The Hard-Nosed Business Case for Employee Ownership

Hello, everyone. Welcome to the 21 Hats podcast. I'm your host, Lauren Feldman. This week, Jay Goltz explains how he got interested in selling a percentage of his business to his employees and why he quickly lost interest once he started reading books, attending seminars, and talking to accountants and lawyers who specialize in employee stock ownership plans. To Jay's ear, they all made the ESOP sound expensive, complicated, and risky. This was not something he had to do. So why go to the trouble? Why take the risk? When he kept asking questions, and over time he sensed that many of the problems he was being warned about didn't have to be problems. As of now, he's pretty much concluded that an ESOP could help him secure retirement for his employees while generating more profit for his business. In fact, he's confident he will make more money owning 70% of the company than he does now owning 100%. But he still has a few lingering questions, which is why we invited Corey Rosen to join the conversation. Corey helped draft the legislation that created ESOPs, and he literally wrote the book, several in fact, on how the plans work. All of which led to one inevitable question for both Jay and Corey. If ESOs are so great, why are there so few of them? Even in good times, owning and running a business can be a lonely pursuit. Our hope is that these weekly conversations brought to you by our brand new sponsor, the Great Game of Business, will let owners know they are not alone in facing challenges. Same thing with our daily newsletter, the 21 Hats Morning Report, which the magazine named the best newsletter for business owners and which you can subscribe to for free at 21 hats.com, where you can also find transcripts of our podcast episodes and lots of other articles and interviews. Joining me this week on the podcast are Jay Gatz, whose companies in Chicago include a picture frame business, artist frame service, and a home furnishing store, Jason Home, and Corey Rosen, who is founder of the National Center for Employee Ownership. The episode is titled The Hard-nosed Business Case for Employee Ownership. Welcome, Jay and Corey. It's great to have you both here. Jay, let's start with this. You were hot, you were cold. What got you hot again? What triggered your interest most recently? Well, frankly, first, I was hot on it because I recognized there was a problem with two things. One is my employees. I never looked at my 401k balances, and I was frankly horrified when I saw how little money most people have put away, and I care about my employees, and that was concerning. You have a lot of employees who've been with you quite a few years, right? I've got 100 and some employees, and many of them have been with me over 20 years. When I say many, uh, probably 2025 people have been with me over 20 years, and I'm concerned about that. And secondly, I'm just thinking about, I'm not planning on going anywhere, but who knows what happens. I'm thinking, what can I do to make the business more solid going forward, and I just, frankly have no interest in selling it. So the ESOPs seemed like a good solution. And then I embarked on going to seminars and reading books, and I went from the joy of ESOPs to the oil of ESOPs. And I said to myself, yeah, I don't think I want to deal with this. And I threw in the towel. And then I was talking to someone about it again, and I started to do some more research. And in my mind, I figured out, I think that things that were giving me the oy are not really problems, I think. But that's what we're here to talk about. That is what we're here for. Corey, what would you want to know about Jay's business to know whether he's a good candidate for this or not? There are a few kind of baseline questions I ask every company. The first one is, are you profitable enough so that you could, even though it's on a tax preferred basis, you could use future deductible profits. To buy out your shares over time and still have enough money left over to run your business successfully. If you don't have both of those, there's really not a way that you can do this. Second issue is if you're leaving, well stop there for a second, Jay. I understand you have to be profitable enough for this to work, which probably takes out 99% of businesses or other. I got that part. So so far so good. One is you have to be profitable enough for the math to work. And are you? Um, I don't know this year, but certainly in the short run, yeah, I, I should absolutely be, I mean, I'm, I'm big enough that I think, frankly, I'm a prime candidate. I'm big enough to pull this off, so I think so. Yeah, that should be fine. Sorry, Corey, I interrupted you. What were, where were you going next? Sure, no problem. The second issue is if you're leaving, do you have success or management? Same kind of question really that a bank would ask. They want to know if you've got success or management in place for obvious reasons. I have a very solid management staff. This is not the Jay show. I barely deal with customers. I barely deal with vendors. I have done the proverbial work on the businesses that are in the business, so I'm solid. I've got half a dozen key managers here. I plan on hanging around, but if I'm not here, I believe I have a key management staff to pull that off. So check. Right. Third one is, are you big enough? Now, you'll get lots of different feedback from advisors on this. The big enough question is, it costs money to set up an ESOP, and it could cost anywhere from 100 to $500,000 typically for businesses that are the typical ESOP candidates. Depends in part on the complexity of the transaction, the size, and other factors. Now, realistically, if you sell your business to anyone else, it's going to cost probably as much money, and often more because when you do sell to someone else, if you're using an M&A advisor or a broker, they're going to charge a success fee. And most ESOP deals don't involve success fees, some do, but that's a percentage of your transactions. So if you've got a $5 million business, they might charge you $200,000 just as a success fee, plus the lawyers and all that. So, it isn't necessarily cheaper. In fact, it's usually not cheaper to sell to another buyer, but if you've got 1015, 20 employees, That may be hard to absorb, and you want to look at some other option if you can find one. When you're talking about size, Corey, are you talking about revenue? Well, you know, I think the, the really the best way to look at this is to say, if we did an ESOP, and we paid, let's say $150,000 if you're a real small company, that's maybe what it would cost. We paid $150,000 and We still now have to pay off the loan to purchase the company. Do we still have enough money left over from the profits that we make and reserve that we have so that we could do it, and be given the enormous tax benefits of an ESOP both to the seller and the company, that it would be worthwhile. And so typically the break point is somewhere around 20 employees. There are some ESOPs that are smaller than that, but that's a reasonable rule of thumb. Obviously you're bigger than that. Another issue, an important issue is, and I think you've kind of answered this, Jay, is what do I want to do with my business in terms of the alternatives of selling? Do I want to get out really quickly? I want to sell to somebody who can give me all the cash up front, and I want a price that's as high as possible. After taxes, because there are a lot of tax benefits to selling to an ESOP, turns out maybe 15% of the companies that end up selling to an ESOP could have gotten a better net value for the seller by selling to, say, private equity or some other consolidator. So if you're in that situation, is that your preference? I want to get the most money possible, or are you more concerned about Legacy and maybe also, and this is, I think, relevant to what Jay is saying, that you want to get out some now, some later, or maybe even want to sell 100% now, but you're not ready to retire. You'd like to stick around in some capacity in the company. Selling to an ESOP lets you do that. Selling to a consolidator or a private equity usually doesn't. Am I obsessed with getting the maximum money out of it? Absolutely not. I'm not selling the company. I'm just not. I have no interest in watching some private equity or anyone else come in and destroy what I built for 43 years. No interest whatsoever, don't need the money. I'm not doing it. So that's easy. I don't need the cash out at all. I mean, I could keep the money in it and lend it to the company. I'm thinking about it for two reasons. One is, I absolutely want to do something to help my employees put retirement money away, and two, I'd like to help the business down the road that when the day that I'm not here, that it's a little more solid and it seems like this, this could do it. I have a friend who sold his business for tens of millions of dollars, and I told him that I'm concerned about my employee's 401k balances, and he just turned to me and he just said, why is that your problem? Right. OK, I can't argue with that. I'm not about to tell any business owner that they should worry about that's everybody's own business. I'm not making any judgments whatsoever, but the answer is, maybe it's not my problem, but it is my concern and I do want to do something about it. So, um, he obviously doesn't care, so he's certainly not a candidate. I do care about the employees. I don't need all the money out right now, which is why I think I'm an excellent candidate for this. Let me ask you, Corey referred to the uh likely price for doing this. He put it between 100,000 and 500,000, I think. I know you've been doing a lot of your own research, Jay, going to all kinds of seminars and reading books. Does that square with what your expectations are? I have to tell you, one of the seminars I went to, at the end, the person said, and I'm, I don't exaggerate, this is exactly what he said. The cost can be 1%, 3%, 4%, but don't hold me to that. Yeah. Great, great. Like, really, so like, OK, in my case, I believe that the math has to work, and that doesn't just mean what your profit is, how many employees you have. In my mind, as an entrepreneur, it's about, OK, what's my return on investment and doing. Sure. And I believe that a little bump in marketing, just a little, you'd get 1% more business because of this. Wait, wait, wait, let's hold that conversation for later. I do want to get to your hopes about what this would mean for the business, but, but first, you got to get there. You got to do it. Uh, are you comfortable with that price tag that Corey mentioned? I'm not comfortable with half a million dollars. Um, I don't know what drives it that high. So, no, 100 and something? OK, I don't know. I, I have to, I haven't gotten that far. I'm certainly still in the process of figuring this out, which is why I'm glad to be here today because I, there's, I still have some key questions that I haven't gotten answers to. Well, when you're looking for advisors, of course, you want to shop around and if you go to our website at NCEO.org, there's a service provider directory and what we encourage people to do is talk to a lot of people, because you're going to get very different pricing. But here's where you're gonna see the big difference. There are some service providers who charge success fees. And their argument, and it's not a bad argument, but their argument is, We could also sell your business to someone else. And we want to give you advice on what all your alternatives are. And if you end up selling to an ESOP and not to some consolidator, we get less money. So we don't want to have that incentive and you don't want us to have that incentive. And so we're going to charge you a success fee. And that's typically in the range of 2 to 3% of the transaction, plus you're going to have some other costs as well. On the other hand, there are a lot of service providers who work like any other attorneys and trustees and valuation firms, and they work on an hourly basis or they have a fee based on the particular service they're providing. That's gonna cost you a lot less than the ones who charge the success fee, but they're not gonna be thinking about how else could you sell the business. So if you've decided you want to sell to an ESOP, you probably should focus on those, and that's going to get your cost in the lower range rather than the higher range. OK, that was very insightful. I didn't know that. The idea that someone's gonna make an argument, the meeting would have been over the second I heard about the concept, because that's just revolting to me. Oh, so you could, you could have gotten more money out over here, and since you didn't, you still want to get that money, so I should pay you for something you didn't do. Like, yeah, I don't buy that at all. So, um, all right, well, that explains that. Yeah, I'm, I'm not paying a success fee. Not happening. So, OK, that's good. Yeah. There there's one other consideration that people should understand when they're making the decision, which is ESOPs come with rules about how the stock gets allocated to people. And I have talked to people over the years who say, if I want employees to own the company, I love all the tax benefits, but I am not comfortable with not being able to pick and choose who gets how much stock. And it's a small number of people who feel that way, but there are people who feel that way. And if you feel really strongly about this, this isn't going to work. If what you really want to do is have 7 people become the owners. Then you got to do it another way. No, no, that part I got, I got the whole concept of discriminatory, blah blah. No, no, I, I got all that because in my mind, this doesn't replace if you have some kind of bonus plan or whatever. I get that this is not a one size fits all. Yeah. This is a supplementary retirement fund thing that everybody, I, I'm totally good with that. That fits fine. I do have some questions about the, the core of how that works though. And, and by the way, while there are all those rules for ESOPs, that doesn't preclude you from how you pay bonuses to people or some companies give key people something like stock appreciation rights. That's pretty common. You can do that. OK, now, that part I got down. I'm just, you know, the person who's, who's just standing there. Gaming pictures that makes, you know, whatever, $42,000 a year. I'd like to know when they retire, they're also going to have some money. So this isn't just for key people. I want it for everybody. So that's why I say, so far so good. It seems to fit where my head's at. All right, I want to try to run through a bunch of the issues that have come up. Jay, you've heard from a lot of people that this is just hard to do. How big a concern is that for you? What I've learned lately is that everybody's definition of what heart is is different. When I look at this, I think, wow, what a great thing. I can include, I can give people a good retirement plan. And I would think that the ideal candidate for this, which I think I am, is already a collaborative kind of company working with their employees. Mhm. I don't know why, and Corey, you said it in your own book, 3 different places, you talk about how this is hard work, this is hard work, this is really hard work, and I'd like to ask you, what's the hard work part of this? Because to me it's like, it sounds like a joy. thing like, hey, everybody, I'm gonna sell you 30% of the company, and it's gonna cost you nothing and we're all going to make more money together. Where's the hard work? So, of course, I would say that hard work isn't necessarily unjoyful. Hard work can be very joyful indeed, as probably anybody who's an entrepreneur can attest. But what I'm referring to there is that once you set up your ESO, That the expectation that, well, now everybody's just gonna get it, and they're all gonna act like owners and everything's gonna be wonderful, it doesn't really work that way. Like anything else in companies, if you want to achieve the results, you have to work at achieving those results. And what the research and our experience shows is that companies need to commit to things like setting up an internal communications committee with employees who are going to be in charge of helping explain not just how the ESOP works, but how the company works. It means, ideally, and these aren't things you have to do, but these are things that make it work a lot better. Becoming more of an open book company, starting to share key metrics with people. And it's, it's not really just focused on the income statement. It's about all the metrics at the particular work level that make that work contribute to the company's success or not. It's things like creating high involvement management systems, work teams, and employee committees and ideas teams. I wrote a book called Beyond Engagement, and the first line of the book is, it's simple. The best companies are the ones that generate the most ideas from the most people about the most things. And that, that concept beyond engagement and the rest of the title is how to make your business an idea factory, that concept comes from the notion that if you just give employees the opportunity to share ideas and information, if you have an open door policy, nothing's going to happen. Everybody has an open door policy. You need to have a structure for how employees can identify problems and identify ideas. So one of our members, Hypertherm, about 1800 employees, 100% ESOP company, one of the most awarded of our members, generates about 4000 usable ideas per employee per year. Imagine if you have a company that generates 2 or 3 usable ideas per employee per year, how much better you'd perform. But this doesn't just happen by magic. This happens because you have people spending time figuring out how to do it and allotting the time for employees to participate in those things. OK, that totally makes sense. And to me, it sounds like it's just good business, which is why I'm getting excited about this. I'll tell you the three big things that most people are being dismissed by that say, 00, ESOPs, here's the big 3, I think, if you talk to the accountants or the lawyers who maybe aren't as familiar with it. The first one is, oh, there's a problem with evaluation with those things. OK, um, my answer is, all right, you get the valuation, if it's not what you thought it was, abort mission. OK. I mean, am I wrong? No, that's, that's right. And so people understand when you do an ESOP, you'll have a trustee and the trustee will hire a valuation firm who determines what a financial buyer would pay for your company, not a strategic buyer. A lot of business people, maybe most, have this idea, and frankly, unfortunately, for most, it's a fantasy, that there's a buyer out there who is a strategic buyer who will pay this substantial premium for your business. And as I mentioned, maybe 15 or 20% of potential ESOP candidates have a buyer like that who can offer them more money, so After the tax benefits of selling to an ESOP were taken into account, they would do better. But, you know, and I think this is probably true for a lot of the feedback you get from advisors. Remember, a lot of the accountants don't know how to do ESOPs, and they're afraid that if you do one, they'll get somebody else. Absolutely. That's one of my big breakthroughs I had in my head, that, yeah, they're not They don't want anyone else to party. Yeah, and mergers and acquisition advisors will make more money selling you to someone else than they will to an ESOP. And so they definitely will tell you, oh, it's a terrible idea. It only works for this, or most of them fail, or you know, ESOPs have a default rate on the loan used to buy the company of 2 per $1000 per year. So the notion that they're, they often Fail is just not true. No, and I, and I'm telling you, I really believe that that conversation with the accountant or lawyer, I truly believe it lasts about 20 seconds and it's done. Oh, you don't want to do those. Those are a pain in the ass. Hey, where do you want to go for lunch? Right. That's what I've seen. Evaluation is 120, well, a lot of people could go to retire at once and you have a payout crunch. Correct me if I'm wrong, because this one, I just, I think I figured it out. If you don't take out a big bank loan to finance it, that really shouldn't be a problem. Is that true? Hold on for a second there. Let's, let's explain that, Corey. I think Jay's referring to what happens at the time of uh the sale where the employees are purchasing the company. The employees don't actually lay out any of their own money. Money has to be borrowed, correct? Right, but the problem I'm talking about is if it's 10 years from now and they want to retire. No, I understand that, but I, I want to start with the basics. Sure. So there are a number of possibilities here. One is if you start soon enough, you don't have to borrow any money at all. You just contribute cash each year, and the ESOP buys more and more shares over time. That process might take 10 years or so. But most owners want to get more money up front, and so how do you get that? Well, you borrow it. And you can borrow it from banks, you can borrow it from mezzanine lenders, if you can find those. There are those people in the ESOP space, they will charge more than the bank, of course, or you can do a seller note. The typical transaction where the owner wants to get out all at once, or at least very quickly, you get as much money upfront as possible from senior debt. Then that depends, of course, on the collateral you have to offer. But let's say that's 40% of the company. I've heard some companies get as much as 60 or 70%, but let's say it's 40% of the company, and so the other 60% is paid with a seller note. So you're saying pay me off over time, and typically the term of those seller notes is 5 to 7 years. So, you won't get everything up front, uh, you'll get, you know, a significant amount of it in the first couple of years. But if you really feel like I got to get all this money up front right now, Then it may be that you need to sell to somebody else, unless you can get this mezzanine debt, which will fill that gap, but the mezzanine debt's pretty expensive. I met with my bank, they have a division. All they do is, is lend money to ESOPs. There were quite a few of those. Yeah, all he does is, and I have to tell you, he's part of the reason I'm talking to you today. He said, he just loves his job, he loves what he does. He doesn't see a lot of problems with these. And he explained to me, I go, is this going to impede my ability to get a credit line? He goes, We're not lending money to the company, we're lending it to the trust. That's right. And there's no collateral. Like, we're doing it hard, I think he called it a hard loan, meaning they're going to look real carefully at everything and make sure it's safe. But, um, in my case, I don't even know that I'd bother doing that. I would, I don't need the money. I would just go ahead, which is why that potential problem in my mind doesn't exist. Um, if, if in 10 years somebody wants out, there should be money sitting in that account. Corey, is Jay right about that? Yeah, well, banks who do ESOP loans do love them, because why wouldn't you love a loan that has a default rate of 2 per 1000 per year. So yeah, they and a lot of banks figure, well, if we can do your ESOP loan, we'll also get all your other loans, and we can get your line of credit and whatever else. So, banks have been very favorable towards ESOPs. The seller note, there are a lot of people who say, I don't even bother with the bank, and if I can get paid off over 8 years. That's fine. I, you know, I, I don't need all the money upfront. I'm gonna get some of it each year, and that's fine. And that's plenty of money for me. I don't want to bother the bank and seller notes are kind of an attractive investment because they're going to be priced in today's market, probably 8 to 12% on the interest rate. That's exactly what he said. And this is what made me realize, boy, the math works very nicely on this. I think to myself, wait a second. So what if you said, Well, Jay, your, your business is finally getting a critical mass. You're going to get much more profitable for the next 34, or 5 years. Boy, you could be giving away 30% of your profits, but then I say to myself, wait a second. Getting 10% of that note is gonna chew up half of that money right off. So, I got, I, I did my My own little analysis, the math works. Yeah. I believe, if I think I'm right, this might be the only time I've actually seen a situation where I can have my cake and eat it too, that I can both make money, more money, and take care of my employees at the same time. I, I, I think I can pull that off with this. Well, that, that's how typical ESOPs work. And there's even another wrinkle where some owners, about 20-30% of the seller notes. The seller says, Well, I, you know, I, it should be 9 or 10% interest. Give me 4% interest and give me the present value of the 6% interest I've forgone in the form of a warrant. And a warrant is the right to buy stock at the transaction price for, say, 6 years into the future. And so if the share price goes up, I'll go to the company and say, hey, just redeem this warrant. So I'm actually going to benefit from the share price going up. So that's a deal that can be structured and it needs some more advice and you know, more lawyers and appraisers getting involved, but it's not uncommon to see that. OK, and that leaves me with the 3rd 1. These are words right out of an accountant's mind. Oh, the administrative costs for that are really high. OK, now, I've gone to enough webinars, I've talked to enough people. It sounds like, correct me if I'm wrong. The administrative costs of getting the appraisal and having the trustee of $50,000 to $75,000 a year or less. OK, good. Yeah, so the administrative cost is just the people keep all their records, and that's gonna cost, oh, in the range of $100 to $200 per employee. That's not a big cost. Trustes gonna cost. And you don't have to use an outside trustee after you've done the transaction. So about half the companies don't pay for that. I think it's a good idea. That's going to cost you $20,000 or so per year, and the valuation is going to be another, which you have to do annually, is another 15 to $20,000 probably 150. And then if the law changes, you need a lawyer. OK, so you just gave me 10 $20 and so it's $45,000. OK, so we're in the same neighborhood. Here was my revelation, and this is only personal. This is how I feel. I am absolutely going to stop my 401k matching plan that has always made me sick. I don't like it. I think it's completely wrong. 401k matches benefit the people who make a ton of money or have spouses to make a ton of money, have no children, they can max it out, and the rich get richer, and the poor guy who's making a $62,000 a year and has two kids, they can say very little, he's getting nothing. So my 401k match this year is going to be about $30,000. So right out of the bat, instead of $45,000 I'm going to take that $300 so now it's going to cost me $15,000. So a number of companies do that. Most companies don't fiddle too much with their 401k because taking something away from people, they might not be happy about that, and ESO's just an add-on, but you can definitely do that. I should note, by the way, for anybody out there with a 401k, the typical match is based on what the employee defers, but you don't have to do it that way. In our own organization, we have a 401k for our staff and everybody gets 3%. OK, in my company, I have an unusual situation perhaps unlike an accounting firm. I got people making You know, everywhere from, you know, $35,000 a year to a six-figure income. So it's all over the place. For me to just give everyone a number, it wouldn't be very much. So that, that really wouldn't work. So, um, that's why, and, and in this case, the higher paid employees are going to be coming out real well with this, and I would show them, look at, you're going to lose, you know, $4000 here, but you're gonna make $100. So I'll just explain it to them and Yeah. And like I said, that's going to finance a lot of the administrative costs. Before we forget, I want to go back to the issue that Jay raised before, Corey, in which he, he was talking about the concern that I know a lot of ESOP owners have with what happens if you have a bunch of employees leave one year and you have to buy them all out simultaneously. What do you need to do to be prepared to do that? How big an issue do you think this is? What you need to do is plan for it, and it's not an issue much in the early years because, first of all, you don't have to start paying off these distributions till you will acquisition loan is paid. And there's a lot of in the weed stuff here about how, you know, because the loan typically goes to the company and then is reloaned to the ESOP and the internal loan is on a longer term so that the shares are allocated over a longer period of time. But you can probably wait typically 10 years before you start paying people out unless those people are retiring or die or disabled. So there's, there's some flexibility on that. But after the first several years, you really need to start carefully planning for this repurchase obligation and making sure that you have a a really practical solid way to pay for it. We've done extensive research on How many companies end up in trouble because of this? They just, they can't pay it. And when that happens, they just typically have to sell the company. It's a really small number where that happens. So successful companies are able to put aside the money to do this. Part of the reason that that happens is if you become 100% ESOP, you don't pay any taxes. And that's not a loophole. It's not something some clever lawyer figured out. It's a law passed unanimously by the Congress in the late 90s. So you don't pay any taxes. That's a lot of money to save, to deal with the repurchase obligation. And by the way, turns out that 100% ESOP companies are on a real acquisition binge. Once they've paid off their initial debt, they start accumulating a lot of cash. And cause they're typically successful companies and they're going and buying a lot of companies. In fact, one of the things that we're We're gonna start providing more resources on is for companies who say, like, I really like the idea of an ESOP, but I just don't want to do it in our own company. You can sell to an ESOP company. There are a lot of companies looking for companies to buy, so that's an alternative too. You know, I would say the The the word I would pick for, for, for myself and many other entrepreneurs looking at this is they're apprehensive. I mean, how could you not be apprehensive? You're not sure what exactly it is. And then when you start to get more information, that apprehensiveness could turn into anxiety, which then turns into, see you later, don't need to deal with this, because I simply don't need to deal with this. That's the point. I don't have to do this, but I'm back in the happy mode now of thinking this is the greatest thing ever, so let's see if you can get me out of that. I think the best advice that most companies in your situation can have is, don't just talk to advisors, they have their own interests in what they want you to do, which may or may not coincide with yours. Hopefully they do, but they may not. Talk to other companies who've done it. And we can help with that and see what their experience has been. How does it work? How much did it cost? What were the pitfalls. One of the great things about this community is that it's incredibly sharing, even your competitors will talk to about it. Corey, I've talked to a lot of people who've done ESOPs, and one of the interesting concerns I heard from, from a couple of owners was they were surprised to find out that the employees were not completely sold on this idea. And they were very skeptical. I, I'm wondering, is that something you've heard? Is that something that comes up? Well, you're always going to have skeptics who wonder, how can this really be free? What's really up here? And I think a lot of that depends on what kind of culture you had in your company to begin with. Yeah, the kind of culture that I suspect you do, Jay, in your company, then it's gonna be, you know, and you say, I've got good news and bad news. The company's being sold. The good news, it's, you're the new owners, it didn't cost you anything. Some people are going to react to that and say, in, in some companies, uh, something's up their sleeve. And I suspect. A company like Jay's, they're going to cheer. That's great. Yeah, let's move from corporate culture to just simply, do they trust their boss? Exactly. Which in my case, I think I've demonstrated many times to them. They know that I, I never screw them around and they know that I've gone way out of my way and, and they talk. So that's why I don't think I'd have that problem, um, at all. Yeah. But the, the two things that cause what you're talking about, Lauren, most commonly. One is Companies start off communicating the ESOP, and you, you really have to spend time and resources doing this. Companies start off communicating it as a retirement plan. That's a mistake. That's a hard thing for people to relate to almost at any age. What you'd really want to do is say, I've done this with meetings with employees. I've said, close your eyes. I want you to spend 60 seconds thinking about What would have happened if Jay decided not to sell to an ESOP, because eventually, Jay's going to want to sell, and decided instead to sell it to some private equity firm or to one of our competitors. What would that be like for you? Now think about what would happen because we had an ESOP instead. That's the most compelling thing about an ESOP right up front for people. The second problem is, you say, well, now you're owners, and somebody has an idea about something they can improve, and there's no way to do anything about it because you're still treated like an employee who doesn't have any particular reason to have that kind of involvement. And you're not given any information about how the company is doing because that's private. You can see how people might get skeptical. If you want to run your company, like, you know, Elon Musk wants to run Tesla, maybe not. Maybe an ESOP's not right for you. Good example. Jay, do you have other questions for Corey about how this works? Yes, the, the couple of Just basic ones, which, again, I've, I've gone to numerous seminars and no one's really talked about this. I understand that you've got to like architect this and there's some basic questions. So the easy ones I got, like, what percentage am I gonna sell, um, what's the vesting thing, very easy. What is the pay cap you're gonna use for your percentages? OK, again, easy, and when they leave, explain what that is. What do you mean by the pay cap? The way you figure out the share is divide the salary by the payroll, but they kept the salary for purposes of their percentage. So they'll say the most. Somebody's going to be in there as far as $200,000 or $150 and there's a limit, right? It's 2 legal limit is 305,000 dollars. OK, so I wouldn't, I don't have anyone making that anyway, but I, I would say, OK, uh, your cap is gonna be X dollars. So that that's all very easy. My question is, What else is there? Cause I, I don't unders I, what else is there? It seems like that kind of covers it all, but is there 50 more questions you have to ask yourself? Well, you have to decide what your board is going to look like. It's up to you. Most ESOP companies end up with outside board members because they find it useful. It's not required, but 75% of the ESOP companies do that. You have to decide whether you want to have internal trustees, so employees who would be responsible for the various things that have to happen in an ESOP or you want to hire an external trustee to do it, you have to decide on when do you want to start distributing stock. You have some options about that. And of course, you have to make all the decisions about communications and culture. So those are some of the key things that you want to Decide up front. There are a number of sort of procedural things that go on in an ESOP. You need to be aware of. And we've tried to make that easier. We have, uh, in the documents library on our website, we have checklist. These are the things you need to do this month, sort of thing. So, and that typically is handled through HR for instance, of what information needs to go to the plan administrator. So there's a lot of that just sort of nuts and bolts stuff, but good advisors will walk you through that. OK, here's the one question. I really don't have a handle on that. I, I understand that you take their salary, divided by the total payroll, they get their percentage. My question is, and I just was told this, you can't give any credit for, oh, they've been here for 20 years, like, OK, that made it a lot easier because frankly, I was struggling with that. That's, that's wrong. That's wrong. You can give credit for how long they've been here. Yeah, well, credit in terms of, there's two different things here. One is how much their allocation is. So, to explain this simply, that the ESO, let's say, buys 1000 shares and it pays for 10% of the loan. 100 shares get allocated. And I make 5% of the covered payroll. I get. 5%, I get 5 shares. So you can, you can use relative pay or a more level formula. You could say, I'm gonna give you 1 point for how many years you've worked and 1 point for your salary. So you can do that, you just can't, if the effect of that is that what are legally defined as highly compensated people, which I think is people making over $130,000 a year this year, they can't get more than what this straight. Relative pay thing. So, yeah, you can do that. But where most people are talking about is I've got an employee who worked here for 20 years, and I've got an employee who worked here for 1 year. When we start the ESOP, are they both 0% vested? And you can give credit for prior service for their vesting. You can give them year to year, or you can say every 3 years, you get 1 year of veto, as long as you do it the same for everybody, you can do that. So, OK, I got the vesting part, but what this and this person wasn't a lawyer, so he's just got this wrong. He's involved in the ESOP industry, but he made it sound like, no, the person's been here 20 years, can't get any more than the person who's been here 5 years. You're telling me that's absolutely not true. There, there is a way to give credit for prior service as part of the allocation formula. Again, you just have to have it tested so that the effect of that is somebody who makes $200,000 here gets, in our example, let's say they have 20% of the payroll, they can get up to 20 shares. If this formula would give them 25 shares. They have to get 5 of those go back to everybody else. But if you've got an employee who makes $50,000 a year, uh, you know, this would probably work for them. They get more. So, yes, there's some constraints on it, but it's not impossible. So how does it work going forward? Let's assume that you're, you're, obviously, if you hire more people, is it going to dilute their shares a little bit, but let's just for, for purposes of looking at this, let's assume that You don't add any people. Does everybody keep the same amount every year? Well, each year you get another allocation based on the same formula, and you might decide at some point, let's change the formula to straight pay, for instance. Corey, is that true even if Jay stays at 30%? Which let's assume I am, because that's my plan. But the percentage of ownership is not related to this. This is what happens internally within the EA. All right, this sounds complicated and needs to talk to. Too, too complicated for this, but that, OK, that's good to know. I got it. It's not impossible to do what you're talking about. There are some constraints, but it's not impossible. OK, that's fine. Corey, the rules that you're referring to, are they all national or can this vary by state? Now, this is all part of the Employee Retirement Income Security Act, so state law has, has virtually no impact on ESOPs. Jay, are you still with us? Yeah, no, that's fine. That, no, I'm telling you, the things that turned me off, I've learned were really not problems, and, um, I've so far so good. I haven't seen anything that's gotten me to think, oh my God, wait, this isn't gonna work. Like I said, I did the math and I figured out this should be a net gain for everybody involved. Let me ask this question, Corey. What if for some reason, Jay's business turns? What could go wrong involving the ESOP if he gets it off the ground, but then for because of the recession or whatever reason, the business doesn't do as well. So a couple of things can happen. Of course, if you have a loan, then that's gonna then and you can't pay off the loan, then it's like any other situation, you know, the creditor is gonna say, OK, I need to do something about this. And so, typically what you see when a company runs into troubles, one of two things. If it's really in trouble, you look for another buyer. And you get whatever you can, and the ESOP is bought out, and if there are other owners, they get bought out as well. Fortunately, that doesn't happen very often. I wouldn't say, you know, obviously it doesn't happen never, but it's, it's rare. More common is the business goes through a downturn, you know, and it's it, but it realizes it can come out of it. And so if they have enough reserves, then, then they can do that. They don't have enough reserves. Then maybe, and if you have a seller note, then there's this note is renegotiated to pay it out over a longer period of time, or maybe some of the interest is exchanged for warrants, so the company has less debt. So there are, so you, you're restructuring the debt. So that the company can survive through this. And in some rare cases, the seller is just forgiven some portion of the loan, but unfortunately, that doesn't happen very often. We know from what, you know, just from all the research on ESOPs, the number of companies that face these kinds of scenarios, even during the pandemic was really, really low. Of course, the PPP program helped, you know, some of those companies who might have had trouble got rescued by that. All right, we're running short on time here. There are a couple of things I want to hit. We've talked a lot about the challenges and the issues and what can go wrong. I, I want to make sure we talk a little bit about what can go right. Jay, at one point, you said to me after doing your research, you told me, I'm confident I can make more owning 70% of the company than I am now owning 100%. Explain that. What were you thinking? Yeah, simple math. Here it is. I'm taking the 30% of the profit, whatever that number is, and then I have to back out of that, the interest I'm being paid on the note that I'm holding. So that eats up probably half of it, OK. And then I figured, you can't prove any of this, but I'm in the retail business. People have relations with my employees. How could being employee owned not get sales up 1%, just 1%? Well, 1% is a lot of money, uh, gross profit-wise, so that's going to be a big chunk of money. And then again, even with motivated employees, and Corey, I loved in your book when you said, look, at half your employees are going to work hard no matter what, and the other half might work a little hard. Yeah, sure. What if they just worked, what if, what if my efficiency just went up 1%? Well, I have a big payroll. 1% of that is tens of thousands of dollars. So if you add up the little bit of cost savings, a little more business. And the fact that I'm getting interest, all of a sudden I made more money than I would have made um without selling it on top of the fact. I now have retirement funds for all my employees. So, I just, like I said, I see this as a win, win, win, win for the customers, win for me, win for the employees. It seems too good to be true, but I think it's true. Corey, is he deluding himself? No, we actually have a lot of research on this, and it should be mentioned, just to be clear that when you sell to an ESOP, if you meet certain criteria, that you can defer taxation on the game by reinvesting in stocks and bonds of other companies. So, that's a pretty big deal. If you are an S corporation, the percentage of your profits attributable to the ESOP is not taxable. If you're 100% ESOP, no taxes. If you're 30% ESOP, 30% of your profits are not taxable effectively. So, so there's some big tax advantages that add to the financial benefit of an ESOP, but When we looked at the data, we found that ESOP companies grow about 2.5% per year faster. Than would have been expected if they did not have an ISA. And the companies that combine an ESOP with this high involvement management system grow about 6 to 11% per year faster than would have been expected. How can you determine that? How, how do you know? Yeah, so, so this is called in, in social sciences, uh, you know, it, it's kind of a mash sample, quasi-experimental technique where what you do. we took companies, we took a whole bunch of ESOP companies randomly, and we said, let's compare these companies to companies that are otherwise just like them for the 5 years prior to the ESOP, and then let's compare them for the 5 years after the ESOP. And what we're gonna do is say, well, if Jay's company was growing 2% a year per year faster than its competition prior to the ESOP. But it was growing 5% per year faster post ESOP. Then there's a 3% difference attributable to establishing the ESOP. So this called quasi-experimental technique is the kind of social science gold standard, and that's what the research showed. And here's the key for me figuring it out. Let's say that the social scientists are off. It's, it's half as good as they say it is. Still damn good. Even if it's half, even if it's a third of what they're saying. It more than pays for itself. So I'm not suggesting you got to hit all those, I mean, that would be unbelievable if a company grew 6% more because they want to ease out. I'm not even suggesting that. I'm just suggesting bare minimum, they grew 1% more. That's all, just 1% more. It works. Yeah, it's a modest target. And the other side of that is that There's, there's a lot of surveys that were done. My favorite one was the comparing ESOP popularity to apple pie and baseball. And it actually came out better than both. Well, being a Cubs fan this year, that's not a hard thing to imagine. That's, that's true, but maybe the apple pie. Part of the reason Publix is so successful, and a lot of reasons, but part of the reason is that it's employee owned, and there's some percentage of their customers who just prefer shopping at an employee-owned company because they figure it's good for more people. All right. All of this leads to one obvious question, Corey, which is If it's really as good as Jay is saying. Why don't more companies do this? Cause we know the percentage is tiny. Yeah, of, of the eligible of the companies who are big enough to do it, you know, there's maybe 150,000 companies who are fit the criteria because you know, most companies are really tiny of the millions of companies, you know, under 10 employees or under 1 employee. But I think it's exactly what happened to Jay. They go to their advise. First of all, they don't even know you can do it. There's a large percentage of the business population doesn't even know what it is. There's another large percentage that says, oh, employee ownership, the employees have to buy the stock. That'll never work. End of story. And then there's the the remaining percentage of Jays who go to their advisors who say, yeah, you shouldn't do that. Let's let's go to lunch. And that's a big problem, huge problem. You've kind of hit my 3. I've just one is absolutely they don't know. There's no question. I talked to lots of business owners. Most don't have a clue how it works, so that's for sure. Remember when I told you that the profits were not taxable? Remember your reaction, Lauren, you've got this wrong. That can't be the case. Absolutely. OK, so number 2 is. And I think this is huge. They talked to their accountant or lawyer, it is completely dismissed immediately with, oh my God, they're a pain in the ass. And that's, that's the end of the conversation, cause most people are gonna think, oh well, I can trust my lawyer or accountant, they know what's going on. OK. And then the third one, which, sorry to say, I've gone to these seminars and they managed to unsell me. They say things that are so, they unsell me and I could give you lines. They said that I give us an example. What are you referring to? OK, here's my favorite one. I'm I'm watching a seminar from a well-known company. The speaker says it's like building a house. Well, nothing's perfect. And I think that's like taking your kid to a babysitter your way out, they go, oh, by the way, I just want you to know I'm not the perfect babysitter. Like, what the hell does that mean? I, I still don't know what that means. I mean, that was one. Another one is both of these companies, and these are very big companies that you know extremely well. The person speaking, they both said the same thing. It's basically like a 401k plan. The other one says, and ESOP is simply a benefit plan. It's simply not the case. That's like saying, going to the Cubs game is like being the manager of the Cubs. No, you're in the same stadium, you're wearing a hat, but one of them is being paid to be there, and the other one you paid. Can't say that it's certainly got an element that's like a, a, a 401k plan, but it's not their money. For God's sake, you can't just go ahead and summarize it with they have to say it's like, cause I say to myself, Well, then what the hell do I need this for? I got a 401k plan. That's underselling it by about 80%. The 11 of the difficulties with, I used to be an academic, and when I first started teaching, the thing that occurred to me right away was, it's hard to remember what I didn't want know. That I, things that were concepts that were so familiar to me, I didn't even think about them, that I didn't know where the audience was. And that's true of lawyers, they're experts, and it's hard for them to remember where the audience is. The second problem is The often the people who are the worst at explaining something are the people who know too much. And they want to go into more and more and more detail, and you really at first need to know all that detail. And I've actually had lawyers, I had a lawyer tell me once, I said to him, you know, you're really intimidating people, giving them all these things that could happen and all the and he said, that's the point. is if they thought it was simple, they might not feel they need me. I said, Dave, if they think it's as complicated as you just described, they don't need anybody. No, I, right, I think you hit it on the head. They put up a screen with bank and trustee and with arrows and dots and arrows going around, and I'm thinking, do they seriously think someone's looking at this and going, oh, I understand how it works now. And my phrase, they don't speak entrepreneurs, they're not speaking to me. I want to hear two things. I wanna hear. This is a great way of making sure that all of your employees end up with some retirement, and 2, this is gonna be great for your company and you're gonna be thrilled you did this because everybody is gonna be happier, including your customers. Wow, there's the sales pitch, instead of, let me show you how this works. Corey, have we missed anything? Oh, thousands and thousands of things. Jay, are you still, uh, are you still hot on this? Absolutely. Here's exactly where my head's at. My head's going from, if you fit the criteria, you've got a management team in place, you don't need all the money upfront, uh, you're not worried about getting the last dollar out of the business, you're big enough for the math to work, you care about your employees. I, I feel like I've gone from, should you do this to, why wouldn't you do this? All right. My thanks to Corey Rosen and Jay Goltz and to our brand new sponsor, the Great Game of Business. You can learn more at greatgame.com. Have a great week, everybody. Wait, wait, don't leave yet. If you have a question or a comment that you'd like the 21 hat's owners to address, send it to me by replying to your morning report or by email at lauren@21hats.com. That's L O R E N at 21 hats.com. Do it now before you forget and don't be afraid to tell Jay what you really think. You can take it. And if you got something out of this conversation, help us reach more business owners. Tell a friend, subscribe and review us wherever you get your podcasts. Follow us on Twitter. Subscribe to the Morning Report at 21 hats.com. This episode was produced by Jess Thuberon, founder of Blank Word Productions. OK, now you can leave. Thanks for listening, everyone.