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The Art Of Seller Financing
ESOPs - Beyond The Basics
Presented by:
Kevin G. Long
Chang, Ruthenberg & Long PC
2033 Gateway Place, Suite 500
San Jose, CA 95110
(408) 467-3860
[email protected]
James F. Higgins
Pilot Hill Advisors, LLC
55 Union Place, Suite 131
Summit, NJ 07901
(908) 897-0826
[email protected]
Michael E. New
Evolve Bank & Trust
6070 Poplar Avenue, Suite 100
Memphis, TN 38119
(901) 624-2555
[email protected]
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"So I got this call from a very a very
good CPA firm we work with….."
Acme LLC Case Study
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• Which transaction structure used
• Cost of doing the deal
• Loan documentation and built in checks
and balances of ALL parties
• Transaction trustee vs. post deal fiduciary
concerns
• Need for quality independent counsel
• Contingency planning
Impacts On Transaction
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• Selling Shareholder
• Corporation
• Other creditors
• ESOP Trustee
• Management?
The Constituencies Affected
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• Longer terms for "inside" ESOP loans
• Cost – seller vs senior debt
• Cost – seller vs secondary financing
• Flexibility
• Known creditor
• Ease of "work outs"
• Board presence of creditor
• Subordination requirements – deal and
future
Corporation's Concerns
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• Lend to ESOP or company?
• Collateral
• Retain control over corporate risk?
• Comfort with senior lender, trustee,
management
• Compared to:
• holding back equity
• guaranteeing bank debt
• Mezzanine / portfolio / secondary
financing
Seller's Issues – Risk, Return, Control
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• Pricing / optimizing interest costs
• Mezzanine Debt? Really? Real?
• Post transaction board composition
• Involvement and monitoring
• Secondary stage refinancing – timing?
Trustee's Concerns
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• A seller taking a note must think like a bank
and investor
• A lender wants:
a) sustainable cash flow;
b) assets that can be liquidated to pay off
debt if necessary; and
c) flexibility to modify terms if necessary
• The better seller note structure would be
with the company? the ESOP?
Credit 101
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Pros And Cons Of Bank vs. Seller Financing
Bank
Financed
Seller
Financed
Cash at Closing
Ability to Diversify
Flexibility
Easier §1042 Fulfilment
Independent Oversight
Potential Warrant Upside
Interest Income for Seller
Faster Close and Lower Fees
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Step 1"Outside" Loan
Bank Company
Step 2"Inside"
Loan
ESOPSelling
Shareholders
Step 3Stock TransactionCash
Company Stock
Bank & Seller Financed Leveraged ESOP
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Step 1Seller Guarantee?
Seller note
Step 3Corp Guarantee?
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Step 1Redemption to Corp
Company
ESOPSelling
Shareholders
Seller Financed Corporate Redemption ESOP
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Step 2ESOP Note
Third party beneficiary rights
Step 2Issue Stock to ESOP
Step 1Corp Note
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Step 1"Day" Loan
Bank Company
Step 2"Inside"
Loan
ESOPSelling
Shareholders
Step 3Stock Transaction
Cash
Company Stock
"Day Loan" Resulting In Company Note
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Step 3Seller
Loan to Company
Step 4Day Loan Repayment
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ESOP Note Swap Buy-Out: Step 1
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Corporate
Guaranty
Annual
Contributions
Stock Sale
7-Year
Notes
Company
ESOP Seller
Start with stock sale directly to ESOP for
subordinated 7 yr 6% notes, secured by corporate
guaranty, company pays notes via ESOP
contributions
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ESOP Note Swap Buy-Out: Step 2
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Company assumes
and secures 7-year
notesAnnual
Contributions
Company
Seller
ESOP Gives
combined
note
ESOP
Annual Note
payments
ESOP assigns and company assumes the 7 yr notes in
exchange for the ESOP giving it a note for the combined
balances. Corporate guaranty extinguished in favor of direct
creditor relationship to sellers.
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• Tax Treatment• Interest Income is taxed as ordinary income• Potential Capital Gain Taxation on Warrants• Capital Gains Treatment On Principal - non §1042
• Terms of Seller Financing• Collateral – Corporate – Direct or Guarantee• Return on Investment
• Cash Interest• Payment In Kind (deferred interest)• Warrant (equity kicker)
• Expected rate of return is commensurate with the perceived risk• Loan regs allow terms that would be commensurate from a third party
lender• Generally, leverage is a metric that is used to tier the seller financing• Seller financing positioned like senior debt risk should be paid a
return similar to a bank• 100% seller financed transactions may "tranche" seller notes based
on relative risk profiles• Maturity and Excess Cash Flow• Board Involvement• Financial Covenants
Seller Financing Considerations
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Senior
Debt
Subordinated Debt & Mezzanine
Equity
Corporate Capital Structure
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Risk
Increases
Risk
Increases
Req.
Return
5-
10%
10 -
24%
25 -
∞%
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• Purchase agreements
• Redemption and issuance issues
• Loan Agreements
• Corporate and personal guarantees
(secured vs. not)
• Subordination agreements
• Contribution agreements
• Assignment of pledges
• Voting trusts
Transaction Documentation
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• May achieve same protection as direct loan
to corporation
• Very careful drafting required
• Third party beneficiary rights often
overlooked – equitable remedies
• Events of default can be tied to
performance of funding ESOP
Corporate Guarantees
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• The senior lender wants to have the strongest
position in getting repaid before others
• Seller financing always expressly subordinated to
a bank
• Bank will typically require the seller to:
• Wait for a period before receiving any principal
• Forego interest and principal payments if the
company is underperforming (i.e., a bank
financial covenant is violated)
• Agree to standstill on pursuing rights and
remedies if the company is in default on the
senior loan
Subordination Agreements
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• Typically require borrowers to have at least $5-10
million of historical annual EBITDA
• Are an additional "complicating factor" in getting a
transaction closed
• Are typically not as lenient if the company
underperforms
• May want to be involved in corporate governance
• Can be expensive
• Sellers will often prefer to remain with the company
post-transaction and would prefer to get the sub debt
return rather than provide it to a "stranger"; or prefer
it to third party leveraged 1042 portfolio – even at
capital gains rates on principal
What About 3rd Party Sub Debt Lenders?
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• Some assume that due to the risk profile of
a note, a seller is justified in expecting a
15% rate of return (like a third party)
• The return is a function of the amount
"invested" in the note and the subsequent
cash flows received
• Cash flows received:
• Cash interest income
• Principal both original as well as payment in
kind "PIK"
• Warrants
Seller Note Return "Mix"
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• PIK is interest that is compounded into the
note's principal rather than paid in cash
• (Reverse amortization?)
• A $10 million note with a 5% PIK interest
compounded annually would result in the
following principal balances over time
(assuming no principal payments)
PIK – Payment In Kind
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Beginning Balance PIK Interest Ending Balance
Year 1 $10,000,000 $500,000 $10,500,000
Year 2 $10,500,000 $525,000 $11,025,000
Year 3 $11,025,000 $551,250 $11,576,250
Year 4 $11,576,250 $578,813 $12,155,063
Year 5 $12,155,063 $607,753 $12,762,816
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• Essentially a stock option issued in connection with a
financial instrument / transaction
• A contractual obligation of a company to sell a specific
number of shares to the warrant holder in the future at a pre-
established price
• Example: Jane owns a warrant that provides her the option
to purchase 100 shares of Acme Co. for $10 per share on or
prior to 12/31/17
• Scenario A: If on 12/31/17 the value of Acme stock is $30
per share, then Jane should exercise the warrant (pay $10
per share) and receive the stock
• Scenario B: If on 12/31/17 the value of Acme stock is $9
per share, Jane should do nothing and the warrant would
expire as worthless to her
Warrants Are
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• Essentially allow the holders to conduct a "cashless" exercise to trade
some of the warrants for cash. Example:
• Instead of writing a check for $1,000 to exercise the 100 warrants,
Jane instead forfeits 50 warrants to pay the exercise price in lieu of
cash
• Each warrant is worth $30-10=$20 and therefore 50 warrants would
be worth $1,000
• Warrant holders typically want to get cashed out rather than holding
company stock, so warrants typically have "put" features that requires
the company to cash out the warrant at a specific date
• If an ESOP owns all or a portion of the company, the ESOP's tax
benefits (i.e., 100% S Corp ESOP) provide a strong desire to avoid
additional share ownership outside of the ESOP
• In ESOP transactions, warrants are typically structured so that
company can buyout the warrant (a "call") before the holder proceeds
to exercise and take ownership of shares
• Beware IRC §409 (p): Too many warrants in too few hands may trip
the anti abuse test
Warrants (continued)
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• Creditor's rights in non ESOP scenarios
• Overall governance structure issues
• Seller's protections in ESOP deals:
• Compare guarantee agreements with
retaining stock
• Upside of warrants vs retaining stock
• Voting trust duration
• Desire of Sellers to sit on board until:
• Bank Loan is paid off?
• Their loan is paid off?
Degrees Of Control – Legal Or Effective?
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• Sale of 74% of stock to ESOP
• Senior debt for X% of transaction at Y%
interest
• Seller subordinated note for Z% of
transaction
• Board seat protected by cumulative voting
of 26%. Projected good return and
protection of ensured participation
• Industry gyrations required Trustee / seller
actions to restructure in subsequent year
So What About Acme And Mr. Big?
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