Easy as Pi

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Many of the ESOPs I have worked on over the past 25-plus years have been about as “easy as pi.” For those of you who, like me, slept through algebra class, here is how Wikipedia defines “pi.”

“Pi is a mathematical constant whose value is the ratio of any circle’s circumference to its diameter in Euclidean space; this is the same value as the ratio of a circle’s area to the square of its radius.”

If you have no idea what that means, welcome to the club. Unfortunately, some ESOPs are about as difficult to understand and implement as pi. However, there are some that are relatively simple and straightforward – as “easy as pie.” The first case study I will share is about one of the easiest, most pleasant ESOP experiences I’ve ever had.

The story begins with my client being invited to the headquarters of one of his competitors. The competitor was interested in purchasing my client’s Company and during this meeting offered to pay $25 million for the Company. The CEO of the target company asked the potential purchaser about the terms of the purchase. When the purchaser said “cash at closing,” my client was shocked. The purchaser wasn’t much bigger than my client. My client asked how they were going to be able to borrow $25 million to purchase his Company. What the purchaser said intrigued my client.

The would-be purchaser said that several years ago their company had become a 100% ESOP-owned S corporation. As a result, the company operated as a tax-free entity. Neither the company nor its shareholders paid tax on the company’s earnings. The potential purchaser had “banked” its tax savings and had created a “war chest” that it could use to make acquisitions.

My client’s CEO politely thanked the potential purchaser, said he would consider the offer and get back to him with a decision. However, on the plane ride home, the CEO declared that they were not going to sell to the competitor. Instead they were going to do what their competitor had done. They were going to become a 100% ESOP-owned S corporation.

The next week, I got a call from the Company’s CFO. He said that a few years prior he had attended a seminar at which I had spoken on ESOPs. He had kept the handout materials with my name and phone number and said that he would like to meet to discuss their situation.

There are a couple of reasons I consider this ESOP experience “easy as pie.” The first is that the executives who run this Company are some of the nicest, smartest and most competent business owners with whom I’ve ever had the pleasure to work. The second reason is that all of the numbers just fell into place, as I explain below.

The three owners would be selling their S corporation stock to the ESOP for $25 million. (Note that this is the same amount the competitor had offered.) The annual debt service on the ESOP loan would be $4.5 million. The next chart illustrates how the Company would come up with the $4.5 million per year it would need to service the ESOP debt.

Pre-ESOP Post-ESOP Savings
Shareholder Comp $4,045,296 $ 800,000 $3,245,296
Rent to Related Parties $ 1,164,677 $ 679,710 $484,967
401 Match $147,000 $0 $147,000
Miscellaneous $216,000 $0 $216,000
$4,093,263

 

The “shareholder comp” line shows that the total compensation of the Company’s two top shareholders before the ESOP (“pre”) was $4,045,296. One of the shareholders was age 64 and would be retiring coincident with the establishment of the ESOP. The other major shareholder (age 52) would be reducing his base salary to $400,000 per year and would have the potential to earn an additional $400,000 in bonuses and long-term incentive payments if the Company hit its financial targets each year after the ESOP was established. This “shareholder comp” line assumes the maximum annual payment to the shareholder.

Prior to establishing the ESOP, the Company matched employee 401k contributions dollar for dollar capped at $750. When it established the ESOP, the Company suspended its 401k contribution, saving the Company $147,000 per year. (More on this later in the case study).

The Company had other miscellaneous cost savings totaling $216,000. This included items such as “excess” travel and entertainment, “excess” club dues and related expenses.

As I said above, one of the reasons this case was so easy is that “all the numbers just fell into place.” What I meant by that should now be obvious: The cost savings associated with the ESOP ($4 million) paid 88% of the ESOP’s annual debt service of $4.5 million. This left the Company with an incremental cost to do the ESOP of $500,000, which was just over 11% of the Company’s pre-tax income. Therefore, this Company was able to do an ESOP without it having a meaningful impact on the Company’s profitability or cash flow.

Let’s get back to one of the points I mentioned earlier. I said that when the company established the ESOP, it suspended its contribution to its 401k plan, a very common practice. However, as explained later, the Company contribution to the ESOP will be $1.25 million per year, nearly 10-times more than its 401k contribution.

Since the Company wanted to continue to provide a strong incentive for its employees to contribute to the 401k on a pre-tax basis, the Company used a portion of its annual contribution to the ESOP as a match on employee contributions to the 401k. The 401k plan was mended to state that employee contributions to the 401k plan would be matched with contributions to the ESOP. The matching formula would be: Every $1 of cash employees contribute to their 401k will be matched with a $1 contribution of stock to their ESOP account. This is the same contribution formula that was in place before the ESOP but there are two important differences.

First, there is no cap on the ESOP match – there had been a cap of $750 on the 401k match. Second, the 401k match cost the Company $140,000 per year of cash. The stock match in the ESOP produced no Company cash cost. The Company would be contributing $1.25 million to the ESOP to service the ESOP Inside loan each year. This would result in the same amount being contributed (or allocated) to participant accounts. The only question would be how the $1.25 million would be divided among the participants. In this case the ESOP Trustee first used a portion of the $1.25 million as a match on employee 401k deferrals. The remainder would then be divided among the employees on a “salary ratio” basis. The next two charts illustrate these points.

SALARY RATIO ALLOCATION

Sample Employee’s W-2       $       30,000

Total Co W-2’s          $18,000,000        = .16%

 

In the above example of a salary ratio allocation calculation, we assume a sample employee with wages of $30,000, which equal .16% of the Company’s total wages ($18 million). Therefore, this employee is entitled to a salary ratio contribution of .16% of the $970,000 value of shares available for allocation after the match. This will result in this employee receiving a salary ratio allocation of $1,552. (Please note that for illustrative purposes we have rounded numbers. This would not be done in the plan administration process.)

Assuming this employee contributes 4% of his pay to the 401k, his total Company paid retirement contribution for this year would be $2,752, calculated as follows.

Employee 401k Contribution               =             $1,200

Company Match @ $1 per $1              =             $1,200

ESOP Salary Ratio Contribution          =             $1,552

This employee’s total retirement plan contribution for the year will be $3,952. He will contribute $1,200 and the Company will contribute $2,752.

Many ESOP advisors focus only on the benefits ESOPs provide to selling shareholders and to the companies that sponsor the plans. However, as can be seen from this case study, ESOPs also provide very generous retirement benefits for the sponsoring company’s employees. The next chart compares a typical rank-and-file employee’s annual retirement plan contributions before and after the Company established an ESOP.

Pre-ESOP                                                                     Post-ESOP

$ 750              Employee 401k Contribution         $1,200

$ 750              Company Match                                 $1,200

$ 0                 ESOP Contribution                             $1,552

$ 1,500          Total Retirement Savings                $3,952

5%                  Savings as % of Pay                             13%

 

Prior to the ESOP, this employee contributed $750 to the 401k plan so that he could receive the maximum company matching contribution. After the ESOP was established and the $750 cap on the Company match was eliminated, the employee contributed 4% of his pay ($1,200) to the 401k Plan. It was matched with a $1,200 stock contribution to his ESOP account. Many of this Company’s employees increased their 401k contributions which resulted in the Company matching contribution doubling from $140,000 to $280,000 per year.

The results for this Company’s employees are typical for ESOP companies. Non-ESOP companies, on average, contribute 4% of employee pay to the company’s retirement plan. ESOP companies, on average, contribute 10% of employee pay to the company’s retirement plan. This is why we say that ESOPs benefit all of their constituencies, including the sponsoring company’s employees.

One final point on this case study: Many times the terms of the Inside Loan (between the company and the ESOP) are identical to the terms of the Outside Loan (between the bank and the company). This Case Study illustrates a situation where there was a difference between the loans.

The terms of the Outside Loans were as follows:

Outside Loan     $25,000,000

– Bank Loan        $15,000,000        5 years

– Seller Notes    $10,000,000        Years 1-5 interest only

Years 6-10 principal & interest

The Outside Loan was structured so that it would be fully paid over 10 years. The Selling Shareholders received $15 million the day the sale to the ESOP was closed. They received interest on their Seller Notes while the bank loan was being repaid and received payments of principal and interest in years 6-10.

The Inside Loan repayment was 20 years, twice as long as the Outside Loan. The reason for this mismatch is that the Inside Loan determines the number of shares that will be allocated (contributed to employees’ ESOP accounts) each year. In this particular case, paying off the Inside Loan over 10 years would have resulted in employees receiving an ESOP contribution equal to 18% of their pay. By stretching the Inside Loan over 20 years, employees received an ESOP contribution of 9% per year. While this Company wanted to make a generous retirement plan contribution for its employees (9% is more than twice the national average company contribution to a retirement plan), it felt that an 18% contribution was excessive.

The chart below illustrates the annual cash flow to service the mismatched Inside/Outside Loan for this particular Company. For the sake of simplicity, I have used round numbers.

In Step 1, the Company makes a cash contribution of $2.3 million to the ESOP trust (ESOT). In Step 2, the ESOP uses that cash to make a payment on the Inside Loan of $2.3 million. This payment consists of principal and interest on the loan. This Inside Loan payment results in a release of shares from the ESOT’s suspense account. Since the Inside Loan is for a period greater than 10 years, the “principal and interest” method for calculating share release must be used. This results in 5% of the shares being released from the Suspense Account and those shares being allocated to participants’ accounts. The value at which those shares are released is the price the ESOP paid for the shares – in this case $25 million. This results in shares having a value of $1.25 million being allocated to participants’ accounts.

The following illustrates the calculation in determining the shares released from the ESOT Suspense Account using the Principal and Interest method.

Total P&I Over Life of Loan                          $46,000,000

This Year P&I Payment                                  $  2,300,000

Shares Released                                                   .05 (5%)

In Step 3, the Company pays the amount due under the Outside Loans to the Outside Lenders – the bank and the Selling Shareholders.

As you will note, the $2.3 million annual contribution to the ESOP and payment on the Inside Loan is just over 50% of the amount due in Bank Company $3.5M $2.3M Selling Shareholders ESOT Suspense Account Stock Allocations ESOT Employees Account 1 $2.3M 2 23 $1.0M annual payments on the Outside Loan ($4.5 million). If this Company had not become a 100% ESOP-owned S corporation, this could have been a problem. The problem would result from the fact that the Company would only get a tax deduction of $2.3 million (the payment on the Inside Loan), while it had a total annual ESOP cost of $4.5 million. However, as a 100% ESOP-owned S corporation, the mismatch of cash flow and tax benefits was immaterial since the Company will operate as a tax-exempt entity.


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