EP21 - Interview with ESOP attorney - David Joffe - partial ESOPs

Welcome back. Thanks for tuning in. I'm the ESOP guy and let's continue on this journey to an ESOP. So this podcast is for those that are thinking that they might want to consider an ESOP. And because we've had multiple episodes, if you have an interest and you're just joining the podcast um episode today, and you have an interest in more of the episodes, go to journey to an ESOP.com and you'll find those there. Today, I am excited to have the privilege of interviewing Nashville-based attorney David Joffe. Uh, this podcast episode's gonna be insightful as we talk through the different types of ESOPs, particularly non-leveraged ESOPs versus leveraged. David is the chairperson of the Employee Benefits and executive compensation Group at Bradley. He has been practicing law for over 30 years. His practices, his practice focuses on ESOPs, including representation of selling shareholders, companies, trustees, and lenders. David, thank you for joining us today. Thanks, Bill. I appreciate the opportunity to participate in this podcast. I'm finding your podcast very helpful, uh, listen to several and uh sending for practical information for shareholders and companies interested in ESOPs as well as service providers. So in, in my practice, I've focused on ESOPs in part because I think they're a great opportunity for selling shareholders, companies, and employees alike. It can be very much a win-win situation, and I just enjoy working on the transactions. So 100% Scorp ESOP transaction we know is a particularly advantageous transaction from a tax standpoint, and that's the structure that we'll often see, see, but there are a range of options for ESOPs, non-leveraged, non-leveraged with redemptions, leveraged ESOP transactions, and more traditional transactions. And understanding the options and the process is very important, uh, having a, a well-informed decision. And for some employers and selling shareholders, a partial ESOP can be the right start. That's true. And the reality is when you start talking to some people that look at ESOPs, the reality is that they don't always maybe understand all of the options, um, and even going into, uh, not everyone is ready to sell 100% of their company. So just this idea of talking through a partial ESOP, I think it's very valuable. And when as you, as you go through the process of doing that, there are, um, even as a partial, there's specific options within that. So that's kind of what we're going to get into. Um, when we are, um, looking at that specifically, um, why, I, I guess the reason, why would a selling shareholder want to look at just selling part of their company, um, in an ESOP situation? Well, uh, most of the time what I see is there's a desire to retain voting control, to have that 51% ownership, so in large part, the shareholder or shareholders are controlling the company and how it operates. There are some employers like government contractors, women owned service disabled veterans owned businesses that may have to have a 51% ownership for their government contracts and therefore, you know, will only do a 49%, up to 49% transaction. For corporations, when you have shareholders interested in that 1042 rollover treatment or delaying the tax on gain on property sold, you have to do a minimum 30% transaction, so sometimes you'll see 30% transactions done just for that purpose to get that treatment. And maybe just in general more limited interest and liquidity if the shareholder isn't at that point where they want to sell all of it, maybe a more limited sale is appropriate and and I think in some ways it it can be a less complicated transaction that eases the way to a second stage transaction. Uh, it doesn't, it isn't always the case. It just depends on how you structure it, but there are ways to do it where there's a more gradual approach that I think can make sense for particular employers and particular shareholders. I think that's true. I, I think particularly the ones that I've worked with that are looking at partially ups. The owners are younger, um, they're not really looking to completely exit the business at this point and So holding on to some of the ownership is, is valuable for them and they're looking at the ESOP as an opportunity to, um, of course, reward the employees and they believe, you know, in the ESOP structure because that's a really, really strong benefit um to, to be able to bring to your employees as owners. But they also are able to retain that other ownership as the ESOP really hopefully starts building more value, they're going to be rewarded as owners by doing a partially up there as well. So looking and looking at that, um, when I look at a partially up. You know, there's certainly pros and cons to every business decision that we, that we look at as advisors to, to our clients. One of the cons that I see right away is that a partially up is, is gonna be still pretty costly, especially when we're looking at, you know, a full, a full leveraged transaction. What are some other uh pros and cons that you're seeing within the a partial uh ESOP? Oh, you know, I do think you're right that the cost can be. an issue if it is a leverage transaction leverage in the sense that you're selling stock to an ESO, but there are a range of options. So, um, in the partial ESOP that's done on a non-leverage basis, the employer gets to establish the ESOP, uh, have the plan document, trust all of that in place. Um, it can make that next second stage easier because you'll have a record keeper in place. You'll have a valuation process, which generally can be used, good evaluation firm can be used in 2nd stage and later stage transactions, and you're starting to build the ESOP culture. Uh, it can be a recruiting tool. It can be, you know, other reasons why it's just beneficial to start out the ESOP, even if you're not as a shareholder ready for that 100% transaction. Um, so there, there are benefits. I agree with you there are costs. I think you have to examine the costs and benefits um for your particular business and particular ownership. No, that's, and I think that like my, my comment here is only gonna be really about when is it appropriate to, to really evaluate those costs and benefits and the process that you go through with your advisor. I think it's really very early on up front in that process of looking at all the options. So, so as part of this, the goal of this podcast is to really help uh listeners to understand what your options are, so you're asking the right questions of your advisor. So that at the very front end of the work that we do in terms of creating the feasibility model is going to be answering the questions, what, what, what are the cost benefits of a 100% sale versus a, a partial ESOP, so that the business decision can be made really upfront and you're planning all of that um towards an ESOP strategy. So that you're really cost effectively going about the transaction and not thinking in the, in the middle of the transaction of changing your ESOP strategy. So, I think that's an important um element and this, this, this episode is really gonna be important for you to really better understand that and ask the right questions. If we, um, if, if we go from there, which is kind of real generally, this is partial ESOPs, we're gonna go into understanding the, the leveraged ESOP versus the non-leveraged ESOP. Uh, David, can you clearly kind of explain the difference between a non-leveraged, um, ESOP versus a, um, with and without redemptions versus a leveraged ESOP? Sure, so, uh, when we talk about non-leverage, it's just basically means no loan, no leverage, and in a non-leverage transaction, you can have one in which no loan is required to purchase any stock. The company simply issues stock that it that it's either held in treasury or is newly issued to the ESOP. Makes that contribution. And that establishes the rea, and there's no need to borrow from anybody for that type of transaction. It's just very straightforward. Now, this will dilute the ownership of the existing shareholders, so that is a drawback, and that's why you may consider other structures. So if we go to the next option, a leverage transaction where you um have a loan. There you're going to provide a means to pay the shareholders for their stock, either in cash or in note. If that loan then involves the ESOP directly, there are the prohibited transaction rules that are going to make The transaction more complicated because in that type of leveraged uh transaction, uh, you're going to need a contemporaneous valuation and uh recommended to have an independent trustee. But going further in terms of a variation on that, you can, you can have a redemption that just simply allows the shareholders to sell their stock to the company, not to the ESOP, just to the company, and those shareholders then get paid for their stock. And the company can then turn around and contribute that stock. Now you could have a shareholder say, well, I know you don't have enough money for the company, but I'll take a note and in that sense there's leverage, but it's a very different type of leverage transaction. It's far less complicated. So, um, and it's and it's less complicated. There's less cost, obviously, when you look at the three different things you mentioned, the, um, clearly the leverage transaction because you're including all the The full team members of a trustee, their um valuation firm, you know, and all the elements of their protecting from the DOL standpoint, it's gonna be a higher cost, um compared to this non-leveraged uh transaction. So when you're, um, and so when we're kind of get, we're gonna dig into that a little bit deeper, but when you're looking at this, uh, I guess, you know, from a very layman's term standpoint, and somebody's saying, well, when would a non-leverage ESOP be more applicable as a better ESOP solution? I I hate saying better, but as an ESOP solution that would be, you know, more applicable for somebody that's um interested as opposed to, you know, a, a fully leveraged transaction. Well, I kind of follows up on some of what we've discussed in terms of implementation and then as a related matter, costs, um, but in a, in a non-leveraged situation where you have no loan, non-leveraged, um, the company just establishes the ESOP, it contributes shares to the ESOP, it can have an internal trustee. It will need a valuation, an annual valuation. Um, but the process is probably going to be a lot simpler, and in this way, the company can test out the ESOP concept in a much more limited fashion. Um, there can be less of a need for liquidity for shares. Um, in that sense, it could be a better solution. Um, there are a range of possibilities of what the shareholders are looking for. You know, certainly if you have shareholders that are looking for Complete liquidity. They want to sell all their shares. They, you know, they, they need that money and they or they want it and that's the transition they're looking for, then they're not gonna want this this partial non-leverage, you know, maybe be a bridge, it may be a, uh. transaction strategy that starts the process that leads to eventually having a 100% or 100%. Yeah, I think, I think that might be something when, when I have these conversations with people, um, you don't, you don't exclude the option on the road of being a leveraged ESOP and maybe coming out of, of the company completely at 100% by doing this. And what David's saying is really kind of sets, it sets the stage for you. Um, that a lower, you know, maybe, uh, an easier implementation to get into an ESOP and then maybe down the road, be better equipped to do an ESOP, um, and, you know, and then gain the benefits of, of the taxes, the tax savings that you get that go back into the company as well. Um, and that, you know, at the risk of being redundant, I'm, I'm gonna, we're gonna kind of dig in. I want to dig in just a little deeper on the non-leverage because versus the non-leverage with redemptions and, and you've kind of already said this already, but I, I'm gonna, I'm gonna ask you again just because I, I know when people listen to the podcast. Um, it's like that might be a whole new concept. So when, when we kind of separate the three different approaches here, there's the non-leveraged versus non-leveraged with redemptions and then a fully leveraged transaction. If I took the first two, just explain the difference, um, maybe one more time on a non-leveraged versus a non-leveraged with redemptions. Sure. So, um, the, the ESOP fundamentally needs to get company stock. That's how you're creating the ESOP, that's retirement plan. So the question is how does it get, how does ESOP acquire that stock? Well, in a non-leveraged transaction, the company simply issues stock to the ESOP, makes a contribution to the ESOP. And now it holds a certain amount of stock, and the company can continue to do that, if they do that year after year, um. Uh, or not, but it has usually will have discretion on contributions and so it just establishes the ESOP, no loan, that's how the ESA gets the stop. Well, in the non-leverage with the redemption, the difference is that the way that the company is getting that stock is not just issuing more shares or taking shares out of its treasury uh that it has, it's going to buy those shares from the shareholder. It's going to redeem them. It's just A fancier way of saying purchase. It's going to redeem those shares, give the shareholders money or or even a note for their stock, and now the the stock has their shares, so Simple example, shareholder has 1000 shares, sells 1000 shares to the company. The company pays the shareholder for those shares, you know, based on a good faith valuation. It doesn't require a full blown valuation that has to be a reasonable good faith measure of value. Now the company has 1000 shares. Well, the company can then turn around. 1000 shares is subject to certain limitations and now the ESO has 1000 shares. Exactly that's the basic difference, you know, did it get the 1000 shares just because the company just gave the shares out of its treasury shares that it has, or did it go to a shareholder and buy those shares and then contribute them, right? Now I think that's, I think that was very, very clear in terms of, of, you know, that this whole concept of non-leverage with um with redemptions without redemptions. When we look at the downside of, for the shareholders of doing it without redemption, we're issuing new shares as a company, and we know that that's gonna dilute the value of the existing shareholders um or what they're holding uh from not part of the, uh, not part of the ESOP obviously. Um, why would a shareholder want to or be OK with diluting their value in this type of scenario under the non-leverage GOP without redemption? Well, You know, certainly my shareholders would want to receive value, but it may be in part a factor of uh or factor again the amount involved, you know, if it's a relatively small amount of stock that's being contributed, the shareholder may say, well, that's fine, I don't need to be paid, you know, money for a relatively small amount of stock. I'm OK, you know, with the process of just having to stop contributed, um. You know, we talked about, you know, the redemption adding another layer. It's not that complicated, but it does add a little more complexity because if that company, going back to my example, is going to purchase 1000 shares from the shareholder, it's got to have a good faith reasonable determination of what the value is. For those shares, so it's got to go to the accountant or maybe even evaluation firm's got to determine the value, and it'll have to have a redemption agreement. So that will have to be drafted. So there's a little more complexity. It's not that complicated, but if you had uh a company that you just said I just want to get the ESOP started, I don't, I want it to be as simple as it possibly can be. You wouldn't do the redemption. And you know, one way to look at it is you might have a, a company that sometimes I find companies that have granted, you know, restricted stock that dilutes the shareholder just as well, but companies are willing to do that, um, understanding that there's some delusion and, and maybe they just feel like you can get an ESOP started. There's a little bit of delusion, but it's not so significant. Yeah, I know, I, I, I have known business owners that have given, you know, key members stock in their company, I mean, equity, and, you know, and that's a difficult thing for sometimes to do anyways because you're, you're asking, you know, to take on a partner or whatever. In this case, diluting your value, it, depending on the benefits that you are looking at as a business owner, um, may not be an issue, but it, it is, it's probably a question that some people have when they're saying, hey, why would I, why would I dilute it? So I think that's a That's a very good answer, David, and, um, and I think the key of that whole thing as we talk about the, the options is being prepared to present those options, look at those benefits, and look at the business decision behind each one of them, depending on the objective of the business owner. I know for us, the, the valuation would be tackled at the front end based on the way we do our modeling for the company. So if that became an option, we would just use the valuation we we created, which is going to um Uh, really mimic the way that the valuation would be created with the discounted cash flow method. So it lines up well with a potential transaction down the road so that all we would be doing is updating it as they get closer to a potential 100% sale. So looking at um the partial lease we come back to just kind of the idea of what you're, what you're selling when you sell partial part of your company, you're selling what we would term a non-controlling interest in the business. And we're gonna discuss just kind of briefly how um how that is different for a company versus selling and controlling interest. So David, can you kind of give us some insight on that? Sure. Um, so, um, If the company is selling control, there's a control issue that goes into the valuation, the premium issue. Uh, it's more valuable to buy a majority interest, 51% and it is 49%. So you have that premium discount issue that ties into the value of which the valuation advisors know much more about. Uh, but that's something that the evaluation advisors can carefully consider and, you know, I guess as the selling shareholder, you want to be aware of that because uh you're not necessarily going to get the same price for the non-controlling interest, so that's going to be factored in. And um just going back, you know, generally, we talked about the controlling versus non-controlling interest, um. If the shareholder wants to continue to control, you know. The companies have true voting control, then it will want that 51% or more interest so that it maintains that controlling interest. Um, And it just really again depends on what the shareholder is willing to do and again for the company. Yeah, and just to and to add to what you're saying to, um, you know, being a valuator, there's a, there's a uh uh a great article that I have when I send to clients when I talk about control versus non-control, but it, it goes into the specific details behind what the controlling owners have. you know, basically control over to do, they can set salaries, um, they can acquire companies, they have the voting rights to, to change significant things about the company when a minority owner really doesn't have those, so in a controlling position, you, you have, you're getting a, you're gonna get a premium because you're able to, to, like it says control um very specific aspects of it. Um, of course, a minority owner has a right, they have business rights, but they're not going to be in the same position. And so, Um, premiums versus you know, the lack of control discount is, is very important to consider when you look at that because it's going to reduce the value when you do a partial lease up, it's going to reduce the total value because you're going to take on a lack of control discount in the, in the evaluation model. And so with that, we're gonna, you know, as we look at regarding um the non-control um situation, one of the aspects of this that, that happened, we're gonna talk about the restrictions on a company that is, is selling a partial part of their company less than 49% or less than 51% controlling interest. Um, When it comes to this, I get this question from, from companies, it's how much control am I giving up? When I, when I look at this, one of the aspects of giving up control, if you're selling even a part of the company, is this idea of, I'm a business owner and I just want to keep things going. So for the most part, things are going to continue like they were. But one aspect of this that I wanted to touch on is, is there a lot of work that we do with closely held companies related to normalizing their discretionary expenses. And I think what happens is, is even if you're selling a portion of the company to an ESOP, you're taking on a new minority partner. And so, even though as a business owner, I was able to spend that before on my own, I'm gonna have to really think about um as one example of, of, I'm going to start taking on, you know, less and less of discretionary expenses. So we're preparing our clients for, for that specifically just to make sure they understand their, their business is going to go through a transformation as even having a partial ESOP. And so along that line, I mean, um, what I would say is, is when you look at the ESOP um partial owned company, what other, what kind of restrictions do you say really kind of a part of that, um, even though there's gonna be, there's still gonna be control of the company. Well, I, I do think that if you have the trustee come in, particularly if it's an independent trustee, and you're doing a transaction, they're not acquiring control, um, you are going through a purchase transaction and they're going to be looking at. Employment agreements, compensation, bonus arrangements, expenses, uh, contracts, everything that kind of goes into the, to the business. And um I do think that even in non-controlling transactions, Uh, there are, you know, sometimes agreements that the company will make, uh, that it will do certain things to, uh, like you were saying, normalize expenses and kind of bring the, bring the company, uh, maybe into, into the norm in terms of how it operates and not just operating as solely the way one shareholder shareholder family wanted the company to run. Um, the ESO trustee insist on corporate formalities that haven't been complied with or as closely complied with in the past. So, um, I, I do think there's going to be a change within an ESOP. I think it can be a very positive change because the trustees, particularly independent ESO trustees that have a lot of experience with other companies, will. be able to tell the company they're working with, you know, this is the Primarily see this is the practice is the custom, and I think that can help the company move forward, particularly if it, you know, going back to doing the partial transaction if it wants to do that, that partial transaction and learn what's it like, you know, dealing with the trustee, what's it like dealing with another shareholder and Go from there to the next stage, you know, whether, whether that's 100% or something less than 100%, um, but I think that's, you know, part of the, of the process and I think things will change, um. the ESO is not acquiring voting control, so there's a large part of what The company's doing that is not going to be controlled by these, but there will be some changes um I think that again can be positive. Yeah, there will be, there will be some changes and I think that, that the key to this, and I think that this is what hopefully we really got across was partially ups are are are a great option and they need to be considered in you know, really early on in the, in the advisory process to see if that makes more sense, um, because sometimes it's just too much to try to do a 100% ESO right off the right off the, uh, right out of the gate for, for all kinds of reasons. So. We are, um, unfortunately out of time, but I wanted to say thank you so much for your time today, David, um, the insight you brought from a legal perspective, um, with your experience with the ESOP transactions. Um, is there anything else you would like to share before we, uh, close out? I think so. I just encourage, you know, those people out there that are listening to the podcast, they're interested in learning about ESOs to just Continue learning, look at your options, uh, for establishing an ESOP, do it, you know, think what you think makes sense for the company and the selling shareholders and uh just understand that there are, there are options. There's not a one size fits all approach, um, and finding, you know, what works for you is what's important. Awesome. Well, I just want to wish everybody a great day. Thank you for tuning in to the podcast. Um, if you like what you hear, please subscribe. Um, share it with a friend and with that, we will look forward to, uh, next, the next podcast. Thank you so much.