EP21 - Inside Out: Inside Note Vs. Outside Note - Part 1

This episode provides clarification to the difference between an inside note and an outside note.  In an ESOP transaction there will be two types of notes created when the transaction occurs.  This episode is part 1 of 2 episodes.  The first part explains the background of the terminology as it relates to why these two types of notes exist.  The majority of this episode deals with the inside note and its use in releasing shares to employees as well as IRS code section 404 and limits applied as well as implications related to related to future repurchase liability.  In addition, this episode covers how the tax benefits get created in the analysis of an ESOP from the structure of the inside note. 

Transcript

[0:09] Happy to say guys welcome to another episode on our journey to an ESOP this is the ESOP guy thank you so much for joining today and I hope that you are enjoying your journey and, really the whole point of this podcast as I started to kind of think about you know what we've been doing is really to help people, enjoy the journey so as we do that let's start off with this today.

[0:37] Music.

[1:02] 2015 this is the Inside Out number 1 movie because Inside Out number 2 just came out so this is going to be a part 1 part 2 and I'm so excited about how to think about like I've been thinking about this as far as. Um kind of the mission as I just explained it is with the thought in mind of how how do we enjoy the journey write 1 of the things that that helps to enjoy the journey.

[1:25] Of the ESOP process or being an ESOP company is more and more information about what things are how things work how who does what what are what's supposed to cost all of those things that we've we've touched on. I think really have resonated with me recently and terms of of what is what's our purpose here what's our mission was we as we sit here and talk through all these different concepts. Inside out is going to be um part 1, is going to be to explain the inside note and eventually part 2 will be explained the outside notes you'll understand what that means as we go some of the people that are listening are like I already know what that is um as we go we'll talk a little bit about the implications of both of those in structuring your ESOP. And so the value of this would be for somebody hey do I want to even continue listening would be to say I need to know more about that the structure of an ESOP and how it works from a share release standpoint. How to fix my employees all of those things are going to be things we're going to touch on today so I'm excited to do that, if this is your first episode thank you for joining um we are we've been doing this for 5 Seasons enjoying every minute of it you can go to our website at journey to an ESOP Comm and check out all of our episodes, and for those that are continuing on with us just thank you for listening today and and hopefully this is a helpful um resource for you if you do find it helpful please give us a 5-star rating.

[2:53] And also give it to a friend or somebody that you think hey man they're thinking about an ESOP so maybe they should listen to this. In addition to other things that might be available as good resources.

[3:04] Perfect so as we start off today I wanted to kick into the reason I chose this this Inside Out movie and I do run all kinds of the spectrums between different genres and you know it's not like I'm I'm. A person who and watches 1 type of movie and that's it right so the movie I chose today is something that I really have enjoyed personally I know that my family has enjoyed this movie Personally, the the coolest thing about this movie is I thinkF finally you know I think people have really explained the human, condition psychologically in a lot of ways and I and I think psychology as I talk about it it really isn't an important element of all the things that we talk about when it comes back to ESOP because ultimately.

[3:55] The psychology of its of of the ESOP is like going to affect the shareholders who are selling their stock, it also is going to affect the key people who are taking over some specific roles and of course other things too as we as we continue thinking about this transition to employee ownership I think it's a huge element of that and so with that this movie basically does a great job of Doc of of talking about how the human person, in this case this young girl named Riley um has these in this first movie has these these. Certain emotions Joy sadness disgust anger and how those things can be dominant in some in some cases and other times they can be kind of you know sitting in the background. And so what's cool about it is it really explains how also memories um and and experiences can affect you and and all these things as we continue to grow as people so it's it's just honestly 1 of my favorite movies even though it's, it's um.

[4:58] You know cartoonish it is a cartoon so anyway hopefully that that makes sense now why I chose the movie is because specifically it's inside out so it says inside note outside note right so underneath all that we're going to actually do some some.

[5:11] Technical speak around ESOP so let me let me talk about part 1 today is really about the inside note and and comparing that to the outside note I'll just start very basic. When you get down to structuring an ESOP transaction and this is specific to a leveraged, transaction meaning that there's going to be debt put on the balance sheet of the company when you sell your company as an employee owned company what's happening is is that there's a couple things happening at the same time but the shareholder, or shareholders has their stock that they're selling because an ESOP transaction is a stock sale. The company in this first round of things technically redeems the stock and I'm keeping this very high level and very simplistic but the company would be Redeeming the stock. There's all kinds of things of ways to do that differently but let's just say keep it simple so that means they purchased the shares and those Shares are purchased by the company through financing so that's where the debt comes from now the financing can be in multiple forms it can be in a bank financing which we call Senior debt and it can also be in seller financing which is what we're going to refer to as subordinate debt, the promote that the company borrows or or engages as obligor or basically they're the borrower. Are going to be referred to as the outside notes and so part 2 is going to be to dig into those and structure financing and and implications of of all of that.

[6:41] Today though the other part of it is is that as they do that they've redeemed the stock.

[6:47] There as we establish the employee ownership plan what's happening is that. We're actually establishing a Employee Stock ownership Trustthat will. Account for the shares of stock from the company that they just purchased and the way they would do that is they're they're going to issue another promise note. That's called an inside note so internal inside now we're going to just has a high level what's the difference inside note is between the company and the trust. The outside notice between the company and the borrow or the lender and the lenders could be the the bank and the selling shareholders. So the Insight note as we focus on it it is a promising note so there's just again just a overall high level definition of that as it as it. Um goes as we go into that we're going to talk about the implications of this um a much much much deeper but the main thing is is that. As we think about the inside note what what it does is it establishes a.

[7:50] A relationship between the company and the trust through principal and interest payments. The principal and interest payments on are going to be on an annual basis so if you imagine you have a a car loan or a real estate mortgage or any kind of you know equipment loan every loan has a sense of like how fast is this going to have to get paid off so, in an inside note there's going to be an amortization, time period of time of of how long it takes in the payments are going to be set up on annual payments so not like a mortgage where you have monthly payments or. Other types of of loan instruments where you might have you know maybe more frequent payments um not frequent but maybe quarterly or different things like that. So it looks and feels like a note now the first part I wanted to kind of mention to. The audience as we as we think about this is this is very confusing because I've had so many questions after 1 ESOP deal after another, of what is the ESOP what is the inside note I mean now now people start thinking the company owes this plus they owe the outside note, and all of those things start to become confusing and that's 1 of the reasons I wanted to kind of stop. And take 1 of these kind of terminology topics and just dig into it and talk about things that you really should know and you should know the terminology.

[9:13] You should know the purpose behind this and you should understand the um implications of that as we go through that so the the main thing is is that the inside note first as its established, is going to be the prime the primary way to mathematically calculate the amount, of the value of the shares that are moving fromthe trustto the shares going out to the employees, on an annual basis so so as we think about an ESOP plan let's step 1 step back and say we know that an ESOP plan. Is of retirement plan and we know that under as of retirement plan.

[9:55] We are going to have to set this up in accordance with the Department of Labor rules and make sure that it is in compliance with orisa. So that's the law that governs retirement plans and so from that. When we make a contribution of stocked into people's or any kind of contribution to people's retirement plans we have to make sure that it's done um.

[10:17] To where it can be audited the the Department of Labor can look at it and it needs to make sure it's done you know orderly and that type of thing so that people have a way to predict what's going into the plan. And then the third party administrators who really are the keepers they're the accountants of the retirement plans can come back and track this accurately and and prepare. Uh ultimately participant statements for the employees so as you do set up your ESOP plan what's happening is that each employee is going to have their own statement like their 401K statement they're going to have a statement of how many shares that they have in the planwhat are the VA what's the value of those shares and how many of those have they actually vested in depending on the way the plan document and governance is has been, created in terms of pro the the way that the ESOP plan has been set up and and that's always going to be done during the ESOP process and the ESOP transaction. Plan documents those kind those are going to dictate then how this is going to work. Now going into the ESI inside note what really is happening on the annual basis is the companies making a contribution.

[11:26] So that the shares can be released and the the way that the contribution is being made is in a form of a cash deposit.

[11:35] That's the equivalent of the principal and interest payment on that Insight note.

[11:43] Now 1 of the 1 of the very distinct differences between the inside note and the outside note is that the inside note is a. A payment that is going to be made annually as I said before, and it's it's a non in a sense a non-cash payment that's what I call it it's a non-cash payment and that the cash is going to go from the company into the ESOP bank account, which when you do set up your ESOP trust the trust is going to have its own bank account. And sidebar to that the trust is going to be the signer of that bank account is going to be the trustee. Whomever that is so the trustee is going to beyou know technically in control of that Trust bank account so on an annual basis what happens is that the the company is going to make that payment into the bank account and then the trustee and the very same day is going to move that money back into the operating account of the company that's why I refer to it as a non-cash payment once that is done there is an audit Trail, to show number 1 for the third party administrator hey what was the payment does that match up with the value of the inside note as it's created which we'll talk about in a second as it's created at the time of closing.

[12:57] And once that's done then the third party administrator can go back and say okay based on the initial you know based on the existing payroll census. There thereby thinking about like all of the people in the population of people in the company as they go through that payroll census the most, common allocation method for the employees is going to be using the amount of payroll that the company has at that point in time as a percentage of the payroll you are going to get that percentage of the allocation.

[13:34] So again part of this first part of the of the podcast is just to talk about where that's confusing right that's not the same. If I just stop for a second and talk about the idea that the the company is is also at the same time. Paying out payments to the outside notes and that's going to.

[13:55] Again be part 2 but that's going to be the the company paying out payments to the bank principal and interest payments to the bank on a separate amortization schedule. And also payments out to interest-only probably with the subordinated debt or if the seller has 100% financing principal and interest on the. The whatever the outside note is that cache is not coming back in the company that's why we refer to that as the outside so, now coming back to the inside note the other major difference is going to be this is that the companies inside note is going to be an amortization schedulethat's going to be determined.

[14:33] By theamount of payroll on an annual basis.

[14:39] So this is Again part like how do how does that ambition schedule get get put together so let me just say first off that amortization schedule, should be typically most of the time and most likely going to be longer than the outside note amortization schedules.

[14:55] The outside note amortization schedules are going to bebuilt around underwriting the company's cash flows and what the lender first off if it's the bank what the bank is comfortable with in their underwriting policy and then secondly if it's the seller what the trustee and negotiations with the selling sell sell side advisor and the selling shareholders are comfortable with what makes the most sense so that's the outside notes now the inside note advertising schedule is going to be dependent on the amount of payroll that the company has this is called IRS code section 4 04and what it means is IRS code section 404 says that we can contribute to a retirement plan up to 25% of our total payroll.

[15:40] So if I took just 25% of the total payroll.

[15:46] And I said all right how much is that how much is that on an annual basis I would be able to contribute up to that point right so that's going to be the first measurements of what should we set the amount or amortization schedule app now 1 of the variables of the inside note in the in the amortization schedule is going to be. Uh a principal and interest calculation based on adjusted federal rate so the normal.

[16:11] Structure of the inside note is going to be to take the IRS allowed interest rate something around 4 and a half percent right now it changes you know with the interest rates. And use that to do an amortization schedule and what we're looking for is the principal and interest on an annual basis which represents. The total cash contribution that cash contribution has to be less than 25% of the total payroll.

[16:40] In addition to the company's 401K match so if the 401K match. That the company is going to continue with say assuming they are going to continue thatthat's going to reduce the 25% limit too so whatever that is, whatever the 25% of payroll is minus the 401K match is going to be what's left over that that's going to be 1 of the variables with, respect to selecting the amortization schedule for the inside note the interest rate we just talked about obviously at the higher the rate you know the more we eat in the 25%. The other part of this is what we would call Benefit testing and so benefit testing is going to say if I look at the amount of my payroll and I look at the amount of that amortization schedule let's just say we started off with, let's just say hypothetically the company was 100% ESOP.

[17:32] And we are like okay I think intuitively we're probably going to be around a 30-year amortization meaning that that 30-year inside note. Is going to we're going to take 1 30th of the stock of the company distribute that out to the employees every year 1 30th eventually and 30 years the stock is is gone. So that's kind of the big picture now if I look at that 30-year analysis and they say all right well what's what's the benefit to the employees and I start getting into the benefit to their payroll and I I start looking at the comparison of a 401k match at say 4 a 4% benefit most of the time the benefit on the ESOP contribution.

[18:12] Um is going to be a double digit return a double digit percentage so it's going to be somewhere around 12% roughly now there as we think about the now the variance is between 1 company to another I may have maybe a a few amount of people in 1 scenario, with a large valuation and that scenario would would push me to have a longer Insight note because the benefits going to be could be 20 something percent or even more, and that's going to create some issues so what we're doing in benefit testingis we're trying to figure out, optimal amount of the benefit percentages plus um the optimal amount of of just making sure it's it's valuable to the employees too at the same time, we have to be careful not to we don't want to go out too far because then it becomes like wow this is never going to get we're never going to get through this right so there are some cases out there that I think are extreme cases where that Insight note could be like a hundred years. However there are there's definitely I think as the longer you go the more difficult kind of the the perception of all of it when you get down to it now.

[19:20] The shorter you go the other side of the coin is this the shorter you go the more Shares are going to come to the to the employees and so if you start talking about the idea of the connection between what the inside note does it's such a critical element to the structure and the planning of the ESOP now this gets even more complicated as we talk about partials which we're going to come into and and you know a little bit as we go through this but the the main thing is is that. As we think about the release of shares, we are what we are doing in this very beginning step of structuring and shaping and figuring out the best place how to how to work this out to be optimal is we have to be considering repurchase obligation. For the company so hypothetically if my inside note was really 5 years or less 10 whatever I mean if it was some very short period of time what that really means is my release of shares to my employees. Is happening much much quickerand that's a problem because I could create a lot of repurchase liability for the company um and what.

[20:26] Take it from the employees perspective like wow all this all these shares show up the companies does really well suddenly they have a lot more in their retirement account and then. You know I'm they're thinking wow I'm light bulb goes off I'm going to just go ahead and and. Call it a day and retire and so the the bottom line is who knows what they're going to do with it but the point is is that we have to be thinking about the repurchase obligation as as part of the design and the benefit testing. And so some of those things as we as we talk about this let me kind of bring it to this specific part so that there's a real clear understanding of of when does this actually happen I mean when when do you guys start talking about. The structure of the inside note so um as I talked about this I think it's important because I want to I want to kind of address people that are jumping into the process right now or are there in it and they may not have done this yet.

[21:19] I I would kind of always kind of glean to a couple things as as I talked about the the ESOP transaction process in general. So the ESOP transaction process first and foremost is designed to break down all of the parts and pieces of planning, then jump into what I would say is sell-side advisoryand. Yeah I would say that that everybody kind of probably has a similar path to get to closing but but for the most part it's important to kind of designate what what what are you doing when are you doing it so in this situation, the very first thing I always tell people is if we got to start off you got to start off in your planning with valuing or coming up with some kind of valuation model. Or some valuation of the ESOP itself for for the transaction like what is the transaction going to yield to the shareholdersobviously that's the first and foremost thing because if that doesn't work why even why even do anything else right it's just going to be this this um, jumping into structuring inside nodes isn't really make any sense if the value doesn't work for the shareholders but let's assume we get through that next that first step the Second Step then.

[22:25] It's kind of often referred to in the ESOP industry as feasibilityso in feasibility you know the word feasibility is feasible right Is it feasible is it going to work. From what perspective are you talking about is it going to work from the shareholders perspective is it going to work for for the companies, perspective in terms of having cash flow to pay off all the debt is it going to work to for the key person you know scenario is it going to work for the rank and file is it going to work for all of those are elements does it work in relationship to the IRS and does it work in relationship to the Department of Labor and all all of those things are kind of in a in a uh orientation around the idea of is is this feasible or not now inherent in saying Is it feasible we're also saying is how do we actually structuring even though there this is feasible this is feasible this is feasible meaning, I could go with a plan B plan or C plan all of which are feasible what I'm really saying is what's the best structure for the people that are involved.

[23:27] Now that includes my again the shareholder the company the employees the key people and all that so so some of this as we talk about it, um is important to keep in mind. The feasibility models have to be in my opinion have to be holistic and balanced out the equation between, uh the value of the business what the shareholders want to get out of the transaction and then what the company really wants to do now having said all that this is where this is why I kind of started getting into the to the feasibility part this is where the Insight note. Needs to be talked about at the very beginning. With if you're in this process what I would say to you is if you don't understand the inside note at this point and you're going through and you're moving past feasibility into. Cell site advisory. I'd be like stop you know let's talk about this because it's this is so important is this is going to be so 1 of the 1 of the aspects of this in feasibility.

[24:27] Is going to be number 1 it may not be like let me just say this it may not be exactly what we just talked about it may not may not be a third year it may be something else happens between now and the closing. But what we're saying is is that it is it is the kind of the overall type of structure that we we anticipate and so. What's Happening Here is that you're you're also kind of determining um, if you are let's just say you are a corporation and we thought we start talking about the tax deductibility of the contribution. This is where the contribution deductibility comes from this is where an inside note um the the P the principal and interest are deductible from taxes as a cc Corporation, that's going to be really critical for you to understand because that is going to give us as we plan. Infeasibility the direct amount of cash flow that's available to service debt so what I'm what I'm talking about right now. Is like I'm putting we're all putting our company Financial hats on and we're thinking cash flow like how does the company going to service the debt obligation plus the ESOP compliance cost.

[25:38] The inside note here is incredibly important so the amortization of the inside note is going to yield an amount that's going to be part of what we would calculate for our contribution.

[25:49] Now as I said earlier, the partials are even more important because partials we're going to have to do the analysis on cash flow as it affects the from a tax perspective. Whether you're a c or an s on a partial you have to figure out what the contribution is which again is is going to be.

[26:09] It defined by the percent the amortization schedule so let's just go back to 30-year amortization principal and interest that's going to yield an amount of money that can be contributed to the plan that has to be the other part of this feasibility model that has to be. Less than the 25% of my payroll. So having said all that when I talk about this it's like that's what that's really what kind of what feasibility is is trying to figure out what well I'm going to go to a c or an S am I going to be a partial or 100% what we're doing is we're playing with the inside note.

[26:46] Not playing with it but we're we're talking through the inside know the potential and possibilities of that and whatever we end up with in that initial analysis. It's going to give us an annual principal and interest amount that we feel like is confidently going to be deducted from the taxes creating a tax benefit now tax. 101 will tell you in general you can never ever ever ever ever.

[27:12] Ever deduct principalfrom the company's income from a tax perspective except for. An ESOP and this is where it gets confusing because when people hear that they think oh I'm deducting the principle of my outside note payment no you're not, you're going to deduct the interest of the outside note payment but you're not going to deduct that principle you're deducting this principle which is the contribution the reason you can deduct. From a tax perspective this principle and interest is because it represents. The actual dollar amount of the value of the shares that are being put in from the trust into the pockets of the employeesso what the IRS is doing is they're saying we are going to allow you to deduct that from your taxes because it's truly a contribution. Even though it's not a dollar contribution it's a share contribution. And that is so important for people now the the 1 thing I wanted to say about that is I have had people start to when they start thinking about the the obligation of the company, when it enters this leveraged buyout scenario from a cash flow perspective, as soon as they hear inside know they're thinking promissory note here here's another layer of debt that the company's going to actually owe and that starts to make people a little bit nervous and anxious, now.

[28:32] Anxious anxiety doesn't even come until inside out part 2 anyways because if you see the movie this is where the teenager grow like this girl grows up into a teenager and here comes anxiety the very beginning of her life as we talk about it is going to be just more or less the um. You know emotion of Joy sadness and, um anger and disgust and I forgot fear so those 5 emotions which are pretty basic Primal emotions but having said all that, that nice thing about this is I is I think about it is as we move towards the next part it's going to be hey this is more more complicated right so it's just like as we grow up becomes more and more complicated, so just wanted to kind of share that with you now.

[29:14] Let's talk a little bit about a question that happens around the inside note that I think is really really good and I and I haven't seen a lot of people, dig into this but I do believe it's it's a helpful um opportunity, when so let me kind of back up for a second and just say I'm still within in the ESOP process I'm still kind of in this feasibility part of the process so keep in mind what I'm referring to is going to it should or at least be discussed or should be kind of thought through in the in the, feasibility process but what I'm referring to is is we start thinking about the the valuation modeling process that's going to help the shareholder know what's worth, the feasibility model process as we move into that from the valuation process is going to help the shareholder understand how much cash they're getting out of the transaction. And how much cash they're going to get on an ongoing basis and what's the tax you know effect of that cash coming into them so it could be uh capital gains we could talk about 1042 all these things so. All that's so critical to the shareholder and and I would say that that is always going to be a predominant part of like the planning because it needs to work for the shareholder but let's assume for a second that all works for the shareholder they're they're comfortable with all of those elements.

[30:26] When we're talking about the ESOP process we're talking about the having to work for the company when I when I when I say that I mean it needs to work for the companies. Financial strength and ability like if there's let's just say the company's unpredictable cash flow wise and we're like oh we're going to put all this debt on the books. And suddenly the company's going to have a bad year and now they can't even pay the debt off.

[30:48] That's not that's not good right so we we know we're going to work through that and part of as I as we do that. A good a good analysis is going to be hey what's been historical cash flow really in that analyzing the forecast understanding the predictability of risk that affects the predictability of that cash flow moving forward so much like the bank would do this I mean but in a sense the banks are great but they're really historical minded we. Looking at it from the perspective of History repeats itself dig into the business plan dig into the content of the revenue or the composition of Revenue all of those things kind of are are going to be part of the process that we're going to go through steps 1 and 2 which is understanding like what's behind the forecast understanding what is involved in the um the new 5-year numbers and all of that so that as we prove that out in these first 2 steps.

[31:44] We're going to want as as what this is actually the way we do it and the way we look at it and the way we talk about it we're going to want to have a high degree of confidence. In thedelivery of that cash flow going forward so that we could feel like the company is good to go right and if we can go there and if that happens right then we can talk then we're going to go in and like hey is this work for the key people like within their incentive plans and the things that they have going on where probably going to get into the Tsar conversation and stock appreciation rights but again I'm checking the box it works for the shareholder the company the key people now that the last 1 I want to mention is this is I want to talk about like the employees and so what happens is like. There isn't a lot of modeling done in at least the way I've seen it but we are doing more and more of itto model out. You know with the way we've created the plan. With this inside note how many shares should Johnny or Susie or you know just throwing out names um you know any of these names right how many how many shares of those of the ESOP stock is going to go into their account, on an annual basis and this is where it gets hard what it would be the potential value of those shares in a future period.

[33:00] So now that's a dangerous exercise because nobody is really going to be able to predict accurately what the future holds there's too many variables there's too many things that can happen you know sometimes it's going to go up way higher than we think and sometimes it's going to go down, but the point is it and if you caveat this this way I mean this is my point in doing this type of analysis for for companiesis it's so helpful.

[33:28] To Have your because 1 of the motivations for people to sell their companies to esops which I just did a podcast on motivations a few weeks ago, 1 of the motivations is I want my people to be successful at this I mean I really want my employees to be able to be part of this company and a real. Sincere ownership way right which is what an ESOP does is it's beneficial ownership it's creating beneficial ownership so having said all that the sheer release analysis is going to be again back to the inside note is going to be dependent on this the amortization of that inside note. And then how that's all going to work with assuming a constant payroll census so there should be number 1 there should be some questions about that for you guys to ask your advisors number 2 there should be some level of of detail related to that that I think is going to be super helpful for you to understand, that holistically that it's working for the shareholder of the company the key people and your employees in general that's like the quad win whatever when you talk about it and that and that's really an important I think because you're doing that upfront.

[34:38] In the analysis what's happening because we're doing that level of holistic planning is there there's a a a natural. Um I would say confidence in this next step like we're going to go here here here right but we've built a lot of confidence at the front end that it is, a multiple win scenario for everybody so that's really really important and that's how important it is when we think about the Insight note and the value it plays now, we're going to as we go to Part 2 1 of the things I I'll kind of just tee up now so when you do come back and listen to Part 2 is going to be we're going to talk about the the relationship between the inside note and the outside note. But we're going to talk about some of the the the 1 of the major ways to save some major taxes on your transaction. As you go from 1 fiscal tax period to another fiscal tax period so keep all that in mind it's going to be um really important part of understanding the inside note. And its role there too so so as we do that thanks again for listening today we appreciate um all the support go to our website during into aop.com if you have any questions at all we'd be more than happy to, you know try to answer those as they come in and then if you do like the podcast share it with a friend, and we will see you on our next step on this journey to an ESOP.