By: Robert T. Smith
A recent Wall Street Journal article noted that there were more than 7,400 companies listed on U.S. stock exchanges in 1996 around the beginning of the dot-com fueled bull market. That number has been cut in half through the first quarter of 2018. The reasons for this are numerous, including increased compliance costs and the liberalization of securities laws allowing companies more flexibility to raise capital without public registration. With the reduced number of public company investment options, holdings in private companies have inevitably become a larger share of the investment portfolio of many Americans.
Provided a company has access to sufficient (permanent) capital, remaining private is often the best option for the business. That may not correlate, however, to the needs of the company’s owners. Community banks and other privately-owned companies are routinely approached by shareholders seeking to liquidate all or a portion of their holdings.
With the pressure to provide liquidity increasing, a private firm has several options to consider in making a market for its shares, short of going public. This article discusses alternatives used by privately-held banks as well as non-financial companies to create liquidity for shareholders.
Shareholder Matching Programs
A common practice among Arkansas banks and holding companies is to maintain “buy / sell” lists of shareholders interested in either buying or selling shares of the company. This is a very simple method for the company to assist in maintaining liquidity in its equity. A better market exists, no doubt, the more the shareholder base expands. This is not an issue for many Arkansas banks.
In terms of risk, a bank or other company limits its legal exposure the less directly involved it is in the transaction. We recommend that companies do little more than introduce the parties and avoid handling funds, making recommendations to either side, or becoming involved in price negotiations. The company should also take care to avoid providing special treatment to insiders. Although the board will likely first have knowledge of shareholders interested in selling, the company should ensure that it does not give those individuals a preferential position in a potential transaction.
This alternative is a low risk method of enhancing liquidity for shareholders. Most companies communicate availability of this service in an annual shareholder letter. A shareholder desiring to sell shares can simply contact the CEO and receive names of potential purchasers. The potential seller and potential buyer are then free to negotiate their deal independent of the bank or company.
Private Tender Offer and Share Repurchase Programs
A formal share repurchase or tender offer program is also common as a private company grows and the needs of its shareholders evolve. This is becoming more common for Arkansas banks as their shareholders age and experience heightened liquidity needs. These programs generally take one of two forms, either an open annual offer to shareholders to purchase shares within certain board approved parameters (such as an offer to all shareholders to purchase up to $5,000,000 in shares at book value on a first-come, first-served basis) or a formal tender offer by the company that would typically remain open for only a short period of time, such as a 90-day tender. As between the two, a formal tender offer is viewed as a more proactive approach to providing share liquidity.
Many privately-owned banks adopt annual resolutions specifying a repurchase dollar amount that the bank is authorized to spend on stock buybacks during the year. These programs are discretionary, meaning that the bank or company could suspend its availability at any time, such as where necessary to accommodate cash needs or if the company is engaged in sale or acquisition negotiations.
The per share price will generally be based either on an updated appraisal (if required for an ESOP) or the most recent year-end book value amount.
The primary goal of a repurchase program is to offer liquidity, but some banks have used the program to achieve other objectives. For example, repurchase programs may target a certain group of shareholders for removal, such as out of state owners or those with very small holdings.
Repurchases can be a beneficial use of excess capital to benefit non-selling shareholders as well. These benefits include an increase in book value per share, earnings per share and percentage ownership, and a refocus on the value of holding the stock long-term knowing that liquidity will be available when needed. A routine repurchase program may also result in an increased valuation in subsequent appraisals.
Repurchase programs are common even for smaller community banks throughout the country. Privately held Heritage Bank in Nevada, with total assets of $830 million, recently announced a buy-back program to repurchase up to of $4,000,000 of its shares, representing approximately 5.00% of total equity. Heritage reported having approximately 350 shareholders prior to initiating the stock buy-back.
Similarly, Peoples Trust Company, a $262 million asset bank in Vermont, announced a repurchase of up to $500,000 of its shares. The price was determined based on transactions in the privately held shares in preceding years. The consideration allocated to the buy-back represents approximately 2.00 percent of the company’s total capital.
A purchase commitment of less than 2.00 percent of total capital appears to be a comfort zone for many institutions. When considering the size of potential repurchases in view of the regulatory obligations of a bank or holding company, the institution should consider its ability to continue to satisfy regulatory capital requirements, whether prior approval of the firm’s regulators will be required for a share redemption and whether the transaction could trigger a regulatory application requirement based on the proportionate increase in ownership of non-selling shareholders under the Change in Bank Control Act.
The company must also consider its required disclosure obligations to potential sellers. Because the repurchase involves a securities transaction, the company must determine what non-public information is required to be disclosed to the selling shareholder to satisfy state and federal anti-fraud rules. At a minimum, up-to-date financial information should be provided to the selling shareholder a reasonable period of time prior to closing. Even under the less formal share repurchase programs (as compared to a tender offer), we recommend that the bank adopt a uniform set of disclosures that will be made available to each selling shareholder.
ESOP
An employee stock ownership plan (ESOP) is a powerful and effective tool that can be used by closely held banks and other private companies to address a number of issues. An ESOP when used in the right circumstances can provide several advantages:
Making a Market. Because an ESOP invests in employer securities, it serves as a willing purchaser to create a market in the company’s shares. While ESOPs are routinely used to purchase shares from shareholders, note that a well-funded ESOP may also make direct purchases from the company of newly issued shares.
Tax Advantaged Shareholder Succession. Under what is referred to as a Section 1042 transaction, a selling shareholder (or group of selling shareholders) may completely defer (and possibly eliminate) income taxes on the sale of stock to the ESOP provided that the ESOP owns at least 30 percent of the company’s stock following the purchase. For this purpose, the bank or company sponsoring the ESOP must be classified as a C corporation for income tax purposes.
Employee Benefits. Banks and other companies often times utilize an ESOP as part of an employee’s overall benefits package. Typically, the ESOP supplements an existing retirement plan such as a 401(k) plan to provide a significant retirement plan package for employees.
Tax Benefits to the Company. Most ESOPs are structured as a leveraged transaction in which a loan is obtained by the ESOP (and guaranteed by the sponsor) to purchase stock. The sponsor makes payments (typically on an annual basis) to the ESOP to pay down the loan with those payments being tax deductible at the corporate level. If the sponsor is an S corporation, all pass-through income to the sponsor is received on a tax-free basis. For example, a bank that is 30 percent owned by an ESOP would effectively avoid income tax on 30 percent of its income.
Conclusion
For any private company, maintaining some degree of oversight on transactions in its shares must be of paramount importance. Sales transactions resulting in new ownership whose interest and visions may not align with the company could create significant distractions and other problems. Proactively offering liquidity options to shareholders can be an effective method of encouraging shareholders to first look to the company before considering other sale alternatives.
The information provided above is created by the Attorney Robert Smith in Banking and Finance Practice Group at Friday, Eldredge & Clark, LLP. Robert is a partner in the firm’s Mergers and Acquisitions Practice Group. His diverse corporate practice focuses on representing individuals, companies, and financial institutions in general business, transactional, securities and regulatory matters. He has handled transactions in a variety of industries including the banking, healthcare, real estate and technology industries.
This is not a substitute for legal advice and should be considered for general guidance only. For more information or if you have further questions, please contact one of our Banking and Finance Attorneys.