Doug Houser:
From Rea & Associates Studio, this is Unsuitable, a management and 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. On this weekly podcast, thought leaders and business professionals break down complicated and mundane topics, and give you the tips and insight you actually need to grow your business.
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Employee stock ownership plans continue to grow in popularity. Today, more and more owners are considering ESOPs as their ideal succession strategy. They realize that it is a great way to empower their team and promote continued business growth long after they retire. Today on Unsuitable, we're going to answer the big question business owners are asking concerning ESOPs, what's in it for me? And to help us answer this question, we have ESOP expert Ted Lape back with us again to dig into this topic. Welcome back to Unsuitable, Ted.
Ted Lape:
Thanks a lot, Doug. It's great to be back.
Doug:
Great to have you on as always because this is just such, obviously, an important topic, and certainly very topical, as it were, because so many business owners, as we've seen as, as the Boomers age and all of that, they're ready to get out, right? And starting to think about various forms of how do I exit my business? What's the right way? What should I be thinking about? So from a big picture perspective, what are some of the most common ways that you see ownership transitions take place for closely held businesses?
Ted:
Yeah. Well obviously I think the ones people know the most are you sell to your competitor, you sell to private equity, you do an ESOP, or you try to somehow transition to your management team. And then of course the final one is somehow within the family. Transitioning to the management team always sounds good until they kind of get into it. And what they find out is typically the management team has no money. And you try to do it with post-tax dollars, it takes 15 years, and they say, "Well, I don't want to do that." And that's, a lot of times, when they'll come to us to talk about an ESOP because with all the tax advantages, they end up getting a lot more. The key management does really well, and the tax benefits really help make it happen. So we'll look at, hey, is a sale to a third party better, is an ESOP better, is doing nothing better? Sometimes doing nothing's better because you got to go fix some stuff. We kind of look at all that stuff and help them think through it.
Doug:
Yeah. And we've got obviously companies that it seems like are selling at a record pace. Whether it's people that went through the Great Recession and now COVID, and it's like, hey, I want an exit ramp, right? So really taxes, I mean, when you think about it, and we've got potential for capital gains tax increases, who knows what's coming, taxes are a big driver for ultimately what can be the best decision here, right?
Ted:
Yeah. Last year was a record year for us. And this year we're probably going to double revenue. And a lot of that is tax driven. It's sort of two things coming together. One, you mentioned that people have lived through some stuff. So there was 9/11. Most of them have lived through 9/11, the '08, '09 Great Recession, and now COVID. And when you said, hey, I'm ready to get off the exit ramp, we're hearing that a lot. And then you combine that with that whole silver tsunami, the amount of people over 65, or Baby Boomers. 50% of owners want to sell the next five years, according to all sorts of studies. 75%, the next 10 years. So you've got demographics, you've got, hey, we've been through these three horrible things, and now you throw on the taxes.
So on the tax side, I know you know this better than anyone, but President Biden has proposed almost really doubling capital gains. Taking ordinary income way, way up, reducing the exclusions for what you would give your kids. All that stuff means ESOPs were more popular because, as you know, with an ESOP, you can sell tax-free, the company becomes tax-free, and there's some things you can do that help with the transition for generations. And so when you go to an owner, and you say, "Hey, all that stuff everyone's worried about, you don't have to worry about," they get pretty excited.
Doug:
It's pretty attractive.
Ted:
The other thing that's happening is a lot of people are rushing to try to sell their company by year end. And one thing I didn't think about until we... We also do M&A. We're doing a really large deal right now. But, in talking to a bunch of professionals, they said, "Hey, here's what's going to happen. The buyers all know these deals have to happen by year end. So right around November, all of a sudden, the buyer's going to start changing the deal on the sellers because they know, what are they going to do? They're going to go-
Doug:
They have all the leverage at that point, right?
Ted:
Yeah. Like, hey, am I going to go find another buyer? And we think we'll get a flood of deals then. Because a lot of stuff we get is a broken M&A deals. That's maybe a quarter of what we do. Because whatever happened that they didn't like in the M&A process, a mean buyer, people re-trading, bad for their people, bad for key... Whatever it was, usually the ESOP is a lot better.
Doug:
And yeah, beyond we'll get into some of the tax advantages here in a bit, but I think to me the best thing about ESOPs are it's the culture and the team and the legacy that remains in place. I mean, I can't tell you, even the last couple of years, how many deals I've seen that have been third party sales, private equity deals where, I mean, within six months, half the management team's gone because they can't stand the culture and what's going on. So talk a little bit about that with an ESOP, the consistency that you see.
Ted:
Yeah. No, you're right. Those same studies where they surveyed thousands of sellers found that 75% of people profoundly regretted selling within a year.
Doug:
Wow.
Ted:
And with an ESOP, you don't have that because nothing changes. Usually the seller continues to run the company, and controls the day to day hiring, firing, buying equipment, opening offices, all that kind of stuff. The trustee's really more involved in just what's the fair value of the deal, and not really involved in running of the company. So because none of that stuff changes, the culture doesn't change, the people are more excited. I mean, the culture changes because the people are more engaged. A lot of third party peer reviewed studies show that you have 4 to 5% productivity increases. We've seen tremendous gains where all of a sudden overtime goes down, and productivity goes up, turnover goes down, engagement goes up, and people, it's just more fun.
Doug:
Yeah. We've definitely seen that with our clients that have done them. I would say it's typically 12 to 18 months in before it seems like... Is that your experience where the employees really start to click with that?
Ted:
Yeah. I sort of bifurcate it. The white collar office type employees get it quickly, and it happens pretty quick. Studies show you get about a 4 to 5% increase in productivity of the first year for those people. The more blue collar employees, a lot of times are kind of skeptical the first year or two. And really with them, I almost see it more after the second year. So they get that first statement, and they say, oh, well maybe something's here, but I still don't get it. And they get the second statement, and they've got twice as much stock and the price has gone up both years. And now, oh hey, maybe this thing's real. So I almost bifurcate it white collar versus blue collar.
Doug:
Yeah. Interesting. So let's talk about what can be one of the real advantages, and that is the tax play that you have with an ESOP. So give us an overview of some of the advantages there and some of the strategies, at least from a high level that you're seeing.
Ted:
Yeah. So obviously the ones that people talk about the most is the owner can sell tax-free. The company becomes tax-free. There's additional sort of pre-closing deductions. Those are kind of the big ones that most people kind of look at. When the employees get their money, that's also tax deferred because it's a retirement plan. So those are the big ones.
Why is the company tax free? Let's start with that. That's the easiest. Normally when you do an ESOP, you make it an S corporation, whether you're currently an LLC or a C Corp, or whatever-
Doug:
Right.
Ted:
... [crosstalk 00:10:12] S corp. And there's math reasons why selling 100% usually is the best answer. Now you can sell any percentage you want, but often the 100%'s the best answer. And if you do that, you're 100% owned by a retirement plan, like a 401(k). An ESOP's basically a 401(k) with your stock instead of IBM or Apple, or whatever.
So if you're owned by a retirement plan, you don't pay federal or state tax in almost all states. You don't pay federal tax anywhere. And now you've got a tax-free company. Well, think about if the company's tax free and you're not paying 40, 50% tax, whatever, you got a lot of money to pay back the owner to invest in equipment, money for management, and for the employees. And that's a lot more money. So that's very, very powerful.
And then the ability for the owner to sell tax-free. Well, at current tax rates, it's attractive, it's great. But you don't necessarily need to take advantage of it because you still do pretty well. Well, where taxes are headed, people are very, very concerned. And all of a sudden I'm getting calls, I haven't talked to people in years, they're like, "Tell me about that again. How does that work?"
Doug:
Yeah. Exactly.
Ted:
So all of a sudden, I'm a lot of people's best friend. So that's really good. And then there's just some other, sort of like the Ginsu knife, but wait, there's more. There's other tax advantages that can be millions of dollars that are on top of all that.
Doug:
Yeah. And it's so important to about, whether or not you believe, okay, capital gains rates probably aren't certainly going to double, but they are likely to increase significantly. And the other thing, the big one that I think maybe isn't quite getting as much play, but certainly we're paying a lot of attention to and is very important, and that is the lower lifetime exclusion from the estate tax. That's going to sunset anyway under the current law, and that's going to have a massive impact, right?
Ted:
Yes. Yeah. So one of the things we've done, brief commercial for us, is we've really invested in, we've got five accountants, five attorneys, we've got all these people. And you're right. So it's currently 11 and a half million per person, or 11.7-
Doug:
Yeah. It's, yeah, index for inflation. Yeah.
Ted:
... that people can give. And that's going to go down, I think, to five million. You can tell me at the end of '25. President Biden would like to take that to three and a half million each. Well, if you're selling your company, you sell for 20 million, and then you take that money and you invest it at 10%, or call it 8%, every nine years that doubles. Well, you're going to end up with a lot of money. And if you can only exclude seven million per kid... And I say only. Most people listening to the podcast will say, "Well, that's a lot of money." But if you're selling your company for 20, 50, 100 million, and then you get that and invest it, that's a lot of money. And all the money above what you can give gets taxed to 40%. Well, we have strategies to greatly reduce that, and to transition it to other generations through these to avoid that 40% tax, or at least a lot of it.
Doug:
Yeah. It's so important. And we're having a lot more of those estate planning type of conversations with our clients probably than we have in several years due to the proposed changes, and certainly the sunsetting of that massive exemption. And if you think about it, it doesn't take much. If your business does EBITDA of, let's say, three or four million, well all of a sudden you're looking at maybe a 15 to $20 million type transaction so it's not... People, as you say, it sounds like it's a lot, but it's not. Your business doesn't have to be that big really.
Ted:
No, it really doesn't. And you get into all sorts of issues. And the other thing is a lot of these entrepreneurs, their entire net worth is tied up in the company. They're not thinking about this. It seems kind of crazy to them that they would have enough money they'd have to worry about it. Well when you sell your company, all of a sudden you got money you never had before, and these things become a real thing. And so getting ahead of that is important.
Doug:
Yeah. Now, what have you seen in terms of say the impact of PPP loans and that with deals that are in process, that type of thing? Is that impacting anything?
Ted:
That's a great question. So when you sell your company, whether it's to an ESOP or a third party or whatever, hopefully you've gotten your PPP loan forgiven. If you haven't, you have to escrow it. So what that means is you got a million dollars, and your PPP loan's not forgiven. You go to sell for 20 million. Well, you can't just take all the money. You've got to leave a million dollars escrowed with the bank that did the loan until it does get forgiven. And then sometimes people will get into reps and warranties around that that are, for some reason, it's unforgiven later or whatever, you got to back that money. But that's sort of esoteric. The main thing is you got to escrow it. So getting ahead of that and putting in the paperwork to get it forgiven is a good thing.
Doug:
Is key.
Ted:
So you don't have to deal with all that.
Doug:
But it gets to kind of a bigger issue too. When you look at the last couple of years, how do you sort of normalize what a company really is? Because we've had so many, all these variables thrown at us.
Ted:
Yeah. Oh, and one other thing before we get into that, because that's a great point, if you're with one bank and you're doing the PPP loan, and then you do a transaction and you're going to another bank, that can create some issues that we've had to work through.
Doug:
Yeah. Good point.
Ted:
But in terms of, your right, normalizing, we've had a lot of that because we do a lot of contractors. We do everything. We do manufacturers, distribute, we do all of them. The contractors are about a third of what we do. They're about half of what we did last year. And there's supply chain issues, and there's all sorts of stuff going on.
So when you're doing the ESOP, or if you're just selling to a third party, we have that in our third party sales too, there's all these COVID add backs. Like had it not been for COVID, I wouldn't have had these delays in construction. We're doing them auto parts manufacturer right now. And Honda shut down. So you have all these add backs. So a lot of times what's happening is people are going back to 2019 and saying, well, what'd you do then? And they're sort of basing it off of 2019.
We've been pretty successful about not getting into things like, okay, well, we're going to do that, but we've got some uncertainty around the future because you did have this weird 2020 and 2021. So we're going to look for clawbacks or earn-outs meaning, yeah, we'll give you $50 million, but 10 of that is contention. If you don't hit your numbers, we're going to take away 10 million. Or we're going to give you 40, but if you hit whatever numbers, you get 50. We've been pretty good about not getting into a whole lot of that.
But sometimes you have to because it was so disruptive in 2020, and maybe part of '21, that people are saying, "Hey, I just don't know that you can do that until two or three years down the road." And people are like, "Well, I don't want to wait two or three years so I'm going to get myself in the same position that I would have been if I waited just by doing the earn-out or the clawback because my total value will be based on what I do in the future. And that's what I would have gotten anyway." So occasionally we do get into that where if people really want to do it now, but they want to get value for what they know is going to happen in the future. We get into some of that stuff where they will get that extra value in the future. But we prefer to keep it simple if we can.
Doug:
Yeah. We certainly were dealing with some of that with quality of earnings things that we're looking at. How do you really normalize for that? I'm not sure what the new normal is anymore, that's for sure.
Ted:
Well, yeah. And a lot of our clients are having record years.
Doug:
We're seeing that certainly in construction in many cases. But you talked a little bit about upside too. Now there's ways for, even though a company might sell 100% to an ESOP, there's still ways for the owner, the existing owner, to get some future upside there, isn't there? You guys have a couple of strategies that may work along those lines.
Ted:
Oh, absolutely. Yeah. So a lot of times an owner says, gee, I want to work another five or six years, and I'm going to get paid through the ESOP. Usually you get your purchase price in four years, and then you get a whole bunch of... You don't get all your money at close. So you get about a 12% return on the money you didn't get. So you get all this extra money. Well, you can take that in the form of interest, but that doesn't give any upside if you do better down the road.
So a lot of people, and we're doing a ESOPs, believe it or not, more and more with younger people who want it culturally. And they're like, "Hey, I'm going to be around a while. I want that second bite of the apple, third bite of the apple." So what we'll do is if we're not getting into earn-outs and all that is, instead of interest on the amount they didn't get at close, look at something called a warrant.
And all a warrant is is, hey, after I get all my money paid back, I want a return. I'm especially swapping out my interest and taking a percentage of the value in the future. So they'll get paid back in four or five years all their money. And then a year or two later, they'll get an amount equal to 15, 20% of the value of the company. And the reason that works out well is, yeah, they're taking a little bit of risk that the company is going to do well, but if it does at least as well as they projected, they'll end up getting more money because they get to hold that longer. But it also gets capital gains treatment instead of ordinary income. And that's a much better tax treatment.
But the other cool thing you can do with that is this money I'm supposed to get in the future, this financial instrument, well when I close my deal, it's not worth much. So I can gift that to my kids or put it in trust or whatever, and not use up that exclusion we were talking about earlier. And then it grows to be worth millions of dollars. And I got it out of my estate. I don't have to pay that 40% tax. It grows. Well, that's awesome.
Doug:
Yeah, absolutely. Yeah. When you think about it through all of that, it's a great way to really plan for your future, your family's future. And I think again, as we talked about initially, the coolest part is the legacy, and then the buy-in that you get from the employees. Everybody's so proud to feel like they're a part of the company. And it's tremendous because the company, its identity doesn't go away. That's just so important.
Ted:
Yeah. Culturally, it's wonderful. And the other thing is, I'm sure some wealth management person out there will correct this, but the last statistic I saw was I think the average person retires with like $51,000. Well, with these ESOPs, it's hundreds of thousands. We've got ones that are millions. I mean, you really do change lives.
Doug:
Yeah. Yeah. Your employees can really benefit.
Ted:
We just did one in a small town where they're the biggest employer. And there's a lot of people that are going to be getting hundreds of thousands to over a million in this small town that hasn't been doing great. And it's really going to change a whole lot of lives in that town.
Doug:
That is awesome. I mean, I think that's fantastic. Now we should talk a little bit about there are some additional requirements with an ESOP. You mentioned that the trustee, you are owned by a retirement plan. So the Department of Labor has oversight over that, correct? So talk a little bit about some of those requirements if you could.
Ted:
Yeah. So when we're doing an ESOP, we think a lot about process. The Department of Labor likes to see a certain process and a certain documentation. And so we make sure that we do all that stuff that they want. Now, the owner doesn't have to worry about that. We kind of do that. And then the attorneys are also there. So we make sure that we have a nice process. And we're very fortunate. We've never had any company have any problem with the Department of Labor. And that's an important thing to find out if you're looking at an ESOP, the people you're dealing with. So you got to do that stuff right.
The biggest thing they probably look at is, was it a fair value? Because we do the book, just like if we're selling you to a third party. The data room, all that stuff, to justify it. We can get a nice, fair and full value. But you don't want to be getting crazy values. And sometimes people get a little tricky, and there's some folks out in New York and other places that want to, all of a sudden, trick it up and have triple back flip kind of things going on. The Department of Labor doesn't like that. So we want to take advantage of everything that you should take advantage of, and do some sophisticated planning without getting too tricky where you get in trouble. Though if you do things right, that's not a real issue.
And then going forward, you have a third party administrator who kind of handles a lot of that stuff that you got to think about. They'll file the Form 5500 and do discrimination testing. And they'll look out in the future, and say, "Hey, you got to buy the stock back way down the road, let's make sure we got enough money for that." So you have people that help you think about all that stuff. So getting that right team is an important thing. But if you do all that stuff, it's not a real big issue.
Doug:
Yeah. And we see that in our markets as well. There's other CPA firms, for example, that maybe aren't as comfortable with all the accounting. It certainly becomes more sophisticated. It's a little more challenging. But we love them for our clients. But I know, again, those are things you got to make sure you got the right team in place up front. And your professionals know what they're doing, and aren't going to be scared off by something they just don't have experience with.
Ted:
Yeah. You don't want an accountant who's never done an ESOP, or done two. You don't want to have an attorney that this is, "Hey, I can do that." "Well, how many have you done, and what's the track record?" And same thing with the third party administrator. Certainly the investment banker. It's funny. You'll see a lot of people go, "Oh, I can do that." "Well, how many have you done in the last year?"
The other thing you have to think a little bit about in ESOPs is there's some inherent conflicts of interest that people have. And some people are very clear about that. And other people kind of cross lines.
Doug:
Good point.
Ted:
So for example, most people pick I'm either going to represent buyers or sellers. And if I represent buyers, I'm a valuation firm [inaudible 00:26:58]. I'm working with trustees to make sure they don't overpay, I'm more of a [inaudible 00:27:04]. And we only represent the sellers because how can we represent buyers, be an a valuation firm? And the trustees are the people who hire the evaluation firms. Well, if I got 100 engagements with a certain trustee, they're paying me a ton of money. And now I'm representing my client in a negotiation against that trustee. Well, how hard am I really going to negotiate, right? Because who do I care more about? The guy sending me 100 deals or the guy who I'm just doing the one deal with? And then you'll run into that in all sorts of areas of ESOP. So the people you bring in, it's important.
Doug:
Yeah. Well, that's why you guys are the best out there at doing these things. You take it. You've got a process. You have the right professionals involved. And you know what you're doing. You've been through a number of these things. And you know the way to deal with it. It's just like anything. We all have our areas of expertise. And you don't want to stray from that. And in a transaction as important as selling your business, you should have the best experts involved.
Ted:
I mean, you do it once in your life. It's millions and millions and millions of dollars. So get the right people.
Doug:
Yeah. Well, this is awesome stuff, Ted. I mean, we could talk about this all day and get into the weeds. And it's a fascinating subject, and one that's so meaningful for our business owner audience out there and clientele. We'd love to talk to you about this stuff further. And I know we'll have you back on again. So thanks again.
Ted:
Thanks a lot, Doug. Really appreciate it.
Doug:
Absolutely. And if you want more business tips and insight, or to hear previous episodes of Unsuitable, please visit our podcast page at www.reacpa.com/podcast. And while you're there, sign up for exclusive content and show notes. Thanks for listening to this week's show. Be sure to subscribe to Unsuitable on Apple Podcasts, Google Podcasts, or wherever you're listening to us right now, including YouTube. I'm Doug Houser. Join us next week for another Unsuitable interview from an industry professional.
