ESOPS AND PRIVATE EQUITY - Long Point Capital · • Long Point Capital is the Leading PEG Invesng in ESOPs – Long Point Capital (LPC) has created over 3,000 employee owners in

ESOPSANDPRIVATEEQUITY

THEBEYSTERSYMPOSIUMJUNE26-28,2016

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ESOPSANDPRIVATEEQUITY

•  EmployeeOwnershipcanTransformaCompany“Doneright,employeeownershipcantransformacompany,improveperformanceandaccelerategrowth.Itcancreateasustainedcompe;;veadvantage,drivingbusinesssuccessthatbuildswealthforfounders,investorsandemployeeshareholdersalike.”-BeysterIns;tutewebsite.

•  PrivateEquityFocusesonAcTvelyManaged,LongTermValueCreaTon“Weliketothinkofourselvesasindustrialists.I’musingindustrialistsinabroadsense.WebuyacompanyandlookatwhatwecandotomakeitbeCer.Howcanweimproveopera;ons?…It’sourlong-termapproach,thefactthatwefocusonstakeholders.WeusedtopaymoreaCen;ontothestockholder:Howwelldidyoudoonthisinvestment?Todayweworryabouttheenvironment,thecommunity,theemployees—they’realltopofthemind.”-ExcerptsfromaHenryKravisInterviewwithBloomberg,June2016

ESOPsandPrivateEquityInvestorsShareCommonGoalofLongTermValueCrea>on

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PRIVATEEQUITYANDESOPSWHYITSHOULDMAKESENSE?

•  ComparableReturnforComparableRiskcanbeAchieved–  PEGcanoVenstructuretheinvestmentsothattheprojectedreturnsareroughlyequal

inbothalterna;vessincethePrivateEquityGroup(PEG)istakingthesamecomparableriskintheTradi;onalPEstructureandthePE+ESOPstructure

–  PEGshouldberoughlyindifferentastostructurebasedonprojectedreturns

•  PE+ESOPOffersSignificantEmployee,TaxandMoTvaTonalBenefits–  Employeere;rementplanbenefitscreatedatnocosttoemployees–  Corporateincometaxescanbereducedoreliminated–  Allstakeholdersaremo;vatedtocreateequityvalueandwealth

•  PE+ESOPisAlignedwiththeObjecTvesoftheESOPandtheTrustee–  Valua;on-Privateequityestablishesamarket-basedvalua;on,i.e.professional

investorsriskingmoneyonanarms-lengthnego;atedtransac;onvalue–  Governance–Privateequityestablishesgovernanceprocedurestomaximizegrowthin

equityvaluewhichbenefitstheinvestmentbytheESOPandtheprivateequityfirm

•  RobinHoodResults?

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ESOPSANDPRIVATEEQUITYGROUPSWHEREDOTHEYINTERSECT?

•  ESOPCreaTon-AsanInvestorinaNewESOP–  APEGmayprovidecapitaltoallowanownertogenerateliquiditywhen

sellinghiscompanytoanESOP•  ESOPCreaTon-AsaSellertoaNewESOP

–  APEGmaysellaporeoliocompanytoanESOP

•  ExisTngESOPFinancing–  APEGmayprovidecapitaltoanexis;ngESOPcompanyinneedoffinancing

•  ESOPTerminaTon–  APEGmaypurchaseacompanyfromanESOP

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PRIVATEEQUITYINESOPSWHENWILLAPRIVATEEQUITYGROUPINVESTINANESOP?

•  TheProjectedInvestmentReturnsJusTfytheRisk–  Thereturnsaresimilartothereturnsthatwouldbegeneratedfora

similarriskprofileinanalterna;veinvestment•  ThePEGcanCreateValueandProtectandExitItsInvestment

throughProperGovernanceProvisions•  ThePEGcanStructureitsInvestmenttoMeettheConstraints

ImposedbytheTaxcodeandERISA

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PRIVATEEQUITYANDESOPSWHATAREPEGALTERNATIVESFORINVESTMENT?

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TransactionAlternative

HowDoesitWork?

Bene6its

TraditionalPrivateEquityTransaction

–  CashisgeneratedthroughanequityinvestmentbythePEGandthird-partydebt9inancing

–  Ownersreceiveproceedsconsistingofcashandanequityinterestintheongoingcompany

–  Typicaltransactionsplitofvalue–80%plusincash,20%inequityreinvestment

–  PEGroupcanprovidesigni9icantvaluethroughadditionalexpertise,relationshipsandcapital

–  Incentivescanbecreatedthroughmanagementoptionsandculturechangemaybeminimal

PE+ESOPTransaction

SAMEASABOVEBUT:–  Typicallystructuredasa100%S-

CorpESOP–  Syntheticequityinvestment(notes

andoptions)usedbythePEGinsteadofatraditionalequityinvestment.

–  Ownersreceiveproceedsconsistingofcashandsyntheticequity(notesandoptions)

SAMEASABOVEPLUS:–  Employeeownershipandretirementbene9its

created.–  Seller’staxablegaincanbereducedor

eliminatedifstructuredthroughaIRC1042exchange,potentiallyeliminatingataxliabilitythatcouldapproach35%ofproceeds.

–  Corporatetaxescanbereducedoreliminated.–  PEG,SellerandESOParealignedindesirefor

fairpriceandfutureequityvaluecreation

PRIVATEEQUITYANDESOPSWHATARETHEOBSTACLES?

•  StructuralConsideraTons–  LegalandOwnershipformofcorpora;onmayreducetaxbenefitsofaPE+ESOP

transac;on–capitalgaindeferral/elimina;ononlypossiblewithaC-Corp•  ComplexityandExperTseConsideraTons

–  MostPEGsandM&Aadvisorstypicallydonotpossesstheexper;setoevaluatethePE+ESOPstructureandoVenwillshootitdownratherthanengageoutsideexperts

•  AwarenessandPercepTonConsideraTons–  “TooGoodtobeTrue”–Ifitispossibletoeliminatecapitalgainstaxesand

eliminatecorporatetaxes,thenwhyisn’teveryonedoingit?–  ESOPmythsandmisunderstandingsleadtonega;vepercep;ons

•  IntermediaryIncenTveConsideraTons–  Ifaninvestmentbankerisengagedbyaseller,heisvirtuallyalwaysincen;vizedto

maximizetheprice/valua;onwithoutanyregardfortaxconsidera;ons–  Inthemindofaninvestmentbanker,thePE+ESOPtransac;oncreatesaddi;onal

risk–;ming,complexity–withoutanyeconomicupside•  RegulatoryConsideraTons

–  DOLregulatesre;rementplans,includingESOPs,addinganotherpartytothemix

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PRIVATEEQUITYANDESOPSHOWTOOVERCOMETHEOBSTACLES?

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IntenTon IdeaMakeESOPsMoreAaracTvetoSellers•  WilldrivesellerstodemandtheESOP

alterna;vetoachieveitstaxbenefits

ExtendIRC1042ExchangetoS-Corps,thecorporatestructureforthevastmajorityofprivatecompanies,allowingmoresellerstobenefitfromcapitalgaindeferral/elimina;on.

MakeESOPsAaracTvetoImpactInvestors•  Willincen;vizePEGstolearnaboutESOPsto

createnewinvestorbase

EducateImpactInvestorsonthesocialbenefitsofESOPcrea;on.EducateImpactInvestorsthattheycanachievesocialbenefitswithoutsacrificingreturnsthroughaPE+ESOPinvestment.

MakeESOPsLessComplicatedtoExecute•  Execu;onofanESOPissome;mesasmuch

anartasascience–clearcutguidelineswillmakesitmoreaCrac;vetoPEGs

PE+ESOPtransac;onsaremarketbasedvalua;ontransac;ons–thereisabuyerlookingforthelowestpriceandasellerlookingforthehighestprice.Atradi;onalESOPisaaself-dealingtransac;on.ESOPtrusteesmustlearntoevaluatePE+ESOPdealsdifferentlyfromtradi;onalESOPs.

DemysTfyESOPSandClearUpsMyths•  Don’tdriveawayPEGsandSellersbecauseof

misinforma;on.

ESOPindustryassocia;onscouldcreatebeCercommunica;onprogramstocreateclarity.

PRIVATEEQUITYANDESOPSHOWTOOVERCOMETHEOBSTACLES?

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IntenTon IdeaPublicizeESOPSuccessStories•  Crea;ngaposi;vepublicpercep;onofESOPs

wouldleadmorePEGs,sellersandemployeestosuggestacompanysaletoanESOP.

ESOPsindustryassocia;onsshouldhelptopublicizesuccessfulESOPs.Newspaperstendtorunnega;vestoriesaboutESOPs,e.g.ChicagoTribune,crea;ngnega;vepublicpercep;on.

EducatePEGsonProducTvityBenefitsofESOPs•  IfPEGsbelievethatemployeeownershipwill

createmorevaluefortheirinvestors,theywillbemoreopentothePE+ESOPtransac;on

CreateacademicstudiesthatmeasuretheeconomicbenefitsofESOPsandemployeeownership.

PRIVATEEQUITYANDESOPSSUMMARYOBSERVATIONS?

•  ItCanWork-PEGsHaveInvestedinESOPs–  AtleasthalfadozenPEGshaveinvestedinESOPs,buttypicallyeachhas

investedone;meonly•  LongPointCapitalistheLeadingPEGInvesTnginESOPs

–  LongPointCapital(LPC)hascreatedover3,000employeeownersinsevenESOPssince2004

–  LPCoffersthePE+ESOPtransac;ontosellerswhovaluethebenefitsoftheESOPversusatradi;onalPEtransac;on

•  PEInvestmentinESOPsWillGrowIf:–  PEGsseeacompe;;veadvantageinofferinganESOPalterna;ve.–  SellersrecognizethebenefitsofanESOPanddemandthatPEGsofferitasan

alterna;ve

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Appendix

LiquidityOpTonstoOwnersofCompanies

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WHYMIGHTANOWNEREXPLORELIQUIDITYOPTIONS?

•  ExitStrategyPlanning–  Youwanttodiversifyyourassetsandreducetheriskofhaving“allyoureggs

inonebasket”–  Youwanttopreserveanongoingroleandmaintainequityownershipinthe

Company

•  Re;rement–  Youarelookingtoselltheen;reCompanyandre;re

•  FamilySuccession–  Youneedtoprovideforliquidityforanoldergenera;onaspartofan

appropriatesuccessionplan

•  PartnerBuyout–  Youneedtogeneratethecashtorepurchasethestockofasignificant

shareholder

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WHATARETHEGOALSOFANOWNERWHENEXPLORINGASALETOANESOP?

•  Liquidity(Cash)&WealthDiversifica;on

•  TaxMinimiza;on•  ManagementTeamIncen;ve•  EmployeeOwnership•  Minimiza;onofCultureDisrup;on•  LegacyforOwner•  MaintainOpera;ngControl

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WHATARETHEALTERNATIVESTOANESOP?

•  HireanInvestmentBankerand•  SelltoaPrivateEquityFirm•  SelltoaStrategicBuyer

•  DoNothing

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HOWDOTHEALTERNATIVESMEETTHEGOALS?Traditional

ESOPPrivateEquity

StrategicBuyer

ESOP+PrivateEquity

Up-FrontCashLiquidity

TaxMinimization

After-TaxLiquidity

ManagementIncentive

EmployeeOwnership

MinimizeCultureDisruption

LegacyforOwner

MaintainOperatingControl

TheESOP+PrivateEquityAlternaTvelooksaaracTve–whyisn’titmorepopular?

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•  Whatisit?–  Cashisgeneratedusingonlyaseniorloanfromabank–  Ownersreceiveproceedsconsis;ngofcashandasellernote–  Typicaltransac;onsplitofvalue–30%to40%cash/60%to70%

sellernote

•  Benefits–  Thetaxablegaincanbereducedoreliminatedifstructuredusing

IRCSecTon1042,potenTallyeliminaTngataxliabilitythatcouldapproach35%ofproceedsinCA

–  Corporatetaxescanbereducedoreliminatedifstructuredasa100%S-CorpstructureorusingcertainESOPloanstructures

–  Incen;vescanbecreatedthroughop;onsandemployeeownershipandculturechangeisminimized

–  Controlismaintainedbytheowner,ifdesired

•  Issues–  Significantwealthdiversifica;onisnotachievedbecauseoflimited

cashliquidity

SELLTOATRADITIONALLYFINANCEDESOP

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$100MMTradiTonal

ESOP

$70MMNoteReinvestment

CashProceeds$30MM

AVer-Tax

LongPointCapital

•  Whatisit?–  CashisgeneratedthroughanequityinvestmentbythePE

groupanddebtfinancingarrangedbythePEgroup–  Ownersreceiveproceedsconsis;ngofcashandanequity

interestintheongoingcompany–  Typicaltransac;onsplitofvalue–80%plusincash,20%in

equityreinvestment

•  Benefits–  MorecashatclosingbecauseofPEinvestmentand

addi;onaldebtfinancinggeneratedbyPEgroup–  PEGroupcanprovidesignificantvaluethroughaddi;onal

exper;se,rela;onshipsandcapital–  Incen;vescanbecreatedthroughmanagementop;ons

andculturechangemaybeminimal

•  Issues–  TaxInefficient–Ownerspaycapitalgainstaxes/Company

payscorporatetaxes–  PEgroupwilltypicallycontroltheCompany

SELLTOAPRIVATEEQUITYGROUP

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$100MMSaletoaPEGroup

$20MMEquityReinvestment

$24MMCapitalGainTaxes

$56MMAVer-TaxCash

Proceeds

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•  Whatisit?–  Strategicbuyer,oVencompe;tor,payscashorstock,if

public

•  Posi;ves–  PotenTalformostpre-taxliquidityifbuyeraCributesvalue

toandpaysforsynergies–  Nofurtherriskincompanyinvestmentforexis;ngowner

•  Issues–  TaxInefficient–Ownerswillpaycapitalgainstaxesoncash,

poten;allymi;ga;ngvalueofhigherprice–  Elimina;onofownerupsideinCompany–  Completelackofcontroloverfutureofbusiness–  Mostpoten;alforcultureshocktomanagementteamand

employees–  Riskofreleaseofcompe;;veinforma;onthroughthesale

process

SELLTOASTRATEGICBUYER

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$100MMSaletoaStrategicBuyer$30MM

CapitalGainsTaxes

$70MMAVer-TaxCash

Proceeds

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WHATISPRIVATEEQUITYANDHOWCANITBEUSEDINANESOP?

•  PrivateEquityisins;tu;onalcapitalusedforinvestmentinprivatecompanieswiththegoalofgenera;ngarisk-adjustedequityreturn

•  PrivateEquitycanprovideaddi;onalliquiditytoanownerinanESOPtransac;onthroughaninvestmentintheCompany,whichallowstheownerstoreceivemorecashandcreatemorewealthdiversifica;on.

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PRIVATEEQUITY101RISK-ADJUSTEDRETURNONINVESTMENT

•  Inves;ng-TheGreatertheRiskTaken,theHighertheReturnRequired•  RiskisAssociatedwith:

–  CertaintyofCashFlow–  SizeofCompany–thelargerthecompany,thelesstherisk–  Leverage–thelessthedebt,thelesstherisk–  IndustryCyclicality–themorestabletheindustry,thelesstherisk–  Diversifica;on–themorethediversifica;on,thelesstherisk–  Liquidity–theeasieritistoselltheinvestment(e.g.public),thelesstherisk–  Maturity–thelongerthecompanyhasatrackrecord,thelesstherisk

•  PrivateEquitytakesRisks–  Typicallyinvestsinsmallerprivatecompaniesusingequityanddebt(highestriskprofile)–  Typicallyseekannualreturnsof25%+oninvestments

•  Valua;onMul;plesarebasedbothonriskandongrowthpoten;al

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PRIVATEEQUITY101OBJECTIVES,GOVERNANCEANDLIQUIDITY

•  Objec;ve–growthofequityinvestmentvalueisparamount;thatishowprivateequityprofessionalsarepaid

•  Governance–ac;veinvestorsalignedwithmanagement–  Ac;vewithmanagementteamtogrowcompany–  AlignmentofInterests–managementteamsincen;vizedtocreateequity

value–  Control–Ifcompanyisnotperforming,PEgroupmusthaveabilitytochange

team

•  Liquidity–investmenthorizonstypically5years,requireabilitytogeneratecashliquidityforPEGinvestors,typicallythroughsaleofcompany

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PRIVATEEQUITYINESOPS–TAXISSUES

•  MostTaxEfficientESOPStructure–100%S-Corp.Structure•  ButiftheEquityoftheCompanyisOwned100%byanESOP,

howcanaPrivateEquityfirminvest?•  Synthe;cEquityneedstobeu;lized

–  ConsistsofaJuniorDebtInvestmentwithanEquityKicker(e.g.Op;ons)

–  Designedtogenerateaninvestmentreturnwhichmimicsthereturnthatwouldbegeneratedthroughatradi;onalprivateequitytransac;on

•  Complicatedtostructureandexperiencedtaxadvisorsrequiredtoinsurethatallrulesaremet

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PRIVATEEQUITYINESOPS–FINANCINGISSUES

•  100%S-CorpESOPsare100%DebtFinancedCompanies•  FinancingConsistsof:

–  SeniorLenderDebt–maybebankornon-banklender–  StructuredEquity(JuniorDebt)–  SellerNotes(JuniorDebt)

•  Banksrequirethejuniordebttobeappropriatelysubordinatedtothebank’sseniordebt

•  Requiresasophis;catedseniorlenderwhounderstandsthestructure

•  Investmentbyprivateequitymayincreaseconfidenceofseniorlender

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PRIVATEEQUITYINESOPS–FINANCINGBENEFITS

•  100%S-CorpESOPsgeneratesignificantlyhigherfreecashflowduetotheelimina;onoftaxes.

•  Thehigherfreecashflowmayallowthelenderto:–  Stretchandlendmoretothecompanythanitwouldlendtothesame

companythatisatax-payer,or–  Providemoreflexibleratesandtermssincethecompanyshouldbe

perceivedasabeCercredit.•  Thehigherfreecashflowprovidessignificantbenefitstothe

Company,providing:–  Morecapitalforgrowth,and/or–  Morecapitaltodeleveragerapidly,and/or–  Currentcashyieldonthesynthe;cequitynotes

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PRIVATEEQUITYINESOPS–REGULATORYISSUES

•  PrivateEquityiswellalignedwiththeprimaryobjec;vesoftheESOPandtheTrustee–  Valua;on-Privateequityestablishesamarket-basedvalua;on,i.e.

professionalinvestorsriskingmoneyonanarms-lengthnego;atedtransac;onvalue

–  Governance–PrivateequityestablishesgovernanceprocedurestomaximizegrowthinequityvaluewhichbenefitstheinvestmentbytheESOPandtheprivateequityfirm

•  Constraints–  ESOPsareregulatedbytheInternalRevenueCodeandERISA,socareful

adherencetoIRCandERISArulesisrequired

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PRIVATEEQUITYINESOPS–WHENDOESITWORK?

•  WhenwillaPrivateEquityGroup(PEG)investinanESOP?–  Theprojectedinvestmentreturnsjus;fytherisk

•  Thereturnsarenolessthanthereturnsthatwouldbegeneratedinatradi;onalPEGpurchaseofthecompany

–  ThePEGcancreatevalueandprotectitsinvestmentthroughpropergovernanceprovisions

–  ThePEGcanstructureitsinvestmenttomeettheconstraintsimposedbythetaxcodeandERISA

–  ThePEGcanfindsufficientdebtfinancingforthetransac;on

•  Ifitworks,itprovidesanewalternaTve……

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NEWALTERNATIVE:SELLTOAPE-BACKEDESOP•  Whatisit?

–  Structuredasatradi;onallyfinancedESOP,butcashisgeneratedthroughasynthe;cequityinvestment(notesandop;ons)bythePEGandbankloansarrangedbythePEgroup

–  Ownersreceiveproceedsconsis;ngofcashandsynthe;cequity(notesandop;ons)

–  Typicaltransac;onsplitofvalue–80%plusincash,20%insynthe;cequityreinvestment(notesandop;ons)

•  Posi;ves–  Thetaxablegaincanbereducedoreliminatedifstructuredthrough

aIRC1042exchange,potenTallyeliminaTngataxliabilitythatcouldapproach35%ofproceeds.Corporatetaxescanbereducedoreliminatedifstructuredasa100%S-CorpESOPoralterna;vestructures.

–  MOSTAFTER-TAXLIQUIDITY–morecash,lesstaxes–  PEGcanprovidesignificantvaluethroughaddi;onalexper;se,

rela;onshipsandcapital–  PEG,ownerandESOParealignedindesireforfairpriceandfuture

equityvaluecrea;on–  Maintainincen;vesthroughop;onsandemployeeownership

•  Issues–  PEGwillplayimportantroleingovernanceoftheCompany

$100MMPE+ESOPTransacTon

$20MMStructuredEquityReinvestment

$80MMAVer-TaxCash

Proceeds

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HOWDOTHEALTERNATIVESMEETTHEGOALS?Traditional

ESOPPrivateEquity

StrategicBuyer

ESOP+PrivateEquity

Up-FrontCashLiquidity

TaxMinimization

After-TaxLiquidity

ManagementIncentive

EmployeeOwnership

MinimizeCultureDisruption

LegacyforOwner

MaintainOperatingControl

TheESOP+PrivateEquityAlternaTvelooksaaracTve–whyisn’titmorepopular?

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