Welcome to Disruptive Successor, a show for next generation leaders in family businesses and entrepreneurs who want to disrupt the status quo and take their existing business to a whole new level.
We all know that what got us here isn't going to get us there.This show will provide inspiration, advice and resources to help you create massive impact.
This podcast is sponsored by myself, Jonathan Goldhill, and my company, The Goldhill Group, where we provide coaching for growing companies.
I'm Jonathan Goldhill, and my purpose is simple, to guide entrepreneurial leaders in family businesses towards more freedom and fulfillment.
I want entrepreneurs to get clarity around the changes that will make them and their businesses more successful so they can experience the same freedom I've enjoyed in my life.
Our proven practices challenge business owners to think differently about their business and how they're running it, and quite literally become game changers in our clients' companies.
Learn more at thegoldhillgroup.com website, where you can schedule your free strategy session.Hi, it's Jonathan Goldhill, and welcome back to another episode of the Disruptive Successor Show.
You know, exiting a business and preserving the life's work of an entrepreneur in a family business includes taking care of employees, ensuring the next generation transitions well, and retaining stability when the elder statesman exits.
My guest today is Kelly Finnell, one of the nation's premier ESOP consultants and a sought after speaker on this subject. He has spoken at more than 300 conferences and meetings throughout the United States, London, and Sydney.
And he's published numerous articles on using ESOPs in ownership succession planning, and is the author of the highly acclaimed The ESOP Coach, Using ESOPs in Ownership Succession Planning.
Kelly is the president of Memphis-based Executive Financial Services, Inc., and graduated magna cum laude from the University of Memphis and its law school. So you should know the ESOP myths and why it might be the best exit option.
And today's guest will hopefully cover most of them in our conversation.Some of those myths are, is ESOPs just a compassionate capitalism play?And is that the case for the ESOP revolution?
And should you consider an ESOP for your swan song in succession planning? Now the E is for employee, but do ESOPs really benefit employees beyond the transaction?And how do you get buy-in from your team?And how do you maximize shareholder legacy?
These are the questions we'll be talking with Kelly about today.So Kelly, welcome to the show.
Jonathan, thanks very much.It's great to be with you.
So let's start off where I usually do, which is, so, you know, ESOP is a very niche planning strategy.Tell us how you first got involved with ESOPs and why you've stayed involved with it for more than 40 years.
Well, it seems like many of our clients, I kind of got into this business by accident.When I was in law school between the first and second year, I had a job working for a company in Massachusetts. And it was a group of pension lawyers.
At that point, this was 1979, and ERISA, the law that codified ESOPs, was only five years old.And the lawyers had gotten a letter.There was no email back then in 1979.It was a letter, an envelope delivered by the U.S.Postal Service.
And the letter asked for a white paper on ESOPs. So all of these experienced, seasoned pension lawyers looked around at each other and they all said, we don't know anything about ESOPs.We're going to give this project to the kid.
And in 1979, I was the kid.So I spent much of that summer researching ESOPs and writing the white paper.And so I just kind of stumbled in to this niche specialty.I got out of law school two years later, and this has been my life's work.
Well, so I want you to explain how it fundamentally works.I think that my first introduction to it was when someone said, look, we can either do ISOPs or ESOPs.And I said, well, what's an ISOP?And he said, that's an incentive stock option plan.
So then what's an ESOP?So tell us, how does it fundamentally work, Kelly?
And ESOP is many things all at the same time.So for a business owner, an ESOP is a liquidity succession and exit strategy. And for the company's employees, an ESOP is a form of qualified retirement plan, much like a 401k plan.
But there are some key differences between a 401k plan and an ESOP that allow the ESOP to be not just a retirement plan, but also an exit strategy.So here's what those key differences are.The first is an ESOP can borrow money.
The second is that an ESOP can engage in certain transactions with parties in interest.And the third difference is that an ESOP is required to invest primarily in the stock of the sponsoring employer.
So let me translate that to English and show you how those things come together to create an exit strategy for an under.I said that the ESOP can borrow money.
So those loans come usually from two sources, a bank loan, and then seller notes, an IOU between the company and the selling shareholder.And so now the ESOP has those two sources of capital.
I said that the ESOP can engage in certain transactions with parties in interest.And so in this case, that transaction is the purchase of company stock, and the party in interest is the company's owner. So the ESOP has these two sources of capital.
It uses those to buy stock from the owner.And then I said that an ESOP is required to invest primarily in the stock of the sponsoring employer.
And so those shares of stock that have been purchased by the ESOP become an asset in participants' retirement plan accounts within the ESOP.
And so that's how an ESOP provides liquidity and succession for the owner and provides a long-term equity-based retirement plan incentive for the company's employees.
And so let's understand fundamentally who this is for or who typically takes advantage of it.Because it's been my understanding that if you don't have $2 million in EBITDA, that it probably doesn't make economic sense to put this together.
First, is that true or false?
I think that's a really good rule of thumb, Jonathan.And so I say that ESOPs are not for micro-sized companies.They are for small to mid-sized companies.So let me just tell you about what our experience has been over the last three years.
We've done 25 ESOP transactions.The smallest one was for a company with 1.2 million. of adjusted EBITDA, and the largest one was for a company with 65 million of EBITDA.So let's forget the big one and the small one.Let's average the rest of them.
And the result of that is that our typical client has 4 million of adjusted EBITDA and on average 95 employees. And that's not just our practice.That's pretty much the ESOP market across the nation.
And so ESOPs work really well for companies of that size.And as you suggested, ESOPs can work for much smaller companies.It's just not nearly as financially effective.
So the only client I've worked with that was an ESOP was a manufacturer of automotive mats, accessories.They were doing about $9 million a year, and this would have been in 2005, six, seven, around there. that are there particular industries?
Obviously, it seemed like it worked well for manufacturing, but I've also heard that it can work well for a professional services firm, like a consulting business.I mean, are there industries that it works best in or doesn't work well in?
Well, our biggest market niche are professional services firms, as you suggested.So our biggest industry niche is engineering.We've done 13 ESOPs for engineering firms.
And one of the reasons why ESOPs work so well in professional services firms is that the success of those companies is based almost entirely on company culture.
And if an owner sells to a third party, to private equity or to a strategic buyer, that purchaser is probably going to tell them that after the transaction, nothing's going to change, but we all know that everything changes.
And so if you want to have a liquidity event and maintain the company's legacy and maintain its current culture, perhaps the only way and definitely the best way to do that is through an internal sale.
And the most financially efficient internal sale is an ESOP because of its many tax benefits.
Do you see it ever happen intergenerationally between families where several of the family members might get a larger portion of the stock, but everyone owns some stock?
Yeah, one of the classic scenarios that we see is a situation where perhaps the owner has two children.One of them is active in the business and the other one is inactive.So that's a classic dilemma.
How do you equalize the inheritance of those two folks when one of them is going to get the interest in the business? And so there are several ways to do that.
But the way you'd use an ESOP to do that would be to sell 49 for dead, to sell 49% of the company to the ESOP.Then that cash that's been received will go to the inactive child.And the company then can be left to the active child.
And that way you've equalized the estate between those two without being in a situation where the children have to work together because we all know that that is just fraught with risk and potential problems.
And so here's a solution where they can be treated equally and the one that's active gets the business and the other one gets an amount of cash equal to the value of half the business.
And likewise, so if there were five children and four were inactive, Would you sell 80, 79% and keep 20, 21% and do the same thing?
Gotcha.Okay.What is the process of doing this transition look like?How long does it take?And yeah, talk to us a little bit about that.
The process usually begins with a feasibility study.And the purpose of that feasibility study is to answer the four questions that every business owner has about ESOPs.The first one is a valuation question.
If I sell to an ESOP, what will I expect the ESOP trustee, who's the purchaser of the stock, what would I expect the trustee to pay for my stock?So that's an ESOP specific And so that's the first thing that we provide in the feasibility analysis.
The second is all of the modeling around the financing of the transaction.How much bank debt would we expect you to be able to get?And then how much would come to you in the form of seller notes?
And what would the terms of those seller notes look like? So when we first talked to business owners about self-financing a portion of the transaction, their reaction universally initially is negative.
They'd want to get all of their cash or as much of it up front as possible.
In full disclosure, an ESOP is not right for the business owner who wants to take the money and run.Because with an ESOP, you're going to be paid out over time.So I'm not one of these people who thinks that an ESOP is the answer in every situation.
But if you have a business owner that can be patient and receive their payments over a period of time, The return on those seller notes is going to be extremely attractive.
The seller notes are going to be subordinated to the bank debt and as subordinated debt in today's market, it's going to be entitled to a return of around 12%.
Nice.So a few things come to mind.One is what's the timeframe?I'm typically thinking it's 10 or more years, but could it be less that it's paid out over?
Yeah, I would say that the average is seven to eight years.So the bank debt piece usually has a term of five years, but we almost always see that being paid off quicker. it's going to be structured so that there's no penalty for prepayment.
And so let's say that piece gets paid off in five years and then the seller notes get paid off in four or five years after that.So you're looking typically at a seven to eight year payoff.
And there's got to be some certainty that the business is going to continue as a going concern.And so that must be another area of concern for owners.Are they going to have to stick around to make sure that everything continues?
Or do they have just a business that's pretty bulletproof in terms of the market, the economy, changes in technology, social tastes, et cetera?
I think there are two pieces to that question, Jonathan.I think the first one is that since this is an internal transition, as you indicate, you have to have a strong successor management team.
And that's true of any internal transition, whether it's a management buyout or whether it's an ESOP.If you're going to do an internal transition, we assume that you've got a strong successor management team.
tell business owners that the best candidate for an ESOP is a company where the owner comes in late, takes a long lunch, and leaves early.He or she is no longer micromanaging the company.They've turned over the successful operation of the company.
They've done a management transition already, and now they're looking for an ownership transition.Then the second part of your question has to do with the stability of the business.
And you're absolutely right, again, that an ESOP doesn't work nearly as well in a company with volatile earnings.It's very difficult to get bank financing in a company where the earnings are all over the board and unpredictable.
And so a company that has strong, continuing, predictable revenue is really the best candidate for an ASAP.
Talk to me about the tax benefits, because I understand that there are some really good tax benefits for the owners.
And is it just about the fact that it's being paid out over a number of years and is being treated as maybe ordinary income or long-term capital gains?Or what exactly are those tax benefits?
Yeah, they're tax benefits for the owner and for the company.So first for the owner. In a worst case scenario, the owner is going to pay long-term capital gains taxes on their sales proceeds.
Best case scenario, if they want to put up with some additional complexity, they can treat their sale to the ESOP as a like-kind exchange, similar to a like-kind exchange of real estate.
where they take the stock that they sell to the ESOP, they take the proceeds from that and reinvest it in the stocks or bonds of a U.S.domestic operating company.That's considered a like-kind exchange.
And you know, the other like-kind exchange provisions in the code, this like-kind exchange is under section 1042 of the code.And that's a code section that was implemented in 1984.So it's been around for a long time.
And there are lots of business owners that have taken advantage of this like-kind exchange.So you sell your company for $10 million.Let's assume you have no basis.So you have a $10 million gain.Normally, you'd pay tax on that.
If you elect 1042 tax treatment and reinvest properly, then there's no tax on the gain from your sale to the ESOP. But you do get a transferred tax basis in the assets that you reinvested in.
And so- Sounds like a step up in basis almost.Is that-
Well, it can be.That's what we want to get to.So usually the business owner invest in dividend or interest paying securities, stocks or bonds.
It can hold until their death.So it's a deferral. until the time they sell it.But if they hold on to it till life, then they get to stepped up basis and the deferral becomes a forgiveness.
Interesting.So they're not buying tech stocks, probably, they're buying more utilities or something more conservative.
Exactly right.That's one of my primary examples are how great corporate bonds, utilities, things that have low volatility and that pay current income.
Okay.Now I want to talk about culture, but there's another question that's bothering me because I've heard it from owners as well.My employees don't have any money.So why would I sell it to them?And you would say,
And Aesop solves that problem.And Aesop's entirely financed by the company.The employees don't come out of pocket with any money.It's a benefit plan for them, not an investment plan.And so it addresses that age old problem.
I'd like to sell to my employees, but they have no capital or any borrowing ability.So they can't end up owning my business. And ESOP gives you a way to sell to your employees and have the company finance it.
And Uncle Sam provides a rich subsidy to the company that does an ESOP.Because the company, after the ESOP transaction, is going to operate on a tax-free basis. There's no tax at the company level because it's going to be an S corporation.
If it's not now, then we'll make an S election.So no tax at the company and no tax to the owners either, because the only owner of the stock is going to be the ESOP trustee.And like a 401k trustee, And ESOP trustee is exempt from tax.
So you have Publix supermarket, which is the largest ESOP owned company in the country, 300,000 employees and beneficiaries.And Publix competes extremely well with Kroger because Kroger pays tax.And Publix doesn't.
Publix operates like a church or a synagogue. no tax on its income because it's a 100% ESOP-owned S corporation.
Almost sounds like a co-op, which is a different form of an organization.
And I guess both of these fit into the compassionate capitalism movement.Is that right?
Yes, that's exactly right.So last year, I co-authored an article for an academic journal entitled Compassionate Capitalism. And the premise behind that was business owners can do good for themselves while doing good for others.
If a business owner sells to private equity, the way the government would look at that is you have a rich person, this business owner, selling to other rich people, the investors in the private equity group.
If you sell to an ESOP, you've got a rich person in their eyes who is selling to their employees who aren't rich people.So it is the ultimate wealth redistribution system. And because of that, ESOPs are supported by Republicans and Democrats.
The Democrats love the wealth redistribution and the equity component of this, the equality component of this, and the Republicans love the tax benefits that encourage compassionate capitalism and business owners.
A win-win and so supported by Congress.Now, so it must have a real impact on the culture because everyone is an owner.Everyone starts to develop an ownership mentality.Probably everyone takes an equal interest in understanding how do we do?
How is our finances?How much money are we making on this job?And what do you recommend that owners should do to manage this change or to facilitate this change?
Communicate, communicate, communicate.
So employees are not going to understand this immediately.So they are going to buy in and the company will become more profitable as a result of these.But it will take time.
In all honesty, it's going to take, in most cases, at least three years to instill this new ownership culture. in the employees' minds.And it will only happen in three years if there's a lot of communication.So you need to have meetings.
We call them stock reveal meetings that happen each year after the valuation firm has told us the new value of the stock.And we show that to the employees and they get excited because their 401k plan earned 6% last year and their ESOP earned 20%.
And the reason the ESOP outperforms is because with ESOP, you're getting a leveraged rate of return on the employee's accounts.
So if the company has an organic growth rate of 5%, but the company pays down a million dollars in the ESOP debt that year, then the equity value of the company grows by that 5%.And by the million dollars of debt that was repaid,
So you get this huge rate of return on employees' accounts.And after they see that for two or three years, they are totally committed.
That's exactly what I heard with my mat manufacturer.So look, I know we're short on time.We need to wrap up.So where can people go to find information?
And maybe what advice would you be giving owners who are considering an ESOP, but unsure it's the right move for them?
Yeah, do your research, talk to experienced professional ESOP advisors, and you're welcome to go to our website.We've got lots of educational information there.It's www.execfin.com.
and you'll find an ownership succession planning guide there that you can download and lots of other information.
There are also two ESOP industry associations, and the best one of the two for educational information is the National Center for Employee Ownership. So you can go to nceo.org.
In between those two sources, you'll get lots of information, and then feel free to contact us with any questions.I've also written a book, as you referenced, The ESOP Coach.They can find that on Amazon.
And it's full of case studies, which I think is the best way for a business owner to learn, is through hearing about what others have done.
I agree with you 100%, Kelly.And if we had more time, which we don't, so I'm going to invite you to come back on a future show and let's go over a few case studies so people can really understand how the whole thing worked from start to finish.
I'd love to do that, Jonathan.That'd be great.
Yeah.Thanks so much for being on the show, folks.I hope you got some value.At least if it just tipped your curiosity and you start researching this, go to execfin.com.Get a copy of Kelly's book.I think that I have not read it.I'm curious to read it.
I think there's a lot here.The world is beyond just giving out incentive stock and phantom stock.Think about ESOPs as a solution for exiting your business.
So, and stay tuned for future episodes of the Disruptive Successor Show, and where we'll have Kelly come back and give some case studies.
This podcast is sponsored by myself, Jonathan Goldhill, and my company, The Goldhill Group. where we provide coaching for growing companies.
I'm Jonathan Goldhill and my purpose is simple, to guide entrepreneurial leaders in family businesses towards more freedom and fulfillment.
I want entrepreneurs to get clarity around the changes that will make them and their businesses more successful so they can experience the same freedom I've enjoyed in my life.
Our proven practices challenge business owners to think differently about their business and how they're running it and quite literally become game changers in our clients' companies.
Learn more at thegoldhillgroup.com website where you can schedule your free strategy session. Thank you for joining us on the Disruptive Successor podcast.
If you enjoyed today's episode, please subscribe, review, and share with a friend who would benefit from the message.If you're interested in picking up a copy of my book, Disruptive Successor, go to disruptivesuccessor.com.
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