EP28 - Godfather - ESOP plan design - planning for the deal you cannot refuse...

Welcome everyone. This is the ESOP guy and I'm so excited to be with you today on this journey to an ESOP. So let's start with something like this. So we are on a journey to an ESOP and so happy you guys could join today. Um, if you've been part of this, this journey with me, I'm so thankful that you're here and listening and maybe even watching as we're trying to continue to, to do some new things with the video. And So I'm thankful for that. We are in our, our 2nd season and we're deep into the summer. And as we go forward, um, I just wanted to kind of, kind of give a shout out to those that might, you know, be new today to the podcast and say thank you for checking us out. If you're interested in this podcast, really what I wanted to say is that it has really been designed to provide a resource that people can just stop and listen to in their car. Um, or are on their way to whatever they're doing and provide some information on how ESOPs work and see how that might be a good fit for you in terms of your business planning. So, again, thank you so much for joining. If you're curious about other episodes, please go to our website at journey to an ESOP.com. With that, I'm gonna then kick off this with um this one, this next one. And so I'm building up a little bit as you might be able to tell and uh so listen to this. So I'd say they won't move against you first. You'll set up a meeting with someone that you absolutely trust. Guaranteeing your safety. And at that meeting, you'll be assassinated. I like to drink mine more than I used to. Anyway, I'm thinking more. All right, classic movie, love it. First off, um, these guys are the best actors ever, right? So, Marlon Brando and Al Pacino, just phenomenal, and a classic Epa epic, The Godfather. And so, in this scene, Michael and his dad, They are talking about the plans of the family, the plans that they have to figure out, and it's pretty serious because uh the Brannzini family is moving in on them and things are dangerous and they've got to get things figured out. So they're doing a lot of planning. And it's interesting too, because as I think about. Uh, the movie itself, as we go into it a little bit deeper. Um, I thought that, you know, in this episode, it would be really helpful for, for us to think about the plan of the ESOP as well. And so what we're going to do is we're going to take a, a snippet of the ESOP process, which I'm going to call the ESOP plan design. So the title of this podcast episode today is going to be Godfather Designing the plan for the ESOP Business. This episode is really going to help, I think, put together some things that are maybe not on the forefront of your mind as far as really what is important in doing your ESOP plan. It's, it's going to be things like how does vesting work, how does eligibility work? And those things are not necessarily things that you're not wrestling, you know, maybe wrestling with really at the front end of the process. But I think that's helpful to think about them at this stage of things or just really Be aware of them. So that's what this episode is going to be all about. So if you stick with us, we're going to go into some details on that. As always, if you like what you hear, please subscribe to the podcast. It might be helpful um to not only you but also friends. So if you think that might be a good fit, send it out to them, um, or share it with your friend and and however that works for you on your, on your iPhone, so, or another device that you might be using. So widely regarded as one of the greatest films of all time, the this Godfather movie, The Godfather trilogy, really is um one of the most famous mob dramas of all time. Um it was written by Mario Puzo and was released back in the 70s and Uh, to me, it's something I, I just remember growing up with and it's just this, this really interesting family business dynamic with, with all kinds of mafia issues and, and. Um, crime and everything else, but, um, the movie, I think is very intriguing because it pulls you in the characters are developed so well. The whole business, the family business itself is built around this Genco Pura olive oil company. So there's, you know, this idea of of having this legitimate business, but As I connect that to this podcast, and I say, OK, well, how we, how we're going to get to where we're going to go with, with the idea behind this movie, um, it is this idea that that the family business has a certain culture to it and an ESOP company is going to have a certain culture to it. And when you think about how they got to where they are, it it had to have, you know, an immense amount of planning. I always think for thinking about the crime and people that put this much energy into planning, you know, crime, a crime family or an organized system of crime, and they, they put all that energy into building a real legitimate business, they probably would have been better off and not have maybe all the problems that they had in their life, but Either way, um, there's a lot of benefits to working for the, for the Corleones. I mean, people get paid really well. And so just like an ESOP company, there can be a lot of benefits as well. So there's some parallels there that I, that I think are really good. And the parallels too in terms of what it takes to plan those types of um businesses in terms of planning your ESOP. And so, I will say that, um, unlike the um ESOPs, the family business that you work for and the Corleone's, it's really not um very fun if you're going to get terminated. Um, it's not fun anyways if you're going to get terminated because you really um are not going to like that. And so, But it's, it's interesting too though, the family businesses, um, this family business that the Corleones, um, you know, you're probably, probably gonna spend the rest of your life there and you're hoping that your, your company with an ESOP your people spend the rest of their life there. Anyway. All that being said, I wanted to talk about the ESOP process in relationship to the plan design. So let me start off by saying that as you plan your ESOP, this is going to be an important step along the way and it's, and it really isn't something that we do initially when we, we start consulting with a client. It is something that we do probably after and concurrent with negotiated, when the, when the negotiations are happening. So we want to be thinking about that. I also want to say that this is something that I would, I would Put in the category of expertise and say, all right, it's really the, the uh the ESOP attorneys, the the qualified ESOP attorney's job of, of doing this. And I think that's important. What I want to accomplish with the episode is to, is to really go over all the, the, the maybe the categorical areas that are important to be thinking about when it comes to ESOP plan design. So what I want to do is hope, I really hope to expose you to some of the ideas and really better prepare you to ask maybe right questions as you're going through this process. One of the documents, as we start the whole process, one of the documents that you're probably going to get asked to pull, and you might as well maybe take the time to look at this and think about it right now is the 401k document. The reason this will be reviewed is because there are very similar planning and as we think about what an ESOP is, it is a retirement account. It's a trust, but it's a retirement account, just like a 401k account. Now, there are differences and I want, I want to highlight some of the differences as we start thinking about pulling that document and start walking through that with the ESOP attorney. The main thing is that the ESOP itself is investing in the company, and it's investing its money in the company. And so the company buys shares on behalf of the employee and places those shares in a trust, and the employees then incur, um because of this is a benefit to them, they incur no out of pocket expenses. The ESOP provides a retirement option for those employees who can not afford to make a regular payroll deduction to retirement or Um, most of the time, they're not making a payroll, um, deduction or or putting money into the ESOP. So, as we, as we said, ESOPs generally buy company stock only, that's, that's kind of the, the idea behind it. So, um, that's kind of now concentrating your ownership of your retirement account in one privately held small company stock. So, when we, when we think about that, then it's important to also know that there's that that's a key difference as we start thinking about the 401k plan. Employees earn shares, they don't earn money, so employees will earn shares based on certain criteria such as salary and tenure in in terms of how they're allocated those shares. The shares will rise in value and fall based on how the company performs. Uh, employees have a vested interest and, and this is one of the key elements of, of a successful company. They want, they want to have employees that that are You know, wanting to be part of this whole thing and, and see the big picture. Um, I have a client who recently told me about a couple of employees. They're a couple of years into their ESOP and how excited they were to see the value of their shares go up by $2 a share. So that's exciting. And when the, and when you can connect the dots there, it, it makes it even better because employees start getting it. It does take some time. It takes some time for them to understand it. Um, employees don't control the ESOP shares. The ESOP Trust holds the company's shares on behalf of the employees. Employees cannot trade these shares on the open market. They're just, they're in there and they're connected to the value of the business and that's how it's, how it's set up. And employees will likely need to wait for their funds. It takes time to dispose of stock. When employees leave an ESOP company, the company, um, the plan may require that payouts be spread out over several years. Uh, the company contribution is, um, really part of, of how the ESOP works at the, at the foundational level. So the value of an ESOP account varies based on the factors such as salary tenure, and I said that before, um, but it also will affect if the company is going, goes through a downturn. So, so all of those are connected. So I think that's a real good overview of how the ESOP as we start thinking about now how the 401k works. A 401k is where the employees invest their own money. And so typically employees participate in a 401k by investing um money through their payroll. Employees who cannot afford a payroll deduction in this case, um often include those who are starting their careers and working in lower paying jobs, have a hard time participating in a 401k because they're, they're not able to put that money in there because they they're using it to buy groceries, right? And it's, and it's difficult. That's one of the reasons why ESOPs are so favorable because especially with wealth inequality, because it does help um provide a means for some people to participate in their retirement and because it doesn't cost them anything. In a 401k, there are usually a limited number of investment vehicles. However, there's diversification. So a big incentive for participating in 401k is, is that you can put your money in a lot of different places and spread that out and and build a portfolio, a diversified portfolio of retirement assets. So that's, that's one of the main differences. Um, now, in addition to that, many employers, Will provide a match for the 401k, so. Um, that is really helpful because You know, again, they're putting their own money in there, but if the company's putting more money on top of it, that match for the company is tax deductible, so it's it benefits the company as well. Um, employees earn money, not shares, so that's very different than the ESOP, um, employees invest the money they contribute, and the money they receive from the employer. So there is a, um, there's also no long term connection between the 4, the value of the 401k and the performance of the employer. So, so, It doesn't matter. Now, that is a pro for a 401k, but it's also a con when it comes to employee culture because nothing the 401k doesn't really connect you to the company as much as the ESOP, except for the fact that there's a match. And so that, that definitely is is helpful. Um, employees can do whatever they wish with the funds, they can, um, they could put it all into fixed income or convert it to um real high aggressive stocks within the, um, within what the criteria of the investment options are in the 401k. Um, employees possess both money and they contribute and invested the vested funds from the employer. Um, so when the employee leaves, those funds are available immediately, which again, this is different than the ESOP. Um, the company contribution is easy to express the company 40 matches percentage of salary, which is easy for employees to understand. And the other thing is, is the 401k provides more um readily ready information and compared in comparison to the ESOP and that. The, um, ESOP usually has an annual participant statement. Now, the 401k, you can usually get online and check out what, what's happening in real time with your stocks. So, I, I pointed out those differences because I think it's important to understand that um they're, they're definitely not the same things, but we so when we start looking at the 401k um document, we need to keep those things in mind when we're doing our ESOP plan design. Now, let's just go into now ESOP's plan design 101 and we're gonna just talk through some of the things that are going to be important for you to be thinking about as you walk through that process with your ESOP, qualified ESOP attorney. Um, there are employees that are, that are typically excluded. One of those could be employees that are related to a union. So, um, a union employee is what we call a collective bargained employee. They are, are commonly excluded from participating ESOPs and the premise in that is that the individuals that are part of the union have already negotiated the retirement benefits with the employer. So many times, um, they will not be included in part of the ESOP. So, The eligibility requirements of employees for an ESOP typically are 21 years of age with a service hours of at least 1000 during the year. So this means that your part-time employees would be excluded from the ESOP. All full-time employee, employees um that are set up by the date of setting up the ESO are included in the plan, and they immediately start participating in the plan. Now, that doesn't mean they're vested, that just means that usually they're, they're usually the full-time employees are what we're gonna call the eligible employees they're gonna, they're, they're going to be part of the plan. Now, one of the things about this is a lot of times the plan gets created at a certain point in time during the year. So many times we'll end up effective the affecting the plan as like the beginning of the year. And so you would have, say, if you did that, you'd have the whole year of the employees um that are part of the company as of say January 1st of this year, being part of the plan. One of the things that happens though is when you hire somebody right after you set up the plan and you want to make them eligible, um, that becomes problematic. And what you, what you find is that you're wanting to keep this 1000 hours to help, um, mitigate the problem of having people coming in and out of the company, and maybe that person you hired didn't work out. And so you want to have some of those, um, Um, parameters in terms of selecting the amount of service that you might have. So, so be thinking about that in terms of how people coming are coming into the plan. So, so if you have somebody that's hired after the plan is created, uh, it may be difficult for them to immediately get in and be eligible. They might have to hit 1000 hours before they start. So when we look at the, the measure of those 1000 hours, normally we're going to look at the payroll records and some timekeeping systems to, to determine who is eligible on a full-time or part-time basis. Um, one of the coverage tests that we, you would look at is do they have at least 70%, um, have they at least met 70% of the requirement for, um, being eligible at that 1000 hour level. The normally when we look at the ESOP and the, um, allocated shares, what we're looking at is compensation. So when we define compensation, we're normally going to talk about compensation being um wages based on the, on the W-2. And so that helps to create the allocation. Um, and so as we go through that, we, we, we're, what was happening is that your, your employees then become part of the ESOP. And when, let's just, let's just go through the example. So when you created the plan, maybe January at the beginning of January, um, the allocation would likely occur at the very end of the year, say 1231. So, In that allocation, you're gonna have whoever was eligible, which was the full-time employees, the ones that work, you know, at least 1000 hours that year. So they're all in that bucket and as they, as the allocation is released, so the, the stock that is in the ESOP Trust or the employee stock ownership Trust, ESOT. is going to now release the, the that stock for that year, depending on um what the length of the what we call the inside note is. So if that note is, say 10 years, then 10th of all the stock is going to be released and allocated at that time. If your employee is not there as of 1231, then they're not going to get the allocation. And so that's why it's important to um be able to, to think about who's in the company and plan that. And so one of the things that we would typically do is, is have the client pull the payroll census and really be thinking about um who's in the company and and how these criteria are going to affect um what they're doing and how they're going to benefit. So, what we want to do is we want, we want to protect the company from the issue of some people coming in, folks coming in, not working the whole year and having, um, and having and then leaving. And so that's part of the reason we have the, the 1000 hours and the full-time requirements. So what happens though if your company has an employee that you have, you know, either death, disability or retirement? So what happens in those cases, there's going to be specific provisions in your ESOP plan that allow for them to um either be be allocated appropriately because of those circumstances, and also, um, also vest. So let's talk about vesting for a second. vesting is when um it's a legal term that means to give or earn a right to present our future payment. is most commonly used in reference to retirement plan benefits and employee accrues non-forfeitable rights over employee provided stock incentives or employer contributions made to employees qualified retirement plans. So all of that means that um vesting means that you earn it as you put the time in and the vesting schedules that have to be created in an ESOP plan. Or within, say a 401k plan, um, what they do is they, they make it fair for everybody, depending on, on the way that those things are the way that the vesting is created. Veststing anticipates that we don't want to give immediate credit. And have people immediately get access to um what they've earned in their benefits if they haven't earned it over the, over the vesting that we feel is comfortable and also protecting the company. So a lot of this is about um protecting the company from anything that might happen. So 22 main options when it comes to vesting are What we call graded vesting, um, or cliff vesting. So graded vesting is when say you have somebody coming in over a period of time, they, they can grade um over 5 years and say earn 20% or vest in 20% of the of the ESOP over that 5 year period. Now, vesting isn't, isn't the same as what they're being allocated. It's not the same as being eligible, it just means they're, what they're getting in their accounts is theirs when they've been there for 5 years on 100%. So if you have a person that was vesting on the graded schedule, and they were there for 3 years at 20% a year, so in the 3rd year, they would be 60% vested. And so whatever the balance is at that point in time, if they left the company, then the company would owe them 60% of whatever the balance is in their account. And so that helps the company protect from people coming and going and earning and investing. So now, on a cliff vesting, what can, what can happen is you can basically up to 3 years, you can invest 100%. So that just means you've kind of hit the cliff and now you're invested. So you have to wait for 3 years and you get nothing if you leave in the 3 years. Um, what is Typical and what is common. Um, the typical common way to do this is a graded vesting. You don't have to do the 20% a year. You can, you can grade differently. Um, but the cliff, the cliff vesting is not very common and it, and it really is because it's probably just not that, um, I guess it's not that fair if somebody were there and, you know, they leave 2.5 years into it and they get nothing, so. But that those decisions are really up to you. And really just the point of this is to give you information to help you um think about it and be asking the right questions. Um, there, there, the other part of it is you're an existing ESOP company and or an existing company that has been around for 2030 years. And what happens is you have people come in and say, you know, we're going to do an ESOP, it's great. Now, Bob's been working at a company for, you know, 30 years and helped the company create the value. Now, you know, Doug over here has only been there for 1 year. Now, is it fair for Bob to be on the same prior service credit? Um, Investing schedule that Doug is and Bob's gonna look at Doug and say, no way, I did all this to build the company and so it isn't fair. So there's going to be um a possibility if you want to provide prior service credit that would help um establish immediate besting for those and you can set it up to be Uh, a formulaic thing based on how you're calculating your, uh, vesting requirements and eligibility requirements. And so you might have a 15-year person that would immediately vest. So anybody under the 15 years would, would be now back on the vesting program. So it's it's a matter of looking at, that's one of the You know, we start going back to the payroll census. When you look at that, you really kind of sort through it. Um, you can't really discriminate here at all, as opposed to like with individuals. If I have Bob and Dan, who both worked, you know, 15 years and Doug worked 1 year, Bob and Dan are gonna get the same benefit. If I don't want Dan to be in that, then I got to think about, you know, how I want to set that up correctly. So we can't just discriminate. Um, based on, you know, different people, but we can discriminate in terms of the um number of years that they've worked there and making sure it's fair for everybody. So, another, another aspect of this, when you think about your planning is going to be the requirement for diversification. So, at the age of 55, there for ESOPs, there is an opportunity for, for folks to start diversifying the stock. And so what, what's anticipated here is that you might have um ESOP participants that, you know, concentrated their stock in one area. Um, of the, of the company, and they would need to be able to, to, to make sure they have a good retirement in case they feel like they've concentrated their, their um ownership in that on that, in that one area. So, Now, this is probably for people that, you know, have an existing ESOP for a number of years and so there's been built up value. So if it's a brand new ESOP and they're just and the person's 55, it's not really gonna be that big of a deal, but it's more for companies that have kind of built up some value and have a 55 year old or plus that says, hey, I want to think about this. So, The way it works is if I've reached 55 and I participate in the plan for 10 years, then they have the, the person would have the right during those following 5 years to diversify up to total of 25% of the company's stock. And so that's really an important provision in, in the planning and it's just a matter of, of making sure that that's been part of your ESOP plan when you're putting it together. Um, the other thing is, is that if you do have people leave the plan, um, at a certain age, whether they're vested or partly, partially vested or fully vested, um, what you can do is put in the plan, a way to um pay them out on a lump sum if you didn't want them to be, um, Paid out like if you didn't want to string out the payment. So, so typically you might have like a 5-year provision. So somebody leaves the company, they're gonna get bought out of the company and their plan over 5 years. And so what you, what you find there is that um if their, if their value of their plan, say, is less than 5000, um, you can put provisions in the ESOP plan document. That would say, hey, I, I have the right just to write them a check, so I don't have to set up this payment within administratively, it's gonna cost you more to do that. So, so that'll be something that you'll plan for. So within all of that, um, there is a, a need to kind of think about, you know, your payroll census, and there's a need to think about what you're doing on your 401k and how that relates from investing in eligibility requirements, um, how actual hours of service are qualified. And how, um, the, as you, as you look at who your employees are, um, how you think that might fit with within what they're doing. Um, as we anticipate potential disabilities, um, death or retirement, there are definitely provisions in there to take care of folks in those, those areas so that people don't have to worry about if something were to happen. So that gives us kind of a very good, like I said, overview, that was really the goal of what we were trying to accomplish today, of, of thinking about what is an ESOP plan design, what should I be thinking about preparing for, and then just the process itself. And so if I finish on this, I just wanted to finish on your ESOP attorney really would lead you through this process and, you know, I would not worry about the details or taking notes. I just wanted to like expose you to what that process is going to look like. Um, I've been through it with multiple ESOP attorneys and clients, and some of them do it differently. Some of them have a really nice checklist that they work through. Others just work through your 401k, come up with a draft design in your ESOP plan documents, and then you review those. And so, you might ask your ESOP attorney how they go about that before you start the process, but hopefully that is helpful as you start thinking about um what you can do in preparing for your ESOP. So, With all of that, I wanted to say thank you so much. We will see you on our next step on this journey to AA. Have a great day.