EP53 - Government Contractors as ESOPs - interview with ESOP attorney Andy Watson from Hunstsville, AL

Welcome back. Thanks for tuning in. I'm the ESOP guy and we are on this journey to an ESOP. If you're tuning in for the first time today, I just wanted to say welcome. You can find all of our episodes on our website at journey to an ESOP.com. This podcast is a resource that's been provided to really help an individuals selling shareholders, business owners to understand better what employee stock ownership plans are all about, and whether or not they're a good fit for their strategy in their business. So today's episode is gonna be very um specialized in that we're gonna talk about ESOPs for government contractors. And to do that, we have the opportunity today to interview Andy Watson with Maynard Cooper out of Hunt, the Huntsville office of Maynard Cooper. So, Andy, I just wanted to say welcome to our podcast and thank you for joining. Well, Phil, thank, uh, thank you so much. I really appreciate the opportunity. Thanks for the invitation. Uh, I think your podcasts are awesome, and I'm glad to be a part to address, uh, ESOs in conjunction with government contractors. Happy to do this. Excellent. So Andy, um, let's talk a little bit about your, you know, your background, um, maybe a brief overview of what you do with in in the ESOP industry. Certainly, absolutely. Well, Maynard Cooper and Gale, we're based in Alabama, but our practice is national and because we're in Huntsville, home of Redstone Arsenal, we naturally by geography represent a lot of government contractors, and we represent contractors really across the spectrum whether it's litigation and protest and claims, technology and IP. All the way to the other end of the extreme of just pure corporate transactions with the overlay of the regulatory requirements of government contracting, and in those transactions we have of course M&A, uh, we have dividend recaps and joint ventures and all kinds of other things, but ESOP is particularly important and a powerful combination with the government contractor. And so Maynard Cooper. A is one of the largest ERISA practices in the Southeast and represents a lot of different industries in the in the ERISA world, but in particular with government contractors, we have both implemented and even taken out a number of ESOPs in conjunction with, you know, I'll say M&A activity. Awesome, awesome. Great. Well, I'm so excited to talk about this cause I do, in our market here, we have multiple uh government contractor clients and we represent like the simulation industry in Orlando is a big part of, of our practice and um certainly on the coast, we have the Patrick Air Force Base and so we're very familiar with government contractors and so getting to talk to you about this is really very helpful. Um, one of the questions I get from folks is when we look at the industry segments, um, as far as what works well with an ESOP, how do you, how do you feel like government contractors stack up when, when you're answering that question as far as becoming a good candidate for an ESOP? That's a, that's a great question, Phil. I, I suggest to people that the United States government, and we're talking about federal contracting, by the way, and we can talk about state contractors in another context, but at least the United States government is the world's number one customer, right? The most creditworthy customer that there is. But doing business with the United States government has an overlay of requirements and regulations that you have to comply with. So that said, it's a very stable industry. You know, it's a very, once a government contractor is fairly well established and they identify their pipeline of work and they measure their key win rate, they're fairly sustainable companies that have good cash flows if if they're well managed. Uh, and we find that compared to other industries, they're considerably more predictable. Um, there's also a difference too, and As you look at within the government contracting industry, if you break down the segments, those contractors in particular that work on a cost plus kind of type basis, the costs that are associated with the benefit plans are factored into their rates that they charge the government, particularly it's a services type government contractor. And so we find most ESOPs that are implemented seem to be implemented by services-based contractors like in Orlando. The modeling and simulation industries are a great example. You know, there's a great segue between Orlando and Huntsville, between PEO Stride there and AMC in Huntsville. So we we're very familiar and have great respect for the Orlando companies there and Space Coast space companies. But that services-based government contractor is able to factor into their cost, some of the ESOP cost. And so effectively in an indirect manner, the government is helping to fund and pay for the benefit of an ESOP plan itself. Yup. And so I think that's a, that's a good aspect of, of what, why companies choose to go, you know, from as government contracts into the ESOP world. Um, when you're, when you're looking at you guys have a lot of different, uh, you know, different things. You have M&A and you do other things to help companies transact um and or transition their business from a succession and exit. Um, you know, what, what's your experience with companies looking at the, you know, as government contractors looking at the ESOP compared to Selling the business to a private equity or other third parties. What's your experience with that? That's, I think that's it's very important to know as a company looking, looking to liquidate where you are in the landscape of opportunity. So think about this. Many of our government contractors are small businesses under the SBA regulations, a many play under the NAS code for general engineering. And you know they don't want to cross the $38.5 million revenue metric. So those companies are not very eligible for purchase and by large contractor because those government set aside contracts for small businesses are not, they're really not worth anything in a large business because they're going to lose those contracts. So for a small business government contractor, an ESOP is a great alternative. The company can remain small, the culture is preserved. The ESOP can pay a reasonable multiple of profit, and there is value attributed to those small business-based contracts, those set aside contracts that again, whether the small business or whether it's woman owned or SDVO or AA. There's credit given for that value as opposed to selling in the open market and trying to attract a large business buyer. There are a couple of exceptions like Alaska Native corporations or Hawaiian Pacific corporations, but I refer to those as the buyers of last resort. They, they know their position and they typically don't pay top dollar either. So if a company though is eligible, if it is a large business or has full and open contracts, then certainly it could consider selling to a strategic, selling to a private equity firm, or doing some other alternative means of creating some liquidity. And those processes are much different, and appetite is very different. You know, strategic is typically looking for a widget, a technology, or a group of highly technical people that they want to add into their organization. Private equity firm is looking to grow value, and they're looking for multiple arbitrage, and they may be adding the target into another portfolio of companies, or they could be building a portfolio and using the target as a platform. And ultimately though, the private equity firm is going to harvest its gains and sell the company. That's its ultimate end goal. And so for a principal, right, that's interested in leaving a legacy and preserving culture, many times that just isn't very appealing to a long-term founder. Um, and so ESOP becomes a very viable option at that point. I think there is a difference, and, and so you can speak to this better than I can about valuations. Um, typically we see the multiples in an ESOP transaction are lower for many of the subsets of government contractors than what we would see in a full and open sale on the, on the open market in an auction process. Yeah, so, so to jump into the valuation side, I think that. You know, as you, as you kind of hit it, like some of these service businesses with that are government contractors, everything relies on the contracts going forward. And so you're building a model to understand what the forecasted cash flow is gonna look like. And with government contractors, one of the particular interesting parts of it is that they grow. And more, and I look at it as a stair step growth process, like they'll be bidding on a lot of contracts and they'll get, they'll get up to another tier and that's gonna certainly impact their future cash flows, which is gonna impact their evaluation. So, In ESOP valuation, we tend to lean towards strongly towards the kind of cash flow anyways, which is built around an income approach valuation of a forecasted cash flow. And so we're allowed to really, I think go through that, you know, but it's gonna be in that forecast, the questions are gonna be. Centered around the viability and predictability of those future revenues. If they're tied specifically to existing contracts, that's easy. If they're, if they're tied to potential wins, that's obviously more difficult. And so what we do, we do a lot of work to, to work through that forecast and ask those questions early on. To help the client to better understand, you know, if they're worth more money on a forecasted basis than they are on a historical basis, we want to make sure that we're able to discuss and answer those questions that are going to be asked by the trustee in the, in the sale process way before. we get there. And so we're tying down a lot of potential loose ends, and we may be putting their probability factors lower or higher depending on the potential for each of those contracts, but we're going to get deep into um a discussion on the specific contracts. And so I think that what you said regarding service business is really important because a lot of these companies have built a really good brand reputation with the government and, and really with an ESOP, they're allowed to continue that on with this, this legacy, um, as opposed to being wrapped up and rolled into a bigger organization. Yes, I completely agree. I think that The future pipeline, frankly, whether it's ESOP or other types of M&A with a government contractor that future pipeline is, is very critical, very important. In fact, I'll tell you one of the only ESOPs, noniminate that we dismantled, we intentionally took out is what we had put it in maybe 10 years prior and then we were taking it out because the company literally had 75% of its work up for recompete. In the next 12 to 18 months, and there's just tremendous risk ahead and those employees, one of the founders, the management, they looked at what was happening and the employees had tremendous amounts of value vested in the ESOP and so they looked for a way to Basically dismantle the ESOP, roll the gains that they had into their 401ks, and management took on the burden and the risk of driving through that, uh, recompete period, but it was affecting evaluation dramatically. Yeah, I think that's a, that's a good topic for another podcast too, because the whole idea of dismantling something that we put together that's so somewhat complicated, um, but I, you know, to, to touch on that, that's important because it's sometimes people think. I did an ESOP and now there's no other choice in the future, you know, and it's not true because a lot of these companies are selling off to other companies later as they get larger ESOPs, um, you know, being a small government company, it's like government contractor company. I have had so many clients over 30 years, um, be approached by private equity group and they go through the whole process and then the deal blows up and it's very, it's a kind of classic and the company gets frustrated and they thought they were gonna get this big multiple and You know, and they go through due diligence, and it's just not happening. And so you can't, like all you can do is say that that's possible for somebody who knows what, what, what they're gonna do when the buyer comes in. But that's been my experience. So it kind of comes back to the idea that you said, I mean, if you're a bigger company and you have widgets and products and technology, then that's very sellable. But if, if not, you know, what you have is a good, good group of, of employees that can keep bidding on good work and, and hopefully keep that going and make sure it's, it's viable for the future. Right. Absolutely. Exactly. You know, one thing we should probably touch on is what's very helpful, I think in, in that stair step growth you referred to is the ESOPs are able to make an S selection. And so many of, many of our smaller government contractors are already as corporations experiencing a pass through tax treatment to the principals, but that ESOP is a qualifying, one of the very few qualifying trust that can own the company and still have S corporation status. And that's, that's what banks, the lenders that are financing the ESOPs, particularly focus on because the cash flows are very dramatic. The cash flow from a government contractor. You know, when you alleviate, uh, if there areC Corporation, alleviate that corporate tax, or when you have this dramatic cash flow going into the ESOP directly that it can use for either more share repurchases or other investments, um, or the, obviously the repayment of the debt that financed the stock acquisition in the first place. Uh, those cash flows as an S corporation are, are just very powerful. They are. If there's, if there's any fun in the feasibility stage, Andy, it's when we get to go through and play with those cash flows and and show an S corporation and those adbacks, it's, it's because it's really telling and people, a lot of people, like, you know, it seems like because we, we talk about it all the time, they don't know that an S corporation is tax exempt if it's owned by an ESOP. And so when you're able Like demonstrate that with financials and cash flow. It's just, it's very powerful. Um, and I think, you know, when the owner is trying to get bought out too, like, look, you know, the buyout's gonna, if if you're taking a seller note, you're in a way better risk position with the company because it has all this additional tax that was, it was paying, and now it's paying you that. So it's almost like the government is, well, the government is funding that that buyout because you're not paying taxes anymore. So, but that's, that's a great point, yeah. So let's talk about like size of government contractors. When you look at, you know, like you, we talked a little bit about small companies, you said you kind of use that $38 million revenue target. Um, is there, is there companies, government contractors that are too small and that we shouldn't, you know, if they're thinking like, hey, this sounds good to me, um, wanting to make sure we're, we're giving them the information they need and then also we'll talk about companies that maybe are too large. Yes, that's, that's a, that's a great topic. Uh, when an owner is looking to liquidate and harvest their value many times, they are just too small. My rule of thumb at least has, has been a revenue metric, and it's around $5 million. If, if the company, if we can't put in place at least, at least a $5 million ESOP, then it's not, it's very difficult to justify the upfront cost. But there's also another facet, and that is the ongoing cost of maintenance, and ESOP is an expensive benefit plan, frankly, you know, with the requirements of an annual valuation and just the plan administration, you know, keeping up with share allocations per account, um, the, when the employees leave, when they, when they come into the plan, there's just a lot of plan administration, that's typically you engage a third party administrator for that purpose. But it's a lot of maintenance and so the cost factor you have to look how many cents, what kind of cents on the dollar of benefit are we paying to maintain the plan and it needs to be justifiable. Right, yeah. That's one, and one thing on the feasibility, we will load an expected compliance cost into the ESOP for the ongoing maintenance. You have to know what you think it's gonna be, um, but definitely that will, will inhibit a smaller, a very small company going through the process. Um, one of the, one of the areas we look at is the number of employees because as an S corporation, we have to comply with 409P. And so my rule of thumb there is it needs to be at least 15 to 20 people and it's probably the smaller on the very small side, um, because if you fully allocate those shares that are available to a 100% ESOP, you're gonna have more than, you're gonna have one person owning more than 10%. That's gonna be a problem for your, for your 409P test. So I I'd say that. So on a bigger size, what would you say for a government contractor because I think they do have more options as they get larger in terms of the strategic sale. Yes, I think as they're as they cross that small business set aside, they and they're competing full and open. They have many other options that are very competitive in price and you know picking the right partner for culture, you know, many of the same objectives can be achieved, but there can can be a point where it's just too difficult to implement, you know, we've We've implemented ESOPs with 150 employees and that goes pretty well. We've done 2 tranches and third tranche of share acquisitions from companies at 600 and 700, but that's after the plan was already implemented. It was originally implemented in that 150 type size, and we've exited plans, yeah, at 1200 employees, but there's no way. I say there's no way I would not really want to try to implement an EOP at 1200 employees. It's a lot, right? That's crazy. One of the, one of the things that that I wanted to, wanted to kind of ask you is you have this question. So I have, I have a hub zone company or have a woman-owned disadvantaged business or I have an 8A or all the different designations and then now 8A has this graduation 9-year period, so you have to. Kind of like be planning for that. What's with the ESOP owning those companies at 100%, um, the certification, you know, I'm kind of making a comment, but I also wanted to talk about it, is going to eventually go away. Is that, is that true and what is, how does that affect their future revenues? Yes, it's true, and it, and it will affect their future revenues if they lose, if they're ineligible to bid on contracts that they, you know, otherwise won because of the status. It's very similar to why you wouldn't go and sell to a strategic or private equity firm. If the contracts are going to be lost because of the transaction, then there's not much point in doing it. That could be very problematic, yeah. Yeah, which, which really is one of the advice pieces here is, is that your business as a government contractor, if it's overly dependent on a certification, it's going to hurt your valuation, and you as a business owner have to go through the process of building a strong bidding proposal process in your company, um, that's not relying heavily on one or two certifications. And, and it's not relying on other things as well. So what we're trying to do is build a, you know, when we're evaluating the evaluation, we're going through like the company's ability to win work, we're looking at the, the process that a company writes proposals, who's doing it, how are they getting work is gonna be a central question and but it's also a, a planning, a business planning thing. You have to be thinking, how do I continue to diversify my reliance on Um, certain, certain, you know, certifications. The AA has a process for them to move away from AA. And if you're following the AA process, it, it's kind of helpful. Um, so any thoughts on that for companies to be thinking about? Yes, the investment bankers say to me that, and I've been in pitches with them where they say those very words, Phil, if you want to grow value, if you want to grow equity in your business, you have to diversify it. You have to become not dependent on these set aside status contracts. There's nothing wrong with them. And in the meantime they can provide the necessary cash flow to grow the business, but over time there has to be a plan. You know, an exit plan and to wean off those types of contracts and, you know, I'm not sure if folks are aware, but the SBA actually came out with a new set of regulations at the end of October about M&A. And if you basically now if you have a bid that is pending and it is premised on a status and you within 180 days of submitting that bid, enter into a letter of intent or complete a strategic transaction. You have to give the government notice and your bid can be canceled. The old rule was when you submitted your bid with price and cost, whatever your status was on that date was preserved all the way to a ward. And so we, we're still scratching our heads about enforcement and what that's going to look like and what it may do to the protest world, but it goes to the point that you have to be thinking about your contracts that are even in your bid pipeline. When are you going to wait for an award? How important is that award? Is it a status premised award? And, and to your point, Phil, at some point to really grow equity that are, that there would be dollars paid for, you really have to diversify away from the status. Yeah, absolutely. Um, but that's, I, that's the first time I heard about the LOI rule. So that's very important important information. What, what is that, um, is that under a certain legislation for the SBA? Yes, it's, um, it's a new, it's a set of rags, um, that it was, I think, released October 28th, uh, and it deals with the small business status. It's in 13 CFR 125, those, those provisions there. Well, that's you're so good like you know all the. Yeah, the exact regulation. So, so definitely, um, be thinking about that, that, that makes it a big difference in terms of what you're planning and your LOI in terms of, of your sale of the company and, and so very, very helpful. Thanks, Andy. um. So going into this, um, this as we go into the deeper part of, of talking about a company going from government contractor. And, and selling their business to an ESOP. Um, let's talk a little bit about the selection of the trustee and how that is important in terms of, of how they select their trustee. Well, as you know, Phil, that the trustee plays a critical role of managing the ESOP Trust, and in that process, the trustee truly is an arm's length purchaser of shares from the shareholders of the company, and there is a true negotiation that takes place there. The Department of Labor has litigated a number of high profile cases in this area that in fact, caused many corporate trustee organizations to exit the industry, uh, because, because it is a it is a, it's different than a pure M&A transaction with a strategic or a PE. I mean it's everyone is dealing. Uh, together and we're trying to get our employees to become owners of the company through an ESOP, but at the same time, the trustee has to, on behalf of those employees can only pay a fair price. And so there needs to be a, a fair negotiation and a determination to a real process of what is a fair price. So it's highly important to select a trustee that One knows what they're doing, and two, certain just ESOPs generally, but number 2, understands government contracting and understands valuation as we talked about in the context of government contracting. And 3, someone that you can work with over time, you know, this person's going to be engaged in your business going forward. On behalf of your employees participating in the plan. And so there's a, you know, I'll say personality check there as well. For sure. Well, and, and to dig deeper into that, um, what happens is the transaction trustee many times becomes the the independent trustee for the plan as time goes on. And if they don't have, you know, certainly they should have the experience to do the transaction anyway. So when you're interviewing the trustee. And you really do need to ascertain their understanding of government contracting and the way that that type of industry functions. And then secondly, knowing that if they check out there, then the ongoing process of them being the independent trustee for the company is gonna be important for them to have that knowledge because they, they need to understand how government contracting business works, especially when they're representing the employees and, and the stock of this plan. Um, going into the role of a trustee, you know, on an ongoing basis. So I think the, the stress that's really important and, you know, going through those questions and checking their references is something that we go through a lot just to make sure we've got the right trustee involved. Um, I agree, I agree. I, I think it's very important. And you know, as we've said, I, I think in the past we saw many companies, uh, not choose an independent trustee, and not, not choose a third party transaction trustee. But to do the deal with one or two of the principals acting as trustee and the way the rules and the law has evolved, I mean, we've always recommended against it, but it is just fraught with conflicts of interest, you know, the fiduciary duties, one running to the company as a as a shareholder. Many times the principal is also on the board of directors and is also selling shareholder to the employees are becoming shareholders and so there's many facets of fiduciary duties here that can really only be cleansed with a truly independent trustee on the other side of the transaction. Yeah, and I've had that, that gets asked from us too, and then people are like wanting to play that role and wear the hats, and I think part of it is. To not have to deal with the trustee, you know, asking questions or whatever ongoing, but it really does help overall and that's, that's really everybody, every professional ESOP person is gonna tell you in general you're better off having an independent trustee, um, manage the plan just as future goes and the amount of time it takes to do the work. Um, so, so let's talk, let's talk a little bit about like one of the questions that gets asked as a government contractor is like, um, how am I gonna get my money, right? So if I want to sell my business, um, and there's really two ways to get your money. You're gonna get your money by, um, the company they're buying you out on a seller note or a bank financing the transaction. So from your experience, what are some issues and opportunities that lenders, the ESOP lenders will, will present to government contractors as they think about financing these transactions? That's, that's obviously, it's a, a key step in the transaction, but we found lenders are very eager for these loans. There's no shortage of competition for ESOP loans, and, you know, they have a maximum. A limit as to how much the bank will lend, but it is different than the typical line of credit that's offered to a government contractor. And many times your line of credit is a function of your account receivables and your backlog, your whip, and there's a borrowing base you submit every month to the bank and that determines your, you know, your maximum amount of loan availability. In this instance, that while the bank might measure that, they are willing to finance what I refer to as the air ball, and that is an amount over and above your borrowing base. It's basically cash flow lending, and they put some metrics around it to bring it back within the borrowing base in a reasonable period of time. And that's part of the negotiation with the bank is what is that period of time and what is the cash flow obligations. And what financial covenants are involved with the, you know, debt service coverage ratio, for example, as it steps down over time. But the bottom line is you can borrow more money from a bank for an ESOP transaction than you probably think. And it's, as we mentioned earlier, And this corp status, ESOP, the bank's aware of the cash flow power, and it's one of the few instances the bank is really willing to genuinely step into that air ball and finance the cash flow. Yeah, and I, and I think what, and I really appreciate you saying that, but I think you're Experiences in Huntsville, um, and not to, to disparage our banks here in Florida, but there's not a lot that will look at it. So a smaller transaction if it's a $38 million revenue this government contractor business that has, you know, an ebi of 2 to $3 million is going to have a hard time getting financing in Florida. And that's just my experience. So, So geographically, I think that definitely is different for each market. um, and finding banks that do, and this is where the advisor really helps, um, but finding banks that do ESOP lending and being, and finding banks that will be competitive at that is, is part of the job that has to be done early on in the process. And one of the things about the uh government contractor is you're really building a cash flow model on this forecast and the evaluation is gonna reflect the forecast. But the banks were are gonna look at historical cash flow. And even as a, as a government contract lending bank, um, they're gonna consider that. One of the things that, that Andy and I were talking a little bit about was this idea of a pos a potential for the bank to provide a, a vehicle or a credit vehicle that it can, can expand with the growth of the company on an ESOP transaction. I think you call that an accordion feature, Andy. Yes, that's that's what I refer to it as. But your ESOP lender also wants to be your primary lender and understands you have the business needs operating lines of credit and additional capital or may want to, you know, take out those seller notes which are typically more expensive debt. And so many times right on the front end in our credit facility we add in that accordion feature that can be expanded, you know, the line is where the amount of availability is bumped by, you know, a couple million dollars or more on on the triggering of certain events, right, your financial metrics or whatever your debt service coverage ratio is something. And so when our government contractor hits that next big contract, as we talked about in that stair step growth, there's automatically additional capital available that's inexpensive relative to the seller note and maybe other sources of capital, and they don't have to go back and, you know, unfortunately they don't have to call their lawyer to restructure the loan documents or put in a new facility. Yeah, yeah, that's, and that's a great feature. And I think that's something that as you, as you explore those opportunities, you want to make sure that you're working with advisors uh that understand government contracting as well. And that's kind of where I wanted to, to land the plane a little bit with Andy is that obviously, he's got tons of experience with government contracting. Um, there's a lot of different types of attorneys out there and different ESOP attorneys even, but to have an attorney that understands. Government contracting, I think is very important, um, because he's so well, you know, versed in all of those issues, um, as, you know, including, as we talked about the, the lending side, um, you know, helping, understanding the designations, all of those are very particular to the industry and there's more. Um, but so with that, my, my final comment would be just simply to make sure that you, as you're working as a government contractor, make sure that you're working with advisors. That really understand your industry really well, um, from all the people that you're gonna work with. Um, Andy, do you have any other final comments for us? No, I would just wholeheartedly second that. I think it's critical to have advisors engaged in the process early that like Phil, the ESOP guy literally, who can do the feasibility study and measure out if this is really the viable path for you to move forward. And then to assemble a good team, you know, I think it's important for borrowers' council, lenders' council, ESOP council, everyone to understand that's in that deal to understand the nature of a government contractor and what they're doing. So I, I've really enjoyed this, um, Phil, I enjoyed talking with you and enjoy, you know, every time we're on the phone, it's nice to, to cover some different topics, but this has been very enjoyable and I appreciate the opportunity. Thank you very much, Andy. It's great. I think your wisdom and everything was really good. I think it'll be a really good resource for people to, to check out. Um, so thank you for your time today, and absolutely, absolutely. So as I, as we close out this episode, I just wanna remind you all to, um, if you like the podcast, please subscribe and share it with a friend. Have a great day and we will look forward to our next step on this journey to an ESO.