EP29 - The Art of War - Negotiation of an ESOP transaction.

Thank you so much for joining the podcast today. I'm the ESOP guy, and we are on a journey to an ESOP. If you've been continuing on this journey to an ESOP, you know, we pretty much are taking different topics each week, and we're going into those to truly try to present a resource for those folks that are thinking they might, they might want to use an employee stock ownership plan in their business strategy. That might be to help their business grow, that might be to help their business work on succession planning, that might even be to help the selling shareholders to exit the business. But for whatever reason you're looking at it, um, there are a lot of things you actually can do with an ESOP. So for those that are joining for the very first time today and listening, I just wanted to say thank you and welcome. If you like what you hear, please look at our website, journey to an ESOP.com, where you, where you will find multiple episodes of this podcast. The title of the episode today is The Art of War, which I'm borrowing from an author who by the name of Sun Tzu, and it's a book written for military strategy. So today's topic is really about negotiations for an ESOP. What's true about it and the journey to an ease up, if you stay on this journey and you're actually working through the process, is that you will eventually find yourself in a negotiation with a trustee and their team. So what we're going to do today is focus on this idea of nego negotiation as a business planning concept. Now, I realized that as I talked to business people, most people, most business people have experienced some type of negotiation that could be at the very simple level of just hiring someone and negotiating their compensation that could be. Negotiating a contract or or customer issue that could be even negotiating an M&A transaction for your business when you're acquiring. Um, so a lot of folks have dealt with negotiation. And so this is going to though focus itself on the best practices related to negotiating an ESOP transaction. So as always, if you like what you hear, please rate the podcast. Your feedback is very important for us, and subscribe. And also, if you do think it's going to be helpful to somebody that you know, please share it with a friend. So today, in the art of war. Written by again by Sun Tzu, there are 5 essentials for victory. He will win who knows when to fight and when not to fight. He will win who knows how to handle both superior and inferior forces. He will win whose army is animated by the same spirit throughout all its ranks. He will win who prepared himself, waits to take the enemy unprepared. He will win who has military capacity and is not interfered with by the sovereign. So essentially the Art of War teaches us. To rely not on the likelihood of the enemy, not coming, but on the our readiness to actually receive him. So when we talk about readiness from this concept or this, this book, it's going to be the readiness of being prepared for what's coming. And I think that's the essence of of pulling out what, what we can from the art of war. So what is true about an ESOP negotiation is this, the better prepared you are for the negotiation, the better the outcome will be. But what does it mean to be prepared and that's what we're going to cover on this episode. So let's just start with the process of going towards an ESOP, and we're going to go through this very, very quickly, but just the beginning steps as we go to towards it. So I think that's all important because of the context of each of these steps in terms of how we're going about a possible ESOP transaction. And so the very first step is going to start with the goals and objectives of the selling shareholder. So how else do you know that you want to be an ESOP unless you've worked through that practice of really asking those questions? What do I really want to get out of the potential sale of my business, whether that be to sell a portion or a part of my company, or that that be I'm going to sell all of it. And so those goals that, that step of goals and objectives is very important. Once that's established, I guess in a sense, the selling shareholders should have a real strong idea of what it is they're trying to accomplish. And as they go into the next step, I guess the the the main thing is, is as we go through each of these steps is, is continually keeping in mind what the original goals and objectives are at the very first stage. So as we go in the next stage, it's going to be what is our business worth? And so creating some sort of evaluation model and our, and our role and what we do is we want to make sure we create a valuation model that's going to just like a battle plan, it's going to show us what it's going to look like once we get into negotiation. And that's a very challenging aspect of doing ESOP work because we might do a valuation model 6 months before the transaction. And so what we want to do is make sure we incorporate the elements. Of flexibility in the model that makes it that make it easily updable so that as we go through planning the strategy of going into negotiations that we're really doing it with every single step that we take. And so the valuation model is no different than that. The next step would be to go into the feasibility model once we know what the numbers are, now we can use the numbers to create a cash flow model and look at the tax benefits of the ESOP and then look at and determine financing to determine how much that we're going to have to bear in terms of cash flow or how much the company's gonna have to bear in terms of cash flow for the transaction. What that's gonna do is it's gonna help us move into the next step, which is our ESOP strategy, so that we understand how much we're gonna sell and when potentially the transaction's going to be. We're gonna also look at that as how we want to utilize synthetic equity in the transaction, namely warrants or, or SARS. We're going to better understand what we want it to look like on the plan document side. So there's going to be a a general ESOP strategy created out of those elements. And again, I wanna, I wanna Uh, continue to say that each one of these steps is very important because they're leading us towards understanding our battle plan as we move into this concept of, of negotiation. Once we're done with that, we're ready to present to uh the process of hiring a trustee, so going out into the marketplace to find the trustee that's the right fit for our ESOP strategy. So what we're doing there in this step is we're, we're going out and we're interviewing the trustees and we're basically hiring the B side team to begin the steps of moving into due diligence, which And when I stop and talk about due diligence, one of the things that you should be keeping in mind is due diligence kind of starts with, I guess, officially with hiring the trustee, but it really does start with the very beginning as well. And when we talk about due diligence, we're getting closer and closer to the step of negotiation. So one of the best practices is to always keep in mind your checklist of items prior to uh even starting the transaction. So what sort of information are you going to need to provide in due diligence and why? Because when you go into negotiation of an ESOP transaction, you are negotiating um in areas where you've already planned your, your um communication to the trustee. And so due diligence is not just providing documents, it's communicating to the trustee and their financial advisory team. So once we've done that, we're ready to then go into negotiation and negotiation works like this, if you haven't been through a transaction, the, the trustee, the independent transaction trustee is going to make an offer or your side, your yourself side is going to propose an offer, and then that offer is going to be counteroffered by both sides until there's an actual uh Uh, final purchase price and all the other elements of, of what you're negotiating are finalized. Once that's completely done, the battle's over and now it's, it's time to put it all together and, and close um the hopefully what you would have as a victory at that point of what you really wanted to get out of it. And so as you go back to the goals and objectives, did we meet our goals and objectives in the process? And that's when we know we've won the negotiation. And so then at that point, plan documents, other documents, and you move into closing. So that's a real quick overview of the steps it takes towards an ESOP transaction. And as I move through it quickly, obviously, there's a lot with each step, but again, I wanted to point out that every single step you take in negotiations or in an ESOP transaction is part of what I would determine in the negotiations, um, all the way up until you finish. So, preparing for negotiations at the very beginning really is important. And, and I think as, as I, as I alluded to this in your goals and objectives, you really have to know what you want to get out of the negotiations at the front end. And I'll and I'll stop and say one of the things that this is going to uh illuminate in the process of working with a client or working as you, as you think about what you want as well and on as being potentially the client is hiring an advisor. Is your style of negotiation. And there are some negotiations that are what I would say are win-lose negotiations. And I think it's very important to understand that that that style of negotiation is you as a sell side are trying to win at the expense of the buy side losing. And I think that's a very dangerous style of negotiation for Ease up transactions, simply because it matters what happens to this company after you're done with your closing. And I believe that to me philosophically speaking. And I'm, when I'm starting to think about preparing for negotiations at the very beginning of, of the step of goals and objectives. Philosophically, I believe a win-win negotiation strategy or or or style of negotiation is, is more applicable when it comes to ESOP transactions. And so in that case, a win means as a selling shareholder, they win, because they got the fair market value of what they believed the valuation was worth, or what they had built up in their models. On the employee side, the employees win with an ESOP company that's actually producing what it needs to produce for them as well. And so then you have this long term sustainable ESOP at the end and all through that process, of course, um, There's going to be, you know, even with a win-win negotiation, there, there's going to be a lot of back and forth, but the idea is beginning with the end in mind is thinking, I want to be, I want this to be a win-win for, for those that are involved in this transaction. So with that, I think that's the first step of preparing for negotiations. In the classic movie that is so famous and based around a real historical character, William Wallace, not to stop and say for a second. The movie Braveheart. And you got to know I'm a movie buff, so you, if you've been listening to this podcast for a little while, you know, I, I love movies, but this is actually one of my absolute all-time favorite movies. When people say, hey, what's your favorite movie? Um, if I don't list this in the top 5 movies, um, something's wrong with me that day. So this is absolutely one of my favorite movies. Um, in this movie, William Wallace, who is our hero. In the movie, has assembled a team of Scotsmen, and they prepared for battle, really with one aim in mind, so their goals and objectives were really clear. It is to beat the English. really worse than that, but so as William Wallace runs out into the middle of the field on horseback. He's going out in the field of battle to, to negotiate with the English military leaders. So he goes with this and as, as you see this epic scene, he goes out with this very strong arrogance, knowing that he and his people are prepared for battle. He's absolutely prepared for battle, but he goes out into the field with the other Scottish nobles. Who have been so used to negotiations being, well, we're out here for a battle, but we will take land and titles instead of going into battle today, which seems probably pretty logical, but that's not what William Wallace wants. Ultimately, he's not negotiating just to beat the English. What he really wants. Is freedom, and then he makes his cool speech about freedom. But the point of all that is that, um, William Wallace isn't, is a great negotiator in that scene, only because he gets exactly what he wants out of it. And he just really ticks him off because he wants the English to come in at at them because he's got this great battle plan. And so he and his group of blue-faced war painted rebels were prepared with first the right team. And the right battle plan and ultimately, they knew what they wanted. And so, so the first part of being prepared is just essentially those aspects. And we're going to cover that in this, in this episode of, of building the right team, making sure you have the right battle plan and really continually understanding what is it that you want out of this ESOP transaction. So who's on your team? Let's talk about that for a few minutes. So, shareholders intending to sell stock to an ESOP. are going to um be represented by an independent trustee who is Looking at in their termed a transaction trustee as well, they're looking at. Making sure that they have on the buy side of the transaction. have represented their interest in the right way. And then they haven't overpaid for the, for the stock, and they have come in with the right price and they've they've also come in with all the other elements that they need. So the independent trustee, when they move into this, what's true about a transaction is they'll never act on their own. And so the idea of building your team is you should not either. The ESOP trustee will normally retain ESOP legal counsel, as well as a financial advisor. ESOP transactions and are typically um have these teams, these, these trustees and their attorneys and their evaluation firms that work on other transactions too. So what one of the advantages that they have already is that they've already worked on other deals together. So you're going in as you start to think about your team, you're going into a transaction, most likely with experienced team members on the other side, on the buy side. And so When the ESOP trustee is looking to negotiate, you know, at the end, they're looking to, to provide a good deal for the ESOP and even would pay something less than fair market value for the ESOP. So what we need to know is that's what they're coming, that's what we're walking into. When we prepare for um building our team or you prepare for building your team. So picking your advisor advisor is obviously really important. So let's talk a little bit about hiring the right deal advisor. So here are a few points to consider and helping make a good decision. So the role of the deal advisor. is to negotiate the most favorable price, terms and conditions for the selling shareholders. Now I'll just stop and say back to our goals and objectives again. If your goals and objectives aren't being considered in the price, terms and conditions, then your deal advisors and misaligned with what your intentions are. I think that has to be constantly assessed and as a selling shareholder, you need to constantly assess that with your deal advisor and who you're hiring. So, one of the major differences in this, this transaction negotiation is that the independent trustee really is the one that makes the final decision on their side. The deal advisor really is more of a representative who is helping the selling shareholders work through the process and help negotiate, but this the deal advisor is not the one who's making the final decision. That is the selling shareholders' move. So again, when you are in the midst of that negotiation, you want to make sure that your goals and objectives are properly represented by the deal advisor, because you will be in the midst of making these final decisions, and you want to make sure that you're, um, you're represented correctly. I think one of the things that to begin with as well when you're picking your team is, is and really kind of gets goes back to the goals and objectives, goes back through the evaluation model, it goes back through the feasibility model, it goes back through the ESOP strategy is, is what do you want this transaction to be on a very general surface level? Does it, do you want it to be a simple transaction? Or do you want it to be very complicated? Now, part of that is going to be rooted into what your goals and objectives are for the transaction. So it's not It'll be that complicated transaction will really be a result of your goals and objectives and what you want to get out of it. And so constantly refining those is going to be important because at the end, what we do know, if it's a very complicated transaction, it is going to cost more, it's going to take longer and you're going to have to. Um, make sure your prep, your, your preparations are, are definitely more in tune with your team. And so making sure you know where you fall on that spectrum is gonna be important. So, so for instance, in that, you may end up deciding in your goals and objectives that you want to use warrants. But the decision when you start making the decision to use warrants, which will help. Um, provide additional interest income in the transaction where you, you get a lower rate up front, maybe that you were talked, you know, into that as part of the deal from your deal advisor. So you really have to ask yourself the question, do warrants really make sense? And then I've done another episode on warrants where there Used in about 27% of all transactions. So maybe 1/4 of all transactions use warrants. So you have to ask yourself, why do companies use warrants? Why do some selling shareholders use warrants and why do others not? And so part of it is, is just understanding what you want to get out of the deal. And there's no right or wrong answer here. It's just a matter of you knowing what you really want to get out of it. But also then, Understanding the implications of all those um aspects of the complexity of the deal. So where you, where this is going is you should really be asking the right questions for your team before you hire them. So let's, let's just go through a few that you might want to ask, how does the deal advisor strategy um affect you and is that strategy in align with your goals and objectives, which is something we kind of covered already. How does the deal advisor strategy affect you in terms of the future, in terms of what happens to you in the future of your, uh whether you seller note, how the seller notes affected by that, how does the future company be affected by that? How do your employees, how are your employees affected by that? So that's going to be important to understand not only the present goals and objectives that you're trying to get out of the transaction, but also what does this mean for you as things go on in time and really looking at your own fiduciary responsibility in the transaction, how is that being represented into your, your questions for the deal advisor? So when you, when you come back to that, then how does your deal advisor when when we talk about this idea of a win-win strategy? What is it that they get out of the transaction? Um, obviously, they're going to get paid and how are they going to get paid? Is it going to be a transaction fee or they're going to get paid, um, on a consulting fee? How does that work? Um, I always think that's very important. And when you think about that, if I put, if I put my Deal advisor team together, and they're, and my goals and objectives are to try to get the very highest, highest price. Then I may feel better about a transaction fee. But if I do that, I know I got to know that they're, they're going to try to get the highest price at no no matter what happens because they're going to get paid for that. So does that put undue pressure on the future of the ESOP? And so how do I balance that out and knowing that you have other options and you have to have to ask the questions and do the research. So preparing my team and hire my team is very important. One of the parts of that, obviously include, but I want to make sure I really stress this because I only really talked about the deal advisor role, but it really always include, maybe it makes sense for you to get your own attorney, not just the corporate attorney that writes the plan document, and then the attorney that represents the trustee, maybe you want a third attorney that represents your interest. And again, having that done upfront is going to be very valuable to you because You're going to have them to ask questions um from the standpoint of how they're seeing the transaction. Now, preferably you want an attorney that has ESOP experience in that regard. Um, the, the second would be a banker, and your banker may be a great advisor in this, certainly understanding their, the company and the relationship if they're a great banker, and I've done other episodes on, on the banking advisory role and how important it is. But bringing your banker into the conversations early on in the process would be an important step in building your advisory team. Obviously, your CPA now, the way we do ESOP advisory work is that we, we are a CPA firm, so we automatically bring that element into the equation. But if, if your deal advisor is not, then you definitely want your CPA involved in your transaction. They're going to play a critical role in understanding your tax, the tax consequences all through the transaction before the transactions done and then after the transaction is booked. And then I did another episode on insurance advisors, and I think we often overlook how important it is for insurance, our insurance advisors to look at what are the costs of insurance before ESOP and after ESOP, because that's a very interesting aspect of it as well. So, when we go through that process, what we know is we start with what we really want to get out of it. And as we build the team, we're going into this concept of, of having a win-win negotiation. So we get to this next step of really saying, well, what is it? What are we really negotiating? So if you haven't gone through a negotiation, I'll give you some general areas that we're actually going to negotiate. So clearly we're going to negotiate the valuation or the purchase price of your stock. So what you are selling your stock for. And going into that, the idea of evaluation, which I kind of mentioned briefly, what you're going to want to do is really understand, how did you come up with that number. And as I said before, the issue with ESOP transactions is you're preparing for something that's going to come down the road. So every time you have a new month of information, your valuation and the and the actual net proceeds of that transaction are going to change. So I think what's critical about this step in in understanding the the negotiation site for evaluation. is you as a selling shareholder really do need to understand and get behind the numbers with your deal advisor and understand that the con the continual potential changes that you have in your valuation based on changes in your interim financial statements, changes in that, within that, within your balance sheet, um, how does your forecast look and are you um above your forecast or you below your forecast? And so you're constantly looking to try to update that part of it as you, as you go into that part of the negotiations. How will the ESOP deal be structured? Will there be bank financing or seller financing, and what's the portion of each that you're proposing in your negotiation? Will there be any redemption of stock prior to the transaction or will it be all sold to the ESOP? Is there, are there synthetic equity instruments involved? So as we've mentioned before, would we use warrants at what percentage on a fully diluted basis would we use warrants in the transactions? So that will be something that would be negotiated with um an interest rate and an internal rate of return. What management incentive plans are, are we going to look at in terms of negotiating and what SARS or stock appreciation rights programs. Again, another form of synthetic equity that benefits your key management and what percentage are those SARS um related to the deal? Will there be any deal structure related to it? This is, this is gonna bring us right back to the very beginning, the goals and objectives. If the goals and objectives of the owners are selling shareholders are, we don't want any deal structure, then we really need to talk about that as we go through the process of planning the negotiation very at the very front end of the very early end process. Now, with COVID, I will say this part of the negotiation is very difficult because trustees have more of an inclination to do more clawbacks because they have less risk and going in and buying, buying a company with some uncertainty related to COVID. That's all that is going to be more prevalent in an EAP negotiation. So will there be clawbacks, will there be earnouts? How will the deal structure look? The next level of um or the next element of negotiation would be governance. And so what's the board of directors of the ESOP company going to look like, whether we have a controlling interest or we have a non-controlling interest, and we start thinking very, at the very beginning to who might those independent board members be? Um, and have that in the back of your mind as you go into the negotiation because you, you want to know that, yes, OK, I'll accept an independent board member that this is the one I'm thinking I want to use. What's the term, this is the next element. What's the term of the ESOP loan, um, whether it's 2025, 30 years, and within the limitations of the ESOP contributions and how does that work? So preparing for that as well, again, early on in the process, which should be done in the feasibility model. What is my required working capital in the transaction? How much required working capital should I be required to have, which is going to affect the net proceeds of the deal when you get, when you get all the way through the transaction. So just a brief overview of the elements of what you are actually negotiating and how important it is for those to be um presented. So as we go through, as we've gone through that this, this episode, I think the major thing that we would summarize this is, I really understand your desired style of negotiation. I'm not here telling you you should do a win-win. I just think that that for, for what we look at is more balanced for a regulated transaction where the Department of Labor can review the transaction later and where you have an impact to your employees and when you're doing it. So that's my, that's my recommendation when you, when you look at this. Um, the next thing would be Looking at your process of all the steps that I talked about. So understanding your goals and objectives very clearly, as I summarize those, I think the the key thing, and this is the exciting thing about working on ESOPs that I love. Is that you ultimately are building a puzzle piece that all these different parts and pieces that we talked about within the process fit together. And if you do them really well, when you get to the table to do negotiations, I believe it becomes a lot smoother, the expectations are. Um, much, much easier to understand. And ultimately my goal, and I believe when you look at what your deal advisor goal should be, is to align what I am doing in the work we're doing towards each one of the steps of the process to align those continually with the goals and objectives of the selling shareholder with what you first started. So that at the end of the negotiations, you really did get what you wanted to get out of the transaction. And that you weren't really surprised by it all, except for there is a back and forth process and it is negotiation, and it is an arm length transaction. So there is a sense for, for this to be a really true uh type of transaction that you'd be working through. So with all that, I will say. That ultimately, one of the, one of the best reasons to do an ESOP in, in terms of working through the transaction is at the end, you get this ultimate rush, which William Wallace coined in the movie Braveheart, we didn't really coin it, but he did, he did use it in his speech that we all want freedom. So if you go through this process and you gain freedom, then you've won in your negotiations and that is a great victory. With that, have a great week. Thank you for listening to the podcast. If you like what you hear, please subscribe, rate the podcast and share it with a friend. We look forward to our next episode and we'll talk to you then.