In one of our issues on this site we discuss the hostile takeover of NCR by AT&T. The eventual outcome of this transaction was still somewhat in doubt when the article was written. On February 21, 1991, NCR announced a new $500 million dollar employee stock ownership plan. An AT&T spokesman charged NCR with ballot stuffing, in anticipation of its upcoming board meeting. NCR's reply was simply that the company had been considering an ESOP for more than two years.
While most people are familiar with the ESOP, few are aware of the details and specific benefits offered by this highly refined financial technique. We are fortunate in being able to publish the following article.
The Ultimate Exit Strategy for private sellers of a business is an employee stock ownership plan (ESOP). While an ESOP is attractive for many different reasons, one of its major financial benefits is not available to a seller which is a corporation taxed under Subchapter C of the Internal Revenue Code. Generally, only shareholders of closely held corporations are eligible. The shareholders can be individuals, partnerships, trusts, estates, and even Subchapter S corporations. "Private sellers" is the term we use to identify those sellers who do qualify for this extraordinary ESOP financial benefit.
As their businesses mature and private sellers begin the planning process for their exit, several choices are available to them: (a) an initial public offering; (b) sale to a strategic buyer, financial buyer, outside third party, or supplier; (c) redemption of stock; (d) sale to management; (e) sale to employees (the ESOP); (f) a combination of (c), (d), and (e).
Instead of undergoing the expense and uncertainty of a public offering, or attempting to sell their equity portion of the company to an outside buyer, private sellers can create their own buyer—the employees of their company. In so doing, they can enjoy tax benefits unrivalled by any other exit strategy.
Employee stock ownership plans have evolved from a novel academic concept into a sophisticated tool of corporate finance that is well integrated into the mainstream of the American business community. ESOPs have been used as an employee benefits tool and a takeover defense measure by many publicly held corporations, as well as a means of taking a publicly held company private. ESOPs have been used not only for ownership succession and capital formation by owners of closely held companies, but also as their ultimate exit strategy.
Here are some points that can be used in demonstrating why an ESOP just may be better than a sale, merger, or public offering, as well as a superior technique of corporate finance.
If the owners sell their closely held company to another company or third-party buyer, as private sellers they will pay an immediate capital gains tax; they will lose control; and they will probably not be able to retain any residual equity.
If they sell their stock to the public, they will incur an immediate capital gains tax; they will become subject to the jurisdiction of the SEC; and they will risk the possible loss of control.
If they enter into a tax-free merger, the capital gains tax will be deferred, but they will lose control—and they will still have all of their eggs in one basket.
If they sell to an ESOP, they can defer the federal capital gains tax; they can maintain control of the company; they can retain residual equity; and they can invest the proceeds in a diversified, virtually risk-free portfolio of stocks and bonds without incurring a capital gains tax—all while rewarding the loyal people who helped them build their business.
The foregoing ESOP benefits are achievable as a result of Internal Revenue Code Section 1042, which provides a road map for the tax-free rollover of proceeds from the sale of stock to an ESOP. This requires that the ESOP acquire 30% or more of the common equity and that the sellers have had at least a three-year holding period. The sellers must reinvest the proceeds in other U.S. domestic securities within a period of 12 months.
An ESOP can enable a corporation to finance the purchase of its stock at a lower cost than a conventional stock redemption.
An ESOP creates a direct link between employee productivity and employee benefits. In many companies, an ESOP may be a more effective employee incentive plan than a pension or profit sharing plan. It may also be possible to as much as triple the company's contributions and tax deductions.
An ESOP can facilitate and provide a means to finance acquisitions.
ESOPs also have numerous uses in public companies. An ESOP can enable a public company to go private; to finance a competitive tender offer; to facilitate a leveraged buyout; assist in defending against an unfriendly takeover; and even help reduce the skyrocketing costs of post-retirement medical benefits.
Another tax law provision enables banks to exclude from taxability 50% of the interest earned on an ESOP loan, provided the ESOP owns more than 50% of the company's common equity and passes voting rights through to ESOP participants. As a result, ESOP loans can be obtained below market rates of interest, to facilitate tax-free rollovers, going-private transactions, leveraged buyouts, and other ESOP transactions.
Suppose that XYZ corporation, started in 1965, has grown well, and it is now time for the private sellers to sell—in order to create liquidity for their estate, or for any number of other sound reasons. The following example reflects the major additional financial benefits available to qualified shareholders of XYZ.
Following is an overview of the potential benefits an ESOP transaction could provide to the selling side. For purposes of this example, we have assumed a 100% ESOP buyout from a private seller, with a transaction value of $10 million, and a negligible or zero tax basis in the securities sold. The proportionate benefits of using the ESOP technique of corporate finance would accrue to the parties to the transaction regardless of size.
Section 1042 of the Internal Revenue Code enables shareholders of privately held companies who have a three-year holding period, to reinvest the proceeds of a sale of stock to employees through an ESOP into U.S. domestic corporate securities (public or private) on a tax-deferred basis.
As evidenced below, the total additional seller benefits attributed to the ESOP exceed 70% of the transaction value. It is the overall magnitude of the enhancements which an ESOP can provide that appeals to potential sellers and makes an ESOP worthy of evaluation.
The sale of their position to an ESOP is the best exit for private sellers for the following reasons:
1. As private sellers, they have much greater control over the timing and terms of the transaction than they would dealing with an outside third party.
2. They may be able to sell their stock and reinvest the entire sale proceeds on a 100% tax-deferred basis, rather than merely reinvesting the proceeds that remain after paying federal and state capital gains taxes. A taxable sale would leave less than 75% of the sale's proceeds in many cases. This deferral of tax could last throughout their lifetimes, therefore creating a greater return on the invested amount of funds realized from the sale of the business.
3. ESOP transactions are easier to finance, due to the tax-deductible nature of ESOP principal payments, which creates improved cash flow coverage and ratios. This is particularly the case in times when credit availability is tight. The deductibility of dividends on stock held by the ESOP makes many more ESOP transactions possible than ever before.
4. In addition, when more than 50% of a company is owned by the ESOP, the lender may be able to exclude from its income one-half of the interest it receives on the loan to the ESOP. This normally permits an ESOP to borrow at approximately 75-85% of the interest rate that would otherwise be applicable, while at the same time increasing the yield to the lender.
5. When properly designed and communicated, an ESOP can make a big difference in employee motivation and productivity, enhancing value for every shareholder.
To summarize further, in a sentence: "The ESOP is The Ultimate Exit Strategy for private sellers."
Mr. Smiley is the chairman and chief executive officer of Benefit Capital, Inc. He is a founder, lifetime honorary director, and past president of The ESOP Association. He is co-editor and contributing author of Employee Stock Ownership Plans: Business Planning, Implementation, Law and Taxation, published in 1989, with updating Yearbooks, published periodically by Maxwell MacMillan/Rosenfeld Launer. We look forward to another article by Mr. Smiley in the near future.Non-ESOP |
ESOP |
|
| Gain on sale | $10,000,000 | $10,000,000 |
| Tax (combined federal and state)1(35%) | 3,500,000 | 0 |
| Net proceeds | $6,500,000 | $10,000,000 |
| Reinvestment Benefit: | ||
| Additional after-tax proceeds from an ESOP sale | $3,500,000 | |
| After-tax reinvestment return (assumed rate) | 7% | |
| Annual annuity stream increase | 245,000 | |
| Life expectancy - years (assumed) | 15 | |
| Total value of increased annuity | $3,675,000 | |
| Computation of Additional Total Financial Benefits to the Seller: | ||
| 1042 rollover benefit | 3,500,000 | |
| Seller reinvestment benefit | 3,675,000 | |
| Total additional financial benefit from an ESOP sale | 3,675,000 | |
| 1. Assumes California resident sale where this benefit is recognized for both state and federal tax purposes (rounded). | ||
In our opinion, creation of an ESOP solely as part of a takeover defense represents misuse of a technique originally designed to foster employee ownership of corporations. NCR issued 5.5 million shares of new preferred stock to a trustee for its ESOP plan. The trustee was to hold these shares, pending purchase by NCR employees over the following 25 years, as part of a company retirement plan. The plan was initiated by NCR through issuance of one share of stock to each of its 24,000 employees. The trustee would have been permitted to vote all 5.5 million shares in the same proportion as employees vote their individual shares, presumably on behalf of existing management.
Law suits concerning the ESOP were filed in federal courts by both AT&T and NCR. At issue was whether the ESOP was instituted primarily as a takeover defense, and thus constitutes ballot-stuffing.
Sellers considering use of an ESOP should review all facets of the potential transaction prior to commencing the process. As with any complicated legal or financial transaction, it is imperative that companies considering use of an ESOP avail themselves of the best possible professional counsel.