Transcript No Slide Title

ESOPS IN THE CAPITAL MARKET:
THE USES OF LEVERAGED ESOPS BY CLOSELY
HELD COMPANIES AND BY PRIVATE EQUITY
FUNDS AND OTHER INVESTORS
May 18, 2010
Schuck Law Group
Law Offices of Edwin G. Schuck, Jr.
Biltmore Tower
500 South Grand Avenue, 19th Floor
Los Angeles, California 90071-2609
(213) 683-5376 Direct
(626) 485-8959 Mobile
(213) 683-5366 Fax
[email protected]
AGENDA:
Opportunities for Closely Held Companies and Private Equity Investors to
Use Leveraged ESOPs as a Financing Tool
● Closely held company sells to an ESOP as an alternative to
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an IPO, third-party strategic or financial (PEG) sale or a
leveraged recapitalization
Closely held company buys another company using an
ESOP
Closely held company sells to a PEG
Closely held company sells to management and a PEG
PEG sells portfolio company to management
PEG takes a public company private (Zell-Tribune)
Public or private company divests or “spins off” a
subsidiary to management and/or a PEG
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What Makes a Leveraged ESOP a “Capital
Markets” Leveraged ESOP?
 Investments in leveraged ESOP transactions by PEGs,
Mezzanine Fund Investors and private investors
 Such investments typically are in subordinated
unsecured “mezzanine” debt and/or detached warrants
or other “capital appreciation” instruments
 S corporation warrants must have FMV strike price but
can be “penny” warrants if the investor is routinely in the
business of lending; C corporation warrants can be
“penny” warrants
 Stock purchased by the ESOP can be financially
structured to be high value/low equity percentage to
reduce other equity holders’ dilution
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What Makes a Leveraged ESOP a “Capital Markets”
Leveraged ESOP? (cont.)
● Senior lenders are often themselves capital markets players
who will place the mezzanine and equity on a fee basis
● Management is incentivized outside the ESOP with “synthetic
equity” awards and “rollover” of existing equity and/or
deferred compensation balances
● ESOP trustees are often sophisticated and well-advised
financial institutions who understand the role of private
equity and the role of the ESOP initially as co-investor and
ultimately, on the “exit,” as (i) a possible buyer from the
PEG, (ii) a co-seller with the PEG or (iii) the sole remaining
shareholder after the PEG is redeemed
● PEGs can take public companies private using ESOPS
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What Makes a Leveraged ESOP a “Capital Markets”
Leveraged ESOP? (cont.)
● S corporation ESOP tax savings generate enhanced cash-flow
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and liquidity – tax savings alone prior to exit can equal the
debt incurred in the acquisition
S corporation ESOP tax savings can then finance the PEG exit
by paying off the mezzanine debt so that new senior debt is
available to redeem the warrant
Public or private companies can dispose of subsidiaries in a
management-led leveraged ESOP buyout using PEG
financing
PEGs can both acquire and dispose of portfolio companies
using leveraged ESOPs
Other qualified defined contribution plan balances can be
moved into an ESOP to provide additional financing;
overfunded defined benefit plans can roll over excess funds
into an ESOP under some circumstances
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What Is a Leveraged ESOP?
● A Leveraged ESOP is a tool of corporate finance that can be used by
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closely held companies and also by PEGs and other capital markets
players to enhance returns on both buy-side and sell-side transactions
An ESOP is an Employee Stock Ownership Plan that is a “qualified”
deferred compensation plan regulated under ERISA and the Internal
Revenue Code
An ESOP is similar to a profit sharing or 401(k) plan but is designed to
invest primarily in company stock – there are no diversification
requirements except for long-term participants
An ESOP can borrow from related persons without penalty – and
thereby becomes a “leveraged” ESOP
An ESOP must have an ESOP trust with a fiduciary trustee
Trustee can be independent (discretionary) or directed by a named
fiduciary (such as the Administrative Committee)
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Leveraged ESOPs: There Are Four Principal Tax
Incentives to Use Them
● Section 1042 capital gains deferral and ultimate
elimination for non-C-corporation sellers of
nonpublic C corporations
● Effective deduction of ESOP loan principal (and
interest)
● Deduction of dividends paid on ESOP-held shares
(C Corporations) (but not for corporate AMT)
● S Corporation ESOP: flow-through of corporate
income to shareholders – no corporate-level tax –
and ESOP trust (a tax-exempt entity ) shareholder
pays no shareholder-level tax
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Section 1042 Permanent Capital Gains Tax Deferral
for C Corporation Shareholders
● IRC § 1042 permits shareholders (other than C
corporations) of non-public C corporations selling shares to
an ESOP to defer indefinitely capital gains tax on the sale
● ESOP must own at least 30% of value of all company stock
after sale
● Selling shareholders must within one year purchase
qualified replacement property (“QRP”)—stock or debt of
any domestic operating corporation – sellers can usually
get over 90% tax-free liquidity with a secured margin loan
on QRP specially designed to have a FMV equal to its face
amount (“floating rate notes” or “FRNs”)
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S Corporation ESOPs, Qualifying
Warrants, Options and Straight Debt
● S Corporation income flows through to shareholders – generally no federal
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corporate-level tax except for tax on BIG (if any) of former C corporations –
no tax on BIG after 10 years – BIG can be avoided with creative structures
ESOP as S-Corp shareholder pays no federal income taxes or UBIT on its
flow-through share of corporate income
Limited types of shareholders
One class of stock requirement – but non-voting common stock is permitted
No flow-through taxation to holders of qualifying “synthetic equity”
(restricted stock, restricted stock units, warrants, stock options, SARs,
phantom stock and other forms of deferred compensation) or straight debt
because those instruments are not a separate class of stock
No dividend deduction available
No section 1042 capital gains deferral available
Reduced contribution limits apply (irrelevant if 100% ESOP-owned)
Subject to IRC §409(p) anti-abuse regime
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What are the Mechanics of a
Leveraged ESOP Transaction?
● Company establishes an ESOP and an ESOP Trust
● Bank and/or sellers provide “traditional” outside financing
to Company (“outside loans”)
● Other, “capital markets,” players can be non-traditional
outside financing sources to Company: PEGs, mezzanine
investors, private investors (in the form of other “outside
loans” and warrants), other qualified plan balances
● Company lends money received from outside sources and/or
its own funds to ESOP (exempt “inside loan”)
● ESOP Trust purchases Company stock from shareholders or
from Company
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What are the Mechanics of a
Leveraged ESOP Transaction? (cont.)
● Stock purchased by the ESOP with the “inside loan” is held in a
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suspense account within the ESOP
Company pays deductible contributions and/or dividends to
ESOP that ESOP uses to repay “inside” loan debt from
Company
As the “inside loan” is repaid, shares in the ESOP are released
from the suspense account to ESOP employee accounts
Company repays bank and other outside loans, in effect with
before-tax dollars
Company or ESOP repurchases shares from employees after
employment terminates at the then FMV – therefore Company
must plan for repurchase obligation funding
An ESOP itself may be a seller or a buyer in a capital markets
“exit” (or may remain as sole shareholder after a capital
markets redemption “exit”)
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Basic C Corporation Sell-Side
Leveraged ESOP Transaction
Cash
Company
Bank
Outside Loan Note
Exempt
(Inside)
Loan
(Note & Pledge
of Stock)
Cash
PEG and/or
Mezzanine Funds
Cash
Shareholders
Sale of
Company Stock
ESOP
Cash
Special
Stock
Other Qualified
Plan Balances
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Basic S Corporation Sell-Side
Leveraged ESOP Transaction
Cash
Bank
Company
Outside Loan Note
PEG and/or
Mezzanine Funds
Sale of
Company
Stock
Exempt
(Inside)
Loan
Note (& Pledge
of Stock)
ESOP
Shareholders
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ESOP Loan Repayment
Deductible
Contributions
and/or
Dividends
Company
Outside
Loan
Payments
Bank, Mezzanine,
PEG Lenders
and/or Shareholders
ESOP
Inside Loan
Payments
Release of Shares Pledged
as Collateral and Share
Allocations to Individual
ESOP Accounts
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A Typical C Corporation ESOP
Capital Markets Sell-Side Transaction
● In one or more Section 1042 ESOP transactions selling
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stockholders sell most or all company stock to ESOP and get taxdeferred liquidity
Preferred “equity,” subordinated debt and/or warrants – warrants
can be “penny” warrants – to PEG, Mezzanine Investors, Private
Investors
Can use high-value/low-equity preferred stock to minimize
dilution of other equity
Stock options, phantom stock or other synthetic equity granted to
key management to allow key executives to own eventually 5-20%
of economic value of entity outside ESOP
The tax savings from tax-deferred sale and deductible debt
principal make the C corporation leveraged ESOP far superior to
an IPO secondary or a leveraged recapitalization on a net after-tax
proceeds basis
S Corporation election – further tax savings
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A Typical S Corporation Capital Markets Sell-Side
ESOP Transaction
● ESOP buys relatively small amount of stock from selling
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shareholders
S corporation effects taxable redemption of all of the stock
held by selling shareholders for cash and possibly
subordinated notes (installment sale)
Subordinated debt and/or warrants are sold to PEG,
Mezzanine Investors, Private Investors
Stock options, phantom stock or other synthetic equity
granted to key management to allow key executives to own
eventually 15-30% of economic value of entity outside
ESOP – must avoid § 409(p) 50% limit
Company uses S corp. tax-free operation to accelerate debt
reduction
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A Buy-Side ESOP Transaction –
The Zell-Tribune Deal (12/07)
● Tribune Co. – a NYSE Company
● $8.4 Billion Market Cap
● Owner of 12 big city papers, including the Chicago
Tribune, the Los Angeles Times, Long Island
Newsday and numerous television (including KTLA)
and radio stations
● Owner of the Chicago Cubs and Wrigley Field
Stadium
● 21,000 employees
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Zell-Tribune: A Buy-Side
ESOP Transaction
● Largest ESOP deal in history
● First going-private transaction using a leveraged ESOP
● High-profile capital markets transaction using an ESOP
● Post-closing tax-free sale of assets to pay down debt
● Bankruptcy two years later
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Was over-leveraged
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In a deep recession
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In a declining industry
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Zell-Tribune: Simplified Transaction Steps
Step One:
A. Tribune Company forms ESOP
B. Company lends $250 million to the ESOP, and the ESOP buys $250 million of stock at $28
per share (discounted from the trading price of $34 per share)
Step Two:
Company makes tender offer to public at $34 per share. Company borrows initially
$8 billion from banks and redeems approximately 50% of the public shares, returning
approximately $4.2 billion in capital at $34 per share in the tender, using balance of
initial loan proceeds to pay off existing debt and for new working capital
Step Three:
A. Cash-Out Merger: Company borrows another $4.2 billion from banks and squeezes out the
other 50% of the public at $34 per share ($4.2 billion) leaving the ESOP as the 100% owner
B. Zell invests $315 million and receives at par a $225 million subordinated unsecured
nonconvertible note (straight debt) and at $90 million an immediately exercisable 15-year
warrant to purchase 40%, fully diluted, of the Company’s equity for $500-$600 million
C. Company makes the S election – Zell’s subordinated straight note and warrant are not
treated as outstanding stock
D. Management is awarded 8% synthetic equity, fully diluted (phantom stock) – thus avoiding
IRC § 409(p)
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Zell-Tribune:
Post-Transaction Capitalization
Trustee
Banks
ESOP
$225 Million
Unsecured
Straight
Note
100% Common Stock
(52% Fully Diluted)
Zell
$250 Million
(with exempt loan)
Management
8% Phantom Stock Units
$90 Million
Tribune
Corporation
15 year Warrant 40% Fully Diluted
$500 Million Initial Strike Price
increasing by $10 million per year
to a maximum of $600 million
after 10 years
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Zell-Tribune
Post-Closing Capitalization (cont.)
Owner
Investment
Instrument
Ownership
ESOP
$250 Million
Stock
52% fully diluted
(purchased with
an exempt loan)
Zell
$225 Million
Subordinated
Note
-0-
Zell
$90 Million plus
$500-$600 Million
Strike price
15-year
Warrant
Management
Future Services
Phantom
Stock
8% fully diluted
Banks
$12.2 Billion
Senior
Secured Notes
-0-
40% fully diluted
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Zell-Tribune
Corporate Governance: the Tribune ESOP
● ESOP owns 52%, fully diluted
● Independent Trustee
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Acts for the exclusive benefit of the employees
Acts to maximize the long-term value of plan assets
Directed by ESOP Administrative Committee after initial transaction
● The Trustee cannot be an advocate for employees on
issues such as pay, layoffs, or other work-related
issues
● The Trustee votes the shares as directed by the
“named fiduciary,” subject to “pass-through” votes to
participants only for mergers, sales of substantially all
the assets of a business, recapitalizations and
reincorporations
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Zell-Tribune
Corporate Governance: the Board
● Zell was elected to the Board and is its Chairman
● The President and CEO of the Tribune remained on
the Board
● The representatives of the Chandler Trusts resigned
from the Board
● The majority of the board is independent
● Lawsuits
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Zell-Tribune: Post-Closing Events
● ESOP annual contribution was scheduled at 5% of payroll –
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union members included
a 3% cash balance plan was also adopted for employees
Defined benefit plans are fully funded. No wage concessions
Tribune is now selling assets to pay down debt in a
depressed economy – using a creative joint venture format
structured to avoid tax on BIG during 10-year post-election
period
Example is sale of Long Island Newsday to Newscorp using
an LLC joint venture structure where Tribune retains a
small (5%) stake and gets tax-free cash from Murdock –
cash is tax-free because of debt guarantee
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Zell-Tribune: Post-Closing Events (cont.)
● Estimated 10-year tax savings from the ESOP S corporation
structure is about $1.4 billion
● About 40% of those tax savings will accrue to the Zell
acquisition entity
● Tribune also benefits from “benefit replacement” (replacing
current defined benefit cash contributions with non-cash
ESOP contributions) – about $265 million net present
value savings at WACC over 10 years
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Use Of Various Merger And Acquisition Formats
With Leveraged ESOP Transactions
 ESOPs can be used by closely held companies in
taxable and nontaxable acquisitions of target
companies. The following transaction formats
exemplify taxable and tax-free acquisitions using a
leveraged ESOP to fund the transaction so that the
financed purchase price can be deducted with
contributions to repay the ESOP loan.
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Use Of Various Merger And Acquisition Formats
With Leveraged ESOP Transactions (cont.)
Cash Merger As Taxable Asset Purchase
Bank
Shs
ESOP
(2) $ Loan
$ P Stock Purchase (3)
$ Cash (4)
(1) $ Loan
P

Merge (4)
T
In this transaction, a traditional leveraged ESOP is used to finance the taxable cash
acquisition (by statutory merger) by the acquiring company (P) of an unrelated target
company (T). In effect, the entire cash purchase price is financed by the buyer with
before-tax dollars. The exempt ESOP loan is repaid with tax-deductible contributions to
the plan and/or dividends on the employer stock held by the plan.
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Use Of Various Merger And Acquisition Formats
With Leveraged ESOP Transactions (cont.)
Cash Forward Triangular Merger As Taxable Asset Purchase
Bank
ESOP
(2) $ Loan
$ P Stock Purchase (3)
$ Cash (4)
(1) $ Loan
P
S
Merge (4)
Shs
T
 This transaction uses a leveraged ESOP stock purchase to finance a taxable asset purchase
from a target corporation, using a forward triangular merger format. As in the preceding
case, the purchase price is, in effect, fully tax-deductible to the buyer because the exempt
ESOP loan is repaid with tax-deductible contributions to the plan and/or dividends on the
employer stock held by the plan.
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Use Of Various Merger And Acquisition Formats
With Leveraged ESOP Transactions (cont.)
Reverse Triangular Merger As Taxable Stock Purchase
Bank
(1) $ Loan
(2) $ Loan
ESOP
$ P Stock Purchase (3)
P
S
$ Cash (4)
Sh
Merge (4)
T
 This transaction effects a taxable stock purchase via reverse triangular merger
using the proceeds of an exempt ESOP loan. As in the asset purchase models,
the purchase price is, in effect, fully tax-deductible to the buyer.
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Use Of Various Merger And Acquisition Formats
With Leveraged ESOP Transactions (cont.)
Merger (“A” Reorganization w) with ESOP Merger
Bank
P
ESOP
(6) Merge
(4) Cash
T
ESOP
(5) P Stock
(1) $ Loan
Shs
(4) Sale of
T Stock
(3) $ Loan
(5) Merge
P

(2) $ Loan
T
In this transaction, the target (T) establishes an ESOP or uses its existing ESOP to purchase target’s
stock on a tax-deferred Section 1042 basis from its shareholders. The acquiring company (P) lends
borrowed cash to the target which re-lends the cash to the target ESOP in an exempt loan. The target
ESOP buys target stock on a Section 1042 tax-deferred basis from the target shareholders. Target and
target’s ESOP then merge tax-free into the acquiring company (P) and its ESOP, respectively in
exchange for P stock. The exempt ESOP loan is repaid with the tax-deductible dollars.
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Use Of Various Merger And Acquisition Formats
With Leveraged ESOP Transactions (cont.)
Forward Triangular Merger (“A” Reorganization)
Bank
(2) $ Loan
ESOP
(3) $ Loan
P
S

(4) Purchase P Shares
$ Cash
P shares (1)
Shs
Merge (1)
T
In this transaction, target (T) is first merged tax-free into the acquiring corporation (P) or its
subsidiary (S) in a direct or forward triangular merger in exchange for P stock. The P stock is
then sold by the former T shareholders on a tax-deferred basis under Section 1042 to P’s
ESOP. Continuity of interest is not violated because the ESOP is not “related” to P. Treas.
Reg. § 1.368-1(e)(3), (4).
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Use Of Various Merger And Acquisition Formats
With Leveraged ESOP Transactions (cont.)
Reverse Triangular Merger
(4) Purchase P Shares
Bank
(2) $ Loan
ESOP
(3) $ Loan
P
S

$ Cash
P shares (1)
Shs
Merge (1)
T
This transaction as in the preceding case, involves a tax-free merger, in this case a reverse
triangular merger for P stock, followed by a tax-deferred Section 1042 sale of the P stock to
P’s ESOP by T’s former shareholders.
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Use Of Various Merger And Acquisition Formats
With Leveraged ESOP Transactions (cont.)
“B” Reorganization
(4) $ Purchase P Stock
Bank
ESOP
(3) $ Loan
Shs
P stock (1)
(2) $ Loan
P

$ Cash (4)
T Stock (1)
T
The same result is obtained with a tax-free B reorganization where T stock is acquired solely
for P stock and the P stock is then sold in a tax-free Section 1042 sale to P’s ESOP by T’s
former shareholders.
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SUMMARY:
Opportunities for Closely Held Companies and Private Equity Investors to
Use Leveraged ESOPs as a Financing Tool
● Closely held company sells to an ESOP as an alternative to
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●
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●
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●
an IPO, third-party strategic or financial (PEG) sale or a
leveraged recapitalization
Closely held company buys another company using an
ESOP
Closely held company sells to a PEG
Closely held company sells to management and a PEG
PEG sells portfolio company to management
PEG takes a public company private (Zell-Tribune)
Public or private company divests or “spins off” a
subsidiary to management and/or a PEG
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ESOPS in the Capital Market: Conclusion
● Closely held corporation shareholders have tax-
enhanced exit/liquidity/succession/acquisition
planning alternatives to traditional modes
● PEGs and mezzanine fund investors are presented
with the opportunity to invest in innovative new
transaction structures using leveraged ESOPs to
enhance their IRRs on both the buy-side and the
sell-side
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QUESTIONS??
Schuck Law Group
Law Offices of Edwin G. Schuck, Jr.
Biltmore Tower
500 South Grand Avenue, 19th Floor
Los Angeles, California 90071-2609
(213) 683-5376 Direct
(626) 485-8959 Mobile
(213) 683-5366 Fax
[email protected]
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