Ep4 - ESOPportunity - Episode 4

Welcome back to Journey to an ESOP. I am the ESOP guy, and we have been on this, we're really beginning this journey to an ESOP together. Um, my mission of the podcast is to educate business owners and management team members that are with companies that are not currently ESOPs, employee stock ownership plans, but do have an interest in looking at this as a possible growth, succession, or even exit strategy, or a combination of all three. I will tell you that I, as I've, as I've done ESOPs for a number of years now, I've learned that there's a lot of wrong notions about ESOPs and not just in the uh companies and that you talk to the business owners that you talked to, but also with within the financial institutions and, and I'm on this journey to an ESOP with you to try to help. Clarify the process, simplify the process, and I think that there's, there's many wrong notions about ESOPs being not being too complicated or other things. So that's where we're, that's what we're all about on this podcast. If you like what you hear, please share it with a friend. Today's episode is going to be entitled East Opportunity, Green Light, and this is episode 4. I'm just coming back from a trip that I made to an ESOP conference in Chattanooga, Tennessee, and I was thinking through the conference and the ESO opportunity. title came to me as, as I had been talking to my wife about doing this podcast and my wife is so unbelievably cool, and she's so creative and she's like, well, why don't you combine the word ESOP with opportunity and the East opportunity. So that's where the, the, the name of the episode came from. But it essentially asked the question. Why would anyone Want to convert their company to either a 100%. Employee stock ownership plan or a partial ESOP. What is the underlying opportunity? And I've had people at the end of meetings many times say, just, just sum it up for me. Tell me why I should even think about doing an ESOP. And and it kind of goes back to the very beginning when I first did my first episode, which was enough information to be dangerous. And it was, and I was talking about there's so much information and and when you really kind of try to get to the core of it, business owners, Have to make business decisions and to make a business decision on it, you really just have to understand and summarize what are the points, what are the pros, what are the cons? And is this right for me? And so this, this episode is going to be really about digging into the East opportunity. I recently had a meeting with a financial institution regarding ESOPs and their questions that they had were around the, the issue, I guess controversial issue of ESOPs having a reputation as being contentious or problematic, you know, more from an after the fact type of situation. And when I asked to further, I asked the question to further investigate what their, what their real question was, it was, hey, there's issues with the stories are that this company sold as an ESOP and they were overvalued. And so there were some issues around that and the Department of Labor looking at the transaction or the opposite was true. It was so undervalued that the original owners were upset at the transaction. And I will say that I think that that that actually exists in the world and and it has contributed to a lot of the wrong notions about ESOPs, and I, and I think it's going to come back in this, is this podcast goes into more of the process of understanding the actual ESO opportunity, or the opportunity of an ESOP. One area that I, that I look at and I, and I'm wondering about and I question myself is how when ESOPs are created and the transaction is done, how the, and I'm not saying this from a real negative standpoint, I'm saying this as an observer, how the investment banking community goes into an ESOP transaction, which is a fairly regulated transaction. And I say it's regulated because it's very specific in terms of how the Department of Labor looks at the evaluation methodology, and it's very specific as to how they look at, um, who's involved in independence related to the transaction. And so, when there's an investment banking, Firm involved in an ESOP transaction, there is an incentive for them to be paid on the transaction fee. So my one question really as an observation for the community of the ESOPs is, is how can that bring about the best type of process at the end. So I think a lot of the overvalued type of scenarios could come from the process that the ESOPs go through in in very in the very beginning stages. And I think when I, when I look at this, really the question of what is the opportunity, I think we need to deal with first, what is, what are the negatives that are on the table and get those off because I think the negatives of those stories really cloud. That what I think is a real, real opportunity for business owners, and it's a really strong option when you're comparing it to other options of exiting your business. So Looking at the process deeper, I will, I will start with this idea that when I was, when I was younger, uh, when I was younger as a child, I would do like with kid games outside, we played a lot outside and, um, much more than our kids play outside today. So we didn't really have, um, video games or whatever, but we would play outside and when I was really little, we would play a game called Green Light Red Light. And if you know what this game is, you basically have a conductor of the game. And that person's job is to say green light, yellow light, red light. And as they say green light, yellow light, red light, um, the other kids are moving closer and closer, and the one that wins is the one that can move faster when it's green light and as fast as they can and slow at the yellow light and make sure they stop at the red light so they don't get kicked out of the game. And so, that's a fun game to play with a kid, but I want to use that as our process that we talk about when we're trying to determine is this a good opportunity for you as a business owner. So when I, when I go through the process of looking at the ESOP being an opportunity, I'm using this type of, of green light, red light, when we're putting together some in the process that we're going to go into, when we're putting together certain things that we're gonna, we're going to ask the question, if we get at the end of that part of the part of the phase of a green light, then we're going to move on to the next stage of, of the process. If we're going to get a red light, then we're done, and we don't have to worry. And so deeper down in this is this idea that the ESOP transaction itself really has within it, the necessity of the owner winning, the employees winning, the even the Department of Labor winning. Everybody involved needs to win in, in the transaction. And so a long time ago, as I went through um the beginning, my first part of my career, I used in this win-win idea proposition and everything I tried to do. And if I was doing a banking deal, I would always ask myself, is the client gonna win? Is the bank gonna win? And I had this one situation where the client way back then where the client was Wanting me to approve one overdraft on their account after another, an overdraft is when they, when they don't have enough funds in their account, and then the bank officer has to approve and it's basically giving them credit each time. And the bank doesn't like that because it's, it's not a very good credit risk and it's not very good um behavior. Your, your client who's worked with you and your bank should have plenty of cash to cover all the checks that they write. So this guy, I called him, um, he was a helicopter business in a helicopter business. had a um a service that they did. And so I called him the helicopter guy and one day I said, hey, you're gonna have to come in and clear this overdraft. And he shows up with like thousands of dollars in, in cash. And I'm, and I'm sitting there thinking to myself, I have no idea where this pile of cash came from. And I said, you know, I cleared the the overdraft, of course, but then I said, hey, you know, after that was all done, I said, this is just not this relationship that we have here with the bank and, and with your company. It's not a good fit for us. And so we proceeded and we, we closed the accounts and we, and we moved on. But the the reality of that was that was a win. Lose and we were losing at that in that situation. And so those can't, those aren't sustainable. And the point of all of that is, is that if you do an ESOP without this green light, red light process, I believe it's not sustainable. I believe there's, there's going to be something that comes out in the wash and nobody wants that. So When I look at going into like the, the process, I just want to kind of start talking through and I, and I talked about this a little bit, but this pre-ESOP timeline, which is really incredibly important. And the first two beginning steps of that or the 1st 3 years, we would really need to identify what the goals and objectives are of the owner. And those need to match up. And if those match up with an ESOP, then we're a green light, and then we move on to the next phase and the next phase would be this, this evaluation phase where we're thinking about. And we're putting together a model based on the Department of Labor's preferred method of valuing, which is gonna be the discounted cash flow model. And out of that work, we're gonna create a value range, and the value range needs to work within the objectives of the owner. And if that's good, then we're gonna move on, we're gonna have a green light. And then the next phase is going to be working through the feasibility and is, is the is the transaction with this value range feasible within this value range from a cash flow, a tax perspective? Does it work from all the different angles? And if it's yes, then it's a green light. So as we look at that, what we're really doing is we're building the win-win each time because we're considering within each step, what is it, not just the owner, but how does this affect the employees and how does this affect the Department of Labor and everybody involved? And so, when I, when I look at the, the life of a business owner in my career, As a, as a banker and then managing partner of a CPA firm and now, you know, as a consultant, has been 27 years. So I've got to work, I've got to work with the privilege of working with a lot of different business owners. When someone or a group of someone spend their life working and investing and risking their dollars, their time, their reputation, their hard work, all based upon a vision and really not even knowing if that's gonna work out or not. And by really think I'd say the grace of God that they accomplish what they set out to do. Um, maybe even they take over their parents' business and they do something that, that, you know, in this, they grow the business or whatever it is, but they're taking this incredible risk. When I do a evaluation, it's really impossible to, to capture what that value is, that emotional value that they've put into this business. It goes well beyond cash flow and risk ratings. And then I know like deep down, you know, there's, there's a number being put on this, and it's their life's work. And so that's a very sensitive part of the process. And this is part of the reason that I really like succession plan work and I really like getting into those questions because they, you have to be looking at all of these, these, these angles, and you have to be sensitive to the fact that the employee has all kinds of not just financial motivations, but other motivations as well. When I, when I consider the, um, the work that they've put in, the grit, determination, the leadership, the fact that they've, they've spent this time inspiring others, they've knocked down barriers, they've survived through seasons that really seem impossible. I realized that, you know, the sensitivity of this, the, the importance of this is huge, and I, and I, and I go back to the idea that the process itself is so critical to demonstrate whether the opportunity works or not. And so, to capture that from an entrepreneurial standpoint, 11 thing I've been doing recently is just reading some, some history and Not knowing a lot about Shakespeare, I've been brushing up on his history as an indelible part of, of all great writers as we know what Shakespeare did. But when I read further in history, he was really a, an entrepreneur who invested in real estate in addition to all the things he was able to do. And one piece of real estate that he invested in was called the theater. And in 1599, The theater was built upon this, this piece of property that the land lease was actually expiring. And they, in the middle of winter, him and his, his group took the whole theater apart, and they, and they brought it across the Thames, and they rebuilt the entire theater and they renamed it the Globe. And so just to demonstrating that kind of grit and that determination of an entrepreneur, it takes a lot of grit to do something like that. Now, in 1613, unfortunately, they were in a, in a, in one of their plays, and they, they, um, blew a cannon off and it actually um erupted into a fire and it actually burned the building down. So they built it again. And so just looking at those types of things, I know business owners that have that type of entrepreneurial spirit that they have, they don't stop. And so when I, when I pull this together, and I say, like, what is the opportunity that you have to sell your business to NSAP? I, I'm very much aware of of how sensitive and critical this type of conversation is. And I'm also aware that, that, that's why I think this is such an important podcast, because I think some people look at this as well, you're just going to sell your business and it's this multiple and, and here we go and let's move on. Um, I think we got to stop and really talk about the, this, the value of this because the opportunity really needs to be there. So the first piece that I'm going to get into is just the idea of the value of the ESOP. is that it is going to be and it should be based upon a fair market value. After working this hard on your business, it's surprising to think that you're going to sell something for less than fair market value. And that's why going through the process of the valuation that I talked about, we need to establish a realistic value range that you, as a business owner agree with. And if that is, yes, I agree that value range works for me. We're not saying you should take something less than fair market value, then it is, it's a win-win and it's a green light. The next is what would be the opportunity within the structure of the ESOP for the business owner and then also the surviving entity to participate in the tax benefits of an ESOP. And so to work through those, really I'm going to name them and just work through those, but then there's obviously a lot more going into explaining these tax benefits in later podcasts. But the first is, as an owner, I could participate in a QRP or a qualified retirement plan. So I could actually take my, my, my sale price and move that money into um public stock. I could take private stock and exchange it for public stock under the 1042 and I can defer capital gains. The second is, if I'm an S corporation entity, I can use the ESOP to shield my surviving, the entity that bought my stock, surviving entity um from income tax. And so whatever portion I've sold or 100% can be protected under this tax shield, then I can also look at principal and interest deductibility. Of the payments that are being made on the note for the ESOP. So just really quick, is, are those benefits going to be an opportunity for the business owner? And in those cases, when you put that together with the analysis and the feasibility, and they're, they're going to be a win-win. If they fit the criteria of, of how we've created um all of the first steps of, of the goals and objectives and the evaluation and this and this model using the tax benefits. So that's a yes and that's a green light, so we move on. The third is this idea of what type of control and involvement as the owner do I get to participate in. If I'm an owner who at the very beginning of the process says I would very much like to be still involved in the company, but I would like to go ahead and start moving ownership to the ESOP, then very simply, there's a lot of possibilities within that, that are absolutely opportunities for the owner to continue on. Working in the same job that they had before, being on the board of directors, or working through their exit over a period of time. So, so absolutely being involved is important. So there's a, there's a win-win and there's a green light and we move on to the next one. The 4th would be just the opportunity for growth. When we start getting these payments knocked down with the tax provisions on the Scorp, we're going to actually start to accumulate more cash and we're going to be able to use that cash to fund and invest in growth, and that could be through acquisition, through strategic hires, through funding the business plan and any other ways that makes sense that the board of directors approve. So is there an opportunity to grow my business once I've done an ESOP? Absolutely, yes, that's a green light and we move on from, that's another win-win. The 5th would be looking at the smooth transition of the, of the exit of the owner. It doesn't ESOP afford the possibility of, of smoothly exiting the owner through the process. And it absolutely does because what it does is it allows for, for us to incorporate the management transition plan within the ownership transition plan. And so as those converge. The owner has the ability to, to operate in different, in different areas. So, in some cases as a management transition plan is more mature, and the owner has the desire to exit, then that can be affected or the opposite. They can, they can elongate that process and be part of the company as long as it fits within the governance of the ESOP. The 6th is, how do the employees win? There's a benefit here in terms of the East opportunity. Do my, does this even matter? And I, and I absolutely think this is, you know, with, with all the ones we've talked about, one of the most important ones we're looking for a win-win. Does do the employees win and they win because they benefit from the, from owning the the stock over a period of time. The company wins because they're helping their employee base become more motivated to do and be highly engaged in the functions that they're, that they're responsible to do. In addition, they are more likely to retain those folks um through the process of, of having vesting schedules. So absolutely, from an employee standpoint, both the company and the employees win and the owner that sells wins because there's a, there's a stronger structure base of employees to continue to generate the revenues and the cash flow to pay the debt back for the owner. So win, win, win. And that's a green light. 7th is this idea of the opportunity to have my business be a legacy business. If, as I described the difficulty of starting a company and and going through founding it and and all those things, if it's the desire, at the very front end of of the conversation, if it's the desire of the business owner to have a legacy of the name of the business moving on and continuing on. Then I believe there is a great opportunity within the ESOP structure to accomplish that. And even more so because there's the sustainability. Of continued business plans and thinking long term and forecasting the next step, all of those things happening with an ESOP. So legacy is, is a profound benefit to an ESOP, and that's a win-win, and that's a green light. So we move on to the final one, which is not all of the opportunities, but the final one that I'm going to name in the podcast, which is the owner that sells their business to an ESOP. Has the option of selling their business to the managers. It has the option of selling their business to a strategic buyer. And, and in some cases, it's, you know, maybe selling it to managers, but they're really the kids. When I look at the risk of those transactions, I'd say the ESOP has some of the least amount of risk really depending on the deal structure related to each of those scenarios. Now, within a management buyout, the risk is less because there's certainly more cash related in an ESOP with the tax benefits to pay down the note. And so just by virtue of having more cash, um, within a management buyout structure, you're gonna have less risk. In addition, because the ESOP itself is, is governed by a board of directors and has an independent trustee typically assigned to it, there's going to be less risk because there's more governance of that entity after the transaction. In comparison to a strategic sale, if the strategic sale deal structure is built around more earnouts where there's loss of control, then there's risk related to that transaction that the owner definitely has that are, are more than they would have in a ESOP transaction. So again, I think that there are those are quick, very quick areas of benefits of an ESOP opportunities that you would have as an ESOP. And really the, the, the context of all of this and the conversation was, you know, looking at really understanding what a business owner is doing by taking that step towards a succession and an exit plan and how important it is for them to really understand the opportunities within the ESOP. So if, as I as I went through that, if you like what you hear, please share it with a friend, um, and please join us next time on our next episode. Thank you.