Ep9 - Interview with an Orlando ESOP Attorney - Jay Van Heyde

Welcome back. Thanks for tuning in. I'm the ESOP guy and let's continue on this journey to an ESOP. This podcast is for those that are thinking that they might want to consider an ESOP, sometimes for a growth strategy, sometimes for succession or even an exit of their business. Today I'm excited to have the privilege of interviewing Orlando-based attorney Jay Van Hyde with the Dean Mead firm. Jay and I have done multiple ESOP deals together over the years. Jay has actually been working with ESOPs since 1989. As an attorney, he has represented the trustee of the ESOP buying the company's stock, typically from the founder. He's also represented the company itself and occasionally the selling shareholders. Although the roles and the deals are in a sense adverse, Jay's experience and my experience in ESOP transaction is that all the parties involved, the attorneys, the trustees, they're all rowing the boat in the same direction. And so today we're gonna, we're gonna get into some questions for Jay. Jay, thank you for joining us today. Well, thank you for having me on. I'm delighted to be part of this. Great, great. So just to start off, Jay, uh, do you find that most ESOP deals are really complicated and therefore create difficulties in, in getting deals closed and getting deals done? And what would, what's your experience with that? Um, I, I wouldn't describe them as being really complicated, uh, just like anything in dealing with the Internal Revenue Code or, uh, uh, any, you know, governmental type based uh benefit. There, there's technicalities, but I don't consider them to be really complicated and unfortunately, Uh, there's a large number of professionals like you and I that that do this all the time and have done enough of them to make it fairly easy to, um, you know, smooth out those, those bumps in the road and explain exactly how all this works. It does take, you know, some work to get to the, uh, to the finish line. You're having to do things that, you know, aren't. Normal in your everyday business life, such as putting together, you know, forecasts and thinking about tax qualified retirement plans and whatnot, but it's just part of the process, but I consider it to be very manageable. Great, great. And that's my experience too, and I asked the question because I do see a lot of people look at it initially that that just is just too complicated to even get started with. Uh, Jay, what are the most difficult situations when it comes in your experience in doing ESOP transactions that you have encountered in actual deals? Well, first of all, an ESOP transaction legally has to be an arm's length transaction. So the ESOP trustee, typically an outside trustee who's engaged to represent the ESOP. That individual has to, you know, treat it as an arm's length negotiation, you know, with the company and it's selling shareholder. So you have to understand that you are negotiating the sale of business, number one, number 2 is it involves a valuation. Uh, by law, the employer securities that the ESOP is buying. Um, uh, the, the trustee cannot pay more than praised for market value, so you've got to go through the, the process of valuing the company, uh, you know, on a very professional basis, and, and so that, that involves, uh, you know, some difficulty just in terms of doing the, uh, projections necessary to value the company and then negotiating the transaction. But, but otherwise, um, you know, the complications are just what you would think would occur when any two parties are trying to negotiate the purchase of a sale of a business. Yeah, and so and just looking at that question too, my experience has been. That a lot of those get dealt with at the very front end of the feasibility process. And I think some, some difficult situations can be the owner might think that their business might be worth more than it is. And so what you want to do is vet that out there at the front end of, of feasibility so that you're not getting too deep into the deal and then having a big gap between what their expectation is on the, on the sale price and what the trustees willing to negotiate on a on a sale price. And I, I find that The better you do your feasibility work up front and set expectations realistically, the smoother that transaction can go through the whole process because it does, it does have to be met on both sides. That's an excellent point, and that I oftentimes will meet with the individuals who desire to adopt an ESOP for their company and You know, I could spend an hour or two trying to basically teach them ESOPs 101, and typically at the end of the day I ask them, is this something you feel that you would like to proceed on? And if the answer is yes, I always advise that the next step is to engage someone like you. That can actually do a feasibility study and, and, and look at the financial information and, and look at the, the, the employee census, who are the employees and, and, and, and what the, you know, all the factors associated with, with being an ESOP might be. And I really think it's important to do a feasibility study early on and also some type of uh what I call a desktop valuation. To make sure that everyone is sort of in the same place in terms of, you know, what's a realistic value for the company so that there isn't some false expectation in the mind of the selling shareholder. For instance, they might think that the company is worth $10 million whereas someone, you know, with with experience and valuing companies might conclude that it's only worth half that. So I always encourage early on a feasibility to study to make sure you can show how the transaction would work using numbers and also to look at some type of a desktop valuation to make sure that the expectations are, are realistic. That's great. That's great. So Jay, moving into the, um, one of the one of the things that you do for an ESOP deal, um, is create the document plan, the ESOP document plan. Can you explain the typical areas that that document plan, the ESOP document plan covers when you're creating the ESOP kind of brand new? Sure. Uh, let me first say that an ESOP, uh, by definition, is a profit sharing plan designed to invest primarily in employer securities. OK, so instead of like in a 401k plan, the participants are investing in mutual funds. The the thing that the ESOP is investing in is the company stock or the employer securities. OK, so again, it's a profit sharing plan. So most of what you're having to talk about in terms of putting the plan document together are very typical terms for a tax qualified profit sharing plan, similar to a 401k plan. So, you know, the plan document will define. Who's going to be covered by the plan? When do they come into the plan? How do they vest in the, in the plan? When will they be paid out from the plan? Those are the key, the key factors in the plan document. That's right. So, when you're looking at the, the, the one thing I wanted to point out is the vesting gets discussed a lot. So when you're looking at vesting for the, for the plan document, what are the typical vesting criteria that you use when you're advising a client and, and how do you go about helping the, the client actually make those decisions? First of all, the, the Internal Revenue Code itself has some outer limits in terms of, you know, what the vesting schedule must be, meaning you must vest a person by a certain time period. And so there's two different schedules in the Internal Revenue Code, and those tend to be the the schedules that we look at, but I would say the vast, vast majority of Uh, ESOP plans have a vesting schedule that basically says that after 2 years of service with the company you're 20% vested and then it goes up 20% every year, so that would be 3 years, 40. OK, 4 years would be 60, and by the time you get out 6 years of service with the company, you're 100% vested. Investing basically is the percentage of your account balance that you get to keep in the event that you leave, uh, die, or become disabled. And it, and it becomes an issue and I, and I bring it up too because sometimes the, the, when the client is creating the ESOP, their, their concern is that how do I really help my people that have been with me for, say, 20 years and 30 years. And so in, in talking through that a little bit, what is the latitude that you have as a, as a, a new ESOP to accelerate the vesting period and, and what do you see as a typical way to reward somebody that's been an employee for that long? Well, oftentimes these are companies that have been around for a considerable amount of time and, and so there are, there is a group of employees that have greatly contributed to, you know, the success of the company and have, have basically helped the Uh, founder, you know, build that value. OK, so if the company is worth $5 million or $10 million or more, there's, there's probably a group of long-term employees that you could say, but for them, there wouldn't have been this $5 or 10 or more million dollars, right? And so if you were just to start from scratch and say that If we put the plan in in 2020, OK, and everybody starts the same. You have to be here two years in order to be 20% vested, 3 years to be 40% vested, etc. Then there's really no reward for the people that, that truly created the value, uh, the big value of, of the company. So one technique that we typically use is to grant what's known as prior service credit. And so as an example, we might say that For every 2 years or maybe every 3 years that a participant has been engaged by the company prior to the time it starts. So in this example, prior to 2020, so for instance, for instance, every 2 or 3 years that you've been here, you get 1 year of vesting credit on that schedule. So for instance, it's every 2 years is a 1 year of prior service credit. OK, then a participant that has already been here 12 years could start the plan 100% bested. and there you're saying to these long-term employees, it's sort of an acknowledgement that hey, you're the one that helped me create this, this value, and I want to reward you for it. That's great. I think that that comes up a lot in my discussions with clients as well, and they, they, because they're doing ESOPs, they want to make sure they reward people. It's part of the reason. They want to do an ESOP because they want, they want the employees to win at the end of, of the deal as well, so. So let's shift over a little bit. One of the questions I get from companies is, how much is this going to cost me, um, when they're thinking about an ESOP? Can you speak to what you see as, as a typical budget that a company should plan for in terms of actually doing the cost of doing the transaction? Well, there, there, there can be quite a wide range of, of cost, uh, typically the, the larger the company, the more things that they are into, uh, but you know, just as a threshold, you know, I, I would say it's, it's going to cost more than $50,000 in total, uh, for all the various professionals to, uh, you know, to be involved and, and let me break that down a little bit. Number one, you're going to have to hire an independent trustee to represent the ESOP and its participants. So that's expense number 1. Expense number 2 is that the employer securities or the company's stock have to be bought at an amount not to exceed fair market value. So you have to have that valuation. So the ESO trustee is going to have to engage. Uh, and an independent valuation firm. So that's the second component of the cost. Number 3, there's going to be a lawyer like myself at a minimum 1 lawyer who's going to be doing all of the documents, and you have to keep in mind that number one, you're creating an ESOP, OK, that's a tax qualified retirement plan. So there's a plan document, and summary plan description and and a submission to the Internal Revenue Service. That's on the one hand. Then on the other hand, there's going to be all these documents associated with the purchase of those uh shares of company stock. It's, it's the documents that, you know, that document the purchase and sale of, of, of the company. So that's the third component there. The larger the transaction, the more likely it becomes that the independent trustee is going to want either his, her, or its own legal counsel. So that's a potential for there being another professional involved. So again, it's, it's a, it's a wide range depending on the size of the transaction. Then you also have to consider, as I mentioned earlier, that you know I often talk to people about this class on ESOP 101, and if the decision is made to move forward, I always advise that there be some kind of a feasibility study such as what you're doing and a desktop valuation such as what you're doing. So you'd have to factor that in as a potential cost as well. Then afterwards, after the transaction, there will be ongoing costs associated with an ESOP. The independent trustee typically stays, although it's not necessarily a requirement, but the trend is that they stay as the owner of the company's stock, and there must every year still be a valuation done of the of the employer securities. OK, so there's two costs post transaction, and then the third is just like a 401k profit sharing or whatever type plan, there's going to be annual administration or record keeping for the plan. So the bottom line is that the ESOPs are not. an inexpensive thing to do, but oftentimes there's very good results in terms of the company and the shareholder that's too, and I think that when you look at comparative transaction as well, if you're going to sell your company. It's probably in line, and maybe less than some of the other sales. If you're doing merger and acquisition work, you find with attorneys in those, in those types of deals, um, the costs are either comparative or, or maybe even higher, so. So moving on, 11 thing I get from clients a lot is this question and they go to, they go to conferences and their, and their, their questions are, you know, what is a warrant? How do I use a warrant in an ESOP transaction, um, and should I use a warrant? Um, Jay, can you explain that in layman's terms, in terms of the benefit of a warrant to the seller? Warrants in ESOP transactions are typically Uh, used in connection with the the financing of the ESOP transaction. And let me say that it's very common in ESOP transactions for the selling shareholders to at least in part, be part of the source of the funding. So it might be the case that the company is able to borrow some of the money. Uh, to lend to the ESOP, which then turns it over to the, uh, you know, to the selling shareholder, but typically the selling shareholder, uh, also has to take back a promissory note for, for part of it. The promissory note is going to, of course, include the payment of interest. And you know, interest is an expense on the company and it's a drag on cash flow and so what the warrant is meant to do is, is, is try to reduce the current amount of cash pay interest that the company has to pay on that seller note. So as an example, if a company were able to borrow part of the money to buy out the selling shareholder, the bank would be the first lender in line there and, and they might get an interest rate of who knows what, 45, 6%, 7%, whatever. The selling shareholder uh then would have to be the one taking the second tranche of, of these, um, promissory notes, OK? So they would be junior to or subordinate to the bank. Anytime you're subordinate to a lender. you typically are entitled to a higher interest rate because you're assuming more risk. The first lender has to get paid before the second lender gets paid. And so the interest rate on the seller note might be at a higher rate. It might justify the selling shareholder asking for, you know, 89, 1011, 12% interest. Well, the company might not want to be paying that high of an interest rate, especially if it has to pay the, the uh the bank its its interest rates. So what the warrant does is that it takes the place of part of the payment of interest. And so in effect it can buy down the interest rate. So maybe instead of an 89, 10% uh coupon rate or interest rate on the seller note, maybe the interest rates only 4%, and the warrant then will appreciate in value over time and when it's ultimately paid out, uh, that warrant's going to take the place of the foregone interest in that transaction. That's true. And then the company itself can use that um lower cost of financing at the front end to create more cash flow to, to make sure that they're able to handle all the other um aspects of the business, regarding cash flow requirements. So, so they're very useful, they're used a lot and it's something that is, is, is asked a lot when I'm, when I'm talking to companies. So thank you for the, for that explanation. Um, on warrants, and, and they really, as we talk about the ESOPs, there's really a lot to know. And that's why it's really important to, uh, when we're doing this podcast is to tune in to, to certain podcasts that you're interested in. We are out of time today to continue the interview, but I wanted to say thank you very much, Jay, for your time today. And um from your, the insight that you have in the ESOPs and Um, just enjoyed talking to you more about that and appreciate that, you know, you're making time for us today. Oh, you're welcome. Great. So as we close out, I just want to remind you, if you like the podcast, subscribe and share it with a friend. Have a great day and we look forward to next time.