Employee Stock Ownership Plans ESOP Services, Inc. Copyright 2008 ESOP Services, Inc.

2  Overview  ESOP Uses for Your Clients  The Mechanics  The Advantages  Creating an ESOP  Candidate Checklist ESOPs

3 Overview  11,000 ESOPs in U.S. (10% of private sector)  3,500 majority owned by the ESOP  2,000 are 100% owned by the ESOP  Found in all industries with more than 25% in manufacturing  71% of ESOP’s are in companies with fewer than 250 employees  At least 75% of ESOP’s are or were leveraged, i.e. they used borrowed funds to acquire stock bought by the ESOP  As small as a few dozen employees and as large as 40,000 (Source: The ESOP Association)

4 What is an ESOP? An ESOP is a Tax Qualified, Defined Contribution, Employee Benefit Plan (ERISA) Invests primarily in the stock of the sponsoring company “Qualified” in that sponsoring company and selling shareholder receive various tax benefits Technique of corporate finance May use debt to purchase employer securities

5 What is an ESOP? (continued)  An Employee Stock Ownership Plan (ESOP) is a very flexible financial and equity incentive instrument that uses corporate tax-deductible or tax-free dollars to achieve a variety of individual and corporate objectives, including shareholder liquidity, perpetuation, raising working capital, and charitable giving 5

6  Answers the question, “What are my alternatives for business perpetuation and creating liquidity?”  Sale to Third Party  Merger  Sale to Management  Corporate Stock Redemption  Initial Public Offering  Gift or Other Transfer to Heirs  Wind-Up Business and Liquidate  Leveraged Recapitalization  Sale to Employee Stock Ownership Trust (potentially tax deferred with “tax-free” dollars)  Creates liquidity, in part or whole, enabling the business owner(s) to diversify their portfolios Why ESOPs ? 6

7 ESOP Uses for Your Clients  Provide a market (at fair-market value as determined by an independent appraiser) for partial or complete sale by existing shareholders with “tax-free” rollover treatment if ESOP ownership in a C Corporation is 30% or greater (IRC 1042)  Borrow from a bank, the sponsoring company, or sellers to purchase a block of stock  Make corporate tax-deductible contributions, including loan principal and interest payments via the ESOP (25% of Payroll + C Corporation Interest)  Gain a corporate tax deduction for C Corporation dividends passed through the ESOP to employees, or used to repay ESOP debt (excluded from 25% limit) 7

8  Income attributable to S Corporation stock owned by an ESOP is not subject to federal income tax  Raise working capital (Dilutive)  Charitable giving  Going private  401(k)/ESOP combination plans ESOP Uses for Your Clients (continued) 8

9 The Mechanics Non-Leveraged and Leveraged

10 Non – Leveraged ( 1)Company sets up an ESOP Trust (2)Company makes annual tax-deductible contributions in cash or stock to the ESOP (3)Cash is used to buy stock from current shareholders (4)Shares are allocated to the accounts of eligible employees within the ESOP based on salary (4)ESOP holds stock for employees and annually notifies them of how much they own and how much the stock is worth (4)Employees receive stock or cash after they retire or leave the company, a vesting schedule applies Employees ESOP (1) Company Shareholders 2 3 4

11 Leveraged ESOPs  The ESOP receives a loan and uses the proceeds to purchase stock from current shareholders  These shares are held in trust and are released into employee accounts at a rate corresponding to debt amortization

Lender Leveraged ESOP (1) Lender lends to company (2) Company lends to ESOP (3) ESOP buys stock from existing shareholders (4) Company makes annual tax-deductible contributions to ESOP. (5) The ESOP then in turn repays lender (6) Employees receive stock or cash when they retire or leave (vesting applies) Cash 1 2 Contribution 4 Note 1 Cash Stock 3 Shareholders ESOP Company Annual Payment 5 Note 2 6 Stock or Cash UP-FRONT FLOWS FUTURE FLOWS

13 ESOP Lenders  Owner/Selling Shareholder  Take back a note in exchange for shares  Taxed on principal upon receipt at capital gains and interest as ordinary income (if installment sale treatment is elected)  Advantage: Entitled to higher interest rate; subordinated to bonding company and bank  Disadvantage: 1042 Tax Free Roll over requires proceeds to be reinvested within 12 months  Bank  Loan is to the company which makes “mirror” loan to ESOP  Typically 7 years  Assessment of company credit  Advantage: Selling shareholder ends up with cash up front  Disadvantage: Lenders look to collateralize short fall with proceeds, Bank will not subordinate to bonding company  The Company  Cash rich company can make loan to the ESOP  Advantage; Company repays itself with market rate of interest

14 Perpetuation Planning C Corporation IRC 1042 “Tax-Free” Rollover  Seller can elect to defer gain on C Corporation shares sold to ESOP by reinvesting all or any portion of the sale proceeds in Qualified Replacement Property (“QRP”)  QRP is stock or debt instruments of a domestic operating corporation  QRP must be acquired within 12-months of the ESOP sale (or 3 months before)  After the sale, ESOP must own at least 30% of company

15 * QRP must be evaluated by an experienced investment advisor to ensure compliance guidelines are met. * *Eligible issuer must have: more than 50% of its assets used in the active conduct of a trade or business no more than 25% of its gross income from passive sources Eligible**Not Eligible Common Stock Convertible Bonds Corporate Fixed Rate Bonds Corporate “Floating Rate Notes” Municipal Bonds US Government Bonds Mutual Funds Foreign Securities REITs Bank CDs Qualified Replacement Property General Guidelines*

16 Perpetuation Planning C Corporation IRC 1042 “Tax-Free” Rollover (continued)  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 or any other section 83 transaction, nor from a qualified retirement plan  Seller, certain related individuals, and greater-than- 25% owners generally cannot participate in ESOP allocations  10% excise tax applies if ESOP disposes of stock within three years, except for normal benefit distribution  Above rules do not apply, if seller does not elect the “tax-free” rollover

17 Tax Status Conversion  C to S or S to C  IRC 1042 “tax-free” rollover as C Corporation transaction, then convert to S Corporation  S Corporation convert to C for “tax-free” Rollover – five-year wait to convert to S  100% shareholder approval for S Corporation election

18 Comparison of After-Tax Proceeds 90% 8% 50% 40% 100% 75% 50% 25% 0% IPO Recap Stock Swap ESOP Percent available to invest in diversified portfolio Percent remaining in company stock

19 Assume:$500,000 pretax income 10% growth rate 40% effective tax rate Pretax Income 500, , , , ,050 Tax Savings 200, , , , ,820 Total Tax Savings $1,221,020 = more than 2x’s current income! 100% ESOP – Five-Year Value of Tax-Free Operations By Electing S Corporation Status (The ESOP can own less than 100%, with a proportional reduction in tax-free income.)

20 “Outside” Equity incentives for ESOP S Corporations Attacked! House Ways and Means Committee Proposes Cutback in outside equity incentives (Stock options, Stock Appreciation Rights (SARs), Warrants, Phantom Stock, etc.)  Legislation introduced 10/25/07 by Chair of the House Ways and Means Committee, Charles Rangel [D-NY], has as a so-called loophole closer, a provision that impacts an S ESOP corporation’s granting equity incentives to employees by assessing additional taxes that could exceed 100%.  Existing Structures to be grandfathered.

21 Advantages for the Company  Substantial tax savings (40% to 100%)  Corporate perpetuation  Cash flow increased  Pre-tax dollars repay debt  S Corporation stock owned by an ESOP is not subject to federal tax (California and most states mirror)  Tax-deductible C Corporation dividends  Justifies accumulated retained earnings

22 Advantages for Stockholders  Creates liquidity at fair market value (as determined by an independent appraiser)  Control maintained (if desired)  “Tax-Free” rollover treatment available to sellers in closely-held C Corporation (IRC 1042)  Establishes value and provides liquidity for estate planning  Selling shareholders excluded from ESOP participation can be “made whole” by the corporation (deferred compensation)  Additional equity incentives still available (stock option, bonus, purchase, phantom stock, etc.)

23 Advantages for Employees  Employees share directly in equity growth of company  ESOP employer contributions tend to be larger than profit sharing contributions  Proven motivator and builds unity and team spirit  Retains key employees (25 years of studies)  Accounts accumulate tax-free and are tax-favored at distribution  Employees can realize dividend income  Buy/sell agreements ensure future employee ownership through the ESOP

24 Creating an ESOP Preliminary Analysis  Preliminary Assessment Questionnaire Phase I  Preliminary Valuation  Feasibility Study (“Decision Package”)

25 Creating an ESOP (continued) Phase II ~ Implementation  Plan design  Financing  Employee communication  Repurchase obligation planning/funding  Independent transaction valuation Phase III ~ Ongoing  Administration  Annual valuation  Communications

26 Yes/No ___/___1. The entity is a corporation taxed in the normal manner. Please check type of corporation. "C" Corp. ___ "S" Corp. ___ Professional Corp. ___ ___/___2. The company is closely held, or if publicly traded has a significant concentration of ownership ___/___3. The company has payroll adequate to support an ESOP (Minimum $500,000) ___/___4. The company has a strong pretax, pre- distribution/bonus earnings and cash flow over the previous few years ($1,000,000 +) Is an ESOP Right for You? ESOP Candidate Checklist 26

27 Yes No ___/___ 5. The company expects to have strong pretax, pre- distribution/bonus earnings over the next few years ($1,000,000+) ___/___ 6. The company has paid substantial federal income taxes during the past few years ___/___ 7. At least some stockholders are motivated to sell some stock; e.g., planning for retirement, liquidating an estate, entering a new business venture, children not involved in business, etc. Is an ESOP Right for You? ESOP Candidate Checklist (Continued) 27

28 Yes No ___/___8. If one or more principal executives will be departing in connection with the sale, there is strong management available to take their place(s) ___/___9. The company customarily makes payments to a 401(k) or profit sharing or other employee benefit plan that could in the future be made to an ESOP ___/___10. The owners are psychologically willing to share ownership with their employees, assuming an attractive transaction can be arranged Is an ESOP Right for You? ESOP Candidate Checklist (Continued) 28

29 ESOP Services, Inc. Founded in 1984, ESOP Services, Inc. responds to the needs of business owners to understand and analyze the ESOP’s impact on the company, shareholders, and employees, focusing on the financial aspects of cash flow, tax savings, shareholder liquidity, and employee benefits. We specialize in all aspects of Employee Stock Ownership Plans for both private and public companies throughout the United States and internationally. Our unique approach emphasizes the financial aspects of ESOPs, while coordinating the many diverse elements necessary to successfully establish an ESOP. P.O. Box Albevanna Lane San Diego, CA Scottsville, VA Phone: Phone: Fax: Fax: