transferring a business to key employees

TRANSFERRING A BUSINESS TO KEY

EMPLOYEESFor

Privately Held BusinessPresented by:

Sam G. TorolopoulosATI Capital Group, Inc.

ATICG © 2010 ATI Capital Group, Inc.

ATICG © 2010 ATI Capital Group, Inc. 2

BUSINESS TRANSFER SPECTRUM

For Financial Professional Use Only

T R A N S F E R M O T I V E S

Employees Charitable Trusts

Co-OwnersFamily Outside (Continue)

Outside (Retire)

Public

ESOPs Management

Buyout/Ins Options Phantom Stock Stock

Appreciation Rights

CRTsCRATSCRUTsCLTsCLATsCLUTs

GiftsSCINsAnnuitiesGRATsFLPsIDGTs

Buy/Sell Russian

Roulette Dutch

Auction Right of

First Refusal

Negotiated One-Step Private Auctions

Two-Step Public Auctions

Consolidated

Roll-ups Buy and Build

Recaps

Initial Public Offerings

Direct Public Offerings

Reverse Mergers

Going PrivateINTERNAL

TRANSFERS

EXTERNALTRANSFERS

T R A N S F E R C H A N N E L S

T R A N S F E R M E T H O D S


PUBLIC CAPITAL MARKETS

Large Publicly Traded Companies

• Have unlimited access to capital

• Are focused on profit maximization

• Are not concerned about Tax minimization

• Are Strategic minded

• Are not concerned with creating personal wealth for the “owner” of the business.


PRIVATE CAPITAL MARKETS

Privately Held Companies

• Capital is limited to the owner’s guarantee

• Are concerned about Tax minimization

• Are primarily concerned with creating personal wealth for the “owner” of the business.

• Are tactical not strategic (wear many hats)


DIFFERENCES THEREIN

• Very few if any privately held “C” corporations pay double tax.

• All/most “S” Corporations pay income tax.• Owner of a private company is obsessed with

minimizing or eliminating income taxes.• Public companies do NOT pay income tax

therefore, CEO could care less about the amount or rate of corporate taxation.


DIFFERENCES THEREIN

• Officers of a publicly traded company can sell some, most, or all of their stock or vested options before retirement, at retirement or after retirement….there is a ready market for the stock.

• Officers of a privately traded company have no such ready market for their stock.


DIFFERENCES THEREIN

• Owner of a private company seeks to grow family wealth (starting with himself)

• CEO of a public company seeks to grow share value and\or pay dividends

• Board of directors of a private company (if any) are reluctant to make changes to management

• Board of directors of a public company will act quickly to remove non-performing Mgt.


DIFFERENCES THEREIN

• CFO of a public company strives to obtain capital at the lowest possible cost (WACC)

• Owner of a privately held business has VERY limited access to capital (will take what he can get)

• CEOs of privately owned companies think tactical

• CEOs of publicly traded companies think strategic


POTENTIAL BUYERS

• A Corporation

• An Individual\Individuals

• A Qualified Plan


HUMAN CAPITAL

Every corporation has three basic categories of human capital

• Legacy Generation Current owner or founder

• Next Generation or Senior Mgt.

• Rank and file employees


BUSINESS OWNER’S MOTIVES

• Most business owners want to: “leave a legacy” behind in their business extract VALUE in an efficient manner that will

not negatively impact the Company’s legacy remain in control for a period of time


MANAGEMENT’S MOTIVES

• Management wants to: grow the business\take more risk. to create VALUE that will first pay off the seller, and

second increase their personal wealth. See to it that control passes in an efficient but

determinable manner. Extract the value that they have paid for and created in

order to enhance their personal wealth.


BUSINESS OWNER’S UNKNOWNS

• Very few business owners: know what their options are understand how their motives impact the

decision process understand the opportunity cost of one option

over the other understand that their business has multiple

values on the same day


TRANSFER TO MANAGEMENT

Making It Work For Everyone!

For Financial Professional Use Only


MOTIVATING THE SELLER

• Transition is a process not an event

• Quicker and more confidential than 3rd party sale

• Deal structure can be more flexible

• Legacy of the Company continues

• Personal sentiment of the owner “Mgt. has earned it”


MOTIVATING THE SELLER

• Upside growth potential for both seller and management

• Can provide continued service to the Company as officer and\or director

• Control over “control”


SELLER CONCERNS

• Deal structure Cash, debt, earn-out

• Mgt. generally has no capital or “skin in the game”

• Loss of control• Contingent liabilities• Maintaining Mgt. enthusiasm

“Who gets what percentage?”


SELLER CONCERNS

• Should a private equity firm be involved? Control\Minority What is P.E. exit strategy? Where will that money come from? Will management be willing to work that

hard and stay that long? Impact of P.E. representative on the board?

MGT. BUY OUT EXAMPLE



ASSUMPTIONS

• Gross revenue = $50MM• EBITDA = 10% of revenue• Annual Growth = 10%• Depreciation = Cap Ex at 2% of revenue• Taxes = 34%• Working Capital increases at 12% of revenue

growth• No existing debt


ASSUMPTIONS

• Value @ 5X EBITDA• $10MM bank debt• Mgt. can raise $1MM• P.E. infuses $14MM• Annual Growth = 10%• 100% of excess cash to pay down bank debt• EBITDA value multiple @ 6X after three years


MBO EXAMPLE

In thousands Current Yr. 1 Yr. 2 Yr. 3 Exit

Revenue

10% $50,000 $55,000 $60,500 $66,550 $66,550

EBITDA 10% 5,000 5,500 6,050 6,655 6,655

Depr.\Cap Ex. 2% 1,100 1,210 1,331

Interest Exp. 7% 700 568 413

Pre-tax income 3,700 4,272 4,911

Taxes 34% 1,258 1,453 1,670

Working Cap. Incr. 10% 550 605 666

Principal Pmt. 1,892 2,215 2,576


MBO EXAMPLE CONT.

Valuation Current Yr. 1 Yr. 2 Yr. 3 Exit

EBITDA $5,000 $6,655

Multiple X5 X6

Value 25,000 39,930

Financed

Bank Debt 10,000 (1,892) (2,215) (2,576) 3,317

Mgt. Equity 1,000 2,442

P.E. Equity 14,000 34,171

Totals $25,000 $39,930


SELLER’S RESULTS

• “Cashes out” and receives $25,000

• Remains on the board of directors

• Remains as an officer

• Possible incentives for growing the company

• Maintains privacy of the transaction


FOR THE P.E. GROUP

• Purchased 93.33% of the equity $14MM/$15MM for 56% of the purchase price $14MM/$25MM.

• Value of P.E. equity went from $14MM to $34MM representing a 244% increase over three years.


FOR MANAGEMENT

• Only came up with $1MM• Mgt. equity went from $1MM to

$2.442MM representing a 244% increase over three years

• Didn’t guarantee the $10MM loan• $10MM loan reduced to $3.317MM• Continuity of Mgt. position\board

representation


CONCERNS FOR ALL

• 100% of excess cash flow is used to pay debt not grow the Company.

• Where is Mgt. going to get the money to buy-out P.E. group?

• P.E. realizes lion’s share of actual equity growth.

• Undo emphasis on short-term results.• Shareholders’ Agreements?


CONCERNS FOR ALL

• Mgt. conflict of interest.

• Mgt. ongoing appetite for new Majority owners when P.E. sells.

• Owner motives outweigh Management motives.

EMPLOYEE STOCK OWNERSHIP PLAN

A Pre-tax Management Buyout?



WHAT IS AN ESOP

• ESOP = Employee Stock Ownership Plan• An ESOP is a QUALIFIED PLAN under

the Employees’ Retirement Income Security Act of 1974 (ERISA)

• See Sections 401(a), 4975(e)(7), and 501(a) of the Internal Revenue Code of 1986, as amended, and Section 407(d)(6) of ERISA, 1974


UNIQUE FEATURES OF AN ESOP

An ESOP trust “ESOT” has three very unique features:

1. ESOT must own “principally” stock in its sponsor company.

2. An ESOT is the ONLY qualified plan under ERISA allowed to BORROW MONEY!!

3. The trust can purchase the Company in “Stages” (multiple transactions).


TAX ADVANTAGES OF AN ESOP

ESOP structures have the following tax advantages:

• Seller can defer tax on sale indefinitely 30% or more for “C” corporations only

• Seller can be a participant in the ESOP Only if tax deferral on sale is not elected

• Company tax deducts the principal and interest on ESOP buyout loan

Available for “C” and “S” Corporation ESOPs


TAX ADVANTAGES OF AN ESOP

• “S” Corporation ESOP pays no tax on pre-tax income for the percent owned by the ESOP.

If 100% “S” Corporation ESOP, then 100% of pre-tax income free from tax.

ESOP EXAMPLE



ASSUMPTIONS

• Gross revenue = $50MM• EBITDA = 10% of revenue• Annual Growth = 10%• Depreciation = Cap Ex at 2% of revenue• Taxes = 0%• Working Capital increases at 12% of revenue

growth• No existing debt


ASSUMPTIONS

• Value @ 5X EBITDA• $25MM Seller Note• Five year vs. three year horizon for MBO• Mgt. need not raise ANY capital• Annual Growth = 10%• 100% of excess cash to pay down bank debt• EBITDA value multiple @ 6X after five years


ESOP EXAMPLE

Current Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 Exit

Revenue 50,000 55,000 60,500 66,550 73,205 80,526 66,550

Growth 10%

EBITDA 10% 5,000 5,500 6,050 6,655 7,321 8,053 8,053

Depr.\Cap Ex. 2% 1,100 1,210 1,331 1,464 1,611

Interest Exp. 7% 1,750 1,603 1,419 1,192 1,064

Pre-tax income 2,650 3,237 3,905 4,664 5,378

Working Cap. 10% 550 605 666 732 805

Debt Repayment 2,100 2,632 3,240 3,932 4,573


ESOP EXAMPLE CONT.

Valuation Current Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 Exit

EBITDA 5,000 8,053

Multiple X5 X6

Value 25,000 48,318

Financed

Equity N/A 39,795

Seller Debt 25,000 (2,100) (2,632) (3,240) (3,932) (4,573) 8,523

Debt Balance 22,900 20,268 17,028 13,096 Totals 48,318


SELLER’S RESULTS

• “Sells” for $25MM plus interest (over $7MM in interest in our example buy yr. 5).

• Does not have to pay tax on sale.• Can receive lump sum for balance at time of

bank refinancing during year three or four.• Remains on the board of directors.• Remains as an officer.• Possible incentives for growing the company

via cash based incentives.


SELLER’S RESULTS

• Can be paid more quickly due to Company paying less tax for “C” corporation or NO tax for “S” Corporation.

• Continuity of transition.• Has Mgt. buy-in from day one.• No P.E. involvement.• Seller is a more flexible lender in case of

economic downturn.


FOR MANAGEMENT

• No down payment, no guarantee on loan.• Ownership in the ESOP as participants.• No P.E. group on board of directors.• Continuity of Mgt. position\board representation.• Clear understanding of process on day one.• Can earn additional equity via synthetic equity.• Increased compensation under “cash-based”

incentive plans.• Will accumulate more equity value in the ESOP

than with MBO.


CONCERNS FOR ALL

• 100% of excess cash flow is used to pay debt not grow the Company.

• Company must set aside money to meet repurchase obligation on ESOP stock

• Seller in control longer 5 yrs. vs. 3 yrs.• At the end of 5 yrs. Company still has

$17MM in total debt.• Shareholders’ Agreements?


CONCERNS FOR ALL

• Owner motives outweigh Management motives.

• Stock in ESOP allocated based on payroll (no extra management incentive).

• Administrative requirements of managing ESOP.

• Trustee of ESOP has some say in Mgt.


Contact Information

Sam G. Torolopoulos, CPA/ABV, ASA 1674 Keller Parkway, Suite #140. Keller, Texas. 76248 214-920-1616, fax 214-920-1617 [email protected]

Web Site:www.aticg.com

transferring a business to key employees

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