Doug:
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. A few months ago, Ted Lape, a partner at Lazear Capital helped us gain a better understanding of employee stock ownership plans, ESOPs. Since then, ESOP's have generated even more interest within the business community. Which naturally means there are more questions to answer. So to provide additional clarity we've invited Ted back to tell us why ESOP's have continued to gain momentum. And to explain what's in it for the business owner who decides to go this route. Welcome back to unsuitable, Ted.
Ted:
Thanks a lot, Doug.
Doug:
ESOP's 2.0. So we're the new and improved version here today. Love it.
Ted:
Absolutely. I hope I can think of some new lines.
Doug:
I'm sure you will. There's so much knowledge to impart for business owners out there. Because I can tell you being out there, seeing dozens and dozens of businesses, so many of them. I mean it's, I wouldn't say it's quite half but darn near that ask when we talk about transition or succession planning. ESOPs come up. And we point them to our first podcast a couple of months back. So talk a little bit about the trends that you're seeing in the ESOP marketplace. They still continue to be quite active obviously.
Ted:
Yeah. We were surprised.. And I talked about this a little bit in the first one. But maybe we can go a little more depth.
Doug:
Yeah.
Ted:
We were surprised because as a firm our background is more in the mergers and acquisitions, originally. And we also had a specialty in distress. And nationally more people do M&A or some of our competitors sell to private equity, whatever. Rather than do ESOPs. And we assume that would be our practice. However, we really want owners to understand all their options. So when I joined the firm I kind of brought the ESOP expertise. And so we started telling owners about all their options. And then we would bring up ESOP. And the surprising thing was even when we would advise them to go sell to some competitor because there was a roll up going on. And they were going to pay big money. And isn't that exciting.
They were picking ESOP. Seven, eight, nine out of ten times. You know they were picking ESOP. And we initially thought it was all the and benefits of ESOP, that I talked a little bit about this. But to get into more detail as an investment bankers, sometimes you get caught up in the money and…
Doug:
Multiple and all that stuff, and.
Ted:
Yeah. And so with ESOP's you get a similar purchase price. Sometimes you get more. Or sometimes get a little less. But then you're financing some of that. So you get all this extra interest. And we can get into things called warrants. But you get more money over time. It just takes four, five, six years to get it.
Doug:
For the owner?
Ted:
For the owner. And you get a little bit less upfront. There's all the tax advantages. You can sell tax free. The company's tax free. You get to keep running. It's better for your employees. There's all that stuff.
Ted:
And we thought, well that's why they must be doing it.
Doug:
Sure. Makes sense.
Ted:
You know, it's all about the dollars and some of the other stuff. And finally we were smart enough to go back and actually ask the owners, hey, we thought you were going to sell to a competitor. Why'd you do this? And in what we heard was we kept hearing the word significance and relevance. And being able to put your head on the pillow.
They talked about seeing their friends that went... At the club. The first three months were pretty great. They're having a lot of drinks. They're playing golf. They're loving life.
Doug:
Did the bucket list.
Ted:
For the bucket list. Yeah. Traveled. The next few months were pretty darn good. The next few months are okay. And then they were starting to get bored. The Exit Planning Institute did this study where they talked to thousands of clients. And 75 percent profoundly regretted selling after a year.
Doug:
Yeah. That's amazing.
Ted:
And we haven't seen any of that in ESOP's.
Doug:
Because they can still be involved obviously in the culture and the legacy remain and all those good things.
Ted:
Well and the other thing is, the other thing they found out... Because they get into the psychology of all this is. Baby boomers, especially, and I'm right on the cusp of baby boomers. So I get this. Get a lot of their identities, especially men, from their role in the business. It's a community.
Doug:
Yeah. That's their identity. Right.
Ted:
That's their identity. And a lot of what they do is with the customers and the vendors. And the employees. And all that kind of stuff. And when you disconnect that people underestimate how much that affects their lives. They tend to focus a lot on, hey, am I going to get enough money out of this to live the rest of my life? But in what's the number I'm getting? But they don't really think about, well what am I going to do after I actually do this? And they think it'll be great to go again, play golf or hang out on a mile and or something. And then they find out pretty quickly that's getting old.
Doug:
You can only do that so long. But I totally agree with you to the having now been around 30 years and seeing the transitions and successions of all different kinds. The ones that haven't worked aren't due to financial reasons. It's due to the owner exiting that business. And then not having that relevance anymore. And I think we, at the end day, were people. We're all people. And you want to have some type of human connection and relevance. And all that. And ESOP is a way to monetize your investment. It's always the biggest investment for closely held business owner. Right. And then they can still be involved, be relevant.
Ted:
And usually they've made promises to the employees. Maybe not to all the employees. But certainly to the key employees. If I ever sell, they could [inaudible 00:06:54]. Or they got them to join the company because they were going to build something. And then all of a sudden they sell. And they feel like they're letting those people down.
With an ESOP, there's special incentives for the key people on top of what they get through the ESOP. And the owner stays involved. There's not that culture change where maybe they want to leave. So they get to see the company continue to grow. They get to see the people. You know, all the employees. But especially the key people do really well. And they feel like... That's where he heard that other phrase. I can put my head on the pillow at night because I did what I told people I was going to do.
Doug:
Yeah. Now how long... Here's, here's one of the interesting things to me. That you go through the ESOP transaction. And you kind of explain it to the employee base. The owners obviously been involved as soon as you go through and structure put in place. How long, in your experience, does it take for the employees to sort of buy in or get it, so to speak? Where they sort of see that mentality like, oh, I'm an owner. And this is a good thing. How long does that take?
Ted:
So, there's different answers for different companies. I'd say you have to think about sort of white collar professional service firms versus blue collar construction. Or other kinds of firms. You also have to think about how well the company communicates that there is an ESOP. It's a benefit and it's a good thing.
So what we found is in white collar professional service firms that people get it pretty quickly. I think the statistics are on average about a four percent productivity increase the first year. And we had clients that did it incredibly well run. I mean one of the most productive companies going into ESOP industry. And they see that four percent increase the first year. They also had some millennials that were being recruited by a big fortune 500 company you'd know.
Doug:
A competitor in essence, right?
Ted:
Yeah. Well actually not really a competitor. But they did IT stuff. And one of the big fortune 500s needed IT. And the millennial was going to leave. And they said, but they stayed because of the ESOP.
On the blue collar side, we find it takes more like two years now. Now the key people get it pretty quickly. But the rank and file... You usually bring in a communication firm. You'd tell them they think it's probably a good thing. One out of a hundred or a thousand. They try to figure out how you're taking advantage of them. But they think it's a good thing. They Google it, but they kind of forget about it.
And then you get your first statement. And there's always a decent balance there because the value of the company had closed. If you do 100 percent ESOP's basically zero because there's debt to the owner or bank equal to the value. And well now you're tax free and you pay down that debt and it creates equity. Just like if you had a home that was fully mortgaged and you pay on the mortgage, that creates equity.
So there's value pretty quickly. And they start to see that in the first year. And they go, okay, well there's some stuff there. Through that second year and now they have twice as much stock, and the stock price has gone up more. So you see kind of a nice upward... A really nice upward trend where they start to get it.
So to give you an example from a mutual client of ours. The contractor... They are really busy right now. There's lot of contractors are. And they had over 500 thousand of overtime the second year. Well they get into the third year and he budgeted over 500 thousand of overtime. And they were cranking pretty similar. Well he told me he was shocked. They didn't have any overtime. The employees really kind of got it. And you see a lot of stories like that.
I'll tell you one other one because stories are fun. A company where the best sales guy was always complaining. You know, I'm always on the road. It's so hard. It's so hard. You know, I need to say in the best hotels. I really need fly first class. Because... Well it's hard. I'm traveling so much. Well they did the ESOP. And the next thing you know the guy's driving rental with cars. And stay at a motel eight. And so you hear a lot of stories like that.
Doug:
That's funny. Yeah. But there truly is, to your point though and statistic back this up, there truly are efficiency and operational gains that you typically see.
Ted:
Oh yeah. Yeah. I mean if you actually communicate it and embrace it. If you purely do it for the tax purposes and don't tell anyone that really exists then you're not going to get much. But statistics would show you that, yeah, you do get a fair amount.
Doug:
So the key is to be holistic about it. And really embrace it as a part of your culture then as a company. And not look at it strictly like a financial play. Which, obviously, there are benefits along those lines too. So talk a little bit from the owner's perspective. What are, obviously beyond the tax benefits... You may be able to reinvest the proceeds. And do some things that are tax advantaged. And gain some interest. Can you talk a little bit about some of those things?
Ted:
Yeah. So if you're an owner you can sell tax free. It's tax deferred but it becomes tax free. Now how you do that takes some explaining. It's sort of like a 1031 real estate exchange. I don't want to get into all the ins and outs of how you do it.
Doug:
It's qualified replacement property, correct?
Ted:
Yeah. So when you sell your stock, and 1031 real estate exchange, you sell your building. And you might have to buy another one. And you can roll over the gain. And this, if you sell your stock, you can buy either stocks, bonds of U.S. companies and roll over your proceeds. And then you're able to borrow against that to get liquidity. But essentially at the end of the day you end up not paying any tax.
And then the other thing is most people end up as a hundred percent S-corp ESOP. And as an S-corp it's a flow through [inaudible 00:13:53]. And if the owners ESOP trusts you don't pay any taxes. So the owner gets paid a lot... Pretty quickly. If you just... A lot of people say, well, I'll sell to my employees. And they started looking at all sorts of tricky stuff. But yeah, usually it takes 12, 15 years plus.
Doug:
Employees typically don't have a lot liquidity and if they can... And it's all on a note back to the owner.
Ted:
Oh no. Yeah. They don't have any liquidity. They don't want to sign a personal guarantee on a bank loan. So it takes a very long time because you're using an after tax proceeds. With an ESOP they can typically get all their money in five or six years. And that includes not only the purchase price but a lot of interests. So if you sold for 20 million, you might get an extra 6 million of interest. And so that's an advantage.
The other thing is there are some good estate planning things you can do. So again, if you sell for 20 million. You can get an extra, say 6 million in interest. You can choose something in replacement of interest called a warrant. And basically the way it works is six, seven, eight years out, you could get 10 to 20 percent of the value of the company. Well, that's an instrument at close it's not worth much. So you can give that to your children and then it grows to be worth millions of dollars. And when you gift it, it doesn't use that much of your exclusion or your lifetime ability to give stuff to your kids. And right now that exclusion is pretty big. But in 2025 that's going to go down a lot. And there's a lot of legislation that may happen to get it even lower.
Doug:
As those provisions sunset under the new tax act that was passed a couple of years ago.
Ted:
Yeah. But you know, all of the... And this isn't a political comment though. All the democratic candidates want to get that pretty low. So that could change.
Doug:
Yeah. You never know. So there's a lot to explore from the owner's perspective that can be advantageous depending on what their goals are. Right. So. the idea is to make sure you understand what their goals are in the transaction.
Ted:
In the transaction. Yeah. And there's also a another tax advantage that we've taken years to develop that they get before the closing. The doesn't cost him anything. That can be millions of dollars. So it's, there's a lot of stuff on the taxes and the proceeds and all that kind of stuff. Aside from all that stuff we talked about earlier with the significance and relevance and all that.
Doug:
And because if it's structured the right way and done the right way, the company itself is now owned by a retirement plan. Right. So then they can be exempt from taxes as you said. Which benefits the company because then excess cash flow can be either reinvested in the company, pay down that debt, whatever the case might be. Right. Going outside.
Ted:
Yeah. That's exactly right. And I think there's that. And then the other thing that people sometimes get wrong is they think, well now the employers are going to run the company. You know, we'll be voting on what to have for lunch and whether they hire someone. Now you can do that if you want. There actually was a company that set that up and they would vote on what that for lunch. And that didn't work very well. But normally the way it works is the board controls the company. And the seller has a say and who's on the board. So usually is the same people that are running it before the closing are the one's running it afterwards.
Doug:
So talk a little bit, because that's one of the concerns we hear. People are like, oh, now I'm going to have this board. And I think that gets overplayed a little bit. So who's on the board? What is it do? And its purpose, obviously, is to look out for the best interest of the employees. Correct?
Ted:
That's exactly right there. The board... And then there's the trustees, a fiduciary. To make sure that the nothing... The employees are not taken advantage of. But the board is typically three or five people. They can be more. And of the three normally it'll be the seller, one other person from the company that they trust and add value. And then they'll pick a independent person. Independent being they haven't been paying the last year or two as a vendor. You know, for anything that might be a conflict of interest. Or stuff like that. But also someone that can add value.
Doug:
So one outsider? Or maybe you know somebody who's got experience?
Ted:
Yeah. And someone the owner knows and trusts in like in terms of can add value. Or it could be a five person board with two independents, something like that.
Doug:
Yeah. And so how often then does that board typically meet? Like a quarterly type of thing?
Ted:
Yeah. It can be quarterly, semi-annually. It depends on what their attorney and their trustee sort of advising. The trustee is not on the board. The trustee doesn't come to board meetings typically. Sometimes they'll listen in.
Doug:
But they're not there to run the company on a day to day basis?
Ted:
No.
Doug:
And my experience with them is they're not very intrusive, obviously, into the operational business.
Ted:
The thing they really spent a lot of time on is the purchase price fair. And there's an annual evaluation is that right? And is anyone doing anything they shouldn't be doing. But in terms of hiring and firing and opening an office. And all that kind of stuff. They don't get very involved. If you're going to buy a big company. You want to sell the company, things like that. You've got to go to them and say, well, here's the reason why I want to do this. But for the most part they're not very intrusive at all.
Doug:
Maybe present an annual budget and kind of run that by them? That type of thing.
Ted:
Yeah. You'll send them quarterly financials. But yeah, you're not going to hear much from him. Now it's your company's having a lot of trouble you just got to tell him what the plan is.
Doug:
Speaking of that, obviously, we went through a, obviously, financial crisis 10, 11 years ago. But I'm always interested to hear this. And I think there's a statistic about failures in terms of transactions and things like that. If I recall correctly, ESOPs are very, very low down the list in terms of business failures, right?
Ted:
Yeah. The last statistic I heard, and this is dated by a few years, was 19 percent of LPOs fail. Leveraged buyouts.
Doug:
Leverage buyouts.
Ted:
About one half of one percent of ESOPs fail. Because an ESOP is a leverage buyout. It's just tax advantaged one. And I think that's because the employees are engaged. The debts friendly debt. It's the seller debt. And most people that do ESOPs do them for the right reasons. They're good companies. Do them for right reason. And so they're not doing anything crazy.
Doug:
Right. Then the culture stays and all those types of things. It doesn't change, tear away much in terms of... You've now sold to private equity or something. And then the cultures totally different kind of thing. Which we see a lot. So talk a little bit about what you see in terms of like multiples and financing environment. Is that still pretty robust out there in terms of getting these transactions done?
Ted:
Yeah. In both the real world and the ESOP world they're very good. When they did the last tax law change... All ESOPs are valued as if you're a C-corp. Whether you're an S-crop, C-corp, whatever LLC. And they lowered the taxes from 35 to 21 percent. That 14 percent reduction created 20, 22 percent, whatever it is, more cash flow. Well all ESOPs went up in value 15, 20 percent now. If you've got a couple valuation guys on here, I'm sure they'd argue, you know what that number is. But it went up. And you're getting really nice valuations. And you saw some of that in the real world as well. But ESOPs are valued a little bit more on discount and cash flow. Or off the projections. And a little less off of what other people sold for. But you'd definitely look at that. And so we're seeing great valuations.
Doug:
And the banks are still obviously willing to finance them, and all that.
Ted:
Yeah. I think the banks, what we've seen is, banks are really, really getting into lending the ESOPs. Because banks aren't growing that much on their commercial lending portfolios. And what they've sort of figured out is there's not a lot of stuff going on they can finance. Other than maybe for their existing clients to go get equipment or whatever. And that this is a way to manufacture loans and keep all the relationship. Rather than the company selling and they lose the whole thing. And the fact that they're tax free means that the cash. flow coverage is really high.
Doug:
They can recapture some of that. Accelerate it.
Ted:
Yeah. They have to get... A couple people had some ideas that weren't accurate about ESOPs. Or they were looking at things, I think, the wrong way. And we've seen unbelievable changes where all of a sudden they sort of started understand it. And changed how they looked at them. And now they're getting pretty aggressive in a good way. Not a crazy way.
Doug:
Well, and again, their benefit from if I'm underwriting that risk from the bank or whoever, the management stays static. So you're comfortable with how the company operates and who's running it. It's not like, oh my gosh, what are these folks going to do when they come in to run it?
Ted:
Yeah. And it's, your lending is similar model pole that you'd lend to someone else. And there's no longer any taxes. Well, the cash flow is unbelievable.
Doug:
It's great. So one of the questions I would like to ask, how far in advance should somebody, if they're thinking about succession or transition. Is it a couple of years out? I mean, we always like to say let's start the conversation two years out. Is that accurate for an ESOP as well?
Ted:
Yeah. So you have to sort of start with the end in mind. So people say, I want to be out in five years or seven years. Or three years. Or whatever it is. If you're going to sell to a competitor then you can probably wait until you get a little closer to when you want to leave. Although they're going to want you to be there for a year or two to kind of transition stuff. If you're going to do an ESOP since it takes five or six years to get all your money plus your interest. People normally want to be there for most of that. So that means that you want to sell five or six years before you're going to leave. And that you also are going to transition to someone. So have you trained that person? You have to find them and all that kind of stuff.
And if you're going to sell five or six years before that. While you want to start thinking about it a couple of years before that. So that means that you can be thinking about it pretty far ahead. And to quote the Exit Planning Institute, they did all these studies where 50 percent of business owners want to sell the next three to five years. 75 percent in the next 10 years. That means there's a whole lot of business owners out there that, given that lead time, should probably at least be thinking about whether or not an ESOP's a good option.
Doug:
Yeah. Start the dialogue. At least explore and sit down with the right professionals. And try to understand what's involved. So, that's great insight. Well, thank you Ted. 2.0 has been as good or better then a 1.0. So we'll have to keep that trend going. And appreciate that insight. It's very valuable. And I know our business owner listeners will love it.
So if you want to hear more business tips and insight. Or to hear previous episodes of unsuitable visit our podcast page at www.reacpa.com/podcasts. Thanks for listening to this week's show. 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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