10 10 17 Good Morning Truckee ESOP Speech

Good Morning Truckee!

Business Succession – 2017 Opportunities-Options-Impact

Agenda • Setting the Stage - The Closely-Held Wealth Dilemma • Business Succession Alternatives • Employee Ownership Succession for Generations of Business Success • Managing Valuation in Business Succession • Personal and Community Impacts 2

Business Ownership Today: Risk and Opportunity‌

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The Closely Held Wealth Dilemma…

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The Life Stages of a Business Entrepreneurial businesses have a life-cycle: – Getting started – Moving beyond critical mass – Making the right growth decisions – Dealing with adversity – Reviving a static business and then comes…

– Business succession planning 6

The Currency of Equity‌

Tactical: Tax and Cash Benefits

Compensation Substitute

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Key Executive Compensation

Strategic: Engaged Employees

Broad Based Equity Incentives

Profit Sharing Stock Bonus Plans

Statement of Values: Ownership Culture

Gain Sharing Value Plans

Employee Ownership

Overriding Business Succession Issues - 2017 • Public Markets represent a relatively small percentage of the wealth in the U. S. (or the World, for that matter).

• The vast majority of wealth is not in a liquid form.

• Illiquid assets are hard to value and even harder to access.

• Within the next 10 years, a large percentage of the corporate wealth in the U. S. will change hands as the Baby Boomers Retire.

• How Does that play out?

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Closely Held Company Owner’s Issues • Self and Spouse – How to Create an Income Stream for Life After Retirement? And How to Retire Early Enough to Enjoy It? • Children and Other Heirs – How Best to Provide for Heirs both In the Business and Outside of it?

• Business Continuation – How to Provide for Business Succession without Risking The Stability of the Company?

• Employees – How to Protect Employees and the Community from the Negative Result of Unplanned Transition?

• Tax and Finance – How to Make the Best Use of Assets and Minimize Estate and Gift Taxes at the Same Time?

• Pride and Philanthropic Intentions – How Best to Leave a Legacy that Lets a Life’s Work Continue to Serve the Owner’s Objectives?

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Owners’ Expectations • Minimum acceptable PRICE • TIME Horizon for completing the sale of the business • CONTINUITY of the business (e.g., management team, employees, and vendors) • Continued INVOLVEMENT (Or Not) • Characteristics of an ACCEPTABLE BUYER • Other RELATED OUTCOMES (Effect on Family, Charitable Intentions, Etc.)

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Closely Held Business Alternatives ยง Some may be handed down to future generations, ยง Some may be large enough to go public, ยง Some may be attractive to synergistic buyers for high multiples, ยง Some may be attractive to financial buyers, but ยง Many may just wind up being liquidated!!!

A Better Alternative for Many Companies!

Partner with employees to sell the company for full fair market value using an ESOP! 11

Sharing the Future with Employees •

Stakeholders (including employees) can be put in a position to compete for the right to take this equity into the next generation of private ownership using an Employee Stock Ownership Plan (ESOP).

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ESOPs can provide a controlled, friendly buyer at “Fair Market Value”.

– Tax laws provide significant incentives for sales to employees through ESOPs – ESOP is the most tax and cost effective way to finance a purchase of shares of a closely-held business.

– ESOPs can create liquidity in an illiquid estate to better coordinate with estate plans.

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Management/Employee buy-out is a way to preserve an entrepreneur’s legacy and gain access to all or part of their equity at the same time.

Employees are often the most appropriate partner in sustaining a business into the next generation!

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The Option that Addresses the Most Issues

Employee Stock Ownership Plan (ESOP) Your Partner in Business Succession

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What Is an ESOP? •

Defined contribution retirement plan like Profit-Sharing or 401(k) with two significant differences: – Required to invest primarily in the stock of the sponsoring company – May borrow money backed by the credit of the Company in order to do so (leveraged ESOP)

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Can be used for stock transfers from existing shareholders or as a capital raising vehicle acquiring newly issued shares from the Company

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A versatile tool used to accomplish a wide range of financial and employee relations objectives

ESOP’s Role in Succession Planning • ESOPs provide a controlled, friendly buyer at “fair market value”.

• Tax laws provide significant incentives for sales to employees through ESOPs • ESOP is the most tax and cost effective way to finance a purchase of shares of a closely-held business.

• ESOPs can create liquidity in an illiquid estate to better coordinate with estate plans.

• Employee buy-out is a way to preserve a legacy and get all or part of an entrepreneur’s equity out of the business at the same time.

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Basic ESOP Structure Basic ESOP Funding Structure 1. Company Contributes Cash (Or New Issue Shares) to ESOP

Company

2. ESOP Trustee Applies Cash to Purchase Shares At Current FMV 3. Employees Build Equity Over Time Through Allocations

ESOP Trust

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Sharehold ers

Leveraged ESOP Leveraged ESOP Transaction Structure

1. Bank or Other Lender Makes Term Loan to Company Company Lender 2. Company Loans Proceeds to ESOP. (1)

Shares ESOP Trust

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(3b)

3. ESOP Trustee Purchases Shares from Shareholders

Shareholders

Amortization is 100% Pre-Tax Repaying the Loan

Company

1. Bank Loan is Repaid Over Negotiated Period

Lender

(3) 3. ESOP Repays Debt to Company

2. Company Makes Contribution or Dividend Payment to ESOP

4. Participant Accounts Accrue Stock As the ESOP Loan is Repaid Suspense Account

(2b) Participant Accounts

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Special Incentive for Sellers

• Deferral of Tax on Sale To ESOP

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Sellers Incentive: 1042 Tax Deferred Rollover •

Seller can elect to defer gain on privately held C corporation shares sold to ESOP by reinvesting all or any portion of the sales proceeds in qualified replacement securities – Replacement securities are stock or debt instruments of a domestic operating corporation – Replacement securities must be acquired within 12 months following transaction – After the sale, ESOP must own at least 30% of company

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Seller must have owned stock for at least three years prior to sale – Seller cannot have acquired the stock in a compensatory stock option plan, nor from a qualified retirement plan

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Seller, certain related individuals, and greater-than-25% owners generally cannot participate in allocations of shares that have been subject to this treatment.

ESOP Tax Deferred Rollover

Company (C corporation)

Loan Lender

Sale of Appreciated Securities Without Capital Gains Taxes Loan

IRC SEC. 1042

ESOP Trust

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Shareholders

Replacement Securities

Special Benefits for S-Corporations

• Fully Tax Free Earnings 22

ESOP S-Corporation • Effective in 1998, ESOPs were authorized to become shareholders in Sub-chapter “S” corporations • In an S-corporation – Taxes are paid ratably based on relative shareholdings – Shareholdings are attributed ratably throughout each year – Earnings are typically distributed to the shareholders sufficient to cover their tax liability – Undistributed earnings are applied to an “accumulated adjustments account” and either withdrawn tax free at a later date or applied to increase the shareholder’s basis in shares

• ESOP, as a Shareholder, is attributed a ratable portion of the corporations earnings each year.

• Since the ESOP is tax exempt, its share of S-Corporation earnings are tax free!

• There is no flow-through of tax to participants, except with reference to the value of their shares on distribution.

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ESOP S-Corporation The Ultimate Tax Shelter Taxable Shareholders Pay Tax on 1040

S-Corporation

(3) (2a)

(1)

ESOP is Tax Exempt So Earnings Are Tax Free 24

Shareholders

IRS

Earnings Are Attributed To Shareholders Based on Their Relative Stock Ownership

ESOP Benefits – In Summary •

Tax-Free Sale of Stock at Independently Determined Fair Market Value (Section 1042) – Seller may elect to reinvest proceeds and defer (or eliminate) capital gains tax on the transaction

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Fully Tax-Deductible Financing

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Significant Improvement in: – Employee Morale and Productivity – Retirement Benefits – Company Cash Flow

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Tax-Free Corporate Income

Significant ESOP Considerations 2017

Who Controls an ESOP Company?

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Corporate Responsibilities and Positions do Not Automatically Change as a Result of the ESOP

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The ESOP Trustee Represents the Interests of the ESOP and its Participants

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If there is a Major Corporate Decision that Requires the Shareholders to vote, the Trustee will discuss it with Participants and ask for Advice.

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In the end, the Trustee will decide what is in the best interest of the ESOP.

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ESOP is a “stake” in the future value of the Company – Employees share in the value that is being created, but the governance of the Company is not changed.

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How is Stock Value Determined?

• • • •

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Must be valued by independent third-party appraiser ESOP can pay up to fair market value Must be valued annually and as of the date of any purchase/sale Valuation is generally based on: – Value of assets – Capitalized earnings history – Discounted future cash flow – Comparison with publicly-traded comparable companies Premiums and discounts – Marketability – lack of marketability – Control – lack of control

Track Record?

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Some Highlights of Research…

• ESOP companies are 8 – 10% more productive after becoming employee owned than before.

• ESOP company retirees can be expected to retire with 2.5 to 4 times the retirement income they could expect otherwise.

• ESOP companies are less likely to lay people off in downturns, hire back faster and are only 1/5

as likely to go out of business.

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What’s the Score?…(NCEO Research 2016) Type of Number of Total Employer Plan: Plans: Participants: Stock Held: Total Assets: Standalone ESOPs:

5489

1.66 million

$102.9 billion

$115 billion

KSOPs:

1306

12.26 million

$159.4 billion

$1.12 trillion

Total Literal ESOPs:

6795

13.9 million

$262 billion

$1.23 trillion

Other ESOPlike Plans:

2528

1.18 million

$22.2 billion

$64 billion

Total:

9323

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15 million

$284 billion

$1.3 trillion

Employee Ownership and Community Health General Social Survey: PostRecession – 12.1% of respondents lost jobs – but only 2.6% of employeeowners Translated into community impact…

– … without employee ownership, 1.8 million more jobs would have been lost – … a benefit in federal tax revenues of $14 to $23 billion per year 32

More Recent Research – Message is the Same!

• Sampling Recent Research from NCEO (Kellogg Foundation Grant) – ESOP creates median net worth 96% higher than non-ESOP employees – ESOP Companies Pay 33% better median salary – Employee Owners have median tenure 53% longer than others

• NBER Data Show:

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– The Extent of employee ownership is persistently linked to healthier county economies along lines of employment and income stability.

Questions?

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Contact Information: Anthony Mathews, Beyster Institute California Center for Employee Ownership Rady School of Management University of California, San Diego 9500 Gilman Drive #0553 La Jolla, CA 92031 (858) 822-6010 amathews@ucsd.edu

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