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When a company needs to raise capital, corporate counsel must be able to present a variety of creative options to management. One exciting yet often overlooked option is an employee buyout. Although it involves an ordinary sale of assets or securities, an employee buyout involves an unusual type of purchaser. Employees are often overlooked as a potential acquirer, although the company could benefit significantly in terms of employer-employee relations, community relations, corporate control, and most important, tax savings not available for other purchasers. Here are some of the major issues associated with employee buyouts. When a company sells all of its shares or assets to its employees, management becomes a co-owner with the employees only to the extent of management’s contribution from personal funds. The motivational benefits are measurable. A study conducted at Rutgers University in 2000, looking at employee stock ownership plans between 1988 and 1994, found that ESOP companies grew about 2.4 percent faster than they would have without an ESOP, in terms of sales, employment, and sales per employee. Alternatively, the owners of the company can, of course, choose to sell a percentage of the company to the employees. This arrangement has the advantage to the owners of allowing them to keep an ownership interest, which may increase in value, while creating an atmosphere of mutual interest with the employee-owners, reducing or eliminating the “us vs. them” atmosphere in corporate operations. An employee buyout can be structured to purchase any amount of an existing company. Commonly, a company will sell a division or a manufacturing facility to the employees working in it, rather than shutting down or spinning off underperforming or undesirable assets to a competitor. Those employees will often operate their newly separated division or facility as a new, unrelated company. This type of “corporate divestiture” works well when employees believe that they can take ownership in the newly divested company and continue to use their collective knowledge and experience to run the new company effectively. The ESOP may need to borrow funds to acquire the target (a leveraged ESOP), or the entity to be wholly owned by the ESOP may need to borrow funds (a leveraged buyout by an ESOP). FEASIBILITY STUDY Employee buyouts are multidisciplinary, involving issues for lawyers specializing in securities, tax, Employee Retirement Income Security Act (ERISA), and mergers and acquisitions law. And sometimes the Securities and Exchange Commission requires filings to be able to sell stock to employees. As a consequence, transactional costs can be very high. Corporate counsel should first have a feasibility study done to determine the value of the assets to be sold; how much interest there is among employees; how much capital the employees can raise; the effect of the transaction on net income; and the effect of the transaction on corporate governance, including such issues as who will represent the ESOP and what role the ESOP will have in empaneling a board of directors. Proceed with extreme caution in attempting to gather information about employee interest in a buyout. Making representations about the possible sale of a company interest may violate the SEC’s prohibition against “gun-jumping,” or prematurely issuing securities. Under Section 5 of the Securities Act of 1933, the general rule is that the issuer of securities must register the offering by filing a registration statement on Form S-1 with the SEC. The act also requires that the company distribute a prospectus to actual or potential securities purchasers. The cost of this process may deter employees from pursuing a buyout. There are small but notable exceptions to the registration requirement, which your company may wish to explore. Section 4(2) of the Securities Act of 1933 is usually referred to as the private placement exemption. The SEC and the courts have interpreted the exemption to be available for offerings conducted in a nonpublic manner, involving sophisticated offerees and purchasers who have access to or are provided the same kind of information that a registered offering would provide. The sophistication level of both the offerees and the purchasers is important in determining the availability of this exemption. Because of the difficulty in determining whether the private placement exception applies, the SEC decided to provide clearer guidelines by adopting Regulation D Rule 506, which provides a “safe harbor” under Section 4(2). Very small issuers may be exempt under SEC Rule 504, which has very strict limitations. TAX ADVANTAGES Perhaps the most important benefit of an employee buyout is the possibility of creating a tax-invisible entity. In 1997, legislative reforms enabled an ESOP to own S Corporation stock. Because an S Corporation is a form of “pass-through entity,” the portion of its income allocated to an ESOP is not subjected to an income tax. That income will, however, be taxable for the ESOP’s participants when it is distributed to them. On the other hand, income tax will not be imposed on the employee for employer contributions, including matching contributions of company stock to 401(k) plans. Income tax will be assessed, however, when the employee receives the benefits of stock ownership, unless those benefits are rolled over into another benefit plan. Corporate counsel for small enterprises should also be familiar with the Economic Growth and Tax Relief Reconciliation Act of 2001, which imposes a limit on the fractional share of the company that the largest shareholder may own in an S Corporation ESOP. ERISA AND EMPLOYEE ISSUES ESOPs are subject to ERISA, like all other “qualified” employee benefit plans, such as 401(k)s. ESOPs can be combined with 401(k) plans, providing deferral of tax obligations to the employee-shareholders. Employer contributions of stock are tax deductible to the ESOP company. Counsel will face a number of employment-related issues in structuring an employee buyout, most notably ERISA compliance and ESOP diversification issues. A number of threshold issues must be considered, such as how the ESOP will be administered, employee coverage and contribution issues, and distribution issues. For almost any capital-raising exercise, the employees of the company may be willing to participate as a bidder or purchaser. If an employee buyout can be structured, the dividends for both the company and the employees are manifold. Reportedly, employee-owned companies are more productive and grow faster. Also, having employees as shareholders helps to align their objectives with those of management. Most important, employee buyouts also present an opportunity for appreciable tax benefits for both the seller and the purchaser. For corporate counsel, this option is worth considering when devising strategies to divest the company of assets or a division, to sell the company, or to raise capital. Manik K. Rath is vice president and associate general counsel for the Alion Science and Technology Corp., based in McLean, Va., with major offices and laboratories in 35 cities worldwide. Alion recently completed a $130 million employee buyout of assets of the IIT Research Institute. Rath can be contacted at [email protected].

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