S7EP38 - Interview with Josh Sutton, Employee Benefit Attorney

Jason Miller Well, thank you for joining today. And you mentioned one of the words that we tried our best to expand on when we talk about ESOPs with our listeners, and that's complex and putting that into perspective. So you also followed that up with fun, and I know that many people become very engaged over complex topics when it turns in their mind, and there's so many different iterations of how something can manifest. But talk to us a little bit about what you mean by complex related to ESOPs, and let's broaden that picture a little bit and put that into perspective with maybe other types of Ownership or exit or transition options.

Speaker A Perfect. So, the complex and fun is because it's tax-exempt at many levels. So, that's what gets me going as a tax lawyer. If I can find a legal way to have a client pay the least amount of taxes, that makes me very happy. And usually my client likes me. And the ESOP allows taxpayers at different levels to potentially exit tax-free or run a tax-free company at some level. And that makes people excited. And that's why a lot of people want to go do ESOPs. Well, the complexity part of it is that when Congress decided to give us this tax-exempt or this great ESOP feature under the code and all its related benefits, it set up an extremely complicated regime to obtain that benefit. And then you have ERISA fiduciary duties that is added on. So there's the complexity. And, and to your point, most businesses are not run or owned by a tax-exempt nonprofit or, well, tax-exempt trust that, that is the ownership. And that's most scrutinized by the government. So you're adding another layer of— complexity to what would just be an ordinary business. So, that to me is what, you know, and quickly, both the tax code and ERISA are 2 areas of law that they can get right to your pocketbook real quick. And it enforces the highest duties under law. So, if you have a duty under law, that means if you breach it, They can go to your pocketbook. And this is a tough duty. Not only is it the highest, it's the toughest to do. I can't think about myself. I can't think about my company. I got to think about what's best for these plan participants. That's not normal human nature to think that way. So that's the complexity that I think I would want people to understand before they just jumped into the woohoo tax-exempt. This is great. Which is what gets me excited. But there's always burden to any benefit in the tax code is how I view

Jason Miller It. In you explaining it that way, it just made me realize something. And I, this particular type of transaction or exit appeals to a certain segment, or I guess a certain type of individual or individuals more often than others. And I think we find some commonalities in that ability to empathize with the plan participants or the employee base are wanting to do well or be generous to the people that have gotten the current owners in the state that they are to have a successful company to be able to transition to them. And so, that's a little aha moment for me as you're talking through that. And then, the other is you start with the tax piece and Mackenzie often reminds me toward the end of our calls with clients and prospective clients like, hey, talk about the tax thing because there's so many other things that are great about ESOPs that I love talk about upfront. And it's like, oh, that's right. It could be tax-free to the company or to you, or in some cases, we can figure out how to blend those over time. So I find that really fascinating. So I know that these are fun. They're fun for me. And I love that description because it doesn't mean that it's scary. It's not, oh, this is really complex. You should be terrified. And then you should ward it away with your cross and garlic. And it's and get away from it. It's— this can be fun, but it can always be navigated. And I think that that's important for people to hear.

Speaker A I agree. I have come to realize that I get most of my work from bad vendors because they're not doing what they're supposed to be doing. And if a client doesn't know It just becomes worse and worse. And my clients are always very happy when I get them to good vendors because then it makes the process easy. They're educated, they, they feel comfortable, they understand the path, and they go through it well. So to me, if somebody was looking at an ESOP and wanted it to be fun and to be, you know, something that Would challenge them in a good way. Make sure you get a good vendor to help you through that. And for ESOPs, it's really vendors. But if you start with one good vendor, they should get you to the other good vendors in the that are out there. And I think there are plenty of good ones. There are also plenty of not so good ones. So I think if if I was going on the ESOP path. That would be probably where I'd really spend a lot of my time is researching who are the people who really get it, know it, and have the right values. To me, ESOPs, well, another reason I love them is the people who usually want to do them, you know, they may come to me, sometimes it's just for the tax, but usually it's they really care about the company. They need a succession plan. And they love their employees and they like the idea of the employees earning through hard work a retirement that is really completely provided by the company. The employees don't have to do anything but just work there. And those values and morals, if they translate down through the ESOP, now the ESOP is saying to every employee, you're an owner. And, you know, employees steal the staples, owners don't. And I think if you can take that culture and really infuse it in that ESOP as part of the business, that's where I see these ESOP companies really, you know, if people believe that culture is everything, wow. Yeah, I've seen it. When you see an ESOP culture really working, those companies, just their stock is on a constant upward trajectory. Employees are happy. Morale is good. excited to come into work. Now, that's not all the time. I don't want to overstep it, but, you know, business is hard. And I feel like ESOPs actually can be a culture enhancer and help run a business even better. I think I went off question there, but Jason, you can—

Jason Miller We got plenty of others from that, Josh, but I appreciate that. I like to say that that culture that you're describing and the results of that are really like magic. There's nothing else like it. that I've seen or experienced. And it is so very true because it is replicable, right? Each culture is unique, but the fact that culture is that important is based on a legacy of founders and their generosity, or again, their benevolence, I guess, if you want to call it that, in this type of exit really does manifest in a way that doesn't elsewhere.

Speaker A So, and you and I are like numbers guys, right? Like, I'm a tax lawyer. I mean, you're really, in my mind, a finance genius. The culture to me would be, is not like norm, is not our first thing. And so for us to pick up on that, I think, I think, you know, HR would love us.

Jason Miller It says a lot, doesn't it? So your, your comments beg a certain question. At the beginning, you had said that you get a lot of work referred to you by bad vendors. So the question that, and we, We get this in a different way. I think this is a unique way of addressing it. What are, what are some of the qualities that you would say are, are a, a bad vendor? And be as broad so that we're, you know, we wanna play nice, but I think people that are listening wanna know like, hey, where should I scratch my head on this as I'm interviewing my, my first kind of foray or professional in, in the ESOP space? How do I know that this could be bad or this could be good?

Speaker A Sure. You know, and I kind of would go through each of the different vendors, you know, that we hire, you know, from valuation appraisers, trustees, lawyers. But I think the universal is, do they do this day in and day out? I think there are a lot of vendors out there that dabble in ESOPs, And with the best of intentions, but if you don't really do it every day, typically something goes wrong. And so, you know, I have one example is I got a new ESOP client and they told me who their third-party administrator was, and I know who they are and they've always told me they don't do ESOPs. And so I, you know, nicely asked and they said, oh, well, that's one of our historical. And, and of course there's a problem because they don't do it every day. And therefore we got, you know, have something we need to fix. They're an excellent vendor in their space, but you get out of your lane and it's just, again, back to the complexity of code, ERISA administration. You know, we got so many parts of the code that we're dealing with, 400s, 500s. 4000s, right? Prohibited transactions. And then I haven't even gotten to ERISA. So those are the kind of things that if you don't do it every single day, and the issue was 409, right? If you're an S corp, there's a whole area of the code, 409 of the code, little p in parens, that has a really draconian regimen if you violate it. And And so to me, if I know I've got an S corp ESOP, 409 is like the top of my checklist. And, you know, this party was like, they don't need 409. We're not, we don't need to run any 409 testing. And so that's a more concrete example. But the global is they got to be doing this all the time. The real place where I see it, what happens is it usually just slows things down and makes it more expensive. So, there's a lot of what people say, you know, like the banker or the business, you know, the guys who sell the business and people usually go to them. Well, if they don't know about ESOPs, they're running you like they're selling you to private equity or a strategic buyer. They're in that world. They are not aware of the ESOP world. And so, if they're running the valuation, that it's probably going to be very different in how they do it versus how we in the ESOP world value ESOP companies. So from your banker or your, you know, whoever you're using to find and buy and sell the company to the valuation firm, right? And typically there are a lot of vendors out there, good and bad, who will say, well, we'll do a feasibility study. I think that's critical. You got to do a feasibility study if you're thinking about doing an ESOP. And many of these vendors will either give it away or way overcharge for a feasibility study, and we're not getting what we really need. They can throw some numbers around and show you things, but if it's not really done well in an ESOP world, we're going to spend a lot more time dealing with sophisticated ESOP people who will critique us and make you know, will have to make us redo things. So, my people, and, you know, I think I would put you guys in this category, is if I can find people who do this every day and know exactly how ESOP transactions work, and you're in your lane because you know how to do valuations and feasibility. So, it's not just a valuation. It's how does this fit into an ESOP and succeed? That's critical. I have so many bad vendors who, they're just there for the transaction. They're not thinking about post-transaction or repurchase obligations or all the debt financing and repayments we have to do. And if we're not aware of that before we ever sign a document, you're going to hate your ESOP. You're going to absolutely hate it. But if you have a good vendor who comes in and gives you a real value based on how a trustee is going to negotiate value for an ESOP, then we really know what our valuation should be within a range, right? And we'll— and then I know what I'm going to get, not to the penny, but within a good range. So, that gives me the, okay, well, yeah, that's in the money for me. But then I need to know, okay, now how are you going to pay it off? How are you going to get that money? And if I don't have that feasibility aspect with the valuation, we either aren't going to get a deal done or it's going to be a lot longer, a lot harder. You're not going to get the purchase price you thought you were, is usually what happens. They just beat you up in negotiations. So that's why a good vendor— if you get to a good vendor up front, they're going to educate you very well so you really understand what you're getting into before you sign anything. It's expensive, right? This is not something that is just like setting up a 401 plan and move on. This is an entire retirement, qualified retirement plan owning your company. Yeah. So that to me is my vendor speech. And I could go on and on. We could pick each one. Like, you know, the CPA's next, right? I could— attorneys, they're the worst.

Jason Miller I know, right?

Speaker A I'm so surprised you put up with me still, Jason.

Jason Miller Present company excluded, Josh. Present

Speaker A Company excluded. Well, you're a good soul is what it is. You must have 4 kids.

Jason Miller Yes. Yes. So I do have a question for you that you can wax eloquent on, and that is, why do you think, what's your opinion of why aren't there more ESOPs than there are?

Speaker A Yeah. Wow. So I think for business owners, when they hear about an ESOP, they usually go and find a friend who's been in an ESOP and they hear a horror story and that just cements it for them. Now, now they, they don't know why, because they don't know anything about it. And it's not like the other person's telling them all the tax, ERISA, you know, operational debt problems. They're just badmouthing it. Is, is the most common thing I see. The ones who can get over that or don't go that route, but, you know, chat, ChatGPT it, will see the amount of litigation that ESOPs have generated over the past 20, 30 years. And I think that scares a lot of people as well. And, and rightfully so, because what it is, is the IRS and DOL caught up with people who were abusing the system. And those stories are probably those people who did not do it right and got caught up in the system or had bad vendors. And so once they got into the debt payment and the operations, they, they weren't doing what they were supposed to be doing. And so of course things are gonna go south. So I think just like the, you know, out, out in the, you know, TikTok world, I think ESOPs have a bad name, generally speaking. But I think if you are a serious business person who's thinking about selling their company, you're not going to rely on a TikTok or a friend. You're going to go do your diligence. And I think if, again, you can find a good vendor who can help evaluate your company and say, yeah, this will work and here's why, I think then when McKinsey finally allows me to get to the tax part and I can explain how, hey, I might be able to sell your company and potentially you never pay tax on it, right? If you can sell it to a C corp and soon that's going to be even an S corp. So they're even broadening it, you know, and you keep it and you don't need the money. Well, man, we can do some amazing estate planning along with income tax planning. And that's just the beginning, right? Or if it's 100% owned S corp, I can run your company as a tax-exempt org. S corp flows up to a qualified plan. Zero tax. Like, what does that do to your bottom line every year, if I can put you in that situation? So, I am glad the way Mackenzie does it is right. The way I do it is wrong. I put tax first because I'm a tax geek, but she's right. Somebody who's approaching this should really be thinking more about, you know, why are we doing this? And it's usually a succession plan or, you know, to me, I always tell people all the time I raise it, I was like, why? I can get you a liquidity event with this great tax benefit, and you can continue to work for that company and earn it back through a retirement plan and/or warrants or options, you know, or incentive units. I mean, so it's something that can be used just for people who want to monetize, like want to get their money, but they still like their business. Well, let's go. A lot of times it's management wanting to take over from an owner as well. Management sees the benefit. And so, it's a way for management who usually doesn't have a lot of money. to use the company or obtain outside financing to buy out the owner and run the company. And they own it back through their retirement plan. So, those are kind of the things that I think are good. But I've gotten off pace. You know, why people are scared, again, all the litigation out there. Well, there is proposed in the House right now something that is trying to make it easier to avoid litigation in ESOPs. And so, and SECURE 2.0, if people ever remember, that was a few years back. But you're going to see a lot more about ESOPs coming just through the tax code and through, if it continues, Congress continues to fund a lot towards creating more ESOPs. So, I think we're kind of getting over this hurdle of bad publicity for the past quarter century. And I think now if people start to go and ask their friends about ESOPs, they'll probably get positive feedback. And I, you know, there's a lot of organizations, societies out there that, you know, you and I all know and easy to get out where we all get together and rah-rah on ESOPs. And so, I would gravitate towards those organizations because I think they provide a lot of That, you know, both technical expertise thought and how do you run a good HR company through an ESOP, right? How do you really sell your employees that they're not employees, they're owners? And I think owners like that, right? Like, what a great succession plan is. I really have turned over a great company to my employees who run it right now anyways, and now they get to benefit like I did as an owner. And I think culturally it's like so American, right? Like if you work hard, you can own a company. Like, here we go, sign me up. Like who doesn't want that? And so that's why I think you'll see ESOPs continue to grow and you'll see more people doing it. Yeah. What, how about you? What's your Your take on how the world views ESOPs, evil or saves the world?

Jason Miller Oh man. So in this regard, I'm an optimist, and I do think that there there is a saving of the world or saving of America prosperity track that ESOPs have put us on and can continue to put us on. And I know that there are a lot of efforts to your point in Washington and supported by the various organizations that we all know and love. So. NCEO, the ESOP Association, ESCA, Expanding ESOPs, like all those that are out there that are doing the good work of making things more accessible. Finance guy, right? So looking at the landscape of options, and we talked about this on the podcast before, listeners, limited options for exit, infinite iterations within those those options. Not everyone can become SpaceX. No one likes to just sell the desk and chairs. So you're left with these strategic financial/private equity buyer, a management buyout, a generational transfer. And then my favorite is the ESOP in the middle. And with that, where is the finance support? And then what does the industry look at? what's available for that. And I was looking this up recently. There are over 5,000 private equity firms, and there was, as of like the middle of last year, I'm sure there's a more recent stat, there's over a trillion dollars, like $1.3 trillion in available dry powder sitting in these funds. And those funds are aging. So the capital is getting older and they're on a time clock to deploy. And then on the other end, The exit from that fund is taking longer. And so the expected returns for the investors that put their money in is taking longer than expected, and the IRR comes down. And then what does that do? So it creates— I don't want to say a feeding frenzy, but when you throw around Ts rather than Bs or Ms in available capital, and then throw that at a marketplace of aging owners, that are looking for what's next in their life. There is a lot of momentum. And our listeners have heard me say before, money talks. So what happens when you shorten the timeframe, you have a lot of money, and you have someone that is also running out of time? Where is that going to intersect? And so there's something in the neighborhood of like 30,000 PE companies, PE-owned companies that are out there. And then we have 6,500, 6,800 ESOPs depending on the year and what happens when we fall out. And that the numbers are growing differently as time goes on. So when I just look at the finance perspective of that, where is the capital that's available? Where is it coming from? And what are the motivations? I think that that's a big reason why there haven't been more ESOPs. But I also think that it turns people to wanting to explore an alternative. that helps them to preserve their culture, preserve their legacy, live on their own terms, and then ride out what they want to do with their business post being ultimately responsible for it. And we have, we have this off-the-shelf answer of an ESOP helps to solve a lot of that if it's structured correctly, if it's structured well and with forethought. And I believe that Our time or a more generous time toward ESOPs is here or is coming. And that's also why I love the work that I do.

Speaker A Wow. Let me address that a little bit because it sparked some things in me, but I kind of knew that information, but then when you told me, it really kind of hit. So for private equity to have that kind of pressure on them, I see it. It means they're willing to probably give you a higher price for your company. And that's great if cash is all you care about and you don't care about anything else. But I would even caution those people because private equity is not your friend. And you said it perfectly. They're just buying you in order to kind of cut you up or grow you in a way and sell you off to somebody else. So, your company is just meat to them is my view of private equity. And I hope I don't offend anybody out there. But, you know, and so, if you're going to sell to private equity, you just need to know that one, they're still going to make you work there, but now you're not in control of your company. And so, you better really love your private equity firm. And I have yet to hear one business owner tell me they like their private equity firm. And I hope somebody proves me wrong, but—

Jason Miller I hope so too.

Speaker A That's what I go into it thinking. So, if you're already going to want to sell your company, the way I view it is if you could find a strategic buyer that's brilliant, you're probably going to get the most money than private equity. And maybe private equity is getting closer to strategic now based on what you're saying. And then there's fair market value, right? Of which is what an ESOP is. So, I think we would all say, yeah, most likely you're not going to get private equity strategic price tag in an ESOP deal, but we're not going to be too far below it. So, it's like you may be leaving a little bit of money on the table, maybe a lot, but what you're paying for is that You are still going to have to work for 3 years to get this company through the ESOP, and you're in control ultimately. And we could walk through trustee, board of directors, employee, but we keep you in control and it's still your company and you know it better than anybody. So again, I've monetized you and you still get to keep it and earn out more over years where private equity buys you once and that's it. You're done and out and they're going to screw you. And then— Move on. And strategic buyers is going to take you over completely and probably say, get the heck out. And now you're just disassociated. So I could see that more than private equity, but that's rare. I don't see strategic buys happening as often as I'm seeing private equity.

Jason Miller I think

Speaker A That's right. And I just don't think people get the ESOP as another alternative, Jason. I could be wrong. But I think most of folks, you know, in that world, strategic private equity, don't want you to know about an ESOP.

Jason Miller I think you're right in that regard. And we, the advice that we like to give here and to others is spend the same level of energy and diligence ruling it out or ruling it in that you would something else rather than just make a decision without it being informed and without you being educated on it. If it's at all an idea, some people don't, don't— it's not palatable to them, it's perfectly fine. There's no right or wrong answer. But if, if any of the qualities of an ESOP are important to you, then investigate it with, with diligence. And there's one other thing you— when you were talking that I wanted to, I wanted to grab onto. I think it, I think it left me, but if I come back to it, I'll pick it

Speaker A Up. You're good. Yeah, I, I But, you know, selling your company is like, it's your second marriage, so to speak. And it's almost like you're, you know, giving up a child or, you know, giving it up for adoption is what I want to hear. You know, I think that's how people feel. And so the ESOP provides this much more warm way to transition a company than, you know, having some cold corporate buyer gobble you up. And I've seen that a lot.

Jason Miller You brought it back to mind that we like to say when we're talking with clients that after the ESOP transaction, should every, you know, if you're going to stick around, which it's a privilege of this particular transaction that you get to stick around if you want to, But you retain operational control. No one's going to tell you how to come in and run your business, but you do have some oversight now because you're responsible for making sure that business is around to honor the promise that you're making to the retirees and for it to function well. But it's functioned this well so far, and you just get to continue doing what you were doing. And that element, I think, does get kind of shuffled underneath the finance portion and all of the tax, all of the legal and all of the administrative pieces.

Speaker A Got to get it

Jason Miller Right. You get to stay in operational control. And the other part of it is this is the risk that you've taken with your entire life already and bet on hands down every year, year after year to get here. And at transaction, you just exchanged that equity for monetizing, whether it's bank debt or all seller debt or some portion of that. You get to bet on yourself again. And then see yourself get paid for that as you transition it over. So you're not taking a greater risk, so to speak, on the operations of the business that you still get to control from that perspective.

Speaker A Yeah, I agree with you. And I, it makes me as a lawyer, one of the things a well-run ESOP will do is my trustee will actually help with good governance. and help my company. So one of the things they'll ask for is, I want an independent board person. And I think that's a good thing, right? Like, that's actually where trustees have helped us be better on the business side. But they're not putting in somebody that, you know, is their yes man. And they're not, they, I mean, most of my trustees do not come to board meetings if they're comfortable with the clients. They're really quite distant unless needed. And after a transaction, they're really not needed and don't have much to do except Except collect an annual fee. And so to me, that where, you know, you have somebody who's an independent person, I always tell my people, embrace that. Go find somebody in your business who knows your business well and bring them on and pay them because they're going to come in and make you better. They're going to think about things differently. And if you don't bring in somebody from your business, bring in somebody who understands ESOPs. And of course, that panics people because they don't know anybody who fits those 2 categories. And of course, a stranger coming on. Oh, wow. But if you have good corporate governance, that one person is only going to enhance your board. And so, to me, if you start, if you go down the ESOP path, you start to think like a fiduciary, you get this kind of tax fear. I got to comply with the tax code. So, what does the code say? What does ERISA say? What does the plan document say? And if you just go at your ESOP with that in mind, like just go read the plan document. That's what the code and ERISA are trying to do is like, if you do it the right way, you're good. And there's no liability. There's no risk. It's just if you're not following the law and the plan document, then yeah, you're going to get into a heap of problems. So, Again, surround yourself with good vendors and you will have good plan documents. You'll have people who are looking at them, helping you and getting you through. And then the plan should just be coming along in the background. One of the things I worry about is like, yes, we want everybody to be rah-rah. It's an ESOP, it's employee-owned, but we got to run a business. And so, I need my ESOP to actually really just be this thing on the side that's cooking and doing great. Because we have great vendors and my HR team knows how to run it, knows how to communicate out when necessary. And, and it runs just like a good 401 plan or a good group health plan, right? Those are just little benefits that HR runs. My president isn't thinking about, you know, the group health insurance, right? And they're not thinking about the match made to a 401. That's already been baked up through a committee, up to the board and approved, and it's just humming. That's what we want for our ESOPs as well. And I think it takes good vendors and it takes some focus. I think the employer owners need to focus on it, but just like anything, get it running smooth and then let's make this business, whatever it is, widgets, services, the best it can be and make everybody more money. It's great.

Jason Miller Awesome. Well, Josh, you've been very gracious with your time. I really appreciate the conversation today. If there was one piece of wisdom that you would give to a listener who was contemplating an ESOP as the next chapter for their company, what, what would that be?

Speaker A If you're going to use ChatGPT, that's great, but don't rely on it. Make sure you talk to somebody who is a human being and who does ESOPs. Every day. And I think ChatGPT and all this internet and everything, yes, I want you educated, but it's still complicated enough and has so many layers of not just raw law and legal, but subjective, practical business that AI is not able to really educate you to a level you should be if you're really serious about selling your business. So, you still need a human being and you need somebody who's good. And again, I wouldn't start with me. I mean, I'm happy to educate you about ESOPs and people do come to me, but I'm going to turn around and refer them to somebody who can do a real valuation feasibility study that I know will match up to any trustee we pick, their valuation people. It's efficiency. If I've got that great person, Then I know that transaction is going to be small, and that helps reduce my legal fees, which can be expensive. So that good vendor actually helps me look better because now my legal fees aren't ridiculous because you guys are picking that up. And I— so I've seen that ESOPs have become much more efficient as deals go. So they, they're getting better at not being as expensive as in the past. And I think that's one of the reasons is if you get to that good vendor who knows what they're doing, they, they cut through a lot of the crap we used to all have to put up with.

Jason Miller Wholeheartedly agree. And Josh, thank you again for your time. Listeners, really glad that you had the opportunity to meet Josh and hear from him and grateful that you're here as always.

Speaker A Thanks, Jason. Have a great day.