205 | How An ESOP Can Make You Rich | Employee Stock Ownership Plans Explained
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205 | How An ESOP Can Make You Rich | Employee Stock Ownership Plans Explained

And so when you add that 12 percent return and you take the purchase price and the tax savings and tall 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 would have sold to a competitor or private equity. There are exceptions, obviously. But most of them end up with more money and
they accomplish all the other stuff they’re looking to get done. 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 exists. 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 first prerequisite. 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 did so. 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- 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 timing. Yeah. Now you talked a little bit obviously about
the financial part, the tax savings, and that can be significant. Correct? Mm-hmm
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’s
a fiduciary that is your buyer. They’re there to make sure it’s fair to all
the employees and there’s valuation 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 the replacement. 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 companies fail. 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 helped. 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… A little bit more conservative in terms of
determining that future cashflow, basically? 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. 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, 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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