EP2 - ESOPs for Rollup companies - discussion with Steve Goodman - ESOP attorney from Louisville, KY

Welcome back. Thanks for tuning in. I'm the ESOP guy, and we are continuing on this journey to an ESOP. So this podcast was produced for those that are considering using an employee stock ownership plan in their business, and we have gone through a lot of different episodes and a lot of different interviews. If you are interested in those, please go to our website at journey to an ESOP.com. Today's episode is gonna be titled Roll Up Companies and how they Work for ESOPs. And to do that, we're gonna interview Steve Goodman, who is an ESOP attorney from Louisville, Kentucky. Steve's with Lynch, Cox, Gilman, and Goodman. He's got a master's in tax law from Georgetown. He works with ESOPs all over the country and has practiced in this industry for over 30 years. With that, Steve, I just wanted to welcome you to our podcast. Thank you for joining us today. Well it's my pleasure, Phil. Great. So, so with that, Steve, I'd like to start off with just, I know you've been doing this for a long time, 30 years is a long time. Can you just give us a brief history of, of really how you got involved with doing ESOPs and, and just kind of tell us a little bit about yourself. Well, um, I, I went to Georgetown Law School and got my master's in tax law, and, um, uh, at, at that time, um, I had a couple of courses on, on employee benefit plans, qualified plans at Georgetown, and, and uh all of the tax breaks that were available for uh ESOP companies uh were unreal and you can't find them anywhere else in the Internal Revenue Code. So I said there's this has got to be good and when I started practicing, it was funny because I, I remember going to the managing partner when I first started and said, you know, we're going to end up getting sued for this, and I just want to let you know because this is just too good to be true and uh. And it has really turned out to be quite a, quite a career move for me. No, that's great. So that, I think that's just a part like identifying great opportunities and seeing, you know, how you might guide yourself and you obviously had a lot of vision for that. Um, ESOPs are, as we talked about earlier, there's a lot that have changed over the years and um taking all that experience. One of the things that, that we wanted to talk. about today is just the opportunity to work with different companies, but when you have a company that's rolling up, other companies are merging up, um, it creates a unique opportunity to do an ESOP for a larger entity. So I want to kind of just go through the basics and we'll talk a little bit about how that works in the ESOP world. What is, when we talk about a roll up, um, quote unquote, what is a roll up? Well, um, in the ESOP arena, um, we have certain companies that may be too small to, uh, get involved with an ESOP, you know, they have, uh, um, you know, the cost of having to do the valuation and the, uh, the TPA work, the attorney work, um, uh, the feasibility study, um, the cash flow analysis, all of those costs. Uh, sometimes make it prohibitive for a small company. And so what we found in certain industries, especially industries that have, um, generally they're, they're smaller 234 person practices, maybe like a dental practices or optometrists. Um, what we found is that we could take these entities and roll them together to make one entity. And that entity, the combined entity is um clearly able to to do an ESOP and um you know, and the size of it allows it to, to get better financing, uh, to get a better multiple on for valuation purposes, um, it seems to be a win-win. No, that's great. So the, um, it's kind of talk about a little bit about the idea that it's pulling companies together with, within a merger. Um, how do you play a role in that? I mean, I know some companies have people within their company that they're gonna champion a merger, um, but when you get into the actual practicality of it, um, I know some small companies would love to, to merge with others, but there's, there's complexities there. How do you play a role in, in helping? Well, basically, um, one of the things you have to be careful with is you want to make sure the roll up transaction is tax-free. And you can do it in the form of a tax-free consolidation or a tax-free merger or tax-free exchange of stock, um, and so you have to make sure that, that when you're working with clients and you get a, a group of them, and generally, uh, to find the clients is easy because your client generally knows who the competition is and the other people in the industry, they know them from Um, from working on, uh, industry groups, and they're, they're the ones that will say, you know, here's a list of 10 other companies that I think would be a good match for us, um, and generally they, they cross state lines. Yeah, so they're they're just gonna call their friends and say, hey, this is what we're thinking you guys want to participate. Because they're doing a roll up, not, not thinking they're gonna go work with these people for a long period of time. They're doing a roll up and to anticipate an exit with an ESOP. Is that kind of where you're going? Yeah, um, yeah, very good, yeah. So, um, so with that, what, when we get into that idea that they're gonna convince their friends to do this together, um, there's got to be maybe some potential, um. You know, hesitation to pull all that together. How much do you get a lot into the, a lot of the, the convincing everybody, hey, this is, this is the way it works, so everybody can kinda calm down a little bit and say, you know, this is actually gonna be good for everybody. Yeah, I think, so, generally, generally the people that come together have the same goals, you know, we're looking for an exit strategy. How do we get ready for retirement? We're we're looking to take some cash off the table, and so I think it's important that you get when you're getting the group together, everybody has the same goals. And so once you get that in place, uh, you know that everybody's moving in the same direction. Now, where it gets complex is getting into, and this is where we get involved with valuation companies and accounting companies, is, is trying to determine, you know, every practice is different, you know. Uh, you know, insurance agencies, um, dental practices, um, manufacturing companies, you know, do they own the real estate? Some own real estate, some don't. Do we want to include the real estate? Do we want to exclude the real estate? Um, you know, what about debt? Do, do we want to have the combined companies assume the debt? Uh, the, you know, do, do what, you know, what about purchases of equipment in the future? Some practices, you know, some of these companies may have up to-date modern equipment. Others need to put huge capital outlays in. And that's where the difficulty I think comes is to determine what is the value of these individual companies and so that when we roll them into the hole, what percentage of the whole is each one of them gonna have? Yeah, so that's gonna take some work. So analysis, um, I think a lot of pre-planning and, and working through a combined pro forma of, hey, this is what it's gonna look like when you, when you get it all together and then evaluation to say this, this is what we think we're gonna be able to transact for which kind of falls back in a lot of the things that we, we get involved in as well, which, um, I love, I love this idea because I think sometimes a small entity starts thinking their options are pretty limited and they start scratching off the ESOP as, as an option. But if, if, if you're listening to this, it's like there's definitely an opportunity. It just, and it's not too complicated that it can't get done. I think that might be um one of the thoughts I had and wanted to comment on with you, Steve, is that when people start thinking, hey, this is too much to deal with, I just wouldn't want to keep it simple. Um, do you find that you're able to kind of work through that, that maybe objection to this idea of, of doing a roll up? Oh yeah, I mean, I, I think so, once, once you get, uh, it's interesting because um one of the things we're finding is in a lot of these industries, Um, You know, you see someone who's maybe practiced dentistry for 30 years or 40 years, and he's got a practice in, in Wyoming and like not like there's anything wrong with Wyoming, but no, it, but he's got to practice say out in the country and uh who's gonna buy that practice, you know, and, um, uh, if, if a new dentist were to move out there. Um, they're gonna end up getting that practice anyway when the guy retires or dies or And as a result, um, you know, that, that what we're seeing is a lot of these small practices end up our businesses end up selling off for, you know, the, the liquidated value of their equipment and and collecting their receivables. Um, here, when we roll these companies together, we're looking at an exit strategy, you know, now we're, we're putting some value to their, to their company. And so when they're ready to retire, the idea is that uh the, the other people in the group will purchase their stock and by utilizing an ESOP, we can actually have their stock purchased with on with uh tax-deferred dollars under section 1042. We can have the company pay for that buyout with deductible dollars. So maybe the cost of buying their practice is 60%. Um, and you know, it's, you know, and, and a lot of that planning actually comes in up front because as you know, we're buying companies, we're rolling out companies with people of different ages. So you know, if, if we're buying a company with somebody in their 60s or 70s, you know, maybe we're looking at, um, what we're gonna roll together and we'll allow you to sell 50% of your company initially. To the ESOP and do it on a tax preferred basis and then in the next 5 years, you can sell another, the other 50%. Yeah, I know tons of options once you get to that point, you can structure tranches and, you know, depending on the flexibility of what you want as a, as a ESOP going forward. So that definitely helps. Yeah. Um, yeah, going into that, so, and again, I love this idea. This is when we talked about it, I thought this is definitely do a podcast episode on, on roll-ups, um, because I think sometimes when you start talking about the potential for uh, uh, maybe a small business somewhere that doesn't have really any value, um, other than its assets can now suddenly maybe be worth much more. What, what sort of other things when you, when you start putting these together, what sort of um Benefits is the owner receive when when they're pulling this thing together. You mentioned a tax-free exchange um in terms of, of what they get out of the initial merger. Well, you know, and one of the things we see, which is outside the ESO Arena, is economies of scale. You know, what we have is uh buying power, you know, instead of having 10 optome optometric practices, instead of having one optometric practice, you got 10 that are buying frames. So you can get a bigger deal, a better deal on, on your cost, you know, we're sharing space, uh, having a call center, you know, for, for appointments, you know, instead of having 10 different call centers, 10 different uh controllers for the company, uh, you know, you, you have one center, one controller. Uh, one manager, um, you know, so what we're finding out, Phil, and it's really surprising is you can cut out 15 to 20% cost just by combining. Yeah, I mean, that goes right to the bottom line and go back to business valuation 101 for a second. You're, obviously, that means your cash flow is gonna be stronger. Um, you're gonna get a, a, a higher multiple with a, with a larger business, so you're gonna get a less, lesser, um, or less risk rating or a lower cap rate. So your multiple is gonna go up, um, from a lot of different vantage points, you're, you're gonna be worth more in the end when you pull it all together. Correct, correct, and, and you know, and that's even before you get to the tax benefits of ESOP. And you know, so it's um it's a, it's a really in in the industries we've done it in, uh, you know, as you and I talked about, it's, it's kind of across the board, uh, we worked on a transaction um with uh towing companies. Um, uh, you know, we did it for some small towing companies that, you know, tow the cars, but we also have done it for the large towing companies where if a train goes off a track or an 18 wheeler goes over a bridge, you know, they, they, they have these pieces of equipment that are amazing, you know, to, to pick it up, but we've also done it for professional companies like Dennis and And optometrists, uh, we've done it for insurance agencies, uh, we, you know, it seems like it's really good for service businesses because a lot of these service businesses are small, you know, and, and 23 person shops and, um, you know, this, this allows them to merge together to get some buying power to start buying them out over a period of time. Uh, and do it in a tax efficient way by by utilizing. Yeah, one thought I had in the in the process of pulling this off is in the midst of in the interim period where you you've merged all the entities, who's in charge of the company? That's, that's a good question and that's one of the that's one of the negotiations. I mean, you've got 10 companies and 10 individuals that have run their companies. And now, you know, you've got to find a compromise, you know, some, some way of bringing these people together and, and, and what we generally do, um, so is, is we, we start off by having um a board, you know, put them all, all the people are on the board and uh kind of give them an equal vote. Uh, with the idea being that they want to groom long term, uh, uh, president, CEO that will can come in and, and individually run this company long term. Yeah, so, so they Yeah, I mean, so a lot of that in the interim, when I call interim, it could be, uh, you know, a few years before they're really able to pull off the ESOP transaction or is it typically one year? Yeah, and, and so one of the things that's important that I've I've learned is that, uh, uh, you know, the, in certain, if you're doing it with certain professions and certain businesses, it's really important to have that individual still retain control of the local company. Are you with me? I mean, you've got a dent, OK, Doctor Smith. And he's been there for 35 years, OK? You don't want to come in and change the name to Bill's dentistry. He's dentistry yeah, practice, right, exactly, exactly. I mean, you, you want, you want to keep his name on the door. You want to keep his patients there and, um, and so it's important to have goodwill and then uh to keep that goodwill and then at the same time, uh. You know, all of a sudden, you know, the employees that have worked with him and everything has worked for years, you bring a new, new manager in, you know, and, and it just, it doesn't work. And so what we like to do is on a starting point, you know, for a couple of years anyway, keep The local, the local management in the hands of the original owner, you know, have them run their operations and gradually start merging things together over a period of time. You know, you don't want to make too big of a change initially. Yeah, so you, you do, it does, I mean, I think the whole the whole concept of this when you talk about the question of timing, you know, you think a couple of years might be enough to pull it all together or what what's your thought there? Oh yeah, oh, I think easily, you know, you start, um, you know, having um Um, the, the new owners and the new management come down and meet with the different locations, so you start letting them understand that there's something bigger than your former owner. involved here and uh you start, you know, talking about, well, here's our new benefit plan and here's our new health insurance plan and uh you know, so they're, they're catching on that they're part of a bigger than they were before. Yeah. Well, I think I practically speaking, and I think this is probably what happens and I, I have had um a client where we, we merged up two companies that were related. So it's not the same thing where they kind of knew each other. When we were working, we're working through that in that case study, we're working through going towards an ESOP when we first started, we um we kind of paused the ESOP for the first entity. When we merged them together, what happened was We ended up finding we didn't have the strength within the combined companies in, in the accounting department to, to really go through a normal ESOP transaction. So we kind of paused the button and said, you know what, we need some time to um build, rebuild the, the systems between the two entities now. Um, have that synergy between the two, but also have the depth in the accounting department. So one of the, one of the things I learned from that, I think this is applicable here is, um, is you, if you roll something small together, if a lot of small entities roll together, um, I think part of the investment needs to be, you need to invest um in, in good accounting and good people um to where it's like, it's easy to report on QuickBooks for a small dentistry practice, for instance. But when you have 10 companies coming together, you wanna have, make sure that reporting is really done well. Um, and I would also recommend you go ahead and get a financial statement audit to make sure all that somebody else, an independent CPA is certified, hey, that all works and you have One report, you know, for that 1st year, 2nd year, that will help pull that piece together because that fragmented like that, it's very difficult to convince the trustee that this is worth what it really is when they're, when they're asking really difficult difficult due diligence questions. Got it. And the good news is, Phil, that the, the economies of scale, the savings you're gonna have up front will give you that extra money to go and hire qualified professionals. Uh, you know, again, you don't need. Yeah, that's, that's the key. Yeah, that's why when you have, here's what happens is you've got to be diligent about letting people go that don't fit that mold anymore and bringing people that really do so you will have the money within economies of scale, but you got to create the money in making business decisions that create additional payroll and then be um willing to make those, those are tough decisions for small companies because Um, they don't want to let the people they've had worked there go for so long, you know what I mean? And so it's just the practical side of it as well. And you know, one of the things though, you know, we say they're small companies and, and you, you're exactly right, but we've had two or three of these go from, from being small companies to being one of the, uh, you know, top, uh, dental practices, top 4 or 5 dental practices in the country. Same thing with the in the eye industry, uh, same thing in, uh, in the transportation sector. Uh, trucking companies, um, uh, and it's just amazing how quickly it grows. Uh, you know, for instance, you know, so after the transaction, you've got things rolling, all right? Now what you do is you don't quit. You go out, uh, to the market and you go to other competitors, other people in the industry, and you say to them, look, uh, here's what we've done. If you roll into our company. Uh, you can get the same benefits we did, and a lot of times what we'll do is we'll give them, you know, what I like doing is say you merge into our company and we'll give you stock in our company on a tax-free basis and we'll give you some cash. Right. Yeah, so now we're going to end up with 100% of the profits of the business flowing into this group into our into our company, our, our, our roll-up company, and we're going to have the other half being used to buy out the pay out the uh selling the new shareholder that's coming in. Right. Yeah, so yeah, so I mean, and I think some people are definitely looking for that. One of the things I wanted to talk a little bit about as we, as we kind of roll it into an ESOP is when we're financing an ESOP transaction with the bank, um, and I'm kind of setting this up a little bit, but as I, as I do that, I want, I know that that there's some clarity. On bank financing for ESOP deals and I think that to start off with, it's very difficult sometimes for a bank to finance a smaller business because there's not, it's really an air ball type financing arrangement. Um, the bank would have maybe more inclination for something like this. So talk a little bit about the, the financing advantages of, of, of the rollout type of ESOP. Right, and, and you know, Phil, as you and I have talked about, in this world, bigger is better. And um, you know, when, when a bank is looking at making a loan with, if you will, an airball where they have, uh, you know, an industry that doesn't have a lot of equipment, hard assets, um, you know, they, they look at the size of the company. Uh, because, uh, you know, the fear is if, if it's a small company and one sector falls down or 11 of the professionals, uh, dies or leaves, uh, the whole company could come down and not be able to, to pay off a loan. But, you know, it's different, you know, basically, it's the difference is if you have 7, your dental practice and have 7 locations. Versus a dental practice that has 185 locations. You know, the bank feels a heck of a lot more protected with 185 and, and you know, with the type of revenues that come in, it can generate a bigger multiple which will allow the banks to lend a higher amount and at a lower interest rate. Yup. I think that, and that's really important too. I think when you start thinking about the idea behind selling your, your company, um, as an ESOP, you're, you're faced with this choice of do I take a note back or do I want to get my money at the table or what combination of that am I comfortable with? And I think really what, one of the things Steve and I wanted to point out is, is you certainly have more of an, an opportunity to um get your money at closing. Then you, if you have this roll up merger as opposed to, you know, having that note back and there's nothing wrong with taking the note. Um, there's a lot of people really kind of prefer that anyways. It's just a matter of, of what your choices and options are, you know, as a, as a larger entity. Yeah, and so I, I like the, I love the concept of being able to sit down with somebody that's thinking about rolling in and say to them, look, you know, we're planning on, you know, we have 30 locations right now. We're planning on having 200 by in the next 3 to 4 years. So why not take 50% of your equity out now in the form of cash so you can use it and And uh diversify your risk and that kind of stuff and uh and then on the other hand, leave 50% in and go for the ride, you know, and, and hopefully in, in 3 to 5 years that 50% is going to be worth more than than twice what you sold it for. Right. So going into this, like, as we start, we kind of, I think, put a, put a good overview of what the rollup is and talked a little bit about the, the benefits of, of being a rollup company. Um, let's tie it to an, an ESOP transaction. Let's walk through maybe some of the, the ways we would look at this, you know, practically going through, uh, now we go through a normal ESOP transaction, um, and just walk through that a little bit. Well, the, basically what would happen is the roll up is kind of a precursor, you know, the, it's, you need to get the, your, your parent company, you know, the, the roll up, the company that's everything's rolled up into, into position before you go out and do the um and you know, so once you get, you know, the, the 10 companies, the 15 companies, the 20 companies. Get an agreement to that this is how they want to proceed. We then go to the banks and say, OK, here's here's what our rolled up company is going to look like. We get the accountants involved, do a pro forma. This is what our company is going to look like, and you know, we get the banks to come back and say we're willing to lend. This amount of money at this interest rate, uh, you know, we go to 2 or 3 banks and, and play one off on the other and get the best, best deal possible and, and then what we do is, um, you know, we get the company set up and, and, uh, get the financing in place and, and form the ESOP and determine. You know, what are we going to be selling to the CSOP? You know, are we gonna, is everyone going to sell 50%? Are we going to have some that are going to sell 100% and others that are going to sell 20% or 30%? Um, and you know, make those determinations and then we basically just effectuate the transaction. And you know, at that point in time, some of the people may want to do the tax deferred rollovers, others may want to do capital gains, so we kind of give them an option. Yeah, yeah, yeah, I think with, with the, I guess it really kind of depends on the size of the roll up. If you have a lot of different owners. That may look at this and say, you know, I'm not really ready. I prefer to be part of the roll up merged company and other ones are like did this to get out. So I think it probably could vary a lot. Do you see most of this, most of these bigger roll-ups going through more of a partial ESOP sale and then over a period of time eventually getting to 100%, or do you see them going in and go ahead and roll everything up and then do 100%? Is that what, what's your experience with that? You know, it's a combination. It's, it's almost 50/50. We have, uh, and, and I, I kind of, I like both approaches, OK, as you know, Phil, there's nothing more efficient than a 100% Scor PSO and so and so going to the 100% is a, a really great way to do it. On the other side of the coin, especially when you're dealing with, uh, professionals, uh, small operations, um. Uh, you know, dentists, when they come out of dental school, uh, eye doctors, uh, uh, optometrists, you know, they, they're, they, they're looking to own an interest in a company, to own something tangible. And so it's, it's changing their way of thinking to go to, uh, uh, a company that, that doesn't have a Um, that they don't have ownership in again and so it's kind of a learning curve to get to get to that point, but it's also a good idea to have, um, I like the concept of in some instances, what we've done is we'll have each of the groups like, like, for example, in the dental industry, we'll have them sell 50% of their practice to the ESOP. And and or to the roll up company and keep the other 50 individually. So now the dentist is incentivized to work hard in his practice because he still owns 50% of it. He also is is concerned about working hard for the the whole because um if the hole does well, he also has 50%, you know, 50% interest in that also. Yeah, I mean, so they win both sides. The um what's interesting about that was, I mean, again, that kind of business is typically run by the dentist and they're the you know, they're the the practitioner and they're also running the business. When you roll it together, you typically also have professional management, um, and in your experience, the professional management, um, You know, maybe you have a president of all that. What would they be looking to get out of their, of this to kind of really benefit them in terms of, of compensation or is the ESOP enough for them to feel like they've been rewarded, you know, for all their efforts? Well, usually for the executive management team, uh, what we do an ESOP, we'll, we'll do stock appreciation rides, uh, even warrants maybe for the seller. So a way to incentivize them long term outside of the ESOP. Right. Yeah. And I think that's, I, I kind of said that too because I, I think it's important that The rank and file will be benefiting from the ESOP, no doubt, but the people that are putting a lot of energy and extra effort and going above and beyond, um, typically are gonna want to have something more than um just their participant share of ESOP. And so the SARS and, and other incentive plans are gonna be important to um attract them, to get to, to get them to come in, but also to really attract them to stay. And um perform well for the, for the bigger entity. So as you go through that, that's very common to have to structure that together. Oh, you're exactly right. I mean, the worst thing you can do is, uh, do an ESOP transaction and lose your key people. So you, you know, we, we, when we do a transaction, we, we, we are talking employment agreements. We're talking covenants not to compete, uh, and we're talking, uh, incentive plans like a stock appreciation rights. Yeah, for sure. So, so as I, as I kind of roll this back to some of my final thoughts or comments was. You know, when I first thought about the roll up idea on a massive scale like Steve was talking about, um, you know, I think the hesitancy I have when I think about it might be similar as, hey, this is too complicated to even get into and I. And I hope what we talked about a little bit, Steve, is just the idea that it doesn't have to be too complicated, it's definitely doable. And um there's a lot of really strong benefits as the selling shareholders to do this, put this type, type of thing together, but being patient with the process, knowing it's gonna take a few years to do that. Um, what I, what I wanted to say about that is just that if This is one of the reasons I do this podcast is planning is really essential and I think sometimes I can't say this enough that sometimes people wait so long that this kind of roll up option doesn't even get on the table because they need to, they need to move through their exit quicker than later. And so I want, I'm just gonna to stop and encourage everybody to, to be, if you're thinking about doing, you know, something with an ESOP or something with your succession and exit, you're better to start planning it now, um, to make sure that you can look at all these types of options then wait down the road and, and you have to kind of work or work through something too quickly. Um, so that, those are kind of as I think through this, I wanted to kind of make those kind of comments. And for you, Steve, what would you say kind of people need to really think about in this, in this process? Well, I, I think you're right. I think planning is the key. Um, you know, it's, it's too many times, you know, we'll, we'll see people come into us and say, uh, you know, I'm, I'm ill. Our, um, uh, my, my company, uh, uh, is, uh, you know, because of whatever COVID or any other factor had to be shut down, and, you know, they, they get to the point where it's too late to do some, some good long-term planning. And so we're encouraging our, you know, clients uh to start that process as soon as possible, um, as opposed to waiting until They're in emergency and have to do something immediately. Yeah. And I, and I think that. Is what I, what I like about planning early is you can, you can do stuff that you didn't even think you could do because now you have time to put it together. And, in general, I would say the, the, the experience I have and I'm sure Steve would say the same thing, is you're gonna be, you're gonna win more in that plan than you would if you were running through it too quickly, um, with a better valuation, with better terms in your financing, um, with a better group of employees where you're, you're, you know, moving through your exit and it's, and it's a lot smoother, so. Um, hopefully that, that resonates with some people. So with that, I just wanna say thanks, Steve, so much for your time today. And, and when I, as I think about all the, all the things that you have to do as an attorney, I appreciate you taking time to do this, um, because it, it is important, I think, to educate everybody, but I really do appreciate you spending the time to help me do that today. Well, it's, it's been a pleasure. As you can imagine, I am a big fan of ESOPs. I think they're, they're good for everyone, the, the shareholders, the, the employees, the company, and, um, uh, I think, uh, you do a great job with these podcasts and Um, encouraging people to start planning early. Well, thanks so much. With that, as we close out, I just wanted to remind everyone, if you like the podcast, please subscribe and share it with a friend. Have a great day and we will look forward to our next step on this journey.