EP25 - Interview with Greg Daugherty - ESOP Attorney, Columbus OH

Welcome back. Thanks for tuning in. I'm the ESOP guy. Let's continue on this journey to an ESOP. So this podcast is for those people that are thinking they might want to consider an ESOP, maybe as a potential strategy for growing their business or creating a succession plan or even for exiting their business at some point. So if this is your very first episode today, thank you for joining and if you're interested in other episodes, please go to journey to an ESOP.com. This episode today is going to focus on the seller's perspective of an ESOP and what happens to them after the ESOP is completed. And to do that today, we're going to have the opportunity to interview ESOP attorney Greg Doherty from Columbus, Ohio. Greg helps design executive compensation and employee benefit plans for public and private companies and not for profit entities, as well as he answers questions related to stock and non-stock based incentive programs. Like employment agreements, severance agreements, changing control and parachute agreements, as well as other non-qualified deferred compensation plans. Greg also has assisted companies, fiduciaries, and lenders with the formation of employee stock ownership plans and ongoing ESOP compli compliance matters. Greg's employee benefit experience includes providing ERISA fiduciary training and compliance services. So with, with that, Greg, I just want to say thank you for joining us today. Thanks for having me, pleasure to be here. Great. So, so Greg, um, as we start thinking about an ESOP transition and at the very beginning of the process, you know, one of the things that I get involved in is a major concern for the selling shareholders, and it's the question of what am I going to do. You know, after this is all over and, and, and couched in all that is, is certainly all these different selling shareholders have different ideas at the end, and some of them want to stay on and some of them want to have, you know, uh, maybe be with the company for a while. Can you speak to what you see in general about the options for the selling shareholder in say the life after the ESOP is created? Sure, and, you know, maybe to take a step back, you know, it's, what are your options, you know, what are your exit strategy options? And I usually tell people, if your motivation is to get as much cash as you can up front and then you want to retire. You know, go travel the world, go fishing somewhere, but you know you want to just kind of walk away, and ESO's probably not the right option. It's probably sell to a strategic buyer or private equity. But if you want to transition or phase into retirement, that's one of the advantages of an ESOP, because the ESOP allows you as a seller to continue to be involved in the company. You don't have to give it up right away. And in fact, the really both the banks and the trustees are gonna want you to, to be involved. And so, you know, then the question becomes, OK, how involved, you know, how active do you have to be? And I see that, you know, varying usually if there's More than one shareholder usually you'll see one who's still, you know, pretty active and hands on. There's not really much of a change, you know, from before, you know, and after the ESO, at least for the first year or so afterwards, maybe some of the others kind of start to take a step back and hand over more responsibilities, but in general I'd say. It's either you're still active, you know, at least for a year or more and you're starting to coach up the next generation or if you've already got the next generation of management identified, then you maybe start turning the keys over, you know, sooner after the transaction, but I think it's pretty rare that. You sell to the ESOP and then you just retire and walk away. Right? I think that's, that is true. And, and one of the things I see with that is just the opportunity that an ESOP provides inflexibility though, the, the one, the one owner that wants to just walk away, but there's a lot of owners that, you know, aren't really sure exactly when they want to leave. And I think what the ESOP does is it provides some flexibility. I, I had a client who We sold and, you know, I know he was like in his 70s and he just wanted to go fishing, but he wasn't really sure how long he wanted to leave, you know, to, to just get out of there. So he stayed for about a year and it was enough time to where everybody had felt, he felt comfortable, they felt comfortable and it was more of a, you know, I'll go when I'm really, really ready to go. And then at that year later, he was, he was out fishing and he was done. So it's, I like, I like that flexibility and I think that is a, is a an incredible aspect of the ESOP where if you sell to a strategic buyer, they're just going to be like, hey, you're out of here and, and you're done in some cases, so. Um, yeah, yeah. So a lot of times when the owner is staying, you know, on some sort of capacity, they are entering into these employment agreements. Um, what are some standard areas that they need to be concerned about, you know, on their side of looking at the unemployment agreement and what that means for them? In a lot of ways, it's not a whole lot different than negotiating an employment agreement with any other you know with a non-ESOP company, so you'll, you want to make sure that uh the compensation is spelled out clearly and so it may say, OK, here's your annual salary, but then you say. It may be increased or decreased or just it only may be increased, you know, after, you know, every 12 months, you know, subject to a review of the of the board or the compensation committee, you know, will you still be eligible to participate in the bonus plans and other employee benefit plans. The other thing is severance. So again, just like with a non-ESOP company, if you're going to have an employment agreement, you know, for say, you know, 3 years, if the company or the board, somebody wants to just Force you out and I, I don't, I've never seen that, but still, for your own protection, you know, unless it's a for cause termination and cause is generally committing a crime or some sort of fraud or embezzlement, you really, if, if you're not terminated for cause. You know, you're still gonna get paid, you know, maybe the salary that, you know, would have been paid to you for the rest of the employment term or maybe it's just a fixed, you know, 1 year or 18 months. You know, so you wanna, you know, have that protection in there and then, you know, the, the trustee's gonna wanna make sure that the company has a non-compete, non-solicitation so that if you leave and you. Break the employment agreement, you decide to quit. You don't go run off to a competitor. And again, I've never seen that. It really wouldn't make sense to do that if you're all, yeah, you get all the way to the stage of doing an Ere like what that, that does seem like, you know, less probable. But nevertheless, but really what, what happens is, you know, it's usually not just you, the seller that's gonna enter into this, it's gonna be some of the other key management employees will, will have this and so they may not, especially if they're not shareholders. You know, weren't selling shareholders, you know, maybe they're not quite as loyal to the company and so you'd want to put in there, OK, if you decide to go in a different direction, you know, you're not gonna go, you know, go work for a competitor, you're not gonna, you know, take our customer base or take some other employees with you and you know, you're gonna, you know, respect the confidentiality of the information you've been working with, I think. Those are really the main things you see in an employment agreement. Sure. And I think on, on the, on the employment agreement itself as as an owner signs that they're like, hey, I was an owner, and now I'm signing this, um, and now they have, they're, they're entering into becoming an employee again because a lot of these people haven't been employees for so long. Um, one side that I would say is important too is, is, is most of the time they're going to have some type of seat on the board of directors. Right. Which gives them at least a, a, you know, a voice, of course, on the board. It's not like they're just an employee anymore. So, um, well, on that side, just kind of like speak to that a little bit because I think that there's an offset to like, hey, I'm just signing an employment contract. Yeah, and that's right. That's a good point and that's that's a question that often comes up when people are considering whether or not to do an EP and that's You may not be the owner anymore, but you still have a lot of control, you know, over, you know, the day to day operations of the company. So, you know, the, the trustee is the shareholder, but you know, the trustee is more of just a financial you know, investor. They're not looking to micromanage the business and so the big policy decisions for the company are set by the board and the board. You know, typically, you know, maybe we'll start with say 3 people and the trustee will want 1 independent director, but the other 2 can be insiders. So if you sell your company to an ESOP, you can have a 3 person board where you're one of the board members and you know, maybe if you had another shareholder, that person could be on the board or if there's a key employee, you could have that person on the board. And then, you know, you'd only have to go out and find one independent person and even that's not always a bad thing because oftentimes you might say, you know, we could really use this particular skill set, you know, what, what skill set do I want to plug in and you you find somebody who gives you a good perspective on that, but the point is, you know, you could still in some ways control the board. Now the independent director is gonna have a final say on compensation decisions and bonus decisions. You know, so you There's a little bit of, yeah, they're gonna regulate a little bit. You don't have the same freedoms you had for sure when you own the business by yourself or with your partners, so you're gonna have to be regulated a little bit. Right, there's, it's more of a just a check and a balance I'd say even, you know, being regulated, but yeah, I mean, and you get, I mean you get to hire, I mean the trustee has to approve it, but you know, trustees typically they're not the ones telling you who to. Add to the board, it's basically find somebody that you like and if they have a good resume, the trustee signs off on it so. Yeah, and then when you know, I mean, when you know existing companies in actuality, it works out pretty well and people are pretty are pretty comfortable with these, these roles, but it's getting, and the purpose of this podcast episode is really to get you comfortable with that idea of the unknown of entering into some of these things for the first time. So as far as like start thinking about the other key management positions. Um, what are some of the compensation, what sort of compensation or other agreements would be appropriate when you're looking at an ESOP and what, what you want to do as an owner is you want to offer your key management something that, that makes sense for them. Yeah, so what you want, a lot of times you'll say, OK, my key employees, maybe some of them have been around for a long time, and I want to compensate them beyond what the ESOP can give because the benefit in the ESOP, you know, has to be proportional to their compensation, you know, basically their salaries. So what else can you do and in particular. You know, management decisions are going to have more impact on the growth of the company. They're going to be taking, you know, subjecting the company to more risk, you know, it's a risk reward play compared to what a rank and file employee will do. And so you want to. One encourage them to take smart risks because you want the company to grow. You also want them to be rewarded when their decisions, you know, pay off, so you wanna, you know, both attract and retain these, you know, these other management employees. The most common way I see it is often through a stock appreciation rates plan or what's often called a SAR where It's a, it's very similar to a stock option only instead of the employee actually having to pay an exercise price. you just after a certain period of time, say, OK, you know, this is the difference. You know, in value between the date we awarded the Star and the date that we're gonna exercise it and just the differences is paid in cash, uh, kind of the neat, you know, twist on that is. Many times the stars are performance based, so it's not simply. OK, just work for a period of time and then you get. You know, whatever the increase in the value of the, you know, the underlying stock is, it's we'll award you this and pay this out, but only if we hit certain EIA targets. And that's a, I, I, I like that approach because Long term, an ESOP needs to generate cash, and it's going to be a repurchase obligation. There's, you know, you're gonna have to pay out people when they retire. You may have debt to pay off. So you really want to reward the the generation of cash. And so if you have this long-term incentive plan where you say, OK, if we hit this IBIA goal. Then you get, you know, a cash payment equal to the increase in the value, you know, of underlying stock, or sometimes you might say, OK, we have these IEDA goals and to the extent we exceed the, the EBITDA target. You know, any, you know, that a percentage of that excess, you know, can be paid, you know, to the the key employees. And again, the idea is say, OK, what, what are we trying to reward here and let's, let's pay people for it so we get, you know, the, the, the ESOP, the company and the management incentives all in alignment. Uh, you certainly can still do uh short term or annual, uh, bonuses as well. Uh, and the other thing to consider is Especially if you've had someone who's been with you a long time. Maybe, and they've grown the company to the point where it made the ESOP successful, you know, maybe the short or long-term incentive plans aren't, aren't really the best fit, but instead, You know, maybe granting a full value award, so maybe you grant, you know, a cash settled, you know, phantom stock where you say, OK, look, you, you've already done the work. We'll just say, here's, here's bookkeeping, here's a bookkeeping entry equal to so many shares, and we'll we'll pay you the cash value of that when you retire or maybe we won't tie it to the value of the stock. Maybe we'll just put a deferred comp plan in place and the idea is that, hey, you. You've helped grow this company and made the ESOP successful already, so we'll give you more of a just supplemental retirement benefit than than an incentive plan. I think that's a, that's a great point. I think uh we've had these kind of situations because the example with a case study where a client has built a company up over 30 years. And he's now, now he or she's ready to sell the company. Of course, there's a group of people that have helped that, you know, that person or those persons to create value in the company. And, and when I get to that conversation, it's like, well, I know they're the, the, the key people are going to benefit because they're going to be part of the ESOP, but they're gonna have to work, you know, a number of years to, to accrue and as a participant, even at a higher wage compensation wage, they're going to have to work a number of years to create value there. And then they're gonna maybe get a SAR, which means they're gonna have the opportunity to benefit, but again, that's down the road, and maybe you even immediately vest them, but this full value or really does help to provide some, um, you know, contribution to them, what or give back to them, what they've really given to you before you're, as you go through the process of selling. I think that's a, that's a great point, Greg. Thanks, yeah. Yeah. So, if you look at the, um, you know, the, uh, situation with your key management and you go through the process of um participating in, in the, um the SAR, um, the programs like the SAR, they need to be negotiated, you know, we, you kind of mentioned this performance. Um, SAR with the combination of retention SA. Pretty much what I'm, my experience is is the trustees always gonna ask that to be a performance. SA, so part of the negotiations is just, that's just the way it is. Um, they need to do that in order to make sure that they've mitigated risk. Um, when you're going, when I'm going through and helping a client create the SARA, a lot of times what I'm doing is I'll actually model out and it's impossible to predict the actual value of the SARA in the future, but you're, you're using your, your model, your evaluation model, and you're using, you know, what the cash flow and the forecast when you're trying to create what it's gonna be um in the future. So you can set an accurate percentage on the SAR. Um, what do you see, you know, from your perspective, uh, as important planning steps in helping a client kind of make a determination on that stock appreciation rights program? Yeah, so one of them you you touched on, it's, you know, how much. Like what percentage of the shares are gonna be reserved, you know, for the SAR plan, you know, I typically see 10%. I think I've seen as much as 15%, especially if all of them are performance-based SARS, but The trustee's concern is, OK, you're gonna sell me the company, but then if we're gonna have all these SARS out there. And we're basically paying people in a sense, you know, the value of these additional shares. Does that, did I really buy 100% of the company, or, you know, should I subtract that? That's why you typically see SARS designed as performance-based because the argument is, well, OK, I may be diluting you trustee, but I've also increased the value because I don't get this unless the goals are hit, so that. You know, that's something to think about, you know. You know, the performance based and how many stars you actually want to be able to to grant. The other, uh, you know, from a governance standpoint, we talked a little bit about this with the employment contract, but You're gonna want your independent director to, to be able to sign off on any, you know, SAR grants and so that'll be something that's probably gonna be included in the, in the term sheet um. The other, another thing you want to look at is 409P testing and so that, you know, if the company is an S corp. You know, we could probably do a whole podcast on 409, but yeah, we could. But long story short, 409P basically says for an S corp we don't want to concentrate shares whether it's in the ESOP or what's called synthetic equity, meaning, you know, stock appreciation rights. We don't want just a few key employees to have a high concentration of shares in whatever form. We do that and if you violate 409P testing. You know, it could potentially, you know, disqualify the ESOP and it can result in excise taxes and you know, 50% excise tax on the corporation it's a mess. You don't want that right it's a mess. Now the good news is if you work with a A third party administrator who has a lot of experience with an ESOP, they can test this long before the transaction closes and tell you, OK, here's how many stars you can, you know, award and they'll. They can they can update those tests every year, so it really should not be a problem, but it's definitely something you want to plan ahead because you don't want to be caught by surprise. Yeah, and then I was gonna say that's why it is so important, you know, at least to get you an idea of what the impact of those are gonna be and like you said there that include if that synthetic equity is included. In your 409P test, and you just want to make sure you're conservative on it and not promising corporate management something more than you're really wanting to give or able to give them. Right. And then along similar lines, you want to forecast the SAR payments in your in your forecast, you know, you want to make sure because again that's ultimately going to be a cash liability that the company has to pay. If it's designed right and the company's performing well, the company should have the cash to pay it, but that's still You know, again, something that you want to forecast and just make sure that, you know, it's a sustainable expense. Exactly. You know, so, um, so looking at that part of the uh topic related to key management managers, um, one thing that I consider is that this group, um, you know, I, when I make a presentation, you know, in the very early stages, I, I'm always considering that these guys that are key managers could have just bought the company in some cases because they're, they've contributed so much value and, and they make such a great impact, and they're going to make such a great impact for the future um of the ESOP. Um, normally, they are going to exchange, you know, a non-compete, um, if they don't already have one. What other means can the company do to, uh, really retain and motivate this, this kind of level of executive when we're looking at it? Yeah, I mean, that's really a lot, a lot of as we talked about earlier where you say, OK, do we give them a supplemental retirement plan and say, you know, find a way outside the ESOP to give them cash, do we, you know, maybe it's the SA plan or maybe it's just the, the fully vested, you know, phantom stock. You know, those are all things to say, OK, here's some, here's a pretty generous benefit package and this is how we're gonna, you know, reward you, you know, either for, you know, helping get the, the company to this point or whatever, you know, you do beyond that. And give them, you know, give them employment agreements too and say, hey, look, if You know, where you actually put this in writing that we're going to give you these benefits and if You know, we force you out for whatever reason. There's going to be a severance package available, you know, as well. Yeah, my, and my comment there is you've got to get um the, the key people really on board early on in the process of, of doing the ESOP and, and that can be tricky if depending on how you're communicating as selling shareholders to your key managers and Um, where do you, when do you bring them into the discussions? But I think part of the idea is, there's a, there's a, uh, There's a philosophy behind ESOs that I believe culturally you got to embrace. If your corporate managers embrace that philosophy, a lot of what Greg and I are talking about really are, you know, important because you're really trying to take care of the contributions that people are making at, at higher levels. But when you get down to it, I think there's going to have to be a general sense and a consensus that everybody believes philosophically, this is the best thing for us as a, as a business, um. And that's gonna be, I think a big part of this is intangible, and I, I think I don't know how much you see that, Greg, but I feel like that's such an important part of it, and it's, it's not hard, it's hard to talk about because you're really not sure exactly what you're saying. It's a cultural, yeah, I mean, in some ways you need to have the culture already there like a lot of, you'll see a lot of literature that says well the ESOP helps helps build the ownership culture and that's, that's true, but I don't. It doesn't it doesn't always create one that isn't already there. If, if you have an ownership culture or if you have a culture where we're all a family, we're all in this together, you know, then the ESOP will help amplify it. If you have a culture where it's more, hey, the shareholders just been an empire builder, kind of, you know, the dictator, for lack of a better word, that's gonna be tougher, but if you get The the key people especially involved and on board and say, hey, look, this is, you're going to get out of this what you put into it. The other thing that helps is if you know of other ESOP companies, especially somewhat more mature ESOP companies, talk to them and ask them how it's worked out. And a lot of times what you'll find is The people are just excited to be part of that company and you also have success stories on the retirement front and when they hear about that that that makes them. That doesn't hurt anything, yeah, when, and when they actually see the benefits of being part of, part of an ESOP. So, so kind of just as we wrap it up, I mean, my, my final comments are, I think it's really good for the selling shareholders and and the corporate management. To, um, as they plan the ESOP and going to the, to me, this is partly a succession planning strategy and an exit planning strategy, but it's also a strategic planning strategy too. And how, how does this business as it goes into the future, carry on? And I think that as we ended our point on the culture side, I think that's Um, one of the most, to me, one of the most important parts of, of the planning side is to incorporate the, the culture they have now and the culture that they will have as an ESOP. And so those are my, those are my final comments just as we, as we wrap it up in terms of the, the, the group of people that we're talking about their, their. the ones that have created the value, and they're the ones that are going to create the value in the future, um, and sustain and keep this going. And I think that is important that they're paid well. I think it's important that they, they really do embody and um message out that the ESOP culture well into the organization. So, um, Greg, what, what are some of your final comments? Yeah, I'd say along those lines, what, what identify what your goals are and tie, you know, compensation or maybe non-compensation benefits to, to the attainment of those goals, you get what you reward. And so just make sure that you have the incentives lined up and you know, the right program in place for that. Great. Wonderful. I think great podcast. Thank you, Greg, so much for your, for your time today. Um, and it's just seeing that type of perspective, I think it's really helpful for the listeners. So as we close out, I just wanted to remind you, if you like the podcast, please subscribe and share it with a friend. Um, with that, have a great day and we will look forward to, uh, our next podcast. Thank you so much.