At some point, if you’re a business owner, you’ll have to think about trading your business in for retirement. And when it comes to identifying an exit strategy, you can either liquidate, keep it in the family, sell it to the highest bidder, or get your employees involved.
ESOPs have gained a lot of traction in recent years. Similar to a 401(k), ESOPs are defined contribution plans. However, instead of receiving Apple or IBM stocks as part of the plan, employees receive stock of the company they work for. It gives employees literal ownership over part of the company, which creates a personal vested interest in growing the company and ensuring it remains successful.
If you’re a business owner — especially if you’re starting to think about retirement — listen to this episode to learn:
From Rea & Associates Studio, this is unsuitable, a management
financial services podcast for entrepreneurs, tenured business leaders, and
others who are ready to look beyond the suit and tie culture for
meaningful, measurable results.
I’m Doug Houser.
At some point, if you’re a business owner, you’ll have to think about
trading your business in for retirement. When it comes to identifying an
exit strategy, you have a few options to choose from. You can liquidate,
keep it in the family, sell it to the highest bidder, or you can get your
employees involved. Employee stock ownership plans, also known as ESOPs,
have gained a lot of traction in recent years.
Ted Lape, a senior partner with Lazear Capital Partners, is here to explain
what an ESOP is, what it isn’t, the benefits of starting your own,
pitfalls, best practices and more. Welcome, Ted.
Hi, Doug. Great to be here.
Thanks for taking the time. So ESOPs, talk to me a little bit about that.
If I’m a business owner, I hear a lot about that, but I don’t really know
what that means other than my employees are going to be involved somehow?
Yeah. Basically, an employee stock ownership plan is a defined contribution
plan, a lot like a 401(k), only instead of having Apple or IBM in the plan,
you’ve got stock of the company that you work for.
Okay, obviously if I’m an employee, then I have a vested interest in seeing
the company be successful beyond my own pay and that sort of thing.
Yeah, that’s the whole idea and there’s a lot of third party peer-reviewed
studies that show that companies that sell the ESOPs get that benefit, that
the employees do in fact start to care more and that they get better
productivity, less turnover, better recruitment, if they embrace it and
communicate it and do all the things you got to do to let people know it
Now talk to me about when this might be appropriate for a business owner.
Is there a specific company size that fits well or a certain revenue or
EBITDA level where they seem to fit?
That’s a great question. We tend to think of it in terms of earnings,
because you want to have a certain value to do this because there’s some
legal stuff you got to do and some complexity. It’s manageable. But, if
you’ve got a million and a half or two of what we call EBITDA or cash flow,
think of it may be as net income, adjusted for excess owner salary or
whatever. Then you’re probably big enough to be thinking about it. But you
also want to have some other things. The number one thing you want to have
for an ESOP is good management.
If you’re an owner who’s thinking, “Gee, I’m done. I want to go to
Florida,” well, I think that’s great. You ought to go to Florida. But you
probably should just sell your company to a competitor. However, if most of
our clients, the owners, want to stick around for a while, they may not yet
know who’s going to take over after them. They commit to figuring that out,
or they’ve got a pretty good management already, either one. That’s for the
Maybe I want three to five years of kind of tapering down what I do and get
the next level of management sort of trained up, that kind of thing?
That would be very normal and sometimes they think, I can train up the next
level of management. Sometimes they think, gee, I’m going to have to bring
someone in. We see both all the time.
Now from the perspective of the owner, the benefit is I still get something
to do, right? I stay in the business. I stay involved. My legacy stays
around. That type of a thing?
Yeah. There’s two, I guess, sets of benefits. When I first started dealing
with ESOPs, I focused on the first set of benefits, which are, I’ll call,
the features and benefits of ESOPs. Then the second set, really in the last
couple of years, we’ve really come to understand that’s almost even more
important, as good as the first set are, that the second set may be even
more important. The first set is, just to give the short hand, there’s the
ability to keep running the company. Some people think the employees start
running it. That’s not really what happens. The second set of benefits is
there’s a ton of tax advantages. The owner can potentially sell tax-free.
The company typically will become tax free, and there’s some additional tax
savings that would take longer to explain.
Then there’s a lot of times the owner feels a real benefit out of the fact
that the employees and especially the key employees, we hear a lot of focus
on, I’ve made a lot of promises to the key employees. They really helped me
build this thing. They’re going to help it go forward. All the stuff that
they get naturally important. The second set of benefits has really become
bigger and bigger. The more we’ve understood it and that is… there’s a
lot of studies by the Exit Planning Institute and other folks that have
shown that 75% of people who sell their companies are not happy that they
It’s either the way the buyer’s running, it’s not good, or a lot of times
it’s just the fact that, especially with baby boomers, their lives are so
intertwined with the company or their social lives, their life of relevance
They’re emotionally attached, right?
Yeah! And when you disconnect them from the company, which normally happens
in a third party sale no matter what the buyer says. They get disconnected
and that’s very hard on them. Maybe the first three months they play a lot
of golf and that feels pretty good.
You can only play so much golf!
And then you get six months out and well, it’s still right. And then you
know, by month nine they get pretty bored, and then they’re bugging the
heck out of their wife who they were never home with. And now they’re home
with eight hours a day or 20 hours a day. And so the ESOP is great cause
they control the exit. They can still keep working as long as they want.
They can take her back, they can travel, you know, and then if they do
eventually feel good about leaving, they can do that. But they control the
Yeah. Now you talked a little bit obviously about the financial part, the
tax savings, and that can be significant. Correct?
If I do it a hundred percent sale to an ESOP, what does that mean? Big
picture terms in terms of the cost savings?
There’s a couple of different ways go, but the main way that people do it
is they’ll sell 100% and then they’ll convert to an S corporation if
they’re not already an S corporation. And as an S corporation, it’s a flow
through entity, as all you accountants out there know, and if the owner is
the ESOP trust, the ESOP trust as a retirement plan doesn’t pay federal
tax. And in most States, almost all States, it doesn’t pay state tax.
Which is obviously a great benefit for-
Yeah, so you can pay the owner back quicker and that’s a big benefit.
Because essentially, in a typical structure, correct? Not all of the
proceeds are paid to the owner at closing. There’s a portion that’s paid
and then the ESOP pays back over time. Correct?
That’s exactly right. And typically whatever bank would lend is what you
get at closing and then the rest is on a seller note and a different people
do it different ways, but we typically will get about a 12% return on that
seller note. Because you’re behind the bank and that’s a… People like
that. And so when you add that 12% return and you take the purchase price
and the tax savings and all that, most of our clients, almost all of our
clients in the middle market, end up with more money in their pocket at the
end of the day than if they had sold to a competitor or private equity. Now
either are exceptions obviously, but most of them end up with more money
and they accomplish all the other stuff they’re looking to get that.
They’re happier, because I think of that spectrum and typically,
historically having dealt on the finance side with clients that are doing
this or whatever the case might be, we would always say, well, the least
amount of return is if you sell it internally to a family member or that
kind of thing. You’re maximizing your return if you some third party,
national player or something like that. Typically the multiples higher. But
from what you’re saying, if I’m a business owner, I can accomplish so much
more through an ESOP.
Yeah. Basically there’s a third party trustee who a fiduciary that is your
buyer. They’re there to make sure it’s fair to all the employees and
there’s evaluation firm, and they’re supposed to come up with a value very
similar to the real world and they do. Now, there’s just from the way
evaluations are done, unloved and the real world companies like contractors
and niche plays tend to do better in ESOPs. But if you’re a high flying
tech company that’s going to sell for a multiple of sales or someone can
come buy you and take all your costs down and get rid of all your people.
In the real world they’re going to pay more. But by and large you get a
similar purchase price, plus you get all that interest for financing it and
all the tax savings, you end up better off.
And I know from experience, you and I have worked through a number of
mutual clients that have been just, you know, extremely pleased at the end
of the day with where they end up. Not only financially, but again, all of
those kind of a more emotional and softer issues, they remain there, the
employees are happy, they’re happy, all those types of things. But, let’s
talk about some of the difficulties with that. Some of the things that I’ve
seen folks run into, they’re not prepared for the level of say, financial
reporting or the fact that, hey, I was an owner and I just kind of
commingled my personal stuff in the business. Some of those issues have to
be kind of worked through, correct?
Yeah. We spend a fair amount of time with them up front, getting them to
understand that this isn’t your piggy bank anymore. That you’re going to
sell the company and you’re going to take… you get to pick what you could
earn going forward. And the rest of it, that income you’re going to sell to
the ESOP and that you’re not going to do the ESOP and then go get a boat,
and a plane, and a country club. But you’re going to do very well, you’re
going to get that whole purchase price, you’re going to keep getting your
salary and benefits and you’re going to get that additional interest or
other stuff. But no, that’s not your piggy bank and people, our clients,
seem to have gotten that because we also bring in legal and accounting and
you know folks like you that also understand that. And so when we get that
straight up front and then they have those people on an ongoing basis, we
really haven’t seen that. That’d be an issue. It’s where that hasn’t been
made clear up front and people are just trying to throw it together,
because maybe they’ll get some fees or something and they don’t explain all
that. That’s when you get the problems.
And oftentimes you file, and what we’ve see is, that the level of financial
reporting that then say the bank requires or the trustee requires, it
uncovers opportunities within the business. Things that, maybe they weren’t
thinking about or weren’t measuring very well. It really benefits everybody
at the end of the day.
Yeah, we have the whole gamut. We have people that already are getting
audits and they’re ready to go and there’s not much change at all. And then
we have people who are doing compilations. And you and I just worked on a
contractor, who needed to get their house in order. And I think it’ll help
them a lot because now they’ll have better quarterly numbers so they
actually know how they’re doing, versus you know, waiting until the end of
the year and, oh, that’s what we did.
Yeah, the owner always intuitively kind of knew, but now you’ve got to
share that information. Be transparent with everybody, right?
Yeah, and if that owner who really had a good feel for the business by
looking at maybe each job. When he leaves the next person may not have that
intuitive feel because he didn’t grow up in the business and you want to be
able to leave something that someone else can run.
Exactly right, and I think you bring up a great point. One of the things we
always struggle with and talking with clients about it is getting them to
understand that the knowledge transfer is one of the most important aspects
to this. And oftentimes that’s something that gets overlooked. Has that
been your experience, too?
Yeah, you really have to commit to that. So I’ll give you an example of
someone who did it right. A trucking company in town, they did,
warehousing, brokerage, trucking, LTO, list and load. And they had a
president who was the chief sales guy and they had a COO, CFO, and they
said, okay, we’re going to sell this and in the next three or five years
we’re going to train our replacement and be gone. The COO went out, found
his replacement, trained him for a year, just stick around for another two
years, working less, saw that it was working and left. The CEO that trained
his replacement for a year, and it didn’t work out so well, had to replace
Replace the replacement?
Yeah, and train that person for a year and it was looking great. So then he
went to two days a week, stayed on the board, and a that’s working out
pretty well and he’s still involved, but he’s also traveling and playing
golf and doing all that kind of stuff, and they company’s doing great.
Good! Talk to me about, say, post-transaction. What does it look like in
terms of responsibility you have? There’s now obviously a fiduciary
responsibility that is there that maybe wasn’t there before. There’s a
board correct? That’s typically formed.
Yeah, if someone doesn’t have a board already, you’re going to have either
usually a three or five person board. Often two or the three or three of
the five are the old sellers. And then you’ve got to have at least one
independent board member. Independent basically means they’re not a vendor.
And they’re usually picked by the sellers to give some independence because
they’re not a vendor and they’re going to run the company. And the trustee
is not always, but usually what’s called a directed trustee. They’re
directed by the board what to do and they’ll do it unless it’s somehow
going to violate a ERISA. Now they are obviously always independent with
regard to the value of the company. That they have to be because they’re
the ones saying that the value’s fair and determining that. But people
sometimes worry that the trustee’s going to be calling them every day-
Right, kind of in your face, right? What are you doing here?
Yeah! And what they find out when they looked into it is, and they’ve got a
hundred or 200 or 500 clients and ESOPs are incredibly popular. They’re
doing a lot of new ones and they’re taking care of the existing ones. They
just want to get the financials and everything’s all right. Now, if the
company is doing very badly for some reason, they’re going to ask, okay,
well what’s the plan to fix that? And if you’ve got a plan, there’s no
problem. Now, however, if you say, well, you know, we’re five years down
the road, I have all my money and I’m hanging out in Florida and they say,
what’s the plan? And you say, well, my plan is I’ll have another margarita.
Well, that’s a problem, and then you are going to hear from the trustee
cause they’re going to say, you know, we’ve got to fix that!
Yeah, or hope. I hope things get better! I tell my daughters that all the
time. Hope is not a strategy.
Yeah. But that’s really, really rare. If you look at the statistics,
leveraged buyouts, which is what an ESOP is, it’s a tax advantaged leverage
buyout, leverage buyouts fail about 19% of the time. But ESOPs fail about
one half of 1% of the time. And it’s not because it’s an ESOP. It’s because
Right, right. You and obviously your firm, you travel around the country
and are well known, obviously, in the world of ESOPs. What do you see in
terms of trends and things like that in the market place? Is financing
still pretty readily available? Lenders being aggressive that you see? Any
particular industries or anything like that you’re seeing?
Yeah, we see all industries. We tend to get a lot of contractors and a lot
of professional service firms, contractors because there’s not really a
logical buyer, and it’s hard sometimes for the knowledge transfer. Then
ESOPs really help with all. And then professional service, because if you
think about it, all you have is elevator assets. They walk out the door at
night, you want them to come back. And so a recruitment retention, all that
kind of stuff is better. So we do a ton of those, but we do manufacturing,
distributing, and set of distributors, et cetera. In terms of trends, the
values have been growing and they’ve sort of peaked right now. The tax law
change, by the way ESOPs are done, it’s obviously cash after taxes. So when
they lowered the taxes that raise values, you know, 15 20% and so that
And then the stock market and the economy and everything else. We are
starting to see people look at their projections. Because every time you do
an ESOP you’ll project out five years what you’re going to do and everyone
knows you don’t know what you’re going to do those five years. But give us
directionally what you’re going to do. And then they kind of look at that
and then project that out forever. And they say, okay, all that cashflow is
worth a number. Well, they’re starting to say, whereas before maybe we’d
agree that the next five years would be very nice growth. Maybe the
economy’s been gone a long time pretty good, and you know, seeing a little
bit of signs that maybe there’s some stuff out there. Maybe we’ll temper
that a little bit. We’ll still buy undergrowth, but maybe we’ll be a little
A little bit more conservative in terms of determining that future
Yeah, and you still get a great value. And then banks are doing something
similar, especially with contractors. Less so with maybe some other folks,
if you’re an all service business or you’re insulated against the economy,
they’re not… but for the cyclical businesses they’re starting to factor
in a little bit. Maybe we’ll lend a quarter less of a cash flow than we
But for the bank and everybody involved, if you’ve got an initial piece
that’s financed, that’s cash out to the owner and then there’s a seller
note for the remaining piece, that also leaves some flexibility, right? In
terms of what you do.
Oh yeah, absolutely! People are constantly worried, hey, am I strapping the
company? And what they find out is, when you take out all taxes, you’d be
shocked how much cash flow’s there. So normally what we see is there’s
about twice as much cash flow as you need when you do an ESOP, to pay the
bank and the seller and all that stuff. Because that’s the way we structure
them to have some really nice cushion. And so we rarely have companies
getting in any kind of trouble
And then they have the ability, obviously, maybe a couple of years in to
come back and perhaps do another round of that, or in fact, I know we’ve
got a client who has been literally an ESOP for 30 years and it’s long been
paid off, but now they’re going to recast that. You see those kinds of
things happening, too?
Yeah, on new ESOPs, because the owner wants to get paid the money, the
road, and because the company’s tax free, the bank debt gets paid down
incredibly quickly and then we’ll see banks since they got paid down
refinance every year or two to get the seller more money. And the seller,
normally will have the whole purchase price in four or five years.
Then they’ll have that extra interest in another year or two. So they get
it really quickly. And that’s why we almost never see management buyouts
work cause if you try to do it with after tax dollars, it doesn’t really
work out very well. And it takes 15 years or it takes a long time. Whereas
with the ESOP cause your tax free can pay back really quickly.
What about the increased value for the employees over time? You hope,
obviously, the business is successful and their individual share value
increases and then at some point they have to, maybe they retire at some
point and they want those shares repurchased. Do we typically run into
problems with that or is that kind of built into the modeling?
Yeah, ESOPs, the key are to do them right up front and to plan for all that
stuff. If you do that, we don’t have any problems, but people who don’t
plan for that, it is a problem. But there’s some built in safeguards. So,
for example, well, first of all, there’s good value of accretion,
appreciation, because even if the company doesn’t grow, if you think about
it, let’s say you sell your company for 10 million and you get a 10 million
of debt, you know, to the bank and to the seller. Well, every dollar of
debt you pay down is a dollar of equity. Well, and because now you’re not
paying taxes anymore, you’re paying that debt down pretty quickly. So even
as value, the company doesn’t grow, the equity value grows very quickly. So
there’s a lot for the employees. And because you’re not paying tax, there’s
also a lot more cash to buy back shares in the future.
But the built in safeguards are a couple. One, when employees get stuck,
they get stuck every year. That stock vest over six years. So if you do a
new deal, people aren’t going to invest for six years. They invest
partially, a 0% and then 20% then 40 60 80 a hundred, but you know, they’re
not fully vested until six years. And then if they leave, typically the
company can wait five years, and pay out over five years cause it’s
retirement. And then the employee can take that money and put it in an IRA
or 401k. But there’s some time built in there for the cash flow.
So they’ve got some runway in essence?
They’ve got some runway. And there’s some other safeguards we don’t need to
go into that also help out.
Well it sounds like it’s… I mean it’s something that any owner who’s
looking to, perhaps, think about that transition, or succession, or exit
over time, or liquidity event of some kind, it’s a great potential Avenue
for them to pursue.
Yeah. Just about all companies where it doesn’t work well, is again, you
don’t have management. The second thing is you get less cash at close if
people are looking to get most of their cash at close. That’s not an ESOP.
I mean, there’s ways we can do that with mezzanine and equity, but most
people don’t want to do that. So those are kind of the drawbacks, what you
gain though is you get rid of stuff that you get in third party sales, like
escrows and earn outs, all that stuff where, hey, we’re going to give you
money a close, but you got to earn it.
But not really.
Yeah, but the rest of it you got earn and maybe we’re not going to give it
to you and we’re going to fight you for it. You don’t have any of that
stuff and you get all that interest and all that other stuff we talked
about. So if people like that idea, and they’re the right age, then they
should think about it.
Something for business owners definitely to consider. So that’s awesome.
Well thank you Ted! If you want more tips and insight or to hear previous
episodes of unsuitable, visit www.reacpa.com/podcast. Thanks for listening,
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get your podcasts, including YouTube. I’m Doug Houser. Join us next week
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