Employee Stock Ownership Programs

Table of Contents

Employee Ownership in the United States
How the ESOP Works
Employee Stock Ownership plans as a financing tool
Legislated ESOP Incentives
Attributes of a Successful ESOP
Primary Objectives of ESOP participants
Tax-Deferred Rollover Rules
Qualified Replacement Properties

Employee Ownership in the United States

The United States, with over 11,000 employee-owned companies (500 of which are majority owned by employees) has the most well developed employee ownership based corporate finance marketplace in the world. Avis (the car rental firm) is the most highly visible 100% employee owned firm in the U.S. Independent research has shown that employee owned companies are more profitable, reflect greater revenue growth and create jobs at a faster pace, and have productivity growth rates higher than comparable non-employee owned companies.

The most common form of employee ownership is the Employee Stock Ownership Plan. ESOPs function both as a tool of corporate finance and as an employee benefit plan (oriented toward retirement benefits). Of all companies that provide employee ownership, 80% of the aggregate employee ownership in the U.S. is made up of ESOPs, with stock options, profit sharing plans and other employee savings plans, and direct ownership making up the balance.

How the ESOP Works

In the Employee Stock Ownership Plan, a trust is established to purchase and hold ownership of the stock of the employer for the benefit of current and future employees. The Employee Stock Ownership Plan trust is designed to give employees a long-term stake in the financial success of their companies. The stock held in trust is allocated to an individual employee's account within the trust, so that they can identify their self interest in the company's success, but is normally distributed to the employee upon their leaving the employ of the company through retirement, death, disability, or voluntary or involuntary termination.

Employee Stock Ownership Plans are categorized as defined contribution plans and profit sharing plans. Thus, employee owners do not pay any tax on the increase in value of the stock held in their individual trust account(s) until they receive a distribution from the plan. If the employee has not reached retirement age when he/she receives a distribution, he/she can transfer the distribution in a direct rollover to another benefit plan or an IRA without being taxed. When they do reach retirement age, there are special tax provisions which allow retirees to reduce the tax due and spread it over several years.

The employer also receives many advantages from the Employee Stock Ownership Plan. The employer funds the trust by making contributions of stock or cash, and these are fully deductible (subject to very generous limits) from taxable income. Due to the long-term nature of this benefit, and the desire to link the employees' reward to the long-term financial success of the employer, employees can be required to be long-term (5- to 7-year) loyal employees of the firm to receive 100% of their account balance. Furthermore, employees that are thus 'vested" in their stock benefit who terminate voluntarily or are fired may be required to wait up to six to seven years from the end of their employment to begin to receive a distribution of their stock benefit from the plan.

EMPLOYEE STOCK OWNERSHIP PLANS AS A FINANCING TOOL

Eventually the sale and/or diversification of equity ownership interests becomes an important objective of corporate equity holders. This is especially true for closely held middle market size corporations, as well as certain public companies. Leveraged Employee Stock Ownership Plans may deal with these goals very effectively. In addition, for the company that has capital needs to foster growth activities and business initiatives, Employee Stock Ownership Plan financing is among the least expensive and most tax advantaged that may be obtained.

Several examples where Leveraged ESOPs can be particularly effective are described in the following sections.

[1] Divestiture By Individual Shareholders

Individual shareholders of private companies seek to divest ownership for any one of several reasons, including:

• To gain liquidity for personal needs
• To diversify their assets for risk reduction and/or estate planning
• To begin a longer-term ownership divestiture and management transition process.

In addition to the closely held company ownership divestiture, individual founding shareholders of thinly-traded public companies often find that they are unable to sell their interests at financially feasible terms to meet their diversification or divestiture needs due to insufficient liquidity in the public market that would be required to absorb a large block of shares. Often, the price concessions required to sell such a block of shares in the public market are substantial and greatly mitigate the divestiture goals of the founding shareholders.

[2] Corporate Financing

An Employee Stock Ownership Plan can provide corporate financing through sale of new issue corporate shares to the company's benefit plan. The company can obtain low cost and tax advantaged financing through conventional financing sources that will tend funds to the ESOP for the purchase of shares. Because of special tax provisions exclusive to an ESOP, all debt repayment can be achieved through corporate benefit plan contributions. This allows for all principal payments to be made on a pre-tax basis. In addition, lenders will provide reduced interest rate incentives for Employee Stock Ownership Plans exceeding 50 % ownership criteria because the lenders can exclude 50% of the interest income they earn on the ESOP loan. The use of the Employee Stock Ownership Plan as a corporate financing device may be particularly advantageous in a debt restructuring (converting existing debt to Employee Stock Ownership Plan related debt) or as part of a transaction strategy to provide a selling shareholder capital gain tax deferral treatment.

[3] Corporate Divestitures

Corporate owners of subsidiary business units frequently determine that the best sale alternative is one in which the unit's management and employees purchase the company through a Leveraged Buy Out structure. While the parent corporation cannot avail itself of Section 1042 of the Internal Revenue Code taxable gain deferral treatment, an Employee Stock Ownership Plan LBO provides numerous benefits, including

1. greater debt service capacity than conventional LBOS,
2. management continuity, and
3. potential for additional financing funds from management and employees.

[4] Private Company Shareholders Seeking to Incentivize Management

Major shareholders of private companies often begin divestiture of ownership in order to satisfy the goal of management and other key employees to obtain an equity stake in the company. Providing for wider distribution of ownership is seen by many owners as a means of offering additional incentive for commitment and good performance.

[5] Owners Establishing a Potential Market for Future Sales of Stock

Ownership transition may be effectively accomplished in stages over a period of years. Creating a leveraged Employee Stock Ownership Plan to accommodate an initial 30% ownership sale not only allows for the transition process to begin under favorable capital gains tax deferral terms, but also provides the potential for future transactions with the ESOP. Thus, the groundwork has been established to consummate a second stage transaction in order to diversify further ownership.

[6] Meeting the Investment Parameters of Third Party Investors

In situations where the objective is the sale of the entire business by the control owner, additional forms of capital (beyond senior conventional types) are typically needed. The solicitation of mezzanine and private equity funds requires an assessment of their investment objectives and the manner in which an Employee Stock Ownership Plan may be a valuable tool to them.

Many professional equity investors have become familiar with the potential return enhancement which a leveraged Employee Stock Ownership Plan structure can provide. The savings generated through the pre-tax repayment of acquisition debt are shared by all equity holders. In addition, using the sale of shares to an Employee Stock Ownership Plan as an exit vehicle provides the potential for capital gains tax deferral under IRC Section 1042.

The types of situations described above, and the attendant objectives of the transaction participants are fundamental to the free market system. However, during the 1980s, with the growth of ESOPs and the attention given entrepreneurial perspectives, having "a piece of the action" has become a more widely sought employment benefit. It is likely that these perspectives will continue well into the future, encouraged by greater employee participation in the development and implementation of corporate initiatives.

Legislated Employee Stock Ownership Plan Incentives

Employee ownership achieved considerable momentum during the 1980s, in large measure, through the implementation of new Employee Stock Ownership Plans and the expansion of the equity interests held by existing Employee Stock Ownership Plans. This trend was supported, in part, by the broadened use of Employee Stock Ownership Plan LBOS. Their popularity resulted from a combination of favorable legislative initiatives and an increasing awareness of the meaningful advantages of incorporating a leveraged Employee Stock Ownership Plan in an ownership transition situation. Some of the more prominent advantages are as follows:

[1] Tax Deferral of Sale Proceeds

Under Section 1042 of the Internal Revenue Code, individual shareholders may defer capital gains tax on Employee Stock Ownership Plan sale proceeds for qualifying transactions. Requirements for this tax deferral include the following:

1. The Employee Stock Ownership Plan must own 30 % or more of the sponsoring company's total equity value giving effect to the transaction.
2. > Qualifying replacement securities must be purchased within a I 5-month period (beginning 3 months before the sale to the Employee Stock Ownership Plan).
3. > The selling shareholder's holding period for the securities purchased by the Employee Stock Ownership Plan must be at least 3 years.

[2] Tax Deductible Principal

Repayment of Employee Stock Ownership Plan acquisition debt is made by the Employee Stock Ownership Plan using (i) employer contributions and/or (ii) dividends paid on sponsoring company stock. Employee Stock Ownership Plan contributions are tax deductible to the sponsoring company. Dividends paid on Employee Stock Ownership Plan stock are also tax deductible if they are used to pay down Employee Stock Ownership Plan debt or are distributed to Employee Stock Ownership Plan participants. For each $1,000,000 of Employee Stock Ownership Plan debt, the sponsoring company (at a 40% combined effective tax rate) will save $400,000 through reduced tax payments over the life of the loan.

[3] Lender Interest Exclusion

Under Section 133 of the Internal Revenue Code, an institutional lender may be able to exclude from federal income tax 50% of the interest income earned on an Employee Stock Ownership Plan loan. Usually, the effect of this exclusion is to reduce the effective interest cost to a leveraged Employee Stock Ownership Plan (and the sponsoring company). The incremental interest cost savings varies based upon the competitive situation and the tax appetite of the lending institution. Interest rates equivalent to 80% to 95% of the rate otherwise appropriate are common, based upon the capital risk assessment. For example, for each $1,000,000 of Employee Stock Ownership Plan debt used, assuming a 7-year amortization and an interest rate equivalent to 85 % of the regular commercial rate (assumed to be 10%), the Employee Stock Ownership Plan will save about $70,000 over the life of the loan, from the lower interest rate alone.

In addition to the legislated Employee Stock Ownership Plan incentives, it must be remembered that an Employee Stock Ownership Plan is an employee benefit and will probably replace a portion of the existing employer-sponsored employee benefit package. This means that at least a portion of the corporate cash flow required to service Employee Stock Ownership Plan acquisition debt is available as a substitution for existing employee benefit expenses.

All things considered, in most ownership transition situations the participation of an Employee Stock Ownership Plan produces significant benefits for selling shareholders, employees, and the company and also provides a more conducive environment for substantive management investment. Management investors can look to the Employee Stock Ownership Plan as a potential buyer of their shares. These investors have ownership, often substantial, through the combination of their Employee Stock Ownership Plan accounts and the shares held directly. In many instances the appeal to, and participation of, outside third-party investors has been enhanced by the leveraged Employee Stock Ownership Plan's involvement. These professional equity investors find the enhanced debt service capacity and tax savings produced by the Employee Stock Ownership Plan structure to be attractive. In addition, the Employee Stock Ownership Plan provides an attractive potential exit vehicle for these types of investors.

Attributes of a Successful Employee Stock Ownership Plan

Both quantitative and qualitative measurements are used to assess the success of an Employee Stock Ownership Plan. The quantitative measurements include the prospective risk and return characteristics for each source of investment capital, the probability of successful debt servicing by the company, the reasonableness of senior debt provisions, and, where applicable, the effective use of the Employee Stock Ownership Plan capital for corporate finance purposes. The qualitative measures include:

1. the willingness of existing owner to distribute ownership to employees,
2. the commitment of the management group and the company to delivering a meaningful benefit to employees through the Employee Stock Ownership Plan,
3. the quality of the communications programs which are implemented at the time the Employee Stock Ownership Plan is established, and
4. the greater corporate participatory environment.

Longer-term employee satisfaction, increased productivity, and value growth are clearly important to the company, as well as its Employee Stock Ownership Plan participants, and provide the most tangible measures of broader employee ownership.

[1]Individual Client Profile

Ownership transition involves numerous alternatives. This information is limited to the dynamics associated with the Employee Stock Ownership Plan financing strategy alternative. Consequently, the profile of individuals who may best benefit from the use of an Employee Stock Ownership Plan as a diversification tool may differ somewhat from the more "global profile" of an individual highly interested in ownership transition. Some of the more prominent profile attributes are as follows:

• Owner of 30% or more in the business, or someone who combined with other shareholders can effect at least a 30% ownership sale.
  
  
• Someone who desires to reduce present investment risk due to lack of diversification (has all their eggs in the business basket).
  
  
• Someone who does not have an immediate or near-term family member to effect management transition of business without family sale
  
  
• Someone looking to reduce business involvement presently, with slightly longer- term (5 to 10 years) outlook of retirement.
  
  
• Someone interested in taking some value out of company on "tax deferred" basis and without losing any elements of operating control.
  
  
• Someone looking for means to get management and employee base more involved and incentivized to produce wealth. This is particularly relevant where independent management wealth is too insignificant to purchase any sizeable corporate stake from the control owner.
  
  
• Someone interested in effecting a more aggressive estate plan that can provide tax advantaged ownership transfer with recapitalized "low capital appreciation" high income oriented ownership stake.

[2] Sponsor Company Attributes

Certain identifiable company characteristics, when present, create greater potential for using an ESOP as a successful ownership transition tool. Many of these attributes are compatible with companies that would make good conventional LBO candidates. These characteristics include:

• Mature company with modest capital expenditure requirements over the early years of debt service.
  
  
• Sufficient balance sheet strength to absorb Employee Stock Ownership Plan acquisition debt.
  
  
• Sufficient cash flow from operations to cover all debt service requirements.
  
  
• Historical and prospective consistent operating performance (revenue generation and profit margins).
  
  

In addition, a good candidate company will be one which has a well maintained, technologically current asset base, reasonably modest capital expenditure requirements over the early years of the debt repayment period, and a solid management team.

Corporate Financing Scenario

In a more limited sense, an Employee Stock Ownership Plan can be used to restructure and add debt service capacity, as well as lower the overall cost of debt capital. In situations where the capital is used for corporate growth and business initiatives, companies should reflect the following characteristics:

• above-average return on invested capital in order to grow business value at a rate above the cost of capital.
  
  
• A well corroborated business plan
  
  
• Capacity to finance the borrowings under various economic scenarios and at least partially collateralize the debt with corporate assets.
  
  
• A stable and committed management team.
  
  

[3] Basic Benchmarks of Success

Within a long-term framework, the essence of a successful ownership transition that uses an Employee Stock Ownership Plan Leveraged Buy Out is a structure that optimizes the objectives of the transaction participants and the corporation, complies with all pertinent legislative and regulatory requirements of the Internal Revenue Service and the Department of Labor, and remains a viable employee benefit and effective ownership transition tool over time. Employee Stock Ownership Plan LBOs that involve more than just a partial divestiture from an existing owner make these objectives more difficult to achieve unless the capital structure provides for the varying risk/return perspectives of all the participants. Accomplishing these objectives frequently requires the development of a multiple security equity structure.

Addressing the disparate objectives of ownership transition participants is important to a successful post-deal environment. These objectives are more fully described in the table below. (This table may also be used as a convenient reference for ownership transition attributes.)

Primary Objectives of ESOP participants

Existing owners

• Divestiture on the most favorable terms possible
• Diversification of present investment holdings
• Maximization of net proceeds of sale through tax-deferral treatment
• Effective transition of ownership
• Perpetuation of the enterprise

Company objectives

• Capital expansion on favorable terms
• Ability to service acquisition debt on a total pre-tax basis
• Maximization of free cash flow
• Retention and motivation of key executives
• A participatory workforce with a vested corporate stake

Management objectives

• Purchase of equity under the most favorable terms
• Acquisition of active control of the company
• Creation of a structure that relates performance to value
• Provision for eventual divestiture under most favorable taxation terms
• Establishment of a potential exit vehicle for eventual divestiture

Employee objectives

• Greater participation in the performance of the company
• Increased potential retirement plan benefits
• Greater sense of team spirit

ESOP objectives

• Creation of a meaningful benefit for employees
• Participation as an equity investor
• Acquisition of an equity interest at a fair price
• Obtainment of a fair position relative to all other equity investors

Professional investor objectives

• High potential return commensurate with risk
• Establishment of an additional ownership vehicle for key employees

THE TAX-DEFERRED ROLLOVER RULES

The IRC Section 1042 imparts a considerable advantage to the individual who is otherwise subject to sizable capital gains taxation and sells stock to an Employee Stock Ownership Plan. The taxes are deferred indefinitely, if:

1. After the sale, the Employee Stock Ownership Plan owns 30% of the total outstanding stock of the corporation or 30% of each class of stock. The 30% can be attained from state(s) by shareholder(s), new stock issues or a combination of these.
2. The selling shareholder has owned the shares for three years - shares which were acquired through such means as purchase or family gift, rather than other avenues, such as a tax-qualified company stock bonus program or an Employee Stock Ownership Plan.
3. Once the shares are conveyed to the Employee Stock Ownership Plan, the seller purchases "qualified replacement properties" (see below) within one year. (The properties could also be bought as early as three months prior to the conveyance, though this option is rarely used.)
4. The seller makes the appropriate filings with the IRS: the statement of consent signed by the company and the statements of election and purchase from the seller. The result is a new portfolio, generally with a very low tax basis, which is no different than any other portfolio in which the securities have a low basis. No capital gains tax is due as long as the purchased securities are held.
   
   

QUALIFIED REPLACEMENT PROPERTIES

The Employee Stock Ownership Plan sale proceeds must be used to purchase the securities of U.S. domestic operating corporations. More than 50% of the corporation's assets must be used in the active conduct of a business and no more than 25 % of gross income can be derived from passive sources.

Qualified:
U.S. stock, bonds, debentures, other certificates of indebtedness and convertibles, if they are securities of companies incorporated in the U.S.

Non Qualified:
U.S. Government and municipal bonds, mutual funds and real estate investment trusts (REITs).

Convertible securities are valid for the rollover so long as they are convertible into acceptable properties. The conversion is not taxable. "Conversion" to the cash equivalent does produce tax liability on the capital gain.

The purchased replacement securities can also be those of a private corporation meeting the rollover criteria.