EP26 - The Hunger Games - What is the deal with Warrants on ESOP transactions.

Welcome to the ESOP Guy and you are on a journey to an ESOP. I just want to say welcome to those that are joining us for the very first time today. The podcast was created and produced. To really help business owners with the idea of how to use an employee stock ownership plan for their business strategy, and there's a lot of different ways to use it. And if you're joining us for the first time, you will find a lot of our episodes based on the topics, and it's very descriptive. When you go to the website, journey to an ESOP.com, you'll find a lot of different topics and I would encourage you to go there if you're interested and If you have been uh continuing on this journey to an ESOP today, I'm excited with this topic. I wanted to start off with this. So if you are familiar with that whistle, it is super famous, and it is the title of our podcast today, which is The Hunger Games. What is the deal with warrants? So today we're going to do is we're going to cover the, I guess a basic understanding of warrants, but also an understanding of how warrants are used in an ESOP transaction so that you can be really better equipped to ask the right questions um to your advisors and who you're working with on your ESOP transactions. Um, it is important because the warrants are a significant part of the, the way an ESOP would work and Um, you don't necessarily have to use them, but they are used on transactions and I thought, you know, it's probably a good idea for, for us to do an episode on this topic. So with that, if you like what you hear on this podcast, please subscribe to it and share it with a friend. Um, also rate the podcast, that's very helpful as we're continuing to try to make this a better resource for those that are listening. So at the beginning of The Hunger Games. This is a weird looking lady. She's got a lot of makeup on, and she's announcing that Katniss Everdeen. Who um is going to be a contestant, if you want to call that a contestant on The Hunger Games. So the, the plot line of this is that there's a futuristic society, and the powers that be in that society have controlled and oppressed all of the people of their, of their society by using an Olympic type games for teenagers that really are life and death games, more like a colosseum. And so Katniss's sister ends up getting um voted in or or lotteryed into this this system, and so she takes her place. And so right at the end of this first scene, this, like I said, weird looking lady, um, looks at looks at the audience and says, Happy Hunger Games, and may the odds ever be in your favor. When we think about warrants in an ESOP transaction, the idea for this for the selling shareholder is really the same. May the odds ever be in your favor at collecting the future value of this warrant. So the whole, the whole idea of a warrant on an ESOP transaction is what is going to happen in the future? And so like the movie, The Hunger Games, there are multiple challenges when you're dealing with warrants on an ESOP transaction. And you can just sit back and relax and listen to this podcast because none of those challenges are life and death. The seller's desire, we start off thinking about the warrants, the seller's desire and even to do an ESOP is going to be um hopefully thinking about what is the future of the business and what is the future for their employees in this in this business as an ESOP company. Now, that's important because when you start thinking about um ESOPs, you have to always be thinking about the sustainability of the company and, and it obviously needs to benefit the selling shareholders. It also needs to benefit the employees as well. Now, the problem is when you, when you look at ESOPs as leveraged transactions, the one fundamental thing that has to be considered is the cash flow of the company. And the cash flow of the company is going to be um um used up in some way by the debt obligation that the company's entering into. Now, on, on an ESOP transaction, when it's leveraged, obviously, we're, we're putting debt on the balance sheet, and that's going to be either in the form of senior debt with a bank and a seller note with the selling shareholder or, you know, a combination of the two, or entirely a seller note. So really, one of the common ways to finance a transaction is the seller is going to take back a note, as they in exchange for this private stock, the stock that they have, um, that they're, they, the company is buying. So they're going to take the note back in place of the stock. And so, In doing that, there's going to be um a A drain, I guess you would say a demand on cash flow, that's going to be important in order to um pay down the note and make sure everybody has enough money as on the company side to maintain and sustain the company. And that's why when we're doing planning, the advisors going through on the cell side advisors going through and determining the cash flow stream and what could happen and, and really should be doing some type of break even analysis test to make sure that the um the cash flow of the company is sustainable. And so, because when we're looking at, when we're looking at this primary dream being the, the debt obligation um of that beyond the principal portion, what we're gonna get into is, is the actual interest portion. And so the cost of the borrowing is gonna be important to be, uh, to, to look at in comparison to the cash flow. And so, When you have a situation where the cost of borrowing for the seller note, um, will be a drain and we need to free up some cash flow, um, we want to make sure that we've created a situation where the company has enough cash. And so, um, one option is for the potential on the potential transaction is to arrange the terms of the loan according to the amount in time that the company can afford to pay. So really to prevent the seller from getting um on the other side too low of an expected return, the company can then issue warrants to make up the difference between what they're lending the company um on the rate of interest, so that they can reduce the cost of borrowing on the um the beginning stages of them getting bought out. So warrants are defined as a derivative that give the right, but not the obligation to buy or sell a stock at a specific price before the expiration. So the price at which the the underlying stock can be bought is referred to as the exercise price or the strike price. Warrants are structured really so that the warrant holders receive the difference between the strike price, when the warrants are issued, and the appraised ESOP stock value when the warrants are exercised. So common, common issues with warrants are going to be, um, you know, looking at warrants and understanding how to set the warrants are going to be related to the future value of the business. And that's why we started off with this idea. Of the Hunger Games because everything kind of what matters is what's going to happen in the future. And If you look at the future and you're not comfortable with that, obviously, you're, you're going to be less likely to want to even take a warrant. Um, but a lot of times when the selling shareholder is looking at the future, they're, they've been working in this business for so long, they kind of have an understanding of what's going to happen, um, intuitively, or not even intuitively experientially, so they may be more comfortable with that as well. In an article that I read on uh from NCEO this was published back in 2015, so it's a little dated. Um, it points out that warrants were used at that point and about 27% of transactions. I think that probably has come up over the last 5 years, um, but that was really just a limited, um, survey that they did on transactions. So all parties to the transaction can benefit from warrants, so long as they do not provide the seller with too many warrants that would substantially dilute the ESOP's ownership interest. So the balance in the, in the issues that you have when using a warrant. is that you, as the selling shareholder, want to be paid fairly for lending the money to the, to the company. On the other side, the trustees balance is they want to maintain um a healthy and a fair appropriate dilution, but not an over and excessive dilution of the ESOP's ownership interest. So at the time that the warrant is exercised and paid, Um, it could really reduce the valuation of the existing ESOP so much that it becomes problematic. And so that's the job of the trustee is to balance that out. This article also pointed out that there are really no regulations or guidelines published on the use of warrants in ESOP transactions, but there are really tax and fairness issues when in their design and use, and we're going to get into some of the the concepts behind the design of a warrant. Um, but know this, that they're going to be negotiated with a trustee. And so that there is a balance and when you're suggesting um a warrant in a transaction, there's going to be a balance based on the trustee. Um, doing the right thing by the Department of Labor. Now, one thing is true in ESA in the ESOP world, and that is. There is always ongoing controversy and discussion um about warrants and really because of the way the Department of Labor looks at the use of warrants in ESOP transactions and the scrutiny that they go under. And so one issue you have is a selling shareholder. is you have to ask the question of your advisor and you need to feel good about this in terms of, of what you're getting into. Um, if you have an advisor that can, um, and does suggest a warrant that's really going to, um, Be a, a trigger for the Department of Labor, that meaning it's gonna really dilute the shares of the, of the ESOP to a point where it's going to be problematic. Um, then, are you comfortable with that in terms of a potential investigation on the Department of Labor? So you just need to get comfortable with your team and make sure you ask these questions. And, and again, that's one of the reasons I wanted to do this episode is to really get into that conversation. Um, to point it out. And it doesn't mean I'm saying don't use them. It just means I think you have to be asking the right questions when you're being suggested that you use them. Now, the article also points out that it's possible for, you know, as a, as a selling shareholder looking at this as an option. Now, if you're looking at selling your business as as an ESOP compared to selling your business as a, you know, a company to a strategic buyer. Um, there's this concept behind a strategic sale being a strategic valuation as opposed to your financial valuation of a fair market value. And so, As the selling shareholder may be inclined to try to get the highest price and there's certainly, um, they're certainly do that, and anybody that it's your business, so you should sell it to, you should sell it based on the objectives that you have. My, my point here, and this is what the article is saying is that you have to be asking the question, if your advisor is saying use a warrant in order to enhance the deal, so that you go the direction of an ESOP, ask the question, would you do this deal without the warrant? Um, and if you, you know, in order for you to have what you think you want to get out of the deal, because I do think that, that, that can be a distraction or not a distraction, but it can be confusing, and I think it's important to ask, ask those questions because if an adviser wants you to do an ESOP because, and they're trying to make it a more appealing situation by having a warrant, you just want to be making sure that you have um looked at that from all the different angles and you feel comfortable with it. So what we're going to do now is we're going to get into the uh the warrants and how they're using on a transaction so that we can illustrate um their usage and use basically a very simple model. The numbers are really low, it just makes it easier to understand. So our numbers are going to be an ESOP transaction that transacted for $1 million. And in this case, the seller negotiated a 10 year amortization on the sale of their business and they're doing a 100% seller note. They also negotiated with in contemplation of a warrant, a 3% interest rate. Which would match an internal rate of return on that, on that note of 3%. And so the total cost of the borrowing would be approximately $1,165,000 at the end of the, the amortization schedule. So the seller may be expecting based on the lender risk that Um, they should get more than 3%. Now, I would say that definitely would be something I would think that they would want to get more than 3% interest rate. Um, and so to compensate the seller for the risk they are taking, the company could issue a warrant. Now, the warrants would provide a future payment based upon a future evaluation, as I had said before previously. The seller is going to take, um, is taking a risk of a lower interest rate really in exchange for a potential payment for them to reimburse, for them to be reimbursed at the end of this period of time when, when the payments are completed. The warrants then give the seller the right to buy shares of the company after the date of the payment of the loan's last installment for an agreed upon price, which is going to be established at that time based on the ESOP valuation that's conducted. This way, the seller gets an extra payment and consequently increases the return. So, so that's kind of the idea. Even though the warrants are exercisable, I should note that the ESOP trustees not going to negotiate, the company is not going to um have those shares issued. They're going to pay off the warrants because um you don't want to jeopardize the ESOP and have another owner outside of the ESOP. So in this example, we are going to assume that we have negotiated with the trustee a 10% warrant warrant on a fully diluted basis. Fully diluted simply means the shares of the total common shares of the company, um, that include shares that are currently issued or outstanding, but also shares that could be claimed through the conversion of convertible preferred stock or through the exercise of outstanding options and warrants. So once we add that on, we're going to fully dilute, we're going to dilute all of the value based on this additional 10% of new, of new stock. So with that, We are going to walk through the calculation of the value of the warrants and really in order to project how much the warrants payoff will be. And in order to do that, we're going to go back to our valuation model. The company was worth originally a million dollars based upon the purchase price. Uh, from the forecast, we've determined that it should grow by 5% a year. So in this example, the company has 10,000 shares or 10,000 shares of warrants with a pre pre-transaction price of $100. With a post-transaction price of $5 per share. So, what, what the difference in those prices is going to come back to the um the debt that we're putting on the balance sheet. So, this is referred to the $100 versus the $5 per share value. is referred to as day one and day 2 pricing. So the valuation on day one was $1 million. However, as soon as we put a million dollars of debt on the balance sheet, our company now is worth significantly less. So, as the debt though amortizes and pays down, the value of the company then increases, um, and it comes back up. Now, if you hold profitability constant and other risk factors constant, then as we pay off debt, we should come back to the original point of evaluation when it's completely paid off. So, we're going to assume that the trustee uses the post-transaction value as the starting point to measure the warrant's future value. What this means is that the trustee is acquiring 100% of the company's stock, but is negotiating to give up the upside potential on a portion of the company. Now, in this case, we're, we're saying that that would be 10%. So to estimate the future strike price of the warrant, the fair market value of the warrants in the future will be estimated through a model to determine the future growth of the evaluation through this 10 year period. Now, the 10 year period is there because we have to pay off the entire loan before the warrant is able to be um called or exercised. And so, The trustee will require the warrants to be callable after the period of years that that um the seller not repaid. So that's the 10 year period. In the event that the seller note is repaid earlier than 10 years, then the agreed terms of transaction would allow the company to call the warrants. Now that's the trustee side. On the seller side, we're gonna want to make sure that we have a minimal number of years that we can keep the warrants in order for them to appreciate and value and for us to be repaid what we believe is, is in order. And so we're going to have that as part of the, the way we negotiate. So it may be that the company cannot call the warrants for a period of 7 to 8 years depending on, on the way we negotiate that. So to summarize so far, we have um issued and we're, we're treating this as it happened in 1231-19. We have issued warrants as of 1231-19 with a term of 10 years. We have a liquidation date of something in the future after 10 years, we're gonna say it's June 30th, 2030. We have a number of warrants um that are $10,000 which we we talked about. We have a strike price, which is the day two price of $5. And we have an agreed upon, um, internal rate of return, which we'll get into. So, In our example, we assume the ESOP trustee is only willing to allow a 10% on a fully diluted basis or 10,000 warrants. The warrants are called in the year after the ESOP loan is repaid, thus, so we have in 2030, at the end of 2029, we have an ESOP valuation that's conducted. And we then are going to move in and actually pay off the warrant at that point. So sometime around June of 2030. As we go through the model, what we're doing is we're, we're taking the company and assuming a growth rate, and we're gonna assume that growth rate's gonna bring us up to a new valuation number in the, in those 10 in that 10 year period. When we do that, we determine a new share price value of $34.35 based on the appreciated value of the company over 10 years. And so from that, we're going to take that 10 10,000 shares times the $34.35 and we're gonna get a final remaining payment of $343,000 roughly. So when we add that to the payment from the model, we can then calculate all those payments in a uh internal rate of return calculation, and that's going to get us a 7% internal rate of return that we're going to then use to um as part of the negotiated rate of return that we're getting on the transaction for the seller. So in this case, the seller and the trustee have now negotiated the internal rate of return at 7% using this model in order to make sure that they've, and again, estimated the value. Now, what's true here is that the seller um is going to hope for. You know, a valuation that is higher than what we came up with. Now, the obvious reason is because they're going to have more money. So the difference between that $34 and the $5 is going to enhance their total value um of the, of the um redemption or the redeeming of the warrant or the payoff of the warrant. And so, The $34 was after we reduced it for the $5 by the way. So that, that's the final payment they have. So they're going to hope for a higher valuation there. The trustee is hoping that, you know, if he's protected on the bottom, if it does it goes down, obviously, the warrant's going to go down in value. So with that, and my selling shareholder, my, my, my last words in this are that The odds, so the odds will be ever in your favor to maximize the value of what this company is worth. And so you do take as a seller a little risk in terms of that, um, because if the company goes down, you're only getting the 3% interest in this model. And so that needs to be pointed out, and the selling shareholder has to determine whether or not they're, they're comfortable with that risk or not. So I hope that kind of explains, so we, you know, we kind of took the overall definition of a warrant and then we applied it to with numbers and we walked it through step by step to determine the internal rate of return. I hope that really helps you understand what warrants are and how they're used in the transaction to um help in uh accumulating more return on the um the debt obligation you as a lender or a selling shareholder are giving and getting back from the company. So to finish at the end of the Hunger Games movie, one of my favorite parts of the movie is a scene where Katniss is in the tree escaping the bad guys, and she had to go up and I hope I'm not spoiling the movie if you haven't seen it, I'm sorry. Um, she goes up in the tree and it's, and she's just going to be sitting up there and it's a terrible move because she has no way out. And so, fortunately for her in the tree, there is a Um, a, a hive of what they call tracker jackers, which are bees that are, that are really jacked up and they have all kinds of weird techno stuff in them that make you crazy. And so, She ends up being able to cut the tree branch down and the tracker jackers fall on the bad guys and they freak out and um she's able to, uh, to get away from the bad guys. So with that, I would, um, I would say to you, just as you start thinking about the use of warrants and the use of, of, um, you know, anything with your ESOP transaction is be prepared, planning is essential so that you don't get stung. Hope you enjoyed that. Hope you enjoyed this, this podcast. If you like it, please share it with a friend and subscribe and please leave a rating for us. And with that, we will see you next time. Thank you so much.