MBBI ESOPs in a M & A World

1. MBBIESOPs in a M & A World October 9, 2012 Tim Regnitz Vice President SES Advisors www.sesadvisors.com Ken Serwinski CEO Prairie Capital Advisors, Inc. www.prairiecap.com

2. What is an ESOP?

3. ESOP Transaction Basics

4. There Are a Few ESOP Quirks

5. The Money in Motion… at Closing

6. The Money in Motion… Over Time

7. C - Corporation

8. S - Corporation

9. Determining Value in the ESOP World

10. Why Private Equity Should Consider ESOPs

11. Private Equity & ESOPs • Motivating factors • Many portfolio companies have strong cash flows and strong management teams, but lack a clear exit strategy • An IPO is often unlikely and the M&A market may not be as promising as anticipated at the time of investment • Untimely exit strategies can begin to weigh down the IRR of the fund • In the right situation, an ESOP can be the best possible exit strategy for the fund’s return, the company, the management team, and the employee base • Tax Exemption – 100% S-Corp ESOPs • A 100% S-corporation ESOP is exempt from federal income taxes • This tax exemption significantly increases a company’s cash flow, shortens payback period of the debt, and in turn, lowers the risk associated with the transaction and the company • Beyond the transaction debt, 100% S-corporation ESOPs continue to be tax exempt, with the potential of becoming a cash cow, making it more competitive in its markets • The ESOP company has more money to invest in organic or acquisition growth

12. Private Equity & ESOPs • Look inside your portfolio... • A company that consistently generates quality cash flows • A company whose growth rates are not as robust as projected at the time of investment • Companies who have been to market one or more times and have been unable to find an appropriate third-party buyer • Capable and seasoned management team interested in the buyout and running the business on their own • A company that pays a substantial amount of federal income taxes, which will see cash flows enhanced from the owner being 100% S-corporation ESOP • Additional cash flow can be used for several purposes including assistance in paying off transaction debt • Benefits to the Seller • An ESOP transaction offers the seller the opportunity to control the sale process to a “friendly” buyer and make a good return • The transaction is typically less risky as many of the players involved already have extensive knowledge of the company • The players involved in getting an ESOP transaction done are the sellers, company’s management team, company’s board of directors, the appointed ESOP trustee, and the appraiser • Typically, the board will be controlled by the private equity firm (seller) and will thus control approval of the deal

13. Private Equity & ESOPs • Enhancing returns • The return resulting from the sale of an ESOP is often enhanced by a higher rate of return, which is paid on a seller note • The return is made up in two parts; cash interest payments and warrants/stock appreciation rights (SARs) • It is common for cash interest payments to be kept at a minimum, while the return generated from the warrants is maximized • This is done to create a tax efficient structure whereby cash interest payments are taxed as income while payment on the warrants are taxed as capital gains • Also, the warrants allow the seller to participate in the upside potential of the company that will no longer be paying federal income taxes • For private equity sellers, a high return from seller notes will not only provide a boost to the overall return on the investment, but will also make the ESOP an attractive option when other buyers exist

14. Private Equity & ESOPs • Valuation requirements • ESOP purchases must be valued at no greater than fair market value of the company stock • Determining the value of the company will require an independent valuation firm • The appraiser’s valuation can be used to set the value of the transaction and to assure that an arm’s length negotiation has taken place • Often the appraiser is the only outsider involved in the ESOP process for which transaction insiders need to make a convincing argument to the appraiser for why a particular selling price is appropriate • Given the fair market value requirement, ESOP transactions usually do not exhibit the premiums seen in many IPOs or M&A transactions • When a portfolio company can generate a premium above fair market value, a leveraged ESOP is typically not appropriate as an exit strategy • However, warrants used in the financing of the deal can frequently make up a percentage of the premium that the ESOP transaction does not enjoy

15. Conclusions • Private equity firms can use ESOPs as a viable, internal, ready-made exit strategy for a subset of their portfolio companies • IPOs and acquisitions will always be preferred outcomes, but they are not always viable or available at the desired price • ESOP transactions offer the private equity firm the opportunity to control the sale of their portfolio companies back to the employees who originally grew the company into a successful business • The tax efficiencies will offer enhanced cash flows, which will first assist in paying down transaction debt, and will then go towards growing the business • With management support and enthusiasm, the result can be a successful transaction for all parties involved