership Plans. Sometimes, people confuse ESOP with an Employee Stock Option Plan. So, it’s an ownership plan. Similar in many aspects to a 401K plan in that it’s a qualified retirement plan under the IRS rules and regulations. But it’s really the only qualified retirement plan that can do a couple of things. One, it can borrow money and it can use that money to go ahead and buy the stock of the company that’s sponsoring the plan. That’s really what the primary design feature and objective is of the ESOP itself it is a retirement plan.


The plan is company funded. It’s not a situation where the employees take money out of their own paychecks and, for instance, put it in to the plan on a pre-taxed basis. It’s almost like 401K match or a profit sharing plan which is company funded. And because of that the employees do not physically own the stock of the company. They have a financial interest in the company but they don’t directly own the stock.


Because of that they are not entitled, as they normally would as a direct shareholder to the various financial information that would be disclosed to a shareholder. This is a key feature because a lot of times we get people saying well the ESOP is something where the employees are all of a sudden going to have access to all the information of the company. And it’s not the case. They’re not entitled to do that.


The other key feature to understand is that the company that’s sponsoring the ESOP needs to be an S or a C corporation. We’ve had plenty of people who have LLCs that comes to us. But we would need to convert to a C or an S in order for the transaction to get put together because the ESOP cannot be a member in an LLC.


The final thing to keep in mind is that the ESOP can buy any portion of the company stock. It can buy 1% or 1/10% all the way up to a 100%. And what’s convenient about it is that you can do it at one or a multiple of transactions over time. So, it’s fairly flexible from that stand point.


Scott: Yeah, it does offer a great flexibility. So Jim, a couple of questions; first question, ESOP can own any portion of the company’s stock but isn’t there an opportunity to minimize tax if an ESOP owns a certain percentage of the company?


James: There is. There’s a part of the Internal Revenue Code that allows specifically the selling shareholder or shareholders of a company that’s a C corporation. If they sell at least in aggregate 30% or more of the company’s stock to the ESOP, that would allow them to, in essence, defer indefinitely the capital gains tax that would be otherwise due and payable. So, they’re right there. If that as a transaction could be done with one of the companies that are out there then the selling shareholders are going to save somewhere between 15-25%, generally speaking, on the capital gains tax that would otherwise be due and payable.


Scott: Okay. One other question, you talked about how LLCs don’t qualify to do an ESOP. Companies that are LLCs that come to you, do you ever convert them? Does it make any sense? Or you’ve been successful in converting them to a C corporation or an S corporation to do an ESOP?


James: We have, in fact, done that. Depending upon, really one the key issue is whether the company or the LLC has any debt outstanding or not. If it has debt outstanding, it could make it a bit problematic. If for instances the professional service firm that is an LLC and they want to do a transaction, they don’t have any debt outstanding; it’s pretty straightforward they’ll be able to do that. So we have in fact done that.


Scott: Okay. Let’s move on.


James: Okay.


Scott: So, why don’t you walk us through some of the reasons or benefits why owners would want

to consider an ESOP? As you have mentioned a few already, just talk us through some key areas on why ESOP’s are a good tool to use?


James: Sure. Here are some of the things, some of the benefits that you would get out of an ESOP. One is, as we were talking about before, the flexibility of selling all or a portion and doing it in one transaction or over several transactions. Essentially, you’re creating a buyer of stock that you can use over time if the objective is to do it over time. If you want to do it immediately, you can sell a 100% of the company’s stock to the ESOP. So, it’s flexible from that stand point.


We talked a little bit about the tax minimization from the shareholder which would allow the capital gains tax to be deferred. Again, the company’s got to be a C corporation and at least 30% of the company’s stock has to be sold to the ESOP. But that would take maybe a $20 million ESOP transaction and the equivalent on an after tax basis on a regular third party sale would be somewhere around $25 million. So, there’s a pretty substantial differential that you can get by having that tax savings when looking at it from the owner’s standpoint or an after tax basis.

What are the other things that’s nice about the ESOP is, as we know, there’s a lot of private business owners where control is an important feature especially if they’re planning on maybe sticking around for a few more years once the transaction has been completed. Even if the ESOP doesn’t go ahead and buy, for instance, a 100% of the company there’s no change required from the management team as a result of that transaction. So, there’s a lot of continuity there.

But also, it allows the selling shareholders especially if they’re going to be maybe seller financing a piece of the transaction to really, in essence, maintain control of the business until that debt obligation has been fully paid out to the business owner.


Other great aspects of the ESOP are the corporate tax minimization. It’s really the only time that I know of in corporate finance where a company can borrow money and deduct not only the interest, which I think everyone is aware of, but also the principal of the loan. The government is, in essence, subsidizing about 40% of the transaction if not more because the Congress has said this is a good thing. We liked the ESOP for helping up a private business owner in providing some ownership interest for the employees and we’re willing to give the company a nice tax break in the form of interest and principle on the debt that is being used for the ESOP. So, that’s a nice feature.

And then kind of a Holy Grail from a corporate taxation standpoint is situations where we have companies that are a 100% owned by an ESOP and they’re an S corporation. With S corps, the tax liability of the company’s income is not paid by the company but instead it’s paid by shareholder. When that shareholder happens to be the ESOP, which is a qualified retirement plan that company doesn’t in essence have to pay any type of income tax.


So, you’ve got a tax exempt company from the date that the ESOP owns a 100% going forward. And that tax exemption provides additional cash flow that allows the company to pay off the debt. And once the debts have been paid off, it can use it to invest strategically and be much more competitively aggressive with its competitors. So, it’s a nice feature.


A couple of other things that we look at are business owners who like an ESOP because they want to have the company remain independent. They want the legacy to be perpetuated. They don’t want to sell it to one of their competitors or to a third party. They might be concerned about the long term health and viability of the company and they’ve been building it for the last 20 or 30 years. They want to see it perpetuated.


The ESOP preserves that legacy. It also allows the employees to get a piece of that action moving forward. And it helps them recruit, motivate and retain the employees. We find ESOP companies are a lot more efficient over time because the employees realized that they’re not just earning a paycheck but they are in fact generating value for their long term retirement. That makes it a nice differentiator.


And then finally as we talked about before, the flexibility and the ability to have some flex in the way that you put the company out for sale and transact as an alternative to a buy out from a third party.


Scott: I mean wow, Jim. Those are some great benefits for ESOPs. But as I alluded to when introducing this webinar, ESOPs, I guess, aren’t for everyone.


James: Right.


Scott: Maybe you can explain some of the filters owners need to use to determine if their company and the personal circumstance is a good match for an ESOP.


James: Yeah, that’s a good point. I mean, that’s one of the things we try to do upfront is do a survey to understand what the objectives are. And if we don’t think an ESOP’s going to work, we’ll let them know right on. Because it’s not worth anyone’s time going down that path. It’s not going to lead to successful transaction. But some of the things that are kind of the rules of thumb and they’re not at hard the best.


But generally, if the company’s equity value is less than $2million, it may be difficult for the company to take on the ESOP because there are some ongoing carrying costs that are not substantial. But the smaller the company is on a relative basis the larger those carrying costs become.


Because an ESOP is an employee stock ownership plan, you actually have to have a critical mass of employees. So, we generally like to see a company that has at least 25 maybe 30 full-time employees. That helps especially from the tax deductibility for the principal as you mentioned earlier. It’s driven a large part by the company’s payroll.


Like any type of corporate finance transactions or companies being sold, the more stable the company’s earnings are the less volatile they are. The better it’s going to be from a value standpoint and from the ability for the company to get the transaction financed by a bank. So, we like to see stability in earnings.


Scott: Yes. That’s probably one of the bigger ones, isn’t it Jim, as part of the company’s profile?


James: Yeah, it is. That’s really no different than a third party coming in and trying to look at a company to buy. The more stable the earnings are the better off it’s going to be. Consistent with that is the whole point of you can predict the earnings. Are they predictable? Are they sustainable? And for companies that are LLCs, we can get the transaction completed but we have to be careful about the debt that might be on the balance sheet.


Certainly, if an owner or an operator or business owner is looking to get the highest possible price and cash on the barrel head and doesn’t care about other objectives that an ESOP can achieve; then they probably will be better off going out to a third party and trying to sell their company. A lot of times they’ve tried doing that. If they may not be successful, they can always come back to us and we’re happy to take a look at what can and cannot be done.


Scott: In your last slide you mentioned, the viable management. And that’s pretty important too to be able to pull off an ESOP that’s where the owner, kind of, wants to get out of the day to day management of the company. They have to have a strong management team in place to continue the company, right? You got to have a management team in place before you can pull off the ESOP, right?


James: That’s absolutely right. ESOP is not a panacea. It’s not like, for instance, a private equity group that might bring in a management team or even a strategic buyer that can bring in a management team. It’s a company that’s going to stand on its own legs going forward. It’s absolutely critical looking at the company to make sure that ESOP’s going to work. And also from evaluation standpoint, to make sure that the company has a good bench behind maybe that what was the owner operator and making sure that they can carry the company going forward.


Scott: Like what you just mentioned, I mean, lots of these characteristics are the same characteristics you’d want when you want to go to the market and sell may be to an independent third party. So, same basis and same stuff you want to be doing in your company and no matter who you sell to, either an ESOP or a third party or another exit planning channel.


James: Yeah, there are a lot of similarities.


Scott: Alright Jim. You’ve done a great job that’s for giving us an overview of ESOP along with the benefits and the types of owners and companies that ESOP’s work best for. So now, maybe you can put the theory into practice and walk us through one of your actual cases. Show us how you’re able to meet the ownership objectives using an ESOP and some of the financial benefits they received.


James: Sure. A company we worked on about a year ago was a manufacturing company. They had two different shareholders. One was a 60% shareholder who was the CEO and then a 40% shareholder was, basically, a passive investor. They had thought long and hard about selling out to a private equity firm but they had an objective. The objective was they wanted the company, the employees particularly, to carry the company going forward independently. So, they were adverse to a third party.


They actually went forward. Actually, they hired an investment bank to do a third party sale and then they decided to pull back on that. So, that’s when they bought us in. But they did use to have a clear objective from a valuation standpoint. They wanted to get the company to somewhere of a valuation of around $46 million which was at the time seven times EBITDA.


So, we were able to put together for them a 100% leverage buyout transaction where the sellers upfront received $15million from a senior debt financing. They could have probably gotten more than that but they were fairly conservative. They probably could have gotten somewhere to the tune of maybe $25 possibly $30 million. But they’re fairly conservative. They wanted to put in a nice small layer of senior debt. Then they, basically, bankrolled the rest of the $46 million or $31 million net in the form of a seller note.


We structured that so that they got a fairly decent, a smaller rate of cash interest which has an ordinary income tax on it. But more importantly, we were able to justify in the transaction for them to receive some warrants because seller’s notes were subordinated to the senior debt that was going to be paid out later. So there’s more risk involved.


Nice feature of it was that they were selling that at a 100% of the company. But in that net they were actually retaining about 17% through these equity warrants which acts essentially like a stock options that pay out once all the senior debt and all subordinated debt have been paid off. They get to go knocking at the company’s door and saying okay, I want you now company to pay me, the former shareholders, of what was 17% of the appreciation of the company stock after we sold the company. So, it’s a really neat feature and its very tax efficient as well.


The two sellers remained on the Board of Directors. They remained in control of the board. So, they really like that. Especially, given the fact that they had a lot of seller subordinated notes that were outstanding in the company. That’s was a really key efficient feature for them.


We’re able to provide management stock appreciation rights plan to the key employees which represented about 15% of a fully diluted equity value of the company. They were all excited because they were not only participating in the ESOP. But they were also getting an additional value over and above what they were getting in the ESOP by way of this stock appreciation rights plan.

And it was good for the ESOP because everyone is kind of focused on growing the value over time. So, the key employees were definitely tied in. You were going to ask me questions?


Scott: So Jim, I mean, you sold the company once. And now, the owners are also got a second bite of the apple because, like in your example, it’s like almost 30% more in equity. They received this from the warrants associated with the debt piece and then 15% from the stock appreciation rights. Is that right? Am I reading that right?


James: Well, they’ve got 17% of the equity by way of these warrants. That went to the sellers and they got that for, basically, bank rolling $31 of the $41 million from the transaction.


Scott: Right.


James: But separate and distinct from that was the key managers which the two selling shareholders were not in that group.


Scott: Okay, I see. The management and…


James: Yeah. The management team was going to be receiving this separate pocket of equity, what we call synthetic equity, which is paid. That cash out or the value to be received by that group would be, at a point, once all the debts have been paid off and all the warrants have been paid off. They’re the last ones out.


Scott: It’s a great incentive plan for the management team.


James: It is. It is. They were very excited about it because they don’t have the cash to go ahead and try to buy the company upfront. This is essentially something that was going to be given to them over time and they were going to earn it. So it was really a neat feature.


Scott: That’s a great feature.


James: Yeah. And then what’s also a great feature is the fact that the company once the transaction was completed was not going to be paying any federal or state income taxes going forward. So again, all that cash that was going to be going to Uncle Sam to pay the income taxes can be used by the company to get that debt paid out very, very quickly. We predicted somewhere in the 5 to 6 year time frame, all the debt was going to be paid off. Then that company was going to be positioned to go out and make acquisitions and be a lot more competitive. So it’s a great feature.

Other things that came by way of the transaction was the ability for the two shareholders to do some very interesting estate planning techniques and maneuvers that kind of go beyond that scope of what we’re talking here today. But it does provide for some very unique opportunities.


And at the end of the day, the shareholders, the management and the rank and file employees were thrilled because one of the alternatives was selling out to a third party where the company may not have been maintaining its location in the town that it was in. It was a very large employer so the community was quite excited about the fact that this transaction could be completed.


Scott: What a great success story, Jim. It’s great. It looks like they accomplished part if not most of the ownership’s goals and highly successful financially and otherwise. So, that’s great.


James: It really was.


Scott: Maybe you could start diving in to some of the more details in how this works and how the money flows.


James: Absolutely. The way this transaction, again, was $46 million transaction. And $15 million of the $46 million was provided by a bank. So, the bank lent $15 million to the company in the first step which is what we call the Outside Loan. The company then takes that $15 million and itself becomes a bank and makes out a loan to the ESOP.


So, you’ve got a $15 million outside loan that the company may borrow from the bank and then you get this $15 million inside loan. We do that for structuring purposes to allow the allocation of the ESOP shares to be done in a very smooth fashion. That wouldn’t be allowed if the senior lender lend directly to the ESOP. And quite frankly, a bank doesn’t want to lend to an ESOP anyways because that’s not where the company’s assets are. They want to lend directly with a company that has all the assets.


So, the ESOP at this point has $15 million. There was at that point a simultaneous transaction where the company redeemed $31 million of stock from the selling shareholders for the sellers’ subordinated notes and the warrants. Then, the ESOP took the $15 million and, what was at that point in time, bought the remaining shares that were outstanding. And once all of it is said and done, the ESOP became the 100% shareholder of the company. The selling shareholders had $15 million of cash and seller’s notes with warrants for $31 million. And for that, at the end of the day, that’s what the transaction would look like.


There’s a bunch of other moving parts and pieces that are going on in this. But in essence, it’s a combination of redemption and a direct sale of stock to the ESOP. Structurally and from a tax standpoint, this is the most efficient way of doing it.


Scott: Alright. So Jim, the most senior banks because they have any types of credits or do you have to find a bank that specializes in this, or familiar with this type of lending?


James: It’s a great question because there are some national lenders -the big usual suspect lenders - that you would see out there that definitely have experience in doing ESOP transactions. That’s good because they know what to look for and there’s not a learning curve that they have to get down or get up to as the case may be.


But at the same time, quite often, when we’re involved with the transaction there might be an incumbent bank or local bank that, from a chemistry standpoint, is a better fit for the company. In that instance, which is not a problem, we find ourselves educating out that lender - that bank - to see what the ESOP is and understand some of the nuances that they have to be aware of. So that they’re properly structuring it and that it’s going to work out for them. And as a result of that, it will hopefully work out for the company.


We see both the local incumbent lenders working through the transactions. But also, there are some national lenders that do it as well.


Scott: Well, that’s a great service you guys offer to be able educate the bankers because obviously If you already have a relationship with the lender and have years of experience and they understand your business; so, if you can educate them and get them comfortable with this ESOP structure in lending for the ESOP’s transaction, that’s the best of all worlds, it sounds like.


James: Well it’s like anything. the devils in the details and getting the people educated on it so that they can properly structure it is really the key. That’s why we’re there. That’s a service we provide to our clients.


Scott: In a lot of cases when companies take on debt; the owners, a lot of times, have to guarantee that debt, personally. And in these types of transactions, is it the same where the owners will have to continue to guarantee the debt?


James: It’s a function of the company’s size and whether the company has an asset base, that’s what we call the bankable.


Scott: Right.


James: For companies that are less than $10 million of operating earnings, it could be challenging sometimes to get banks to provide finance and beyond what the company’s collateral base would provide. But if you get above that then it can work. A lot of times we’re doing transactions for many service companies and they don’t have a lot of the traditional collateral like equipment or inventory that the banks would find useful to lend against.


In those instances, the selling shareholders may very well end up guaranteeing all or a portion of the debt. We try to make sure they understand that upfront because it’s important to understand that. And sometimes when they see that they might have to guarantee it, they’ll end up as an alternative not using a bank and just seller financing the transaction.


Scott: I’m sure you’ve seen this too and maybe you can describe this a little bit further. At the end of the transaction the owners got, in your example, I think you said $15 million. Let say that the bank does require them to guarantee that, they could choose to maybe not to and say, look I’ll take this $15 million and I’ll invest it in another security then you can use that as a collateral, right?


James: That’s correct. Yes, we’ve definitely seen that…and banks are happy to take marketable securities as collateral on a loan. Then as the company pays down the debt, the guarantee basically gets ratcheted down to zero when all that debts had been paid off.


Scott: Right, okay. So Jim, you mentioned on a previous slide that both interest and principal on ESOP debt is tax deductible. Can you explain how that works and the details behind that?


James: Absolutely. The ESOP, as I explained earlier, is similar in many respects to a 401K plans. So when a company whether it’d be a company matched or profit sharing contributions is being made to a 401K plant, the company records that as an employee retirement expense and it’s tax deductible in the company’s tax return.


Well, the ESOP comes out of a section 401 of the Internal Revenue Code. And when a company makes a qualified contribution to the ESOP that contribution is, like the 401K plan, tax deductible. So, what happens is, let’s just say, the ESOP is on that what we call the inside loan; the ESOP owes money - principal and interest- to its lender which is the company.


For instance, if the company says okay your loan and principal payment is due. It’s $600,000 of principal and interest. What the company will end up doing is it will cut a check for $600,000. It will send it to the ESOP trust as a contribution. This is Step A. And the company is able to take a tax deduction for that $600,000. Then the ESOP takes that check, deposits it, turns around and writes the check back to the company. That’s a principal and interest payment.


So, to the Step A and Step B, there’s a kind of circular transaction. At the end of the day, really, no cash is left anyone from the company’s standpoint but the company’s able to take a tax deduction for $600,000 for the principal and the interest. The company then turns around and takes the $600,000 of cash in case its principal payment and interest payment to the bank on the outside loan.


That’s how the tax deduction is created. This is also the mechanism that drives the allocation of shares for the employees. If the ESOP is going to pay off all its loan over, let’s say, 10 years; then, 10% of the shares that were required in the transaction will be allocated as every 1/10 of the loan payment is being made.


So, every year 1/10 of the loan payment is being made, or being paid to the company, that will release from the suspense account 10% of the shares that were required by the ESOP. Then it is tricked in to the various accounts of the employees who were participants in the plan for that particular year.


Scott: Okay, make sense. Maybe you can give us some view on how this works for an employee, from an employee’s perspective.


James: Sure, The ESOP had a lot of rules that, not surprisingly, are like 401K plans. There is a requirement that, typically, the employees have to be full-time employees to participate and there’s a minimum period that they have to work with the company before they are eligible to participate.

As I talked about before, every year once an employee is a participant, a portion of the shares that were acquired by the ESOP are going to be allocated for the employees that year. Again back at my example, if 1/10 of the shares are being allocated in the year and I represent 10% of the company’s payroll, then I’m going to get 10% of that 10% or I will get 1% of the shares that were acquired by the ESOP in that year.


There is a vesting schedule that is very similar, actually identical, to what a 401K vesting schedule is. A lot of times the vesting schedules are identical. Then the employees that have vested ESOP shares when they leave the company whatever portion or shares are vested; they will receive that benefit over a 5-year period. That’s for people that leave the company because of death, retirement or disability.


The people leave the company because they either quit or they’re fired, they typically have to wait for 5 years. And then, they will receive the value of their vested stock benefit over a subsequent 5-year period. So, they’ve received dollar 1 in the year 6 and then they receive the final pay out on their ESOP benefit in year 10.


Scott: That’s the nice a feature because they’ve kind of correlates with the debt payment schedules associated with the company and the ESOP. So, the ESOP has protection that on Year 1, it’s like you just walked us through when there’s really no money in the ESOP to pay the employee.


James: Right.


Scott: But in terms of the structure of the employee that they have to wait 5 years then there should be money there obviously.


James: That’s right. I mean, it’s like a 401K plan. You’ve got marketable securities that can be easily liquidated and cashed out and provide it to the employees. And that’s why you usually get an immediate payout for people once they leave the company. But for the ESOP, the stock of the company is not the liquid. So, we kind of structure and this is allowed by the IRS to smooth out the obligation for the company to buy out those shares for people that might leave the business.


The other thing it does is it prevents the employee from looking at their balances and saying, okay I’ve got a door prize that I can leave immediately and all of a sudden get a very large payout. It persuades them that things are longer termed and there’s not going to be a quick fix by leaving the company and expecting a large payout at that point.


Scott: Right. Good point. Employee participation is obviously, probably a question mark for owners and really kind of what does that mean. Like do I have to share financial statement or, I mean, how transparent do I need to be with employees if I enter in an ESOP? This chart you got is a great chart. So why don’t you walk us through it?


James: At a minimum, we’ve got companies that do want to share information to the employees. That’s the prerogative of the company and the board of directors and there’s no requirement. But at a minimum, what the employees will receive every year is a statement that tells them what their account balance is - how many shares they’ve got in the plan, what portion of those shares are vested and then what the price of the share is. But that’s the minimum.


They can’t even, from that information, gleam any other financial information on the company. They don’t even know how much the company is worth because they don’t even know how many shares are outstanding. So, that’s the bare bones minimum that they are absolutely positively entitled to under the law.


And there is no requirement that they get any financial statements - information on payroll or who’s making what. And again, they don’t even get to see what the entire valuation of the company is. But that’s the bare minimum.


We do see companies, from a cultural standpoint, thinking that maybe either immediately or more often as time goes on they start getting the employees more involved and showing them some of the financial information. So that they can have better understanding of what the impact is of their day to day work on the overall value of the firm. That’s the prerogative, again, of the company. It’s not something that’s required but a lot of companies do consider that because, culturally if it’s done the right way, it could lead to more efficiency over time.


Scott: All right, that’s great. So, maybe talk to us a little bit about how an ESOP is appraised and how the value is determined for an ESOP and the some of the considerations and issues?


James: Right. The first thing to understand is that when we do an ESOP transaction we’re creating the buyer of the stock and that is a trust. It’s a retirement trust under the Internal Revenue Service. And there is a trustee. That person is appointed by the Board of Directors and the trustee has their own financial advisor which is an appraiser who is an independent party. They have never really worked for the company previously. So, they are objective in looking at the value of the company and they do an analysis, an appraisal, of the company’s stock. They share that with a trustee. And the trustee negotiates with the selling shareholders to get a value that they feel is appropriate within a range that’s been said by the appraiser as an appropriate range for a transaction.


There’s an appraisal that is done upfront for the trustee. Then on an ongoing annual basis so that the employees can at least see what the share prices on their statements; the company’s required to do annual appraisal. Typically, by the same appraisal firm that did the first transaction or appraisal. Again, the company’s getting re-appraised on an annual basis thereafter.

Some of the other things, the nuances, on the ESOP transaction is to the extent of the selling shareholder may have had some expenses that were flowing to the company that they’re agreeing going forward that they’re not going to be having those expenses to go through the company. For instance, they’ll make some compensation. You may have had a business owner that’s may be taking, over the past couple of years, at an average $1.5 million of compensation and they’re agreeing going forward that they’re going to stick around but they only going to take, let say, $250,000 of compensation.


Well, the difference of the $1.5million less the $250,000 or $1.25 million. That would be considered an add-back. That would go back into the company’s earnings of both on a historical and a projected basis for the ESOP appraiser to look at the value and the company’s value. All of the things held constant will be a lot greater as a result of that add-back expense.


Scott: That’s a great feature because, I mean, add-backs are pretty common when you’re dealing with presenting your financials to sellers. But most owners are motivated by tax reasons and really kind of use their company as a way to minimize taxes. So if they can add-back some of those expenses because they’re going on to that way going forward. I mean, that’s really a nice feature.


James: Well if you think about it in that example I had is, let’s say, the differential was $1.25 million; the owner was taking that as compensation and they were paying basically ordinary income taxes on it. But if they could add that back to the company’s earnings and then capitalize off that at 5, 6 or 7 times multiple and then not pay any capital gains taxes on that transaction of selling the stock. It’s a great tax arbitrage.


Scott: So Jim, ESOP appraisals are probably a little bit different than transactional in the sense that the potential transfer channel for owners is strategic third parties, right?


James: Right.


Scott: So, the valuation between transactional third party strategic buyer could be different than an ESOP valuation, right, because ESOP doesn’t really consider the synergies. Is that right?


James: That’s right. I mean, the ESOP appraisers is using a lot of the same tools that whether being a strategic buyer or a financial buyer like private equity firm would be using. But what the IRS dictates for the ESOP appraiser is that, especially as it pertains to looking or comparing to a strategic buyer, the ESOP can’t look at synergies. If you have a strategic buyer coming in and say, okay we’re going to buy company X and when we do that we’re going to get rid of some of the staff that is overlapping what we already have in place. For instance like the payroll, receivables and some of the other administrative parts of the company.


The ESOP is not bringing anything to the table that can create that synergy. As a result of that, the ESOP appraiser really can’t allow for what we call synergistic multiple or strategic multiples or premiums that are paid by a third party acquirer that they can have those synergies. So, that quite frankly, can be a reduction in the value that a lot of folks would otherwise be looking for. But again if a lot for people who don’t want to sell to a strategic buyer, then the way that the ESOP is being appraised is very similar in many respects to how a private equity group would be looking at it. So, you’re not going to get the strategic multiples or premiums.


Scott: Right.


James: But you will get something in it that a financial buyer would be willing to pay for.


Scott: I see. Obviously, walk us through a number of different reasons on why it could be beneficial to the owners. One of those was kind of the potential tax savings you can get out of this. So, you know what, if you’re an owner and you’re considering your options and you need some of the profile requirements of doing ESOP then maybe a good exercise would be to vet this ESOP process out and then compare that to the other alternatives exit channels. We do that by using kind of an owner’s net proceeds calculations which really takes in consideration not only the value or the price. But also takes in consideration the tax implications and the structure returns and so forth. So you really have a good apples-to-apples comparison on the financial piece of this. And I think you do that Jim, right?


James: Yeah. It’s a critical way for people to get a better feel for whether this is the appropriate path to take or not. And to your point, when we’re doing our transaction analysis for our clients, we created this blue print to see if this is the right structure. We will go through and we will show them here are the cash flows that you can expect to receive or here are the tax savings you can expect to receive. And they can compare an ESOP transactions to a third party buyout. It’s pretty powerful to at least allow them to gauge what is the right way for them to go.


Scott: Right. That’s a great analysis there, Jim. So Jim, if owners are considering getting serious about transitioning from the management or the ownership of their company. They want to use an ESOP or think about using ESOP, how far in advance should they start beginning to planning for such an event?


James: We’ll it’s never too early as they say.


But on average, we start talking to people probably about, well, sometimes it can be several months or maybe a couple of years in advance. Anyway, there’s an education process to get them comfortable of what the ESOP is. But typically, we’ll start talking to someone. If we start on it today, we can get the transaction structured over the next 4 or 5 weeks. And then, ultimately, get it executed and financed over subsequent, maybe 6 or 7 weeks.


So, it’ll take somewhere between 90-120 days from beginning to end to get the transaction put together. But the nice thing about it is that you are creating the buyer and we can come in to bring in the professionals that are needed to get the ESOP transaction put together. So, there’s a nice control feature from that standpoint as opposed to sometimes with third parties there’s a lot of variability involved in that process that is out of the control of the selling shareholders.


Scott: Yeah, there’s no kind of due diligence. I mean, there’s a minimal due diligence. There’s no contract to be negotiated and all those kind of things that takes a lot of time, you know.


James: There is due diligence and we help in that process. We’ll go in and vetted as if we’re pretending to be the buyer which is the ESOP trust. And there’s a stock purchase agreement. But there’s not a lot of contention in these transactions.


And we know what the trustees are looking for in this transaction. We’ll make sure everyone has the proper expectation in the process so that it can go as smoothly as possible.


Scott: Jim, you’ve been a well of information and I learned a lot. If our business owner audience would like to contact you, what’s the best way to get hold of you?


James: Well, my contact information is on this presentation. But I’m located at 908-897-0826 and the name of the firm, Pilot Hill Advisors. You can find us on the web at www.PilotHillAdvisors.com.


Scott: Jim, thank you so much for your time and for educating us today.


James: You’re welcome, Scott. And thanks everyone for tuning in.