Dave Cain: Welcome to unsuitable on Rea Radio, the award winning financial services and business advisory podcast that challenges your old-school business practices and the traditional business suit culture. Our guests are industry professionals and experts who will challenge you to think beyond the suit and tie, while offering you meaningful modern solutions to help enhance your company’s growth. I’m your host, Dave Cain. Last week, Dave Phillips, president and chief operating officer of Architectural Systems Incorporated in Columbus Ohio joined us to share his recent employee stock ownership plan experience. This week, we’re gonna get a glimpse into the technical side of the process without getting too far into the weeds. Actually, today’s guest is pretty good at staying out of the weeds entirely, which is good, because from what I understand, ESOPs can be very complex, and our guest today is gonna make it a lot easier. Tim McDaniel, a principal and director of valuation services here at Rea & Associates has returned to the podcast to tell us why ESOPs are growing in popularity, how they compare with other succession options, and what goes into the implementation. Welcome back to unsuitable, Tim.
Tim McDaniel: Well thank you, Dave.
Dave: So not only are you a expert, very famous in the valuation and ESOP area, you’re also a big sports fan.
Tim: That’s correct.
Dave: And of course this coming weekend starts the NFL draft.
Tim: That’s right.
Dave: And as a Browns fan, you’re looking to see what’s gonna happen. Who are we drafting?
Tim: Well you know, I tell my friends, and that includes my new wife, who’s a Bengals fan, why it’s so great to be a Browns fan, because in February, March, and April, we’re all excited, and the rest of the people are bored.
Dave: That’s right!
Tim: And then on the beautiful Sunday afternoons in the fall, we take hikes and do fun things. So that’s why it’s great to be a Browns fan, and I think it’s gonna be Darnold or Allen number one, and I’m hoping for Barkley at number four.
Dave: I got you, I’m totally with you.
Tim: But not sure if that’s going to happen.
Dave: Yeah, good, good, well let’s keep our fingers crossed and we’ll find out this weekend what’s happening.
Tim: Okay.
Dave: So today we’re going to talk about ESOPs, maybe take a little different approach. ESOPs standing for Employee Stock Ownership Plan. ESOP for short. Did I get that correct?
Tim: You are correct!
Dave: So one of the things, maybe, I want to ask, in maybe this question and answer, but do ESOPs pay federal income tax?
Tim: It depends. If you’re a 100% S-Corp ESOP, you pay no federal income tax whether you make a dollar or two billion dollars because it’s a retirement plan. That’s deferred from taxes.
Dave: So that gets a lot of airtime and is that maybe I don’t want to say clouding the issue, but the rush for business owners to step to the plate and put in a ESOP?
Tim: It’s a major component. I mean it is a driver. Just think about it. If you get … an ESOP is a leverage deal. So as 100% ESOP, it’s 100% leverage. So you have to pay a bank back and pay back the shareholder who probably will lend to the ESOP. If you’re paying no taxes, it’s much easier to pay that loan back. So it is a driving force of it, but it’s not the only decision.
Dave: It’s part of the equation …
Tim: It’s part of the equation, that’s correct.
Dave: And some business owners may have selective hearing, and that’s what they hear, and that’s the driving force.
Tim: Right.
Dave: But I think I’ve heard you say time and time again there are many different factors, that being one.
Tim: Yeah. Let’s stay on the tax thing. If you’re a C-Corp and you sell to an ESOP you can defer your gain forever, perhaps, what’s called 10-42, and if you sell to the ESOP they give you a check, you reinvest that money in qualified investments, you don’t pay taxes on that until you pull the money out of those investments. And some people get it, in part of their estate plan, pay no income tax on that deal.
Dave: One of the things that you write blogs, and it’s even in your book, one of the succession plan strategy tongue-in-cheek is die at your desk.
Tim: That’s one of them. That’s not the best one.
Dave: But that’s one of them!
Tim: That’s one of them, that’s right.
Dave: And so let’s talk about a couple other areas of succession plan and where ESOP ranks in that ranking.
Tim: Yeah. So as a business owner, when you have a business, it’s probably more than 50 or 60 percent of your total net worth. It’s a big part of it. So the question is how do I monetize this? And there’s a lot of different options. Die at your desk and let everybody clean it up is not a very good option, but the other options is to sell it to somebody. You could sell it to an outside party. Most dollars you get is what’s called a synergistic buyer. That’s somebody who is bigger than you, within your industry, can pay more because they can cut jobs and do those type of things.
Now the bad news about synergistic buyers is sometimes you lose your identity. Some owners don’t feel good that somebody they worked with for 20, 30 years loses their job, and those type of things, but that gives you the most money on top, but that might be an asset transactions. ESOPs are always stock transactions, so you pay lower tax. So that’s part of the analysis we do a feasibility study. We show the business owner, if you do an ESOP, what’s your after tax proceeds, and compare it to an M and A deal. If you sell it to a bigger buyer. So they can see, in black and white, what the bottom line proceeds would be if they do an ESOP.
Dave: So you’re doing both … on both sides. It’s certainly the analytical consulting to look at the deal, but also you’re bringing in hey there are emotional issues that cannot be measured and that’s maybe a very valuable piece of your consulting team’s process.
Tim: Absolutely. That’s the first question I ask the business owner. What is the most important thing to you when you sell your business? Is it legacy, top dollar? Rarely can you have both. If legacy is the most important thing, that means you have to sell to your employees, and they will not pay the top dollar. If you want top dollar-
Dave: Different approach.
Tim: Different approach, but what I’m finding is more and more business owners are really, really concerned about their legacy, and this is where ESOPs really come in as a great plan for that.
Dave: Why do you think that there’s the shift? Is it maybe the age of the business owner?
Tim: I think there’s a lot of things. They hear horror stories about M and A transactions. How hard the due diligence is. Sometimes they might write a letter of intent, say, “We’re gonna pay you 10 million dollars for this business.” They do the due diligence. “We found some warts on your baby.” That never feels good. “And because of those warts, we’re gonna pay you eight million.” And that happens sometimes in M and A deals. That’s the nice thing about an ESOP transaction. You’re selling it to yourself. You’re selling it to your employees. Once the thing’s negotiated with the trustee, it’s gonna be a done deal in stuff like that. Due diligence process is a lot more smoother.
Dave: Over the course of our careers, we’ve worked with … and these are typical clients within Rea & Associates’ portfolio is they’re family-owned businesses. Family run businesses. Generations to generation, and some of these businesses, they’re coming to an end. There are no more sons or daughters or grandkids to pass the business onto, and so again, maybe this is where you’re seeing more legacy in the ESOP popularity.
Tim: Right. I agree.
Dave: Is the ESOP a fad? Maybe that’s not the right terminology, but is it a fad right now in the marketplace?
Tim: No. It’s not a fad, because both sides of the fence, I mean Congress, republicans and democrats love it. You’re selling it to employees-
Dave: The bipartisan succession plan, never heard of that!
Tim: Yeah, yeah! I mean the republicans sort of like the tax advantages of it. The democrats like that the employees are getting to own the business, so it’s got a lot of support from our government. Banks are feeling more comfortable lending to ESOPs. Business owners are getting more comfortable, more educated about it. So it’s not a fad. It’s a growing thing that I think is gonna continue on.
Dave: So we’re learning more and more and seeing success stories, and so I think that’s what’s breeding the interest.
Tim: Right.
Dave: You know, I’ve also heard you say that the ESOP is not for everybody, not for every business. Can you give us an example?
Tim: Sure. Well ESOPs are expensive to set up because you need a lot of professionals. You have to have a trustee who represents the benefits of the employees buying the stock. They hire another valuation person. You have lawyers involved, you have third-party administrators. Because of that, you have to be fairly profitable. I would not consider an ESOP unless you had 600 to 700, 1000 dollars of EBITDA before you would even consider. So if you’re lower than that, ESOP’s too expensive for you.
Number two is you have to have a succession in management. You can’t sell it to a company that has no succession, no managers to run the business. So there’s got to be a solid core of people running the business behind you.
Dave: Now are these cost, or obviously there’s a one-time cost to get everything set up, but you’re saying it’s even more than that. It’s an ongoing cost here that’s hitting your bottom line.
Tim: Well the ongoing cost is not as bad. That initial cost is a six-figure transaction cost. Ongoing cost, you have to have a valuation every year. The trustee cost could be lowered, and those type of things, but that initial cost is what’s really expensive.
Dave: And some of those ongoing costs could be offset by not having the income tax consequences, depending on the size.
Tim: That’s correct. The other thing is studies show that company’s that are employee owned perform better. It’s funny, one of the very first ESOPs I did was a union shop, was a factory, and the guy who was the owner says, “Oh it’s great,” is walking outside, and somebody’s yelling at each other saying, “You’ve got to get that done, we own this company,” and it’s just sort of this pressure to get things done better. And I see that. I think ESOP owned companies perform better because people are seeing the direct benefit of being owners, and they look at their statement every year and say, “Wow, the stock has gone up, my retirement plan’s gone up.” And it’s all because the valuation of the business has increased.
Dave: Maybe there’s more accountability by each employee to “Hey, let’s watch utility costs, let’s watch our waste cost, let’s watch our labor cost,” et cetera, et cetera. So they are truly part of the business.
Tim: Yup. So I do think those extra costs that you get for valuations and those type of things are made up by increased productivity.
Dave: You’d mentioned some of the other succession plan options. In your opinion, where does ESOP fit in the plan? Is that quickly rising to the top, in your book?
Tim: I think it depends. Again, I ask the owner, “What’s the most important to you?” If you have enough cash-flow, if you’re a successful business, your legacy’s important, and you don’t … one downside of the ESOP, you can’t just sell to maybe the manager or the president gets 80% and the rest get 20, it’s sort of equalized based upon compensation and stuff like that. So if you’re okay with the equal distribution of the stock, some get a little bit more, it’s great. But if you want to reward just two or three employees, maybe it’s not the right thing.
Dave: It’s, yeah, it’s got to be a wide net across the entire workforce.
Tim: Right, that’s correct.
Dave: So you and I had a brief discussion about an ESOP maybe as an estate planning technique where an individual was maybe going to put in their will and their documents that they wanted to protect the legacy, and they were gonna maybe ask the executor to after their demise to ask the executor to develop an ESOP. And we both looked at each other and said, “Wow, that’s unique, but maybe not for everybody.”
Tim: Yeah, I think that there needs to be a further bridge, ’cause if he passes away, then they’ve got to go out and figure out who the trustee is, and I think a lot of value could be lost. So I think there needs to be a little bit more planning, but I think it is a nice succession plan, in that case, so.
Dave: So if I want to start an ESOP and we talked of this with Dave Phillips in last week’s episode, is it’s not one of those things you just, okay, I’m gonna wake up tomorrow and get my ESOP crunched by the end of the month.
Tim: Right.
Dave: You know? Realistically, what’s my timeframe, start to finish?
Tim: Good question. I think with the first thing to do is a feasibility study. And what that does is it gives you a range of what the possible values could be, what your net proceeds would be after tax. It also shows you whether the company can afford it, based upon the valuation assumptions. So again, if you do 100% ESOP, it’s a 100% leveraged deal. Say the company’s worth 10 million dollars when it’s valued. You’d get a 10 million dollar loan to pay off the owner. So the value the next day is zero. It’s 100% leveraged. So can the company actually afford the debt? That’s part of the feasibility study. So once you say, “Yeah, that looks good,” if you said “Let’s rock and roll and get this thing done,” it’s probably a four to six months process.
Dave: Okay. Four to six months. And maybe longer, depending, ’cause you’ve got to get a lot of things lined up.
Tim: Right.
Dave: You had mentioned financing and is this a difficult credit? Is it a tough thing to get financed?
Tim: No. No, it’s just like any other transaction. The bank will look at a multiple of EBITDA, as far as how much you’re gonna leverage. What type of assets they can collateralize, just like any other deal.
Dave: In your valuation and feasibility studies, are you seeing a gradual increase in the EBITDA numbers? Business getting better?
Tim: Well, there’s one thing that’s happened in 2018, is valuations have gone up because of the new tax law. ‘Cause the valuation is all based upon future cash flow, so for a C-Corp, you made a lot of money, your tax rate was what, 34, 35 percent? Now it’s 21%, so there’s more cash flow, thus valuations have gone up right now. So just because of the tax law.
Dave: You know, with these great draft choices we’re gonna have, what do you think? Five wins, six wins?
Tim: Well I like Taylor. I think they just signed Landry to an extension today, I see. Hopefully Gordon stays on the up and up, and yeah, I’ll say six.
Dave: Six? Okay.
Tim: I’ll say six.
Dave: That’d be great, since what did we win over the last two years? One game?
Tim: One game.
Dave: That would be phenomenal.
Tim: Yeah, yeah, well.
Dave: So in the time we have left, let’s talk about how to successfully implement an ESOP, and I’m not sure where to start, even with the questions. Obviously you have to make a decision to get things going, but maybe that’s the tough one. How do you get a business owner to even decide?
Tim: I think, again, the feasibility study is a nice little document that shows range of value, net proceeds, the affordability of it, and we also have a lot of discussions of the advantages and disadvantages, and maybe do some analysis of other exit strategies, what that looks like. And if they say, “Yeah, let’s go,” they probably should have somebody to quarterback the deal. To help pull together the trustees-
Dave: A franchise quarterback.
Tim: A franchise quarterback, not what the Browns have. You know, I just got married two or three weeks ago, and my new wife, bless her heart, she’s a Bengals fan, but she didn’t like the way I decorated my house. I had Brian … posters-
Dave: Oh, sure, sure, yeah!
Tim: And the Farrah Fawcett Poster, and that type of stuff-
Dave: Oh yeah, okay.
Tim: The 1980 dorm room style.
Dave: Oh, yeah. Did you have a blacklight going, the lava lamp?
Tim: Yeah, and all that stuff.
Dave: Okay. All right, now we’re talking. Man cave.
Tim: So yeah, you need a Brian Sipe.
Dave: Yes.
Tim: So we can’t use any other Browns quarterback, well Bernie, we could use Bernie.
Dave: Bernie, yeah.
Tim: Yeah, but we can skip over 30 other names.
Dave: 30 other ones, so, let’s see. Oh, we were at the most important thing. The quarterback. Now implementing the plan, obviously, you had mentioned four to six months. It’s the emotional things we’ve got to get over. There’s the analytical process, the banking, the legal, the valuation.
Tim: Right. So you want somebody to sort of quarterback this, to help you interview the trustees, select the trustee. They’ll select the valuation person on their side. Then you want somebody on your side to help negotiate, get you the right deal. And also, the look of the bank financing. You want to maybe get two or three banks involved to give you a proposal and do some analysis on that. What works, and those type of things.
Dave: The other thing that I’ve heard your group do, as you go through and look at these feasibility studies, is that you’ll hook up an ESOP prospect, let’s say, with another Rea client that’s been through an ESOP. So you kind of, now they have a friend to talk to, somebody that’s been through it, and that’s kind of a valuable part of your feasibility study that goes unnoticed sometimes.
Tim: No, that’s great, yeah. That is so wonderful, to be able to talk to somebody that’s been through it. The advantages and disadvantages of it, and stuff like that, yeah.
Dave: So as our clients talk to one another about ESOPs and they talk about Tim McDaniel’s ability to do a feasibility study, are they gonna say Tim’s in the hall of fame, he’s a top draft choice? He’s a top draft choice this time around.
Tim: We’ll say yes.
Dave: I will say yes, I will say yes on your behalf. That’s kind of an unfair question, but I think they would say a resounding yes, he’s our guy, he’s our quarterback.
Tim: Well I’ve been involved with over 2500 valuations. Been involved with a lot of M and A deals in the last 30 years, so I think I can get a pretty good idea of where the value’s gonna be and the other parts of the ESOP, so.
Dave: And you know you’ve seen a little bit of everything.
Tim: Yes.
Dave: You know we’ve talked about, throughout the last few minutes, about all the positive things that have occurred. Have you run into anything that’s really negative, a downer on these deals?
Tim: Sure. Yeah, the downsides to ESOPs is you have more regulation. The department of labor, and the IRS, are interested in what’s going on. The department of labor is going to audit the initial transaction, so it’s really important to do everything correctly. Have the right attorney, the right valuation people, and all those type of things. There have been some cases … I think this is why people get scared of ESOPs, that there’s been a lot of things in the press-
Dave: More regulation.
Tim: Where the department of labor has come in and audited and slapped some heavy fines, but that’s where I think owners got really greedy and did some things that weren’t correct, but that’s part of the downside, is you’re gonna have some regulations. A little bit more paperwork. The one thing I think is some people get worried. “Well, my employees are gonna own the stock, therefore they’re gonna see the tax returns, they’re gonna run the company.” That’s not correct. They are owners, but the trustee actually holds all the stock.
Dave: Right.
Tim: You can still set up your own board of directors and run the company like you did, but if you were taking big out big … you’ll get an employment contract, so you no longer can take out any salary you want.
Dave: Right, right, there is some control, it’s not the wild wild west by any means.
Tim: There are some controls. Right.
Dave: But not everybody’s gonna make all the decisions. Just because you own some of the stock in the company.
Tim: Yeah, the employees will, if you were gonna sell the company, or do anything major like that, would get a chance to vote. But they don’t run the day-to-day thing.
Dave: Our guest today has been Tim McDaniel, a principal and director of valuation and feasibility studies of ESOPs at Rea & Associates. Tim is located in the Dublin, Ohio office, but travels throughout the state of Ohio, and throughout the country. Home town, I believe, is Wooster, Ohio.
Tim: That’s correct.
Dave: How about that.
Tim: And 2018, 19 is the year we’re gonna have the Super Bowl, the World Series, and the NBA Championship, right?
Dave: There you go! And check our website out. I think Tim has his mock draft coming up here in a few minutes, so check that out.
Tim: Okay.
Dave: Tim, thanks again for joining us on unsuitable today. Great presentation. I’ve really enjoyed learning more about what goes on behind the scenes in implementing an ESOP, and just how important the quarterback is, and it takes a while. Be patient, but get that quarterback in place, and go for it.
Tim: That’s right!
Dave: Listeners, if you have an ESOP related question, go ahead and send them our way. Emails can be sent to podcast@reacpa.com. And don’t forget to subscribe to unsuitable on iTunes to make sure you don’t miss future episodes of our award-winning podcast. Until next time, I’m Dave Cain, encouraging you to loosen up your tie and think outside the box.
Disclaimer: The views expressed on unsuitable on Rea Radio are our own, and do not necessarily reflect the views of Rea & Associates. The podcast is for informational and educational purposes only, and is not intended to replace the professional advice you would receive elsewhere. Consult with a trusted advisor about your unique situation so they can expertly guide you to the best solution for your specific circumstance.