EP9 - Braveheart - Control vs. Non-Control affecting your ESOP transaction.

Good day everyone. I'm the ESOP guy. We are on a journey to an ESOP. Welcome. Thank you for joining our podcast. So with that, I'm going to kick off this right away with this super cool clip. Where are you going? You want to pick a fight? Well, I didn't get dressed up for nothing. I tell them Scotland is free. Go back to England and tell them Scotland is free. All right, I love this movie. There's no doubt. I'm sure you do too, hopefully, um, if not, that's cool. It is um just one of the greatest epic movies in terms of historical fiction, in terms of the telling the story and what the story tells is about. Uh, this, of course, oppressive time in history where England is oppressing Scotland and the rising up of a hero, and that hero is William Walla Wallace. So we're gonna use that today in our podcast. I'm super excited you could join us. If you are just tuning in to this podcast, what you're going to find is this is, as it's called the ESOP guy. This is really not about me. This is about the journey to an ESOP. So for companies that are thinking they might want to use an ESOP or an employee stock ownership plan and they're planning. Then this is the right place for you. This, it's for people that are looking at how is the ESOP work, all the mechanics of it. Um, there's a lot of different topics. If you have any interest in any, any of that, please go to our website at journey to an ESOP.com. So with this episode, what we're gonna, the title of this episode is going to be Braveheart Control versus lack of Control. How does it affect your ESOP? And today, really at the risk of getting into a little math, which I hate doing, but it's absolutely necessary sometimes just to help you understand some of the fundamentals behind some of the things that go into planning your potential ESOP sale. And so, If you stick with it, you'll, you'll hopefully get the example as we go through a model of this to, to determine how does that apply to your company? How does it, um, what some things that you might want to use or really ask, you know, really the whole point of this is to ask your advisors to, to make sure that you're asking the right questions for them. Now I'm also excited to announce coming up the ESOP Guy live. Um, we have established the date is March 31st, so that'll be March 31st, 2020 at 2 p.m. It's going to be a live webinar. So please check out our website, journey to an ESOP.com for that and sign up for the webinar. The podcast is great. The webinar will give you an opportunity to ask questions. So, If that, if you like what you hear in the podcast, please subscribe and share it with a friend and rate and review the podcast if that is um something that you know how to do. So, with that, I wanted to kick it off with the idea behind the movie. So Braveheart, classic movie, love it. Um, why does it resonate with us, I guess, as people? I think it does because it, it calls out to our, you know, philosophically, I think, to our deep cry for justice. Nobody likes for anybody to get beat up by the bully, right? And so this story, which is based on a true story, of course, there's a ton of fiction in it, but it's based on a true story. Um, the underdogs in this case are the Scottish and the people that are oppressing them are the English. Um, interesting, this whole story is like, just really cool because you have such a, um, an advanced, like the most advanced military in the world at the time. And then you have this, this passion and just the sure will of a, of a people group led by William Wallace, who's played by Mel Gibson. They get to paint their faces blue, they get to, uh, taunt the enemy. They don't really care because they're gonna go for it. So you get Mel Gibson waving his large Claymore sword, crying out for freedom. And it just gets you, it's just a ton of energy, um, especially as he starts winning the battles and going at the end in terms of, of really fighting for his country as a true patriot. So, um, I have to say this before we get into the podcast. This is one, is it, is it makes me think a little bit about the political issues, you know, the people in, um, at this period of time, they're ruled by England. Now England does not give a voice to really anybody. However, In the movie, there are these nobles that are in Scotland. And they keep basically doing the same thing. They, they keep, um, really selling off their lands, they, they selling off their people's freedom to England and let England do whatever they want to do. In exchange for that, they get lands and titles, um, they get to enlarge their own personal kingdoms at the expense of Their own people. Now, this is not a political podcast, but I will tell you what was on my mind when I thought about it and then we'll move on. Because as we enter into the political landscape of America today, I have to be, um, objectively critical about where we are as a country. And I've said this before, and I'm going to say it again that our country that is ruled by the politicians of the day in Washington DC. It's the same thing, guys. They are leveraging and utilizing the people of America and selling one issue after another. You know, the whole point of that is, is if you go into Congress and you, you know, you're there for 30 to 40 years, and you come out a $100 million billionaire, um, something's really wrong with that. So again, I don't want to get too political. I do want to point out there's a great parallel there that we're living in right now. And it makes me think about how this whole thing went. Um, where are the people in this country that will stand up and actually talk about it? And so the only thing I want to say about it and is term limits. Congress needs to have term limits, and just that's it. I'm going to say nothing less on that. So, moving into the podcast, control versus non-control, what is it, what am I talking about when I say control versus non-control? Well, control is when you as a business owner, have the ability to Um, basically manage and, and have the majority vote in, in many cases, but you have enough stock that gives you the power to tell everybody what's going to happen. So that's control. And the non-control is you're basically still, you still own the company, but you don't have any real control over what happens. And so I'm going to go through what those control attributes are in a minute. But as we go through that, I want to say that, you know, clearly, when we think about um the abuse of control, we, you know, we get all kind of, I got all carried away my political example. That's not really an issue typically with most businesses. Control usually is established um for multiple reasons, but it's not usually to, of course, um, you know, abuse people or whatever. It's usually just the way that things fit together. Um, for an ESOP, this issue matters because it will ultimately affect the evaluation and will provide um potential issues for planning. So again, as I, as I say that, I just want to point out that my job is to help you kind of think about what the issues are, so that you can ask the people, the advisors that the people that you trust about these things so that you're better educated and you have more information. So one thing is we get into control versus non-control, we'll get into the actual voting rights. So sometimes companies will actually issue stock and some of that stock could be broken into different classes. So one class, say Class A could be voting rights, and then Class B stock could be non-voting rights, and that would definitely determine who has control if you have voting stock or versus non-voting stock. Um, a lot of times voting or control is, is established based on the percentage of the total common stock. So either one of those scenarios is going to establish clearly whether you have control or non-control. So one of, one of the reasons companies use non are voting shares versus non-voting shares instructuring their company. is because they're doing estate planning. And so what they're able to do then is keep the voting shares and then issue non-voting shares and start moving those into their estate planning trust for their heirs. So they don't have to then give up control of the business as they, as they do that. And then additionally, there's the non-voting shares are going to have an additional discount for what we're going to get into for a state planning, it can be pretty steep. And so understanding that valuation, the first thing and evaluation that we always have to be thinking about is purpose. And the purpose of the valuation, if it's to plan a transaction for an ESOP, is going to be different than the purpose of planning an estate planning. So, so gifts and estate valuations are specific and unique and different than A normal business valuation for internal planning or for an internal buy or preparing also even for a strategic buy. So make sure we separate those. However, estate planning itself does use this type of structure. So then you have a company that has, say, voting and non non-voting stock. We have to then prepare the company um through the process to become an ESOP. So in working through a possible ESOP transaction, um, we need to identify what the voting shares are and the non-voting shares are. And the reason this is because um the under the IRC or the Internal Revenue Code section 5123, only the voting common stock held by an S corp ESOP is exempt from taxation. So, the key with that is that we, when we do ESOP planning, And this is just something I find that people, people, if, if you haven't done a lot of research on ESOPs, so you probably already know this, but if you don't, ESOPs that are owned by um as corporations, so the trust that owns the share of the ESOP is tax exempt. So if I have a 30% ESOP that's owned by the, or if I have a 30% company that's owned by the ESOP, that 30% is tax exempt. If you, when you go through the structure of the ESOP under 512, basically it's saying you have to buy the voting shares or you cannot buy um the non-voting shares. So that's very important um when you're structuring a company that has a particular amount of non-voting versus voting shares. So we have to reissue new shares and we're, we're gonna use this into, into the example. So just hold on to that, but it's important when you're, when you're thinking about what you're actually going to structure in terms of your um potential ESOP. Now, 11 thing that we look at too is if we structured 100% ESOP, let's just keep this simple for a second. And we have a company that has some voting and non-voting. It's really not going to be an issue because we're going to just issue shares, we're going to convert those non-voting shares to voting shares. So at that point, at 100% ESOP, it's just gonna, the issue itself just doesn't happen, it doesn't, it doesn't matter. Um, it's not material at all. And but the where I get into this is if you have a company that is considering a partial ESOP, which is very, very popular and a partial ease up can accomplish a lot of things. So in planning, It may not be appropriate for the company to enter into a 100% ESOP because the owner that's selling isn't ready to completely sell out, or it could be that the company's not really ready for that much leverage on their balance sheet. Um, so it, it just make make more sense to, to do a partial. There might be issues or concerns about, hey, I want an ESOP for this part, part of the company, but I also want to sell this other part of private stock to my key managers. And so you end up getting this combination of what we call, what I would call a hybrid of an MBO and an ESOP. So we make it, we make a little more complicated when we have this hybrid MBO and ESOP kind of model, when you have voting and non-voting shares, right? Because now I have, I have a whole bunch of different factors going on. So I want to simplify all that and kind of like to say, hey, we're going to just simplify it by the concept. That we have in valuation, which is what is control versus non-control. So whether I have voting versus non-voting and an MBO and an ESOP, all I need to do is kind of pull it together and say, like, these are the, this is the lane I'm going to stay in so I can really understand what, and what I'm really trying to get to in this podcast is what is the selling shareholder? Going to transact for at the end of the day, knowing that all of these components are going to change the way that they structure and plan the ESOP. Then the other part of it is, is not just the owner, but then if I'm the key manager, what am I actually buying in the business? What am I gonna pay for it? And the key difference between the, the manager buying the privately held stock and the ESO buying the privately held stock is the manager is gonna be using after-tax cash flow out of the company, typically. The managers that buy companies, they typically don't have, they're just a ton of money sitting around. Here's my, here's my big check, Mr. Owner, and, and I'm buying you out. They usually have to use the company's cash flow just like in the ESOPs using the company's cash flow. And it could be that the, the seller is financing the whole transaction as a seller with seller notes. It could be that some of the transactions being financed through bank notes as well. But either way, the company is going to have to have the cash flow to carry it. So I'm concerned with those, the main issue here is how much is the selling shareholder going to get out of the transaction with this type of structure. And so again, specifically, if it's a 100% ESAP with 100% control, this is really not, that's not that difficult to figure out. But when you have the multiple combination EAP with an MBO and, and a um a partial ESAP, then it can get difficult and then when you throw voting versus non-voting in there, it can be difficult. And as I said before with the voting shares, The ESOP has to buy the voting share. So whatever is the non-voting is typically what we're gonna put in the, the, the bucket for the managers. We don't have to, we could convert all of it to voting before the, before the uh um the transaction, but we're just, we're just kind of using that as our example. So we can look at that as a way to kind of make sure we're asking the right questions. So if you're still with me, what I want to kind of go now into is what is the control premium, what, when we talk about control, we as valuation people refer to this as a premium. So if I own 51% or more of a company and I have control, what is this, what does this do for me? What are the attributes of that? And so I'm gonna list off some things that just will be helpful for definition purposes and to get everybody's mind around, oh, that's why that control premium exists or that's why that there's a discount for a lack of control, which is really where we're going with this. So a control premium allows the the the people that are in control, the individual, individuals that own the stock, maybe it's voting stock versus non-voting or controlling ownership percentages, to appoint or change members of the board of directors, to appoint management, fire management, to set management compensation and prerequisites, to set operational and strategic policy and change which could totally change the course of the business, to acquire, lease or liquidate business assets to negotiate and Um, enter into mergers, acquisitions and divestitures. Pause. Obviously, if you're an existing ESOP company, that's going to be a little unique because you're gonna have some voting in that, but just assuming you're not an ESOP company and you have control. Um, it, it allows you to sell, liquidate, dissolve or recapitalize the company. You could acquire Treasury shares, you can register the company's debt to go to a public offering. You can declare and pay cash dividends to shareholders. You can change the articles of incorporation or buyer laws of the company. You can establish, revise or execute by sell agreements. You can select and enter into joint ventures. You can decide on product service offerings, you can, you can change the pricing, you can um establish new markets, you can select and new suppliers, and you can fire old suppliers and vendors and different contractors. You can enter into license agreements and technology agreements for IP, um, and all of these things, there's so many, probably more, but you can understand that if I'm in control of the company, I can really Do a lot, right? So that's the point of that whole list and I didn't want to go into any of the details with that, but I just wanted to give you a quick overview, um, which really is just a helpful list, um, that I got really just kind of going through the research that I did, that will help you to to kind of firm up in your mind that's what control means for a company. So when we get to it from a valuation standpoint, we're now at this place where I, all right, so what does that mean? How do I, how do I actually use what you just gave me to understand how that's going to affect my ESOP transaction. So, um, want to talk a little bit about, as we talked about the premium, just the idea behind a lack of control discount. So the, the idea behind a discount for lack of control is that it's going to Identify the, the shares that are being sold that are not that are giving that that buyer, um, you know, a ownership position, but not a control position so that we, he can't, he or she or that entity like the ESOP cannot buy or cannot control the company like we just talked about in that list. Now, from an ESOP standpoint, they could buy voting shares, but they could buy a a minority ownership of the voting shares. So that puts them into a lack of control and um that is going to come up in the negotiation with the trustee, and we would establish in that transaction, what we, what we estimate for the lack of control. So, in lack of control, I will kind of reference a few things. The IRS um looks at what we call deox, so discount for lack of controls in a 1982 estate tax decision of Woodbury G. Andrews, the court distinguished this discount from a Discount for lack of marketability. So you might have heard the discount for lack of marketability, which is really about um the company is not publicly traded, so there's no public market for the sale of the stock. So this is a different discount. And what that what that means is when we start valuing the company, This discount for lack of control is going to be another discount that's going to be applied in the planning process and ultimately in the negotiation process with the trustee, which reduces the amount of value that the company has to the selling shareholder. So, The formula of this is just going to be that you're going to take technically, 1 minus 1 divided by 1 plus the control premium. So you're just inverting the control premium upside down, so we're applying a discount. So, so as you think about control premiums establishing quantitatively, I'm not going to go there because it's not as typically used, we're gonna typically more go towards this discount for lack of control. Um, there are some exceptions to the rules, so users of business valuation should be aware that some valuation methods produce a non-controlling level of value. Um, where you don't really have a need for an adjustment where the subject being valued is a non-controlling interest. Um, so then in that case, um, the business valuation is going to, um, kind of level it out in terms of, of how that would be applied. And many times that might be um established in the cash flow because if there's no adjustments in cash flow for, for um the control premium, like, The ability to change salaries and different things like that, then, then you have a cash flow that is um on a non-controlling basis. So, I don't wanna make it too complicated, but definitely something to understand as you start peeling back this issue. So, With that, we're gonna go into a a quick example and what we're gonna do here is we're gonna estimate the value of a company's uh voting or the company's stock in a in a potential transaction, understanding that we're gonna apply then the discount um of lack of control within the total framework. So we're gonna end up using what we're I'm gonna call the sequential method, and that is to start off with my market value of equity. I'm gonna divide that total by the total number of voting and non-voting common shares. So that's going to give me a total market value per share um of voting, and then I'm gonna take the discount for lack of voting rights or discount for lack of control, and um I'm gonna apply that then to get my market value of equity per share for non-voting. So, The reason we're doing this is is we're thinking about a potential transaction that has both an ESOP that we're selling a portion of the company to and a management buyout that we're selling a portion of the company to. So we have this example of a, of a potential hybrid of the two. And so the market value of equity in this case is going to be $25 million. The number of shares that we're going to have is going to be 1 million shares. The number of shares voting would be $300,000 of the million. The number of shares non-voting are going to be 700,000 of the million. And we're going to assume in this example, a 10% discount for lack of control. And so with that, you're going to have a per share value of voting stock at $25 and you're going to have a per share value of non-voting stock at $22.50. So you're already seeing that the, the value of the shares are less for non-voting. And so we're gonna Basically say that that non-voting shares are the voting shares that have, are the shares that don't have any control. So you're going to see that play out as we as we put the numbers together. So you have a client here who says, you know, I'm going to sell 65%. I have 65% of the company. I'm going to sell that to the ESOP. I'm going to split the sale between 30% goes to the ESOP and that's 300,000 of my voting shares. So, as we said before, the ESOP can only buy voting shares. I'm also going to sell the 35% remaining stock that I have, that's non-voting, and that's 350,000 shares. So when I apply the the math, I'm simply going to have the voting shares that for the ESOP sale are going to be 300,000 times the $25 which is gonna going to total $7,500,000 of, of stock value. And I'm going to have the 35% being sold to the management buyout for $350,000 of my shares times the $22.50 per share. And that's going to give me $7,875,000. So the combination of those two, when I actually put the sale together, is going to total $15,375,000. So we need a reference point to make this make any sense at all. And so, Just again, the structure of this is a, is a combination sale of NBO and ESOP with the MBO buying the non-voting shares, the non-controlling shares, and having to um this as the selling shareholder apply this discount for lack of control to that portion of the sale. And so when I go to the the next step and really compare that, what I'm comparing it with is if, if I sold my 65% interest, And I didn't have the controlling, um, the control versus non-control, so I had no lack of control discount. I would have sold the company for $16,250,000 or an $875,000 difference between the, the combination of ESOP and um MBO. So the point of this is if I sold my whole 65%, what I'm without a lack of control, I would have had to convert those shares over to over to voting. Or one buyer would have had the total and that would have all been in there. So, so in that case, I would not have had any discount for lack of control. So, so who takes the hit there is the selling shareholder for the amount of what he's actually, he or she is actually selling in the transaction. And is it worth it to give up that portion of it? That's kind of part of the whole idea behind what, what makes sense. So, What we illustrated with the sequential method is just how do you actually come up with the actual numbers and apply the discounts appropriately to make sure that we're keeping all that together and in our minds. So, the, one of the values of this method is number one, it's pretty simple, as I just went through, you know, the math was, you know, we just broke everything down and found the per share value, we applied the actual percentage and the number of shares to each of those values, we combine them. So it's, it's simple to, to put together, it's easy to explain. Um, one of the things about this method is that the IRS recognizes it. It's easy to explain to them if that were ever, um, looked at from that perspective. Um, it's easy to perform and, and, and, you know, going through that, it, it does provide credible results. When you look at it, when you pull that back together, and you say, well, what's happening, it's not going to be equal to your original value of the company, which was 25 million which keep pulled all that back together because We're actually putting in this lack of control discount. So, um, that's, that is part of the, uh, the aspect of understanding um what the model is gonna give. And that's intuitively what we should expect to happen because of all the things we just mentioned. And so kind of to summarize the, the lack of control, it is really for um the portion of the company that's being sold, and it doesn't have to be voting versus non-voting. So if it's um if I, if I'm the company that, if I'm the buyer that's buying a percentage of the company that puts me in a non-controlling position, then I clearly don't have the rights of a controlling interest, and I can't do all the things that I mentioned. At the very beginning of the podcast that are, that are gonna have significant control and and significant impact on what happens to the company. So truly that really does capture then the fact that I'm, I'm glad I'm an equity owner, but I'm not going to be the controlling owner. And so this happens a lot too, and I'll, I'll point it out as we start to close, is when you have a company that decides that they don't have voting versus non-voting, but they decide to go into tranches. And so they're going to have a smaller minority ownership ESOP at the very beginning, that's gonna be a non-controlling ESOP. And so that would have the discount for lack of control. As time goes on, once we cross over in that example to 51% ownership, now we have a controlling interest and you don't have the discount at that point. So I hope that helps you to understand the issue. Um, one of the things I hope this illustrates to you as the listener is, what's the most important thing I think I want to want everybody to think about in, in all of these podcasts. Is planning, planning, planning. Planning is essentially the most important thing you can do. You can't start early enough to be honest with you because there's so many aspects of, of putting together an ESOP that need to be thought about and taken care of. As I close this, this podcast, I want to kind of close with the storyline um behind Braveheart. This is a, a bit of a spoiler, but I wanted to kind of make a point. In the fictional version of this, is that his bloodline, William Wallace's bloodline ends up, um, as he dies, he ends up taking over control of England through the French princess who actually is going to have his baby. And so even though he ends up dying, he still ends up gaining control of England, or at least his family does. Um, I think that's crazy fiction. I don't know if it's true or not, but I thought it would be um an interesting thing to think about as we start thinking about control versus non-control. So with all of that, I just wish you, everybody a happy day and, and, and uh I hope this season of COVID is over for all of us. Um, please check out our website at journey to an ESOP.com. So be looking for the ESOP Guy live webinar, which is coming up March 31st. If you like this podcast, please subscribe, share it with a friend if you think it might be helpful. We look forward to our next step on this journey.