chapter 6 esops as a financial strategy &mlps. agenda employee stock ownership plans (esops)...
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Agenda
Employee Stock Ownership Plans (ESOPs) Establish of ESOPs Implementation of ESOPs Advantages of ESOP Disadvantages of ESOP Types of ESOPs ESOPs as a financial strategy Uses of ESOPs Master Limited Partnerships (MLPs) Tax treatment of MLPs Types of MLPs
ESOP
An employee stock ownership plan is a type of stock bonus plan which invest primarily in the securities of the sponsoring employer firm.
Employee Stock Ownership Plan is an employee benefit plan which makes the employees of company owners of stock in that company
Definition: Defined contribution employee benefit
pension plans designed to invest at least 50% of its assets in qualifying employer securities
ESOPs may be Stock bonus plans Combined stock bonus plans and money purchase
plans May also provide for employee contributions May represent portion of profit-sharing plan
Employee Stock Ownership Plans (ESOPs)
ESOPs different from: Employee stock purchase plans
Enable employees to buy company stock at discount
Participation of all or most employees Shares sold at 85% or more of prevailing market
price of shares Executive incentive programs
Provided mainly to top management and other key employees
Part of executive compensation packages Two types
Incentive stock options Stock appreciation rights
Establish of ESOPs
A company interested in establishing an Employee
Stock Ownership Plan (ESOP) has a wide range of
options in tailoring a plan that is best suited to its
particular needs and goals.
The first step in the process of establishing an ESOP is
to develop an idea of the type of plan that will best
serve the company's interests
Implementation of ESOPs
For implementation of ESOPs the company creates a
trust to which it makes annual contributions. These
contributions are then allocated to the individual
employee accounts within the trust.
employees might join the plan and begin receiving
allocations after completing a year of service with the
company, where any year in which an employee works
at least 1000 hours is counted as a year of service.
Advantages of ESOP
Employee loyalty enhanced
Liquidity and diversification for firm owner
Minimizes dilution of control
Establishes market value for privately held stock which
could be used to value estate
Tax-free rollover is actually only a tax deferral
until securities are sold
Motivates employees because they feel they are
getting
"a piece of the rock“
A ESOP-owned corporation are 100% tax-exempt
entity
Disadvantages of ESOP
Dilution - The equity of the company is being diluted
because of the issue of further equity shares of the
company which ultimately leads to a negative effect on
the Earning per Share.
Fiduciary Liability -The plan committee members who
administer the plan are deemed to be fiduciaries, and can be
held liable if they knowingly participate in improper transactions.
substantially, the ESOP and/or the company may not have
sufficient funds to repurchase stock, upon employees’
retirement.
Stock Performance - If the value of the company does not
increase, the employees may feel that the ESOP is less
attractive than a profit sharing plan. In an extreme case, if the
company fails, the employees willLiquidity. If the value of the
stock appreciates lose their benefits to the extent that the
ESOP is not diversified in other investments
Types of ESOPs
Leveraged Recognized under ERISA in 1974 Leveraged ESOP operation
ESOP fund or trust borrows funds from financial institutions
Lender transfers cash to ESOP trust in return for written obligation
Sponsoring (employer) firm generally guarantees loan
ESOP trust uses borrowed funds to purchase securities from sponsoring firm
Sponsoring firm transfers stock to name of ESOP trust as portions of principal are repaid
Types of ESOPs
Leveragable Recognized under ERISA Plan authorized but not required to borrow funds
Nonleveraged The sponsoring employer contributes newly issued or
treasury stock and/or cash to buy stock form existing owners. Contributions generally may equal up to 15% of covered payroll
Recognized under ERISA Plan does not provide for borrowing of funds Essentially stock bonus plan
ESOPs as a financial strategy
ESOPs may provide shareholders with increased value When the company's performance lags, employee
shareholders are exposed to market losses in an investment that they cannot divest while employed by the firm. Tax credits ESOPs
Provided by Tax Reduction Act of 1975; known as Tax Reduction Act ESOPs or TRASOPs
In addition to regular investment credit in existence at that time, additional investment credit of 1% of qualified investment in plant and equipment could be earned by contribution of that amount to ESOP
ESOPs as a financial strategy
In 1976, additional 0.5% credit added for companies that
matched contributions of employees of same amount to TRASOP
In 1983, basis for credit was changed from plant and equipment
investments to 0.5% of covered payroll — plans called payroll-
based ESOPs or PAYSOPs
Recently, the Reconciliation Act of 2001, exempted employees' elective
deferrals to their retirement plans from the calculation of total employer
contribution to defined-contribution plans such as ESOPs and 401(k)s.
In addition, the maximum contribution percentage was raised to 25%
from 15% of total eligible pay
Uses of ESOPs
Corporate restructuring activities Buy private companies (59% of leveraged
ESOPs) Divestitures (37% of leveraged ESOPs) Rescue operations of failing companies Raising new capital Takeover defense to hostile tender offers
Master Limited Partnerships (MLPs)
Business organizational forms in general Proprietorships and partnerships
Most numerous Mostly small businesses
Corporations Dominant in terms of total assets
MLPs
Four advantages in raising large sums of money
Limited liability for shareholders Unlimited life Ownership divided into many shares — limits
risk exposure Shares freely tradable for liquidity,
diversification, transferability of ownership
MLPs — relatively new form of business organization
MLPs
Master Limited Partnerships Type of limited partnerships whose interests
are divided into units that are traded on organized exchanges
First developed in oil and gas industry Some advantages
Unit tradability similar to stock Limited liability (for limited partners) Continuity of life No double taxation of business earnings
Tax treatment of MLPs
IRS focused on four characteristics to
distinguish between corporations and MLPs
Unlimited life
Limited liability
Centralized management
Transferability
MLPs may have only two of four corporate
characteristics to avoid being taxed as corporation —
usually centralized management and transferability
MLPs typically specify limited life of 100 years
MLPs have limited liability for limited partners but
unlimited liability for general partner or manager
General partner of MLPs
General manager (partner) of MLPs has unlimited liability
Virtually autocratic power Difficult to change general partner in
absence of provable fraud Alignment of interests between general
partner and public unit holders Management incentive fees Ownership of significant number of limited
partnership units
Types of MLPs
Roll-up MLPs Combine existing limited partnerships into
one publicly traded partnership First type of MLPs organized; began in oil
industry by Apache Petroleum Company in 1981
Provide liquidity for nontraded limited partnerships
Nature of roll-up
Before roll-up, there are a number of limited
partnerships in existence
General partners enter into agreement to combine a
number of previously sponsored limited partnerships; in
return for their old shares, units in new MLP are issued
After MLP has been formed, there is a general partner
and units which are owned by limited partners; units
may trade on stock exchange or over the counter
Roll-out (spin-off) MLPs
Formed by a corporation's contribution of
operating assets in exchange for general and
limited partnership interests in MLP
Sold on a yield comparison basis
First roll-out MLP created by Transco Corp in
1983
Nature of roll-out
Corporation holds a number of business segments
Corporation places assets of one or more of its business
segments into MLP
Avoid double taxation of corporate dividends
Establish a new value on undervalued assets
MLP transfers MLP units to corporation which in turn
distributes them to its shareholders
Stockholder hold stock in corporation and own units in MLP
Corporation could sell portion or all of units to outside public
Start-up MLPs
Start-up (new issue, or acquisition) MLPs
Formed by a partnership that is initially privately held but offers its interests to the public in order to finance internal growth
Nature of start-up Existing entity transfers assets to MLP Management company may be involved that provides
services to MLP and probably will be its general partner
In return, management company receives certain percentage of cash flows of MLP
General partner does not have to hold units in order to receive income