Jobs Saved by Hedwin ESOP
April 15, 2004
Congratulations from the Governor
You knew right away that there was something unusual about this ESOP. Arriving to congratulate the employees on becoming a 100% ESOP-owned company were Maryland Governor Ehrlich, the Lieutenant Governor, and numerous state and local government officials. While ESOP proponents might argue that due to the tremendous wealth building opportunities of a 100% ESOP-owned company, a governor should show up every time such an ESOP is formed, the reality is that it may have been the first time in the thirty-year history of ESOPs that this occurred. “We are delighted that we were able to assist the new owners, the employees of Hedwin Corporation, in their purchase of their company,” stated Governor Ehrlich. So what did the Governor do and why did he do it? Why is the Hedwin ESOP a model that may be replicated many times in the future and how did it save 300+ jobs?
Subsidiary for Sale
The story begins several years earlier when Hedwin’s parent corporation, Solvay America , based in Houston , decided that it wished to divest its subsidiary. (Hedwin is a designer, manufacturer and marketer of high performance, specialty industrial containers and liner products sold to many industries.) Late in 2003 a serious buyer emerged. After reviewing financial information and the physical plant, the buyer informed Hedwin President David Rubley, along with the senior management team, to expect significant changes once they had completed the purchase. These changes included moving many jobs out of Maryland , and perhaps out of the country, as well as terminating the company’s defined benefit pension plan. Dave and his senior management team, unwilling to accept these changes, sprang into action. They talked with local, state and national officials to see what assistance might be available. They also talked to their bank who referred them to ESOP Services, Inc., a Virginia-based firm that structures and implements ESOP transactions.
The Offer
The first step was for Dave Rubley to convince the parent corporation to give him sufficient time to put together an offer that would match that of the outside buyer. Dave and his management team were committed to keeping all of the Hedwin jobs in Baltimore and keeping the company’s pension plan in place.
When the parent heard that this would be an ESOP buyout, their response was less than positive. Being from Houston , Texas , one of their initial reactions was “Didn’t Enron have an ESOP?” (They did – a small one.) But through persistence, good communications, and due to the respect that the parent had for Hedwin management, a “stand still” agreement was reached. The agreement specified that the management had until the end of 2003 to complete the ESOP buyout. It was October, and there wasn’t a minute to lose.
Even before the stand still agreement had been reached, Ron Gilbert, the president of ESOP Services, began assembling the company buyout team. When the dust settled the key players consisted of a senior lender, LaSalle Bank, a mezzanine lender, South Franklin Street Partners, corporate counsel, Kirkpatrick & Lockhart, an independent trustee, North Star Trust Company, and financial and legal advisors to the trustee, Willamette Management Associates and Steiker, Fisher, Edwards & Greenapple. RMS McGladrey became the accountant for the soon to-be-formed ESOP Company.
Multi-Investor ESOP Transaction
As stated above, South Franklin Street Partners was the mezzanine investor in the transaction. Their investment was typical of what is frequently found in multi-investor ESOP transactions, mainly an unsecured loan at an interest rate higher than the bank rate, plus a future equity interest in the company in the form of warrants. The transaction also required an investment by management.
Skin in the Game
From the very beginning, management had been advised by ESOP Services that an investment on their part would be required. Management investment typically comes from a variety of sources, including personal funds, IRAs, and/or profit sharing and 401(k) funds. The investment made by key Hedwin management came from several of these sources, and took two forms, equity and subordinated debt. Management would also participate in the ESOP. They had “skin in the game”, which the bankers and investors almost always insist upon.
The Missing Link
Despite the unsecured loan made by South Franklin Street Partners, and a portion of the LaSalle Bank financing being unsecured, there was still inadequate collateral. This is where the state of Maryland , through the Maryland Industrial Development Financing Authority (MIDFA) entered the picture. (Remember that Dave Rubley had worked the phones extensively from the very beginning.) What he discovered was that the state of Maryland has the authority, through MIDFA, to guarantee up to $2.5 million dollars of bank debt under certain circumstances. One of the circumstances is saving Maryland jobs. Since jobs were going to be lost if the outside buyer succeeded, MIDFA sprang into action. In keeping pace with the rest of the buyout team, they completed their work in record-breaking time. The state’s $2.5 million dollar guarantee was the missing link that set the stage for the buyout to be finalized.
100% ESOP
On January 29, 2004 Hedwin employees, through the ESOP, acquired their company from Solvay America (despite the parent’s insistence that closing occur by December 31, 2003, a postponement to the end of January was required and agreed to by Solvay America ). Hedwin was now a 100% ESOP-owned company. The new corporation has elected to operate as an S Corporation. In fact, this was one of the essential ingredients to make the transaction feasible. As a 100% ESOP-owned S Corporation, Hedwin does not pay federal income tax or Maryland state income tax. Money that would have gone to taxes instead is being used to repay ESOP debt, an essential financial ingredient to make the transaction work.
300 Jobs
So now Governor Ehrlich’s enthusiasm, and his spending about an hour with the Hedwin employees on February 20th, is understandable. Because the state of Maryland had the capacity to guarantee $2.5 million of the $17 million dollar transaction, the Hedwin ESOP buyout transaction succeeded, and over 300 Maryland jobs were saved.
Complexity
Why aren’t there more ESOP divestitures of subsidiaries, or divisions of large companies? First of all, the transactions are complex. Without an experienced ESOP quarterback, a banker, an investor, a law firm, an ESOP trustee, advisors and an accounting firm experienced in multi-investor ESOP transactions, the probability of success is reduced. The biggest obstacles however are a lack of a guarantee similar to the one provided by the state of Maryland (most states don’t have the capacity to guarantee debt in the manner provided by Maryland), combined with the lack of parent company understanding and incentives to consider as a first option (as opposed to the last) the use of an ESOP in a divestiture.
Debt Guarantee
The lack of an agency in many states to guarantee a small portion of the ESOP debt has a surprising simple solution. For twenty years the federal government’s Small Business Administration (SBA) has had the authority to guarantee ESOP debt. Yet in that entire time frame, only a handful of ESOP transactions have been accomplished utilizing the SBA guarantee. This is due to two flaws in the legislation, one that has a simple legislative remedy and the other a simple administrative remedy.
The current SBA authorization to guarantee ESOP debt requires that the ESOP be the majority owner. While many ESOPs today are majority owners (the average from The ESOP Association is approximately 70%) many ESOPs start with a less than majority ownership position, and some never obtain majority ownership. (One of the largest ESOPs in the country, Hooker Furniture, owns approximately 33% of the company.) In addition, there is no other requirement under any existing ESOP laws that the ESOP own a majority interest in the company. A minimum ESOP ownership percentage that has been in place for twenty years, and is non controversial, is the 30% ESOP ownership interest required for individuals under IRC 1042, the so-called “tax-free” rollover.
Legislation needs to be enacted that would reduce the requirement for the SBA ESOP loan guarantee to 30%.
Voting Rights
Voting rights required for a SBA ESOP loan guarantee need to be changed so that they are in line with the voting rights of all other private company ESOP participants. The SBA ESOP loan guarantee requirement that ESOP participants vote on all matters subject to a shareholders vote is based on an administrative SBA decision. It was not required in the 1983 legislation allowing the SBA guarantee. This is the only circumstance under current ESOP law that requires private company ESOP participants to vote on all matters. Private company ESOP participants must be giving the right to vote on seven corporate issues, liquidation, merger, recapitalization, reclassification, dissolution, consolidation, and the sale of substantially all of the assets of a trade or business. The existence of the SBA requirement to vote on all corporate matters is one of the major obstacles to its use. Its removal does not require a legislative action.
Lack of Corporate Understanding and Incentive
The remedy here is also straightforward. Many corporations don’t understand the way the ESOP can provide a “win-win” solution for a divestiture, and as stated above, the transaction can be complex. They just sell to the highest bidder, and if they happen to move all the jobs to China that is just the way it works. The solution is to provide corporations with an incentive to sell their divisions or subsidiaries to an ESOP. Suddenly corporations would develop a keen understanding of how an ESOP transaction might work.
“Tax-Free” Corporate Income
The ESOP incentive that addresses this issue directly is to provide corporations with the same tax incentive that individuals have had for the past twenty years. Under Internal Revenue Code Section 1042, the so-called “tax-free” rollover, individuals and partnerships who own stock in privately held companies may sell their stock to the ESOP and defer capital gains taxes. Corporations are excluded from receiving this benefit. Several straightforward changes to IRC 1042 would give corporations an equivalent tax incentive. This benefit, which has been non-controversial for the twenty years of its existence, would be extended to corporations, provided that most of the provisions of IRC 1042 would apply. These would include:
1. The new ESOP-owned company must be privately held.
2. The ESOP must own a minimum of 30% of the new corporation.
3. If the ESOP disposed of its stock within three years, a 10% excise tax would be applied.
4. Because the selling entity is a corporation, it would make the incentive much more appealing if the reinvestment requirement of IRC 1042 was eliminated for corporations. (Under IRC 1042 selling shareholders much reinvest the proceeds of the sale to the ESOP within twelve months in securities of domestic operating companies.)
Several members of Congress have expressed a great deal of interest in co-sponsoring a bill that would “fix” the SBA guarantee, and provide corporations with incentives to divest divisions or subsidiaries to an ESOP. Saving jobs is a highly motivational factor driving their interest. It is the author’s hope that such a bill will be introduced soon, and become a law. Many more ESOPs will be formed as a result, with their proven capacity to outperform their non-ESOP competitors in virtually every category, including job growth. The immediate benefit would be job preservation.
The Hedwin Model
The Hedwin Corporation provides us with an ideal model for future corporate divestitures. Because Hedwin operates as a 100% ESOP-owned S Corporation, funds are available to pay acquisition debt that would have otherwise been used to pay federal or state income tax. The 300+ employees of Hedwin not only kept their jobs, but they now have a direct stake in the equity growth of their company. The ESOP is in addition to their defined benefit pension plan, which management maintained as they promised they would, and a 401(k) plan.
Governor Ehrlich has good reason to be enthusiastic, as do the management and new employee-owners of the Hedwin Corporation.
Ronald J. Gilbert is President of ESOP Services, Inc., a firm specializing in the design and implementation of Employee Stock Ownership Plans. Mr. Gilbert is a member of the board of directors of The ESOP Association, a member of three ESOP company boards, and is co-author of Employee Stock Ownership Plans: ESOP Planning, Financing, Implementation, Law & Taxation. The 2004 update will be published later this year by the Beyster Institute. Prior to co-founding ESOP Services, in 1984, he was Vice President with Kelso and Company. He has written numerous ESOP articles and is a frequent speaker at ESOP seminars. He most recently made a joint presentation with Beyster Institute Vice President David Binns on the subject of ESOP Privatization to a World Bank – IMF – Brookings Institution Conference.
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