EP14 - Interview with ESOP Trustee - Wayne Isaacks from Houston, TX - discussion on ESOPs during the Covid-19 crisis

Welcome back. Thanks for tuning in. I'm the ESOP guy and today we are continuing on this journey to an ESOP. This podcast is for those people that are thinking they might want to consider an ESOP as a growth or succession or even an exit strategy for their business. Going through the process of selling your business to an ESOP can be very daunting and one of the most critical team members along the way is the independent trustee. Today, I'm pleased to be able to interview Wayne Isaacs, who's an ESOP trustee from Houston, Texas, um, who will be able to provide insight from a trustee's perspective. Wayne is a board certified tax attorney and a CPA. He actively works in putting ESOP deals together as an independent trustee, managing the buy side of the transaction, and also has existing ESOP clients. Wayne, thanks for joining us today. I really appreciate you taking time out of your schedule to help our audience better understand the ESOP process. Thanks, Philip. I, I, I appreciate the opportunity to join in here, uh, a couple of preliminary concepts before we dig into it. I, uh, I'm an attorney and a CPA. I've worked with business owners all my life, uh, closely held business owners, and back in 2000, around 2000, uh, it was 1999, but I really got aware of it in 2000. The Scorp ESOP became available where a company could be 100% ESOP owned Scorp would be a tax-free entity. I never cared much about ERISA or working with the ERISA plans up until that point. But then I realized suddenly that this was such a good tax. Advantage, uh, to, to find the money to pay for an ESOP, to pay for the ESOP buyout, that is essentially tax savings would pay it off. I need that, uh, 4 out of 5 of my baby boomer business owner clients would be. Candidates for an ESOP agent strategy, and two or three of them would actually take it. That was before private equity got to be as hot as it is now. So now private equity competes. But, you know, so the issue, so I got involved in doing ESOPs and did a lot of ESOP work starting off as a quarterback, doing feasibility studies and helping my clients implement ESOPs. And then, uh, in 2006, I started working as an independent trustee. Uh, for the ESOP, representing the ESOP as an independent trustee either in a in a transaction or as an ongoing trustee. And the first thing to keep in mind is that there's no law that says you have to be or have to have an independent trustee. You can have an internal trustee in your ESOP, as a matter of fact, probably still today. Most ESOPs are internally trustees, but the ones that get larger, more complexity, uh. Significant number of employees and repurchase obligations on significant transactions. It really makes sense to have an independent trustee both to eliminate liability questions for the sellers and maybe the internal trustee that doesn't feel confident that they can keep up with and not all the knowledge it takes to be an effective independent trustee for the duties that you have. No, that's, that's true. And I like the, the comment on the Scorp is, is great, and I think that's one of the things that gravitated me towards ESOPs as well. It's, it's really gonna be the title for the next, the next podcast is to really dig into that deeper cause when you look at the, the opportunity that an S corporation has to become um a tax-free entity, um, there's nothing like it in the tax code anywhere, so it's, it's tremendous. Um, that's still the biggest secret in America that, uh, that 100%, 100% EO owned Scorp is literally a tax-free entity does not pay. Yeah, I think people sometimes. No, and then when people hear that, they, they don't, if they don't know that when they hear it, they they, they don't believe you and then you have to go through, you know, maybe in the next few steps to convince them, but it's, it's incredible. Um, so, so I know some folks though that are listening are very new to the world and, and. Um, and then others that are listening have a good understanding. Can you in a nutshell explain your role as um the independent trustee in the process of transitioning, um, the company to an ESOP and really from a a where how the trustee works in that in that uh requirements and the requirements of that. So at the fundamental level, the trustee of the ESO's job is to look out for and be totally loyal to the interests of the ESOP participants. So, so that's, you know, we want to protect their interests. We want to make sure that that the ESOP. Functions to provide a retirement benefit for those uh employee participants. So at the very beginning of an ESOP you get stock into the ESOP. It usually gets there either by contribution from the company and stock. Or a purchase by the ESOP of stock either from the company or from a shareholder. And so, so the trustee functions as the ESO's shareholder. So when the ESOP buys stock or, or acquires stock by contribution, it goes into a trust and it goes to The EO Trust, and if I'm the trustee, the trustee actually holds that stock. And acts as the shareholder for the participants, so the participants don't directly own the stock in their name. The ESOP owns the stock and I'm the stockholder for the participants. So then I exercise all the rights and duties of the shareholder that is, I have the right to vote, vote the stock, uh, primarily to elect the board of directors, which gives us our ability to help manage the company or direct who manages the company. And things like whether we're going to sell the company or sell its assets or merge or that sort of thing. So I'm a stockholder for the ESOP. The other thing I do as a trustee, a fundamental duty is I determine the value of the stock. So I had to determine the fair market value of the stock when we buy it. Or when we have a contribution of the stock, I have to make an independent determination with an independent financial advisor independent of the company. To say that we have a fair price in terms and then every year, uh, the stock has to be valued to determine what the value is for the participants and for the eventual repurchase of that stock to pay participants. So we have to have an annual trustee does that. So, uh, so the main duty of the trustee is to act as the shareholder and then the value of the stock. Exactly. And so when it comes into the when when we get into the, the, the ESOP timeline, when we're in the very beginning stages, what's happening is we end up hiring the. to be the independent trustee to manage the transaction. And so that trustee then is responsible to um value what the purchase of that stock is worth at the time of the transaction. And that's, and that's really what Wayne does using a uh a fair market value appraisal by a business appraiser, um, and, and makes his determination on what, on what the negotiated value of the business is at that point in time. Um. Right. And my duty then would also be to negotiate the transaction with the seller, whether it's the company that's selling the stock to the ESO or if it's company shareholders that, uh, they're selling their stock to the ESO one way or the other. My job is to negotiate that transaction and make sure that the terms of the transaction are fair to ESO and there's a price coming to the ESO. So we talk about it as a negotiation. I don't just determine the value and say, you know, this is it, take it or leave it. There is room to negotiate and the seller has to come up with their own concept of what the value. Years ago they used to do a valuation of both the seller and the trustee would use it. Uh, the DOL has considered that a little too clubby. They said, you know, you're really just cooking up a transaction to suit the trust, the seller, so they want the trustee to have an independent determination of value. And this is a lot of reasons why people pick an independent trustee. But, uh, but the seller then should have good advice and good understanding before you ever get to this transaction. And that's what the value of the company is, what they can expect from these transaction. And so that, so that we have a, a fair negotiation. It's just like, you know, my wife is a realtor. When she goes to help somebody buy or sell a house, they don't do it in a knowledge vacuum. The other side knows what houses are worth in the area. They know what a house ought to go for. There may be some, you know, some. Some negotiation, but broadly they're in the ballpark on the value of that house, so we should broadly be in the ballpark the seller and the buyer with a pretty good understanding of the value of the company. And that's, and that's really what, why it's important for the, for the very early on, the seller should have an ESOP advisor, um, constructing the uh a calculation of value and, and, and some type of feasibility so they have a good understanding on their side. Before they get into critical to have an effective transaction. Otherwise things can go haywire. Uh, misunderstand that your costs can go up or you can have a busted transaction. Yeah, yeah, the deal could blow up. So, uh, so looking at that stage of things when the, when the buyer, when the seller is ready to engage a trustee, um, what factors should they look for in evaluating a trustee prior to bringing them into the upcoming transaction? Um, you're both an attorney and a CPA, um, so can you address the, the, also the need for proximity and putting the deals together because it, I know a lot of deals that I work on, there's ESOP professionals all over the country working on them. So kind of two-part question, um, yeah, so what do you want in a trustee? Well, you know, you should meet your trustee. You should interview your trustee. You may not meet him in person. I've been hired a lot from, from a telephone conversation, but But you get a sense that you can work with this person, right? You, you want to know how they approach things, you know, how they explain things to you, how they understand their role, how, how well, well they, they can get across to you if you're the seller of the company, uh, you want to know that the trustee. You can communicate with the trustees. So you want to look for background, the trustee should have a background in these stops. They they shouldn't be, you know, it's best if it's not the first trust EOP they've ever done if you're hiring an independent trustee. Uh, they should have worked or if they've never been a trustee before they should have done. I would say like I did, I worked as an ESOP counsel for years and helped people put EOPs together as a lawyer, CPA, and as a even as a quarterback like, like you do still, but, but so you have experience with ESOPs, otherwise you might as well use your internal trustee and get as much advice as you can, I mean. If you're going to get an independent trustee, they should be knowledgeable and experienced, and you should get a comfort level that you can communicate with them and if they explain things to you and that you understand their role and that you're comfortable with the trustee's understanding of their role, and I'll say the number one thing that business owners who are about to sell whether they're selling a majority interest or a minority interest to the ESOP. They want to know, they want to know how the ESO trustee views managing the company and the first thing I get across to people is the trustee does not manage I've heard that it's a great point because I heard that from a lot of potential clients that want to go to ESOP and they're worried about this trustee managing their business. And, um, and I think it's important. And I think the best advice you have is really interview the trustee, get to know their personality, get to know, you know, the way that, you know, you're gonna, it's like a job interview, you want to kind of get to know what they're gonna say or or how they're gonna perform when you're, when you're working together, um, because once the deal gets going, you're not gonna be able to just disengage. You, it's too, there's too much expense and time put into it. So I think that's yeah, and since I'm an independent trustee and I'm supposed to negotiate a deal for the ESOP. My job is not to protect the interests of the seller, you know, but we don't want to, we want to get along with the seller, but I can't even say I'm trying to get a fair deal for the seller. I know we won't do a deal unless it's fair to the seller because the seller shouldn't do a deal that's not fair to the seller, but so it's necessarily a little bit, you know, we don't have to be adversaries in the sense that we don't get along, but I'm on one side and the seller's on the other side. So, so when I'm an independent trustee and we're gonna, we're going to have a transaction, let's say, to require controlling interest in the company, OK? So a lot of, one of the elements that I'll negotiate for is that the trustee, you have to have an independent trustee for at least 3 years after this transaction closes. That's so that the seller can't. Sell to the ESOP and then replace the trustee with themselves and then really run the company. I mean, really have complete control over the company and the shareholder. So I tell them, it doesn't have to be me, but you have to contractually agree that you're going to have an independent trustee for 3 years. And then I tell them, look, you've hired me for this transaction. I'm giving you a proposal to be your trustee after the transaction. Here's my price in terms. That's provided you still like me. That might not be, you might not get liked the whole time, the whole way, but hopefully we still get along at the end of the transaction, you know, let me know and I'll be your trustee going forward. But otherwise you, you need to find another independent trustee if it's a controlled transaction. So I say all that to say I've always been hired. So far I've always been hired as the ongoing trustee in those circumstances it's close to transit. No, I think that the proof's in the pudding there, but Um, so moving on to the one, I think the one major question that I wanted to get to is, um, And I think it's on everybody's mind right now is, you know, when, when someone, uh, you know, you have someone in a business that's in the middle of a transaction or they're seriously still thinking of going through a transaction when we have so much economic uncertainty in the marketplace. From your perspective, how should they handle that issue? And I know like one issue is they've already submitted forecasts if they're in the middle of the transaction and those forecasts obviously are not going to be probably as accurate now as they would have been earlier. Um, what's your advice on that? You talking about in this COVID? Yeah, I'm talking about all the economic uncertainty of the COVID shut down. That's a real challenge. It's a real challenge to a transaction right now. I don't know any trustees that don't, you know, have a little quivering trepidation about whether they can it's prudent. So trustees are supposed to be prudent. Prudent means cautious. And so can it be prudent to close a transaction in this environment? I'm closing one at the end of the month. But it's with a company that has very stable client base. The projections haven't changed, their backlog hasn't changed their service company. But their client base is municipalities and and large public private or large private. Edities that have long term projects and they haven't had, they had minor, you know, minor pushback on some of their projects. They had new projects come in since we negotiated the deal and we're in the last month. So when I, when we study their situation, nothing bad has happened, and they don't expect anything bad to happen and they're on top of their customers. So we're going to close the deal at a fair price. So it depends on your headlines. What can you tell? I've got another company that I'm trustee for that's in the oil and gas pipeline business. And if we were trying to buy their company today, there's no way we could, we could even say what their projections. Yeah, we can value the company. We can value the company when this is uncertainty. We have to put a value on it, but they're already 100%. If we were buying a stock in this environment, we wouldn't know what, we wouldn't even have a clue how to price it, and it would be so low that the sellers wouldn't sell. So yeah, it's hard to do a deal right now unless you have really stable and and a lot of extra certainty in your output. Yeah, there's just too much inherent risk. With some things and I, and I, and I think it's a good point because I think sometimes it's, you know, it's, it's OK to suspend things and then regroup as things come back together when we have a better sense for the, for what the deal is on hold, we'll look at them again and, uh, you know, we'll look at them every 3 months to see how things are going. People are busy, uh, figuring out how they're gonna do in the next quarter and in 6 months. Yeah, and I think it's, it's about your stability. And one of the things I look at too with that is it's a good, I mean, nobody wanted this to happen, but for some companies that are going through some of sometimes the first challenge ever, it's a good test of their leadership. It's a good test of the, of the stability in their marketplace and where, you know, their ability to move through difficult times. So coming out of this, you know, I think you have, you know, the, the the lemon. Lemonade here with the lemon is like you have this um maybe a stronger business because the management's been through something that's kind of strengthened them as well and and that's, and that's maybe reaching for it a little bit, but I do believe that happens. It happened out of 809 recession and I think it'll happen again here we had that. I've been through all of that and what I'll say is we have some clients that did 100% ESOP became the tax-free S corp ESOPs. It like January December 7 January 8, and over the next two or three years, things fell off very badly. Yep, yep. Two of those companies would not have survived if they hadn't been tax-free ethos because they went a small 11 small one had $2 million in net income for 2007. They had 900,000 net income for 2008. They had 500,000 net income for 2009. If they've been paying income taxes, they wouldn't have survived 208 because they would not have had enough Corp post-transaction. I mean, they wouldn't have enough Corp after tax income to keep to keep the patient alive. Yeah, to pay their bills, yeah, um, to stay alive, yeah, uh, moving into like 11 thought I really wanted to talk about too is negative experiences of these ops and. You know, when you get into some of the complexities of ESOPs, you're going to find there's pitfalls, um, improper evaluations, the 409P, um, disqualified persons, non-discrimination. I mean, and there's a lot because you have, you have ERISA, you have Department of Labor, and you have IRS regulations. Can you comment like on your experience, what's the most common pitfalls you see in putting ESOP transactions together? Yeah, I would say that that common pitfall would be once a transaction, once the seller decides they want to do an ESO, either partial sale or a wholesale to an ESO. You know, the most important thing they need to have is a really good feasibility study, and I don't mean a back of the mass analysis that, yeah, the expected cash flow will pay off the ESOP debt with no tax, you know, after, after the tax improvement, right? I'm talking about, you know, what is the likely. that the projections you're you're using are viable, you know, are, are likely to be sustained to actually achieved. And then, uh, how might you structure your lease out debt in your notes so that if things go up or down, you, you know, you, you may be able to. To, to deal with cash flow, tightness and maybe deferrals and notes, play, play around with it a bit and get a good and get a good understanding of how an EOP appraiser is going to value your company so that and have a good team, uh. Put together to fully analyze your circumstances. You shouldn't have a surprise for that piece. You know, that should all be figured out in your feasibility study. So you need qualified, experienced people. There are some people out there that'll say, oh, you're a candidate for an EOP. Let's just put it together. And they'll take your money and if they take your money and then you get in the middle of it and you find out, you know, no, I didn't understand it that way. I, I want to do it differently or we don't really. said it's got a 409P problem that that really shouldn't happen. Also, the non-discrimination requirements, you can't leave people in or out of the East generally. You can leave unions out, you can leave foreign participants out. You can leave people who are out, that sort of thing. But in general, everybody's going to participate and, and you just need a good run through and a good understanding of your feasibility. Quarterback should fully uh explain the holy circumstance and you got to go through it 2 or 3 times and beat it up to make sure you're not missing. Now it takes, I know it takes for us, it takes a good month or two to get through that whole process because you're You're going through a lot of education with a client where they don't, you know, some are starting at ground zero, they don't even know, you know, anything, and then you go through kind of educating them on the process and I, and I will, I will concur the projections themselves are such a major issue, um, because there's a confusion on, and I, and I did a podcast on forecast because I thought it was very important for people to understand. How to do forecasts. And I, and I find when I do them, I go back and forth with the client a number of times because that is really the centerpiece of everything. If, if those forecasts are pie in the sky, then you're setting them up for failure. And if they, they don't, they don't really know that. And so you really have to lead them through those, um those types of things very well because otherwise, um, you don't want to put someone in a bad position where this is not a, a, you know, they get too far into the ESOP process and then It's either not gonna work, you have a deal that shuts down and um all of those things are, are, are major issues. Yeah, and I can give you a couple of things where we run into, you know, right there at closing, you know. So let's say we're going to value your company, right, still, and we come up with a valuation. Well, my valuation has to be as of the date of the transaction, and that means I have to have gotten my financial advisor to come up with a. You based on the financial statements of the company which were completed 2 or 3 months before the transaction date, right? So then in any private equity or M&A transaction, you have a, there's some things happen from the date of those financial statements, the balance sheet. To the closing, if it's 1 month, 2 months, or 3 months, the company will make or lose money during that period. What happens to that extra money? So a lot of times we have to make sure we structure the deal so that the price is set plus or minus some balance sheet changes like, let's say you make $300,000 since we made our deal at the end of the day of closing, does the ESOP get that money or do you, does the seller get that money? Yeah, that has to be really clear. You don't want to leave that out. And then a lot of people have, uh, they want to get the AAA out if you're already an escort. You know, you need to be very clear on what that is, how you're going to get it out, if you need to get it out, if it's desirable to get it out, how are you going to structure your transaction? And what I've seen is people have understandings maybe with their CPA and what they plan to do, but never put it into the deal. Yeah, no, we, yeah, we, we put that all on the front end in the first phase of the evaluation is analyze AAA. And the other thing we've run into surprises there and some, you know, it, it negotiations, we didn't blow up, but we had to. Well, as a, as a point of advice too we we don't build, we don't do evaluation report at the front we do evaluation. Model that's updable with each month's balance sheet. And I think that's really important because it is, as you said, it's your transaction date that you're buying it at that point. And if you, if your old report saying one thing, you need to, you need to constantly update that as you get closer and closer to the deal. And then the client needs to really understand that as well because there's expectations around that valuation, of course. So, so with that, I know we kind of went a little bit past our normal time. Um, um, I'd love to, yeah, I'd love to do another one because I have some other, other thoughts and questions, but, but for now, I just want to say thanks, Wayne for your insight. I think it was really helpful and, you know, I think with ESOs you could talk about them, you know, really all day, right? Because there's so many things to talk about. Um, but I, I appreciate your insight and I know that for people that are listening to this, I, I think there's a lot of great information here for you and And to take back and for what Wayne is doing, what I like about Wayne is he's, he's very dedicated to the ESOP world and, and, um, with his clients is, he really does put put his best foot forward and trying to help everybody. So, um, so I want to remind you, subscribe to the podcast and share it with a friend and have a great day and we look forward to next time.