The Hard-Nosed Business Case for Employee Ownership

[Music] hello everyone welcome to the 21 hats podcast I'm your host Lauren Feldman this week Jay goldz explains how he got interested in selling a percentage of his business to his employees and while 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 ESOP sound expensive complicated and risky this was not something he had to do so why go to the trouble why take the risk but 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 Cory Rosen to join the conversation Cory 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 Cory if esops 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 whichc magazine named the best newsletter for business owners and which you can subscribe to for free at 21h 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 goz whose companies in Chicago include a picture frame business artist frame service and a home furnishing store Jason home and Cory 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 Cory 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 aund and some employees and many of them have been with me over 20 years when I say many uh probably 20 25 people have 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 ESOP 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 oi 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 figed out I think the things were giving me the oi 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 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 I should be fine sorry Cory I interrupted you where 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 successor Management in place for obvious reasons I have a very solid management staff this is not the J show I barely deal with customers I barely deal with vendors I have done the proverbial worked on the business that of 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 great third one is are you big enough now you'll get lots of different feedback from advisers on this the big enough question is it costs money to set up an ESOP and it could cost anywhere from1 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 transaction so if you've got a $5 million business they might charge your $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 10 15 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 a 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 Ops 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 employees 401K balances and he just turned to me and he just said why is that your problem right okay 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 a 100,000 and 500,000 I think I know you've been doing a lot of your own research Jay on 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 okay 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 is an Entre R preneur it's about okay what's my return on investment in doing this sure and I believe that a little bump in marketing just a little you'd get 1% more business because of this 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 Cory mentioned I'm not comfortable with half a million dollars um I don't know what drives it that high so no 10 and something okay 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 n ceo. 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 going to 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 two 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 either work on an hourly basis or they have a fee based on the particular service they're providing that's going to cost you a lot less than the ones who charg the success fee but they're not going to 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 a higher range okay that was very insightful I didn't know that the idea this someone's going to 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 have you could have gotten more money out of 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 okay that's good yeah there's one other consideration that people should understand when they're making the decision which is is esops come with rules about how the stock gets allocated to people and I have talked to people over the years who say it's 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 seven 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 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 fiz 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 okay no that part I got down I'm just you know the person who's who's just standing there framing pictures that makes you know whatever $42,000 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 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 I don't know why in Corey you said it in your own book three 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 joyful thing like hey everybody I'm gonna sell you 30% of the company and it's going to 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 unjoy hard work can be very joyful indeed as probably anybody who's an entrepreneur can attest that what what I'm referring to there is that once you set up your Esa that the expectation that well now everybody's just going to get it and they're all going to act like owners and everything's going to 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 it 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 pymetric 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 4,000 usable ideas per employee per year imagine if you have a company that generates two or three usable ideas per employee per year how much better you'd perform but this doesn't just happen by m 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 okay 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 oh oh esops here's the big three I think if you talk to the accounts of the lawyers who Maybe aren't as familiar with it the first one is oh there's a problem with evaluation with those things okay um my answer is all right you get the valuation if it's not what you thought it was abort Mission okay I mean am I wrong no that's that's right 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 that after the tax benefits of selling to an ESOP are 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 at the party yeah and mergers and an acquisition advisors will make more money selling you to someone else than they will to an ESOP and so they definitely will tell 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 two per thousand per year so the notion that they're they often fail is just not true no and 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 yeah 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 the evaluation one two oh well a lot of people could go to retire at once and you'll have a payout crunch correct me if I'm wrong because this one I just I think I figured 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 they want to retire no I understand that but I want to start with the basics sure so there 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 up front 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 five to seven years so you won't get everything UPF front uh you'll get you know significant amount of it in the first couple 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 mezanine debt which will fill that Gap but the mezzanine debts pretty expensive I met with my bank they have a division all they do is is lend money to esops there 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's 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 a hard I think he called it a hard loan meaning they're going to look real carefully at everything to 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 Cory is Jay right about that yeah and well Banks who do ESOP loans do love them because why wouldn't you love a loan that has a default rate of two per thousand per year so yeah they and 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 favor able towards esops the seller not there are a lot of people who say I'm even bother with a bank you if I can get paid off over eight years that's fine I you know I I don't need all the money up front I'm going to 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 at probably 8 to 12% on the interest rate that's exactly what he said and this is what made me realized 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 get into critical mass you're going to get much more profitable over the next three four five 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 going to chew up half of that money right off so M I've got I I did 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 working there's even another wrinkle where some owners about 20 30% of the seller notes the seller says well you know 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 six 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 needs a little more advice and you know more lawyers and appraisers getting involved but you it's not uncommon to see that okay and that leaves me with the third one these are words right out of an accountant's M oh the administrative costs for that are really high okay now I've gone to enough webinars I've talked to enough people it sounds like correct me if I'm wrong the administrative cost of getting the appraisal and having the trustee uh 50 to $75,000 a year or less okay good yeah so the administrative cost is just the people keep all the records and that's going to cost oh in the range of $100 to $200 per employee that's not a big cost trustee is going to cost and you don't have to use an outside trustee after 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 15 and then if the Law changes you need a lawyer okay so you just gave me 1020 so it's $45,000 okay 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 is always made me sick I don't like it I think it's completely wrong 401K matches benefit to 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 30 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% okay 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 $4,000 here but you're gonna make 10 so I'll just explain it to them and yeah like I said that's GNA 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 employ es 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 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 the acquisition loan is paid and there's a lot of in the weed stuff here about how and you know because the loan typically goes to the company and then is reloan 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 oblig ation 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 happen 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% Esa companies are on a real acquisition binge once they paid off their initial debt they start accumulating a lot of cash and because 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 going to start providing more resources on is for companies who say I really like the idea of an esap 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 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 sure 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 a 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 advisers they have their own interest in what they want you to do which may or may not Co 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's it worked 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 Cory 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'm wondering is that something you've heard is that something that comes up well you're always going to have Skeptics who want 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 you have the kind of culture that I suspect you do Jay in your company then it's going to 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 in aany 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 communic ating 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 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 and cu So 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 of 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 eso'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 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 going to sell um what's the vesting thing very easy what is the pay cap you're going to use for your percentages okay again easy and when they leave explain what that is J what do you mean by the pay cap the way you figure out the share is divide the salary by the payroll but they cap the salary for purposes of their percentage so they'll say the most somebody's going to be in there for is 200,000 or 150 and there's a limit right it's 200 legal limit is $35,000 this year okay so I wouldn't I don't have anyone making that anyway but I I would say okay uh your cap is going to be X doll so that that's all very easy My question is what else is there because I I don't 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 where you want to hire an exter trustee to do it you have to decide on when do you want to start Distributing stock you have some options about that 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 a documents library on our website we have checklist these are 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 okay here's the one question I really don't have a handle on that I I understand that you take their salary divide it by the total payroll they get their percentage my question is and I just was you can't give any credit for oh they've been here for 20 years like okay 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 the the ESOP let's say buys a th000 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 five shares so you can you can use relative pay or a More Level formula you could say I'm going to give you one point for how many years you've worked and one 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 was so yeah you can do that but what most people are talking about is I've got an employee worked here for 20 years and I've got an employee worked here for one year when we start the ESOP are they both 0% vested and you can give credit for prior service for their investing you can give them year to year you can say every three years you get one year of es so long as you do it the same for everybody you can do that so okay 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's been here five 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 wow again you just have to have it tested so that the effect of that is somebody who makes $200,000 a year 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 give five 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 it's 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 Cory is that true even if Jay stays at 30% which let's assume I am because that's my plan the the percentage of ownership is not related to this this is what happens internally within the esa all right this sounds complicated it needs to talk to a to too complicated for this but that okay that's good to know I got it it's not impossible to do it you're talking about there are some constraints but it's not impossible okay that's fine Corey the rules that you're referring to are they all national or can this vary by state no this is all part of the employee retirement income Security Act so state law has has virtually no impact Subs Jay are you still with us yeah no that's fine that no I'm telling you the things that turned me off I have learned were really not problems and um I so far so good I haven't seen anything that's gotten me to think oh my God wait this isn't going to 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 things can happen of course if you have a loan then that's going to then and you can't pay off the loan then it's like any other situation you know the Creditor is going to say okay 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 that if they're 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 that 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 just forgiven some portion of the alone but unfortunately that doesn't happen very often we know from what you know just from all the research on esops that the number of companies that face these kinds of scenarios even during the pandemic was really really low and 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 okay and then I figured you can't prove any of this but I'm in a 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 own 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 it's 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 so that's a pretty big deal if you are an S corporation the percentage of your profits attributable to theop 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 company grow about 2 and a half% per year faster than would have been expected if they did not have an ESOP 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 that you know it's kind of a match sample quasi experimental technique where what you do is 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 five years prior to the ESOP and then let's compare them for the five years after the ESOP and what we're going to do is say well if Jay's company was growing 2% a year per year faster than its competition prior to the esap but it was growing 5% per year faster post esap 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 W East 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 targetting the other side of that is that there 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 there 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 own 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 because 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 right of you know under 10 employees or under one employee but I think it's exactly what happened to Jay they go to their advis 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 and a story and then there's the remaining percentage of jays who go to their advisers who say 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 three I just one is absolutely they don't know there's no question I talk 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 okay so number two is I think this is huge they talk 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 because most people aren't going to think oh well I can trust my lawyer account they know what's going on okay 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 okay here's my favorite one I'm I'm watching a sem from a well-known company the speaker says it's like building a house while nothing's perfect and I think that's like taking your kid to a babysitter and 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 an ESOP is simply a benefit plan that'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 401k plan but it's not their money for God's sake you can't yeah to go ahead and summarize it with that to say It's like because then I say to myself well then what the hell do I need this for I got a 401K plan that's under selling it by about 80% One one 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 once 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 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 yes they want to go into more and more and more detail and you don't 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 think 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 want to hear this is a great way of making sure that all of your employees end up with some retirement and two this is going to be great for your company and you're going to be thrilled you did this because everybody is going to be happier including your customers wow there's the sales pitch instead of let me show you how this works Cory 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 up front 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 goz and to our brand new sponsor the great game of business you can learn more at great game 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 hats owners to address send it to me by replying to your Morning Report or by email at Lauren 21h hats.com that's l r n21 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 business owners tell a friend subscribe and review us wherever you get your podcasts follow us on Twitter subscribe to the morning report at 21h hats.com this episode was produced by Jess Theron founder of blank word Productions okay now you can leave thanks for listening everyone [Music]