Thursday, January 28, 2016

A Solution for Closely Held Banks

If you are a family bank and want to sell your shares without selling the bank, what do you do? So was the question that my colleague, Sharon Lorman, put to me in my firm's very first podcast edition of This Month In Banking (follow link to listen!).

The question is not for family banks alone. But all banks that are privately held or have one or a few very large shareholders. How do those shareholders exit if they need liquidity for whatever reason?

This month, Old Fort Banking Company in Tiffin, Ohio gave us an answer... form an Employee Stock Ownership Plan (ESOP). Old Fort, founded in 1916, was run for generations by the Gillmor family. Dianne Gillmor Krumsee is the current Chairman. Looking to divest a portion of her stake, the bank's CEO, Mike Spragg, proposed establishing an ESOP to buy $15 million of her shares and therefore preserve its independence and the Gillmor family legacy.

An ESOP is a trust that is a qualified retirement plan designed to provide employees with an ownership interest in their company by investing primarily in stock of the employer. The ESOP is funded with tax-deductible contributions by the employer in the form of company stock, or in the case of the Old Fort ESOP, with cash that was used to purchase company stock. In this case from its Chairman. The bank's press release did not specify if the ESOP was leveraged, meaning it borrowed to fund the purchase. My guess is that it was leveraged with a loan from a financial institution or Ms. Krumsee herself. Either way, Old Fort would have likely secured the loan.

The bank can then make tax-deductible contributions to the ESOP to service the loan. As the loan is repaid, shares held by the ESOP are released and allocated to employee accounts.

Their may be tax benefits to the selling shareholder. According to Internal Revenue Code Section 1042, an owner of a closely held C corporation can defer, and potentially eliminate, all state and federal capital gains taxes on their sale of stock to an ESOP. This is done by reinvesting the sale proceeds in a Qualified Replacement Property (QRP) within 12 months of the sale. Don't take my word for it. Check with your tax adviser. That's another test I didn't take.

Chase has an excellent ESOP primer that I checked out for this post. Check it out for more information.

The benefits of an ESOP go beyond tax benefits for the seller and independence for the bank, in my opinion. Studies show that employees with ownership stakes in their companies tend to run the companies better... i.e. they perform better. A recent FDIC analysis concluded this. 

Indeed, I checked all the Sub S banks in the US, which are mostly closely held banks with significant employee and family ownership, for their financial performance. The table represents my findings.

For its part, Old Fort had a 2015 ROA of 0.96% and ROE of 10.90%. Not too bad for a $475 million in asset bank. By comparison, FirstMerit, also of Ohio, had a 0.91% ROA and a 7.90% ROE for the same period. Oh, and FirstMerit is $25 billion in assets. And just threw in the towel by selling to Huntington Bancshares (ROA: 1.01%, ROE: 10.60%, Total Assets $71B).

The twist for Old Fort, is the $15 million share purchase represented a 45% stake in the bank, which required the ESOP to apply to be a bank holding company. Which it did. And apparently succeeded, because the transaction closed last month.

Well done to Ms. Krumsee, Mr. Spragg, and all the employee-owners at Old Fort Banking Company for executing on an idea to perpetuate the family involvement, provide liquidity, and keep their well-run bank independent.

~ Jeff

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