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The 2004 Technical ESOP Conference November 4 & 5, 2004 PowerPoint Presentation
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The 2004 Technical ESOP Conference November 4 & 5, 2004

The 2004 Technical ESOP Conference November 4 & 5, 2004

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The 2004 Technical ESOP Conference November 4 & 5, 2004

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  1. The 2004 Technical ESOP ConferenceNovember 4 & 5, 2004 Innovative ESOP Transactions Scott E. Adamson Morgan, Lewis & Bockius LLP300 South Grand Avenue, Suite 2200 Los Angeles, California 90071-3132 Phone: 213-612-7365 sadamson@morganlewis.com Louis H. Diamond Buchanan Ingersoll PC 1776 K Street, N.W., Suite 800 Washington, D.C. 20006 Phone: 202-452-7950 diamondlh@bipc.com Jared Kaplan McDermott Will & Emery227 West Monroe Chicago, Illinois 60606-5096 Phone: 312-904-6955 jkaplan@mwe.com

  2. Innovative ESOP Transactions • Using qualified plan assets to fund a non-leveraged S-corporation ESOP • The CRT combined with an ESOP • Convertible preferred and super common stock • ESOP in conjunction with an LLC • S Corp. converted to C Corp. followed by §1042 tax-deferred transaction • Investment in synthetic equity

  3. Parent401(k) ESOP/401(k) Bank OtherInvestors Case 1: Using Qualified Plan Assets to Fund a Non-Leveraged S-corporation ESOP Parent Company A Transaction Steps • Company B adopts an ESOP • Company B employees transfer 401(k) accounts to Company B ESOP • Participants in transferred 401(k) accounts elect to liquidate investments and invest in Company B through ESOP • Senior and subordinated debt are raised, if necessary • Company B elects Subchapter S status • Company B ESOP purchases Company stock with proceeds of liquidated 401(k) accounts, senior debt, and subordinated debt Cash Assets / Cash SubsidiaryCompany B Stock Cash Debt Cash SubordinatedDebt Cash

  4. Case 1: Using Qualified Plan Assets to Fund a Non-leveraged S-corporation • ESOP purchase for no more than fair market value • Third party standard • All transaction elements (warrants, etc.) considered • Financial feasibility • Leverage and debt service • Repurchase liability • Operating cash flow needs • Subchapter S benefits • Refinancing possibilities • Synthetic equity • Repurchase liability • No unallocated shares • Recycling of shares through plan • Company involvement in internal market

  5. Case 1: Using Qualified Plan Assets to Fund a Non-leveraged S-corporation ESOP • Federal and state securities law • Available SEC registration exemptions • Employer vs. employee sourced funds • Rule 701 • Regulations A and D • Private placement memorandum or registration statement • State "blue sky" laws • Fiduciary issues • Trustee role • Information for employees • Trustee responsibility for employee choice • Employee meetings/ "dog and pony" show • Internal market • Give employees right to purchase stock using 401(k) contributions to KSOP • Match 401(k) contributions with stock

  6. Case 2: CRT Combined with an ESOP • Definition of Charitable Remainder Trust ("CRT”) • Trust with charities as beneficiaries • Corpus distributed to chosen charities at end of trust term • Donor receives income interest during donor life • Other aspects • Donor receives charitable deduction for stock contributed • Donor controls trust investments • Replenish estate with last-to-die insurance

  7. CRT FLP Case 2: CRT Combined with an ESOP $10,000,000 51% $5,100,000 $1,900,000 49%

  8. Case 3: Convertible Preferred and Super Common Stock • Company recapitalizes and exchanges special class of stock for common stock • Shareholder sells special class of stock to ESOP • Convertible preferred • Super common • Most effective in sales of minority interest in company • Stock must be a qualifying employer security • Readily tradable common stock • Stock having highest voting and dividend rights • Preferred convertible into best common

  9. Case 3: Convertible Preferred and Super Common Stock - Structure ESOP • Shareholder exchanges existing common for new security in recapitalization • Company borrows funds (if necessary) and relends to ESOP • Shareholder sells preferred stock or super common to ESOP Converrtible Preferred/ Super Common Cash Shareholder Company Converrtible Preferred/ Super Common Common Stock

  10. Case 3: Convertible Preferred and Super Common Stock - Issues • Valuation • Stock valued according to its rights • Value of stock is sum of: • Present value of "preferred" dividend, plus • Value of underlying common stock • "Preferred" dividend often limited in term • Stock may be callable, further limiting value of dividend • Portion of value of stock attributable to "preferred," dividend declines over time • Match "preferred" dividend to ESOP debt service • Tax issues • Convertible preferred - creation of §306 stock • Super common - fast pay considerations

  11. Case 4: ESOPs in Conjunction with an LLC • Create LLC owned by ESOP company • Company can raise capital by selling LLC units • Can structure units to meet investors' needs • Maintain Sub S status • Characteristics of an LLC • Pass through entity for tax purposes • No limitations on rights and terms of ownership interests • No limitations on number or type of investors • Anti-abuse S Corp. rules

  12. Investor Investor Partial Ownership Partial Ownership • Limited LiabilityCompany • Operating entity • Limited LiabilityCompany • Operating entity Case 4: ESOPs in Conjunction with an LLC - Structure • Company assets are contributed /sold to a newly created LLC. • Workforce continues to be employed by the Company and is leased to the LLC. • Company raises capital by selling LLC interests • Alternatively, shareholder could swap ownership in Company for interest in LLC • Anti-abuse S Corp. rules must be considered ESOP 100% Ownership • Company • Employs workforce • Leases employees to LLC Majority Ownership

  13. Case 4: ESOP / LLC Transactions- Issues • Valuation and Financial Considerations • Value of LLC units sold • Fairness and adequate consideration • Returns relative to other investors • LLC solvency • Cash flow between LLC and investors, including ESOP • Tax considerations on transfer of assets to LLC • Potential tax leakage • Fiduciary Considerations • View ESOP transaction and LLC transaction as one integrated transaction • Prudence • Financial fairness • Corporate governance • Qualifying employer securities • Securities laws

  14. Case 5: S Corp. Converted to C Followed by §1042 Tax Deferred Transaction • S Corp. companies may elect C Corp. status prior to ESOP transaction • Achieve §1042 transaction for shareholders • Must remain C Corp. for five years • Maximize tax benefits for S-corporation years • Adopt ESOP on 12/31 of year 1 • Receive extension of tax return until 9/15 of year 2 • Maximize ESOP contribution as of 9/15 of year 2 (attributed to year 1) • Maximize ESOP contribution as of 12/31 of year 2 (attributed to year 2) • Elect C Corp. status on 1/2 of year 3 • Minimize tax liabilities for C-corporation years • Maximize ESOP contributions • Maximize dividends • Financial and valuation effects • Significant shareholder S Corp. tax deductions achieved attributable to years 1 and 2 • ESOP funding implemented

  15. Case 6: Synthetic Equity in ESOP Transactions • 100% S Corp. owned by ESOP is desired • Must purchase shares of non-ESOP shareholders, who may desire an equity-like investment in Company • Non-ESOP shareholders' investment options • Subordinated note • Cash • Warrants • Combination • Consider shareholder tax consequences • §1042 treatment, including basis rollover • Capital gains • Installment sale • Fiduciary issues • Value of securities, particularly warrants • Relative returns

  16. ESOP 100% Ownership Company Case 6: Synthetic Equity - ESOP Transaction Structure Shareholder Receives Cash, Notes, and/or Warrants • Transaction Steps • Shareholder sells existing stake in Company for some combination of notes and warrants. Shareholder could also receive some cash, if desired • Company must raise cash if cash is part of transaction • Structure of notes and/or warrants to be determined Cash, Notesand/or Warrants Shareholders Stock

  17. Case 6: Synthetic Equity - Issues • Subchapter S / ESOP abuse legislation and regulation • Background • IRC §409(p) • New §409(p) temporary and proposed regulations • Nonqualified deferred compensation arrangements • Financial and valuation aspects • Increased company leverage • Enable retention of Subchapter S benefits in company • Practical limits on amount of warrants based on relative fair market and economic values of stock vs. warrants • Future funding needs to "cash out" warrants • Structure of warrants to retain S Corp. election • S Corp. requirements • Fair market value exercise price • Puts/calls may be necessary