Episode 205: What Is An ESOP & How Does It Work? – Rea CPA

Episode 205: What Is An ESOP & How Does It Work?

Ted Lape, partner with Lazear Capital Partners, is heavily involved in ESOP formations and has helped numerous companies determine the right answer for their succession and liquidity needs. Listen to learn more about ESOPs, including what they are and what they aren’t.

What Is An ESOP?

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. 

Ted Lape, a partner with Lazear Capital Partners, joins unsuitable to teach us more about the latter – getting your employees involved. He explains what an Employee Stock Ownership Plan (ESOP) is, what it isn’t, the benefits of starting your own, potential pitfalls, best practices, and more.

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:

  • When it makes sense to enter an ESOP — and when it doesn’t.
  • How ESOPs benefit employees.
  • Potential pitfalls and best practices associated with starting an ESOP.

watch the video

read the transcript

Doug Houser: 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.

Ted Lape: Hi, Doug. Great to be here.

Doug: 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?

Ted: 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.

Doug: 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.

Ted: 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 exists.

Doug: 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?

Ted: 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.

Ted: 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 first prerequisite.

Doug: 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?

Ted: 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.

Doug: 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?

Ted: 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.

Ted: 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 did so.

Ted: 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 their-

Doug: They’re emotionally attached, right?

Ted: 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.

Doug: You can only play so much golf!

Ted: 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 timing.

Doug: Yeah. Now you talked a little bit obviously about the financial part, the tax savings, and that can be significant. Correct?

Ted: Mm-hmm

Doug: If I do it a hundred percent sale to an ESOP, what does that mean? Big picture terms in terms of the cost savings?

Ted: 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.

Doug: Which is obviously a great benefit for-

Ted: Yeah, so you can pay the owner back quicker and that’s a big benefit.

Doug: 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?

Ted: 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.

Doug: 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.

Ted: 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.

Doug: 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?

Ted: 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.

Doug: 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.

Ted: 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.

Doug: Yeah, the owner always intuitively kind of knew, but now you’ve got to share that information. Be transparent with everybody, right?

Ted: 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.

Doug: 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?

Ted: 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 the replacement.

Doug: Replace the replacement?

Ted: 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.

Doug: 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.

Ted: 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-

Doug: Right, kind of in your face, right? What are you doing here?

Ted: 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!

Doug: Yeah, or hope. I hope things get better! I tell my daughters that all the time. Hope is not a strategy.

Ted: 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 companies fail.

Doug: 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?

Ted: 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 helped.

Ted: 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 bit…

Doug: A little bit more conservative in terms of determining that future cashflow, basically?

Ted: 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 would have.

Doug: 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.

Ted: 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

Doug: 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?

Ted: 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.

Ted: 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.

Doug: 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?

Ted: 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.

Ted: 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.

Doug: So they’ve got some runway in essence?

Ted: They’ve got some runway. And there’s some other safeguards we don’t need to go into that also help out.

Doug: 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.

Ted: 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.

Doug: But not really.

Ted: 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.

Doug: 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, you can subscribe to unsuitable on iTunes or wherever you like to get your podcasts, including YouTube. I’m Doug Houser. Join us next week for another unsuitable interview from an industry professional.

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