Stout: Recapitalizing an ESOP

hi everybody my name is Mark Buchanan I'm a managing director at Stout and I head up the firm's esap Investment Banking practice it's really great to be with you all here today and want to give a special shout out to the folks at Rutgers for putting together this employee ownership Symposium I really do think it drives awareness in the marketplace of opportunities with employee ownership and specifically in the case of what I'm going to talk about here today drives awareness of opportunities with employee-owned companies themselves so I'd personally seen fantastic wealth creation occur within the employee-owned model I've had the good occasion of working with some of the nation's largest and most successful employee-owned companies and I can tell you that aligning the interest of the shareholders and the day-to-day workers definitely works out in the best interest of all stakeholders of the firm just in terms of my background real briefly I've been a banker for about 23 years I spent the last decade focusing in on family founder and employee-owned companies and really the Hallmark of my practice is helping esops stay in the employee ownership model and I stress esops staying in employee ownership because it isn't always the case that having an ESOP plan the erisa governed structure that exists out there that's not always the right answer for companies but I do believe that employee ownership is almost always the right answer at least in some form um so what I'm going to talk about today you know is a real life case study a private Capital coming in next to an ESOP to support the mission and the values and the growth objectives of the employee-owned company and what I can tell you is most employee-owned companies as they mature and if they're successful especially end up facing you know significant repurchase obligations and what happens nine times out of ten is that these companies end up throwing in the towel and taking the company to Market and selling out to a strategic buyer or possibly a private Equity buyer in most of those cases the upside for the employees in the future is shortchanged they just lose out on the future upside in the future um cash on cash returns frankly that are available in private Enterprise in the US and I think it's a shame I think we should do more to help these companies preserve the employee ownership at least to a certain extent and make it work within the capital structure that they have so you may have heard about you know private Capital coming in in theory we all know it's possible using the drop down LLC structure which is a separate talk in and of itself but nevertheless I think a lot of people in the marketplace are aware that this opportunity is available but I've actually seen it firsthand working to drive value creation and outcomes for investors for employee owners for management teams and and Boards of directors so I can tell you that it does work and what we're going to do is talk about a case study where a private Capital came in to do exactly that so the case study I'm going to talk about is with a company that I have a relationship with that's in the Professional Services space I'll keep it confidential for obvious reasons here but they're in the people business and the retention and motivation of their employees are critical and enter into the thinking on pretty much every decision that this company makes it's a huge factor for their board of directors to consider as they think about capitalization growth and opportunities that lie ahead for them we did two successive engagements with this client over several years and one was really to set them up for Success over the long term and sustainability and the second was allowed the employees to realize liquidity and diversification from the efforts that they had put in to build this great company and so we're going to talk a bit you know first about the initial engagement that we had as good investment bankers we came in and ran a bunch of Diagnostics on the company including the ESOP plan and what we found was that the ESOP plan was in great shape they had a great Finance team they had good advisors along the way and they weren't really facing material repurchase obligations even though sort of the equity value of the company had definitely gone up and to the right very materially over about a decade so we got to Boiling the ocean to figure out you know what we might do with this company and we quickly found that you know like a lot of ESOP companies they had put in place a stock appreciation rights plan so a synthetic Equity plan to give incremental upside to the key managers and Executives and in fact to retain those folks through the transaction and for the decade that followed so that they would you know stay in their seat and continue to drive value creation for for the Enterprise so we took a look at the stock appreciation rights plan and you know look again at many many Alternatives and decided at the end of the day that the best alternative for them was to terminate the SARS plan all together which might seem a bit antithetical but um you know rest assured that we had a plan for what to do after the fact and the idea was that we would terminate the plan in its entirety trigger a payout of the plan at the valuation that the company had currently on the stock use you know a very simple senior debt structure to be prepared to pay it out but you know really what we wanted to do was get roll over and get buy-in from the key Executives and the partners so we gave them a very strong incentive in the form of a profit's interest so they rolled their stock or their SARS I should say over into a capital interest and then we gave them an incremental profits interest to make sure that their Equity ownership position in the capital stack just didn't change from you know yesterday to today with the recapitalization that we did so there's no more synthetic Equity the executive team owns real actual equity in the firm and you know talk about getting a chance to see the hearts and minds of your key managers this gave um you know the the executive team an opportunity to see where the partners were and how much of them really wanted to roll over into the deal we got a very significant rollover into that transaction of course we had a strong you know incentive it wasn't uh it was sort of the carrot in the stick but the stick was never going to be used um we gave we gave him a good reason to roll into into the structure the nice thing about the new ownership model is it allowed them to stay in the structure indefinitely and gave them an opportunity to continue to see that value creation over a long period of time as opposed to a stock appreciation right which had a very prescriptive payout mechanism it wasn't really a call right it was just a fact that it was on a prescripted date needed to be paid out per sort of the IRS regulations so completed that transaction you know terminated the plan well it might seem on the face of it that we're taking something away from people not at all we replaced it with this new plan and it went over quite well and what that transaction really did for the company of course it allowed them to avoid having the big payouts that I had mentioned earlier over the next three years but it gave them an opportunity really to think about growth and think about ways in which to deploy capital in the future and it and it gave you know the executive team you know real ownership and real buy-in in the firm and set them up for sort of a step two transaction so that was you know step one kind of in a nutshell in terms of what we did there we preserved the employee ownership we just did it in a different way and then moving on to step two I call this sort of the realization phase it's really realization and diversification um so given that step one was was successful and set them up well I think the management team and the board and the executive team came to the conclusion after um pursuing organic growth and M a sort of on their own using their senior debt capacity as limited because um they didn't really have a third party Capital provider to come in and help support that with incremental Capital company was very sort of averse to using all of its debt capacity like many esops to go out and do what is sort of a risky m a strategy so they brought in a Capital Partner and the Capital Partner allowed them to provide an opportunity for the employees to diversify their Holdings and so they got part cash part stock in the transaction and within the esap plan what we did there that was super interesting is instead of continuing on in a traditional ESOP the orisa you know structure that we all know and love we actually turn terminated that plan and provided a liquidity mechanism for folks to diversify their Holdings and roll over into an IRA or they could continue to own stock in the company and so we did an internal Market to allow these ESOP participants to subscribe to incremental Capital within what really was an lbo we had a traditional you know senior debt you know leverage transaction coming on on board with the company's capital structure we had a pref piece and we had newcommon coming in from the investors so it was kind of a traditional lbo and we allowed the ESOP participants the opportunity to roll over into that and subscribe to it so during that subscription process you know you're again just getting a laser focus into the hearts and minds of the participants in terms of what they think about the next phase of growth and the new capitalization of the entity and we were multiple times over subscribed on that transaction you know within the ESOP the ESOP was terminated it was turned into a company stock fund the reason we did that is because you might ask you know okay you've done all of this but you know the Crux of the matter with esops is that they end up having significant repurchase obligations which oftentimes um these ESOP companies from being able to go out and do growth and other value creation strategies well in this case we set up an internal Market within the 401K plan and we said look if folks want to put their shares or to be if they become eligible to put their shares they can do that and then there should be enough demand within the 401K plan with cash assets to buy out that stock we did the exact same thing on the partner side where we have the ownership units and created an internal market for the partners to buy each other out so certain Partners were ready to take liquidity and go into retirement or you know what have you or just you know diversify their Holdings they could put shares in and have those shares bought out and so it really gave an opportunity for people to control their own destiny which is probably one of the knocks on being in an ESOP structure because you can only of course put the shares really upon retirement um there's other ways in which you can do it but the reality is the vast majority of the liquidity that you take in the diversification that you get um is is sort of at time of retirement so what is the prologue on this company I mean still being written this is a thriving company um who you may have come across in the marketplace but they're owned today in a partnership model they've got a new Financial partner you know call it a private Equity investor that put 50 of the common into the company and the management team next to the ESOP owned the other 50 percent and so it's still employee owned they were able to preserve their culture they were able to preserve their values and in fact one of their values is to grow the firm and continue to you know accelerate that value accretion fundamentally this company came to a point where they had accelerated the value accretion on their own for a long period of time and just from the law of numbers they got a very large and then it became a point where they needed help if you will in the form of a new partner to take it to the next level so the company today as we sit is poised for Accelerated growth they have a fantastic Equity partner they've got a pref provider they've got sort of all the elements that they need to do M A and do it successfully and the repurchase obligations that exist from the employee ownership model have been addressed and dealt with and you know not we weren't able to take them to zero just to be clear but we were able to significantly reduce and mitigate those repurchase obligations so that the health of the Enterprise is first and foremost in in the objectives of this company and its board so we really do you think we got a win-win-win and when I say that you know from the employee perspective you got to take some chips off the table and diversify your Holdings and create you know incredible wealth for yourself and for your family and then roll into the next phase of growth and have an opportunity for good returns there for the management team you know you got really buy-in from your from everybody from all the way down to the rank and file up to you know the the CEO himself you knew exactly where everybody stood relative to how much you know am I going to roll into this deal and how much do I believe in this company and what we're doing in the marketplace for the next you know 5 10 15 years so you get like Vision into the hearts and minds of your employees which I think is just great and from the Investor's perspective of course they care about all that stuff that I just talked about um they want alignment with the employees on row on the boat and driving value creation at the firm no doubt about it but they will have an opportunity as well for significant returns and owning this company because it's well positioned in the marketplace and it's a high quality company notwithstanding the fact that it had been in the ESOP structure for the last decade and I do think that of course the employee ownership model helped this company become what it is today so with that I'm going to conclude my remarks but you know I'm happy to chat about this anytime so feel free to reach out to me my email is very easy to remember again my name is Mark Buchanan and the email is M Buchanan stout.com so if you want to chat about this or anything else give me a shout or give me an email and we'll schedule a call to catch up sometime so hope you have found this insightful and useful and enjoy the rest of the conference thank you very much