EP4 - ESOP financing for Government Contractors with Patrick Stoltz at Wintrust Bank

Welcome back. Thank you so much for tuning in. I'm the ESOP guy. We are continuing on this journey to an ESOP. So this podcast has been created for those that are thinking they might want to use an employee stock ownership plan in their business. This podcast has really been an interesting process because we've been able to identify specific topics to help people better understand the ESOP process. Today will be very interesting. We're going to delve deeper into the industry specific industry of government contractors. And the title of the episode today is ESOPs, ESOP Financing for government Contractors. To do that, we are going to have the opportunity to interview Patrick Stoltz with WinTrust Bank out of Chicago, Illinois. And Patrick's knowledge of, of ESOPs is really great, but also his knowledge in working specifically with government contractors is really great. So, so the combination is gonna be very informative and I appreciate um his, him taking the time today. So Patrick, thank you for joining us on the podcast today. Hi, Phil. Thank you. It's really, uh, really nice to have the opportunity to chat with you today. Um, very much have enjoyed both your topics and the content of the podcast. I think you're really, you know, you're, you're hitting a home run. You're really providing great resources to potential selling shareholders, and I'm I'm really happy that you thought of me to participate. Excellent. Thank you so much. So let's let's start off with just kind of this, a good place so people get to know you a little bit better. Uh, can you give us a brief overview of your, your background and working with ESOPs and of course, as it relates to your banking career? Sure, sure. So maybe I'll start with just a little bit of a backdrop on WinTrust in general. So we are an organization that's headquartered in the Chicago area. However, we, we have many national niche type lending platforms and our ESOP Finance Group is one of those platforms. So, Um, my particular background, this is my 30th year in commercial banking, and really the last 10 years have been focused on pretty exclusively on ESOP finance and, and sort of, you know, what, what drove that is, you know, I'm sure you, you're familiar with the baby boomer dynamic and What we found is that many of our clients were transitioning their businesses and so many of them really did not fully understand ESOP as one of those alternatives when potentially transitioning the business. So what kind of began as an educational journey, and I think you can probably appreciate this, Phil, because I think what you're doing is providing Listeners with a lot of education. Um, what kind of began as that educational journey has progressed into a specialty lending group, and our lending group is a group that's national in scope. So it's something we're very passionate about and hope that we can provide some additional resource today. No, and I, I can tell you just based on experience, the work you guys are doing is very much needed because I know personally, there's a lot of banks not to say anything negative, but they don't have the, the, that focus and that niche, and I think it's, it's hard to step into ESOPs as well. I mean, you have, there's a lot to know. So you guys providing that resource to the community of, of doing ESOP deals is really valuable. Um, so going to this, I want to start with this question and really to get the ball rolling. Um, I know people as they, um, they start thinking about when to bring their deal to the bank, and there's, there's been some questions in this, my, my experience with, typically, I think how the investment banking community does it, which is they'll bring the, the deal to the bank at the end of the transaction. The, the banks will kind of, you know, work up their proposals, their, their term sheets, they'll come through. Can you comment on like, I know with, um, you know, just my experience, it helps to get kind of that started earlier on in the process. Um, when you're going through that, what kind of information do you guys typically, I, I guess a couple of comments on that process itself to bring you in when it, when it's a good time. And the second is, what kind of information would you guys want to look at in order to issue your term sheet? Yeah, I think really thoughtful question. I think you know when we work really well with a lot of investment banking groups throughout the country and we have just a huge amount of respect for their process, you know, we're very similar in that many times when we're prospecting a potential client, we spend numerous years sort of educating through the process and And getting the prospect comfortable with our organization and our potential relationship team. And so I think the investment bankers are doing that as well, and they do a great job of that, really educating and selling shareholder of all of the available business transition alternatives. So but so at the same time, your question is a good one. We, we would always rather be brought in earlier in the process just because we feel like being early in the process really helps the company understand the knowledge level, not only of, of us as a lending team, but also a sort of our relationship style and will it be a good fit for the company and And this isn't just about us. This is about the company making a good decision for them and for their company moving forward. So sort of the more we get introduced earlier, the better I think for both sides to really get an understanding of what it would be like to work together, and we believe that, you know, that's very important in a decision making process. And then the second part of your question, I think, you know, start with the idea that Well prepared companies have just a much higher success execution rate. And you know, I guess how do you define preparation is, you know, is it, is it management succession? Is it, you know, build out of a team? Is it the actual financials, is it the forecasting? And you know, we would We would say that we would like to have an understanding of all of those, but specific to financials, you know, what we typically look for is 3 to 5 years of financials. We, we definitely look for forecasts that typically incorporate the next 3 to 5 years. Sometimes it's not. It's just not practical to do that, but typically that's that's the type of forecast that we're looking for. And then, you know, the receivables inventory, payable information, potential real estate or equipment if that happens to be a part of the transaction, and then backlogs, with reports and contracts with, you know, with things that are more um contractual in nature. So. I hope that gives you a good feel for the types of information that the type of information that we look for when we're looking to present a term sheet. Yeah, I think, I think that kind of is what kind of what people expect, especially if people have experience in in getting a bank loan. It's, it's probably very similar um when we look at that and that's the reason I made the comment about getting you earlier involved because when we start looking at the differences between a government contractor and a non-government contractor. I think there's a lot of uniqueness to a government contractor's business, um, in terms of, of how they're structured, um, when you're looking at cash flow for a government contractor and breaking it down with the specific contracts that they have. Past performance, um, just their type of contracts, whether it be fixed price, cost plus, time and material. I think there's a lot of variables there that, you know, for me personally, I like to get everybody's, you know, comfortable with to see, you know, how does this really play out. Um, for you, when you look at that, what, what do you see the differences between just doing an ESOP deal for like a government contractor versus a non-government contractor? Yeah, so. Again, really, really good question. I think what we, I'd like to take maybe take just a step back and sort of provide a little bit of the mindset of senior lenders, which, you know, again, we think is pretty vital to understanding. when you're selecting a lender, so there's a couple of types of lending, and you, your discussion with Andy in the last podcast, I think really Andy did a nice job of saying there's kind of collateral based and then cash flow based lending, so The asset-based type of lending is really sort of most common in banking, but it ties it ties a loan structure to the collateral pool. So, I mean, that's great, but in the case of service-based companies, what do you do if you, if you're not an asset rich company? So, and that's where we live. We live in the space that really Most of our transactions are not asset rich companies, so in a government contractor would be, you know, sort of the epitome of not being an asset rich company, but the assets of the company walk out the building every day. So We evaluate really differently based on the consistency and the predictability of the cash flow, and then we typically apply a multiple and we call that cash flow lending, which you sort of went through with your in your last podcast. And I think given the contractual nature of the work. The government contractor space we just find to be a business model that's really strong for cash flow lending because it's, it's one of those types of businesses where you have pretty clear visibility into how contracts will be worked through and paid out and so it sort of lends itself to be a more consistent and predictable cash flow in nature. So, And then when you, you know, when you sort of layer in Scorp tax benefits into that, we, we even get a better look at the visibility of the cash flow moving forward. But I think the overarching theme is the predictability and the consistency of government contractors we find to be very strong business models for cash flow lending and ESOPs. I think that's that's a great point. Um, so for everybody that's listening and they're wondering, like the, the podcast I did was with Andy Watson, and he's a, uh, an ESOP attorney out of Huntsville. And the episode is episode 53, if you want to check that out, and it was really from the ESOP attorney standpoint, but he brought in a lot of interesting points and we're gonna, we're, I know Pat and I are gonna reference some of those as we go through it. Um, when we, when we get into, uh, really my next question is going to get into kind of more of the underwriting and how you go through that a little bit. So underwriting the cash flow of an ESOP government contractor or potential government contractor, you know, you move from historical to forecasted cash flow. And to me, that's interesting because a lot of government contractors in their forecast. Um, can go through what would, I would call stair step growth. So, you know, lots of growth potentially get, they get that big contract, then, then the whole thing changes dramatically. And so you could have a historically much lower cash flow on an average basis and a, and a much higher cash flow on a forecasted basis, which creates a, a fun valuation because you're trying to kind of make sure you, you hit the right number. Um, when you guys look at it from an underwriting standpoint, um, and you're factoring in You know, that into the deal. Um, how would you, how do you work those into your financing so that, that you can kind of, I know the buyer or the seller in this case going through an ESOP wants to be treated fairly and get the most financing they possibly can. How do you, how do you treat that type of um underwriting the cash flow, um, you know, appropriately so you're doing kind of the right thing and, and for the bank and of course for the client. Yeah, and I think this is where the nuances of government contractors really comes into play because, yeah, I would not be truthful if I said we do not look at historical information. We do, as do all banks. We, we analyze historical performance and we really try to structure our transactions from a debt capacity. Application to to that historical performance. However, we also look at the longevity of the contracts that are in place. Have the contracts been recompeted? How many times have they been recompeted and one? Is this sort of an essential business? Is the history of the task orders and the funding underneath the task orders, is it, is it really predictable, so. There are a lot of things that we analyze even though we look at the historical performance, we take into consideration all of these factors and when we have scenarios, so we're Future cash flows are very clear and predictable and sustainable and show a significant uptick in performance, and I'll give you an example like an acquisition. Scorp PSOs are great acquisition vehicles. If you make an acquisition today, we're going to be looking at historical financials, but we're going to have to incorporate the target company's performance into our structure. And another one would be, you know, clearly a new awarded contract. So what we do in these types of scenarios is we often will build in additional debt capacity. And so the vehicle we utilize to do that. It's called a delayed draw facility. And that delayed draw facility might be 12 to 18 months in duration, and, and really what it does is it takes on a pro forma basis that we we layer on the new debt. So if we put a $5 million delay draw facility in place, we would layer on that new debt and the debt service associated with that debt. We would layer that onto the current performance and as long as the company can hurdle the predetermined metrics we call those incurs tests. Then they would gain access to that liquidity. And so the idea behind it is 112 months from now, the cash flow is going to be significantly improved, and we're going to provide a committed path if that actually happens. So we feel like we have a really good vision of what it's going to look like. And so consequently, we provide a committed path to accessing that that additional debt capacity. And so what I would say is it's it's not all that common, but we, we do utilize it with future predictable cash flows and we think government contracting, we've utilize it in the space and we think that it it really is the right way to to sort of layer in some debt. Both looking at historical financials and the future performance of the company. Now, I, I love that because if you, if you think about it, they, they, they, they know their business space very well, the, the, the selling shareholder of the government contracting company and And having access to those future cash flows for the financing really does make more sense. And that's why I think it's important when we're, when you're looking at who you're working with to determine your financing that you have lenders that can think through specifically your industry and, and come up with a, with really a, a, a product, I guess, in a sense that can meet the needs that you have and, and the, the changes. So having access to that future capital is, is important. Um, I was gonna jump ahead a little bit. So my conversation with Andy, um, we talked, Andy and I talked a little bit about, um, this type of financing structure, and Andy referenced it as an accordion type, um, versus what you talked about was the delayed draw um structure. Can you go into kind of the details of the differences between the two? Oh sure, Phil. So yeah, the accordion that Andy is discussing, we kind of view an accordion as more. A flex facility for working capital and so if a new contract is gained, certainly an accordion could be a part of sort of a pre-committed path to additional debt capacity. The difference is we look at an accordion as sort of that flex facility for working capital, and on the delayed draw term side, we really, it effectively maximizes. The inexpensive debt by replacing the seller notes or other junior capital structures with senior debt. So what we're doing in this case is we're really providing additional liquidity to the selling shareholders. So most of our transactions still have a fairly significant amount of seller debt behind us. And so what these delayed draw term facilities do is they provide a more committed path to Additional liquidity for the selling shareholders again, provided that the metrics are, are hit on a pro forma basis. Yeah, for sure, they got to hit the metrics. Yeah, so really what, what I would say, in other words is, is you're still keeping their working capital and the normal credit that they need for running the business. On top of that, here's an additional piece of capital to take out those seller notes, um, if they hit those projected numbers. Exactly right. Yeah. So now, so that gets a lot, that's obviously a little more complicated, but if you, if you come back to some simple questions that are banker questions, what do you see um in terms of typical amortization, interest rates, and, and covenants that you have in, in this type of lending? Yeah, and I think this is one of those questions. It's it's really kind of all over the board and it's really dependent on both the performance of the company and the overall transaction structure. So our typical term loan structure. I would say the large majority is a 5 year straight payout. We do provide some 7 year type amortizations where, you know, where we see really strong business models and oftentimes we see those business models in the government contractor space. So we have utilized 7 year type financing with government contractors. I think it, you know, we generally will build in excess cash flow recapture. Given that the nature of our lending is not backed by collateral. We like to know that there's a turnover of the debt repayment, and so what we typically do is we create excess cash flow recaptures that more rapidly reduce the term debt and in most cases, what that allows us to do is really get to the subordinated seller notes more quickly. And so there's there's kind of a dual purpose there. And then on the interest rate side, you know, I'd say we're very competitive. Most of our borrowers are You know with LIBO sort of on the on the outs, most of our borrowers are sort of prime, what I would call prime-based borrowers, if not better than prime-based borrowers, so very competitive on the rate side. And then our covenants typically, you know, we we include um senior leverage covenant and a fixed charge covenant, and our senior leverage is really Uh, a measure of the funded debt in the transaction to the EIA levels, and we typically land in the neighborhood of 2 to 3 times, senior leverage. And then on the fixed charge, that's really a measure of cash flow coverage which measures like the EIA versus the debt service of the company and we typically see those in the 120 to 130 range. So those are, those would be, you know, that would be a sort of a typical covenant package. We don't see a lot, we don't have a lot of business models that have a huge amount of cap back sometimes we You know, we do build in some caps look forwards, but generally speaking, those would be the two covenants that really drive our structures. And kind of in addition to that, so you guys on a cash flow basis, what, what would you say on the actual ESOP selling, um, or the portion of financing you're gonna provide, what would you say would be your cash flow multiple that you would, you would say is typical on a typical deal or what range? I would say that we, we lend from a senior leverage perspective. We lend between 2 and 3 times. Yeah, yeah, and and oftentimes we're, you know, we're incorporating. With the help of the investment bankers and other advisors, professional advisors, we're oftentimes adjusting IITA for some level of maybe excess compensation or you know things that won't look the same moving forward but really our true cash flow to the to the company. And so we're we're basing our 2 to 3 times on that adjusted even done number and we, we sensitize things, you know, so that we're not, we're typically not underwriting off of 1 year. IITA is $5 million. The next year it's $6 million and the next year it's $10 million and we're not typically underwriting off of a straight $10 million we're we're going to kind of dig in and understand what drove that increase, really nice trend. But what drove it and, and let's make sure that we're setting up a structure that's manageable for the company moving forward. Yeah, so testing the sustainability of that of that increased cash flow would be important as well. Exactly. Yeah. So, I kind of like a just an off the wall question, like what sort of stuff makes you nervous when you get into a deal, like when you're like some of the like red flags that you're like, hey, that's not something, um, you know, that just makes you nervous I guess in general. So, you know, when we, I kind of touched on it a little bit earlier is, you know, on the what do you look for in terms of financial information. The one of the biggest things though is just the, the management succession, and, and that's something that, you know, you might think as a banker, how do you, how do you understand that? Well, we're, we're gonna, we're gonna dig in on that and make sure that That the management team has been sort of built out to handle a company that now has a little bit of leverage. Typically we go into a new ESOP implementation with a company that, you know, I'm generalizing, but a company that really has not historically been a large borrowing company. A company that typically has not had leverage on the balance sheet, so and cash flow leverage. So we just like to make sure that that the group that's assembled is a group that, you know, has been involved in management matters and can really understand the dynamics that that drive the the the value proposition to the company and So the biggest thing is just sort of the, the one person shop that, you know, wants to do a 100% transaction and not necessarily be involved with the company anymore, that would be one that, you know, would, would scare us a little bit if there wasn't a management team that was sort of built out underneath it. The other piece that, you know, more, you know, more structurally is the things that, you know, are difficult for lenders, one of the biggest things that's that's a difficulty to a lending team is Companies that are very concentrated with one client or maybe a handful of clients, 2 clients, where you're looking at Cash flow lending based on, you know, sort of a predetermined notion that you're not going to lose that client. Well, losing clients, it's as unfortunate as it is, it happens all the time. So we pay very close attention to sort of the concentration side of the house and the management side of the house. Yeah, no, I think those are, those are right on. I think that those are things that have to be, if you, if you are talking to or thinking about this, that you have to really think about that early on in the process. I know we We hit those heavy in the very beginning steps just to talk through what their plan is because it's not just your financing, it's the whole ESOP. It's the whole sustainability of an ESOP and like a concentration issue, for instance, could blow up the ESOP if you have one major customer or two major customers. Um, even, you know, you don't want that seller note to have default either. So even if you didn't do financing. So I think those are really good points and I, I think that that helps people to to think beyond. You know, in their own businesses, what sort of things should you be thinking about if you're, if this is a couple of years away or 5 years away even, you know, those two points I think are, are excellent things to think about in terms of improving um as goals that you would have if, if, if you don't have those 22 specific areas really nailed down. Yeah. Um, I get this a lot. So this is kind of like as we were, as we wrap up, this, this question comes out, what happens? I got, I got a, a client who has their bank and they, um, they're selling, they're selling shareholder, and of course they personally guarantee everything and now they're gonna try to sell it as a 100% ESOP. Um, how do you deal with, they want to get out of that personal guarantee and, and what sort of things do you, how can you actually handle that in terms of your financing? Yeah, so this is a, you know, this is one of those scenarios that it's really difficult for a selling shareholder to justify selling his or her business and then still being responsible for downside performance that, you know, may really have nothing to do with uh with what was the performance at the time the stock was sold. So, I would say in our lending structures we almost never have personal guarantees even in partial ESOPs we almost never have personal guarantees associated with it. There are scenarios where we have, you know, we, where we do seek it, and, you know, we just kind of touched on that. What about, uh, somebody who's concentrated 70% with one client and we still feel great about the longevity of the relationship with that customer and so we, you know, we oftentimes try to find a way to, to, to craft a solution. But it, you know, the guarantees would be at the very bottom of, of our structures and, and again, it's almost, we almost never have them. And, and what I would say as it pertains to that is, you know, when I touched on it just a little bit, our financing structures almost always include significant seller debt. That seller debt is deeply subordinate to our senior position, to our senior loan. And we kind of feel that that more than acts as a guarantee for for good behavior and, you know, we have seen that play out in real life situations. So most of the borrowers Most of the selling shareholders would not sell their business for the amount of liquidity that they get from a senior lender. They would never sell their business for that dollar amount. So the amount that they're still owed is significant and really we believe acts even even better than a guarantee because we want to make sure that they get paid and I know that they want to also be paid, so. So that's sort of our mindset behind not seeking guarantees in almost all of our transactions. I think that's an excellent point. I mean, that seller note does keep everybody engaged in like getting out and you're getting out before they are, of course, because your amortization is usually shorter. Um, so I, I just know that has come up with not just the selling shareholders, but other banks too, they get really nervous when we talk about Not having a personal guarantee. So, um, and I guess one final thought is just, you guys do deals all over the country, you're in Chicago. Um, how does that work and is it, is it if, you know, with, with a client, say in my market in Florida or in, you know, Andy Mar Andy's market in Huntsville, where you may not have a specific office. How does that work? and is that, is that something you have to usually overcome? Yeah, so a really good question. And so again, our practice is national. So in times that are not pandemic times we travel frequently. Most of our clients are outside of the Chicago area. We actually do have client in Huntsville as well as Orlando and your market, so we, we travel a fair amount and We really think that that that will return and although we have gotten, I think all banks have gotten much better at sort of the virtual type transaction execution, we think it's really important to be face to face and so we we're smart with how we travel, but we travel frequently to visit with opportunities. Where you know, we feel we can be a great resource. I think that's, I think that's important and, and as the listener looks at that, I mean, I think because of the niche and having a, a, an expert in this year, what ESOPs are are they're, they're really do. They do require professional experts that do ESOP work. So I think you guys having a national practice and as we do work all over the country as well, it just makes sense and, and I think that's just part of what you would, you know, as you get more and more understanding ESOPs, that's just what you're going to experience more of. Um, so with that, I'll just make a few final comments and kind of let you close on your side too. Um, I, I like the, the specific nature of what you talked about, Pat, with, you know, how you structure that, and I think hopefully, um, what I got out of it for the most part is, is that there's this opportunity if your government contracting company. has a very strong forecast that you can actually borrow more money into that, into the, into the next few years as long as you hit those targets to replace those seller notes to have more liquidity out of the event sooner than that waiting that typical 10 year amortization. Yeah, I think that's exactly the scenario, and you know, we we certainly look at The forecast and how that will play out and we try to be very thoughtful about the structures that we put in place because we don't want to overburden the company, but typically the tests that we put in place make sure that this is the sort of the debt capacity that the company can continue to not be burdened by if that makes sense that makes great sense. So, again, thank you for your time today, Pat, and I just appreciate your insight. I think just bringing that to the table is gonna be really helpful, great resource. Um, I'd encourage everybody um to go to after this podcast, listen if you haven't to episode 53 for Andy Watson, um, if you are a government contractor cause I do, I do think the attorney's perspective and then Pat's perspective on the financing really do you know, compliment themselves very well. And again, thank you for your time today, Pat. Yeah, Phil, thanks again. I think you're, you're doing great work. Your leadership is providing great resources to, to lots of potential selling shareholders, and again, I'm I'm really happy that you thought of me in the process. So thank you. Thank you so much. So as we close out, um, go to my website, if you can journey to an ESOP.com and you can check out all the episodes. Um, if you like this podcast, please share it with a friend. Have a great day. We look forward to our next step on this journey.