EP23 - Inside Out - Part 2 - Inside Note vs. Outside Note

This episode is part 2 of discussing the inside note versus the outside note on an ESOP transaction.  We feature the recently released part 2 of Inside Out - as it is an excellent sequel in the story of how human emotions can play into how we make decisions , in particular how anxiety can cause problems in daily life. The podcast contrasts this to how we deal with the anxiety of the company going into debt for leveraged buyout financing.  The episode focuses on the planning side to provide a sustainable ESOP transaction and helps to provide some terminology for those wanting to better understand and enjoy their journey to an ESOP.

Transcript

[0:09] Truly truly I just want to say thank you for joining today's ESOP guy journey to an ESOP and Beyond. So excited this day we're going to go into some things today I think are just so much um, so relevant to discussion and thoughts and regards to the process of doing an ESOP that this is part 2 of the the first 1 that we did which was on the inside out so listen to this.

[0:37] And what was your name again oh I'm sorry I can get ahead of myself I'm anxiety I I want to Riley's new emotions and we are just super jazzed to be here where can I put myself what do you mean we, I wish I was as tall as all of you who the heck are you. I'm edgy look at your hair oh yeah not happening, okay who's this guy what's your name big fella that's embarrassment he's not really big on eye contact or a like a talking but he's a really sweet guy well welcome to headquarters embarrassment.

[1:14] Welcome to the podcast so anyway this is inside out part 2 and you might not have seen this movie yet and this might be. Pushing it for some people because hey that's a cartoon. I did inside out part 1 which was all about the inside note and this is inside out part 2 which is going to be all about the outside note. As we segue it from both of these things as they as they are part of the ESOP. Transaction and going into some of the details here are super importantbecausewhat this does is it helps people to understand what an ESOP is and what it is not, and we'll talk about, the structure of the outside note and how that affects the company what the purposes of of this is which is ultimately.

[2:02] To figure out how much cash I'm going to get out of the deal and the outside notes are really typically in combination of a senior debt with a bank and the seller note which is the selling shareholders so the combination of those 2, of those 2 parts become the representative outside notes so we're going to go into a lot of the details around, not just the obviously the definitions but just kind of implications of what that does for an ESOP transaction so for those that are thinking about doing an ESOP transaction this will be a good podcast for you to listen to, uh there's there's a lot of confusion when it comes down to the structure of this and so we'll get into thatum.

[2:42] Looking at what we're doing with um the podcast in general we're in the fifth seasonthank you again for tuning in if this is your first, episode please go back and listen to inside out part 1 because it'll probably be better to have those 2 pieces together but either way you can find our episodes on journey to an ESOP calm our website and you can put in there any comments that you might. Want to say hey this was great or help we need help with this or whatever it might be, um and also we can always connect you to people if if you're looking to do that so there's a lot of things there if you do like the podcast 1 Thing a couple things I always ask people are share share with people is. First off share it with a friend at like hey you think they're thinking about doing an ESOP this is a good resource if you think it's a good resource. Share it with them secondly give us a good rating a 5-star rating on on whatever media you're listening to so that's helpful for people to know you know what what to expect in this as a resource to provide, you know which is our mission our purpose is to provide good sound education around esops in a way that's not over like I didn't know what the heck you're talking about so in a way that's very clear. And concise in at a level where where there isn't this ESOP PhD guy in the background telling you about something with some terminology like you don't you don't get so that's a that's kind of our mission and what we've been playing out, as we go.

[4:06] So as we go into this episode the first thing I want to kind of connect to dots is this is and I can't say enough about what I believe is probably 1 of the best movies, even though it's cartoonish and they've got like it is a cartoon even though it has all kinds of like whatever you know around like the surface level what inside out has done is so well kind of talked about the human nature of how how people, of decide things and and they're how their emotions kind of get into these places so the first movie was all about the joy and fear and sadness, and anger you know so these primary emotions that kind of really grip us when we're little that you kind of see as as just, kind of coming out with like more of a a lesser mature person like yeah I can see that and then so it just makes sense right it made total sense like that's a great way to explain what's going on in people and also in how people grow and develop which is a is part of it, which I find fascinating and then in part 2 the the person who we're talking about is this girl named Riley.

[5:13] Who grows up and so now she's a teenager and so suddenly these new emotions come which I which I shared in the the beginning in the intro of the podcast which is anxiety. In envy and and embarrassment and all these things that are kind of our attributed to being super negative when you think about it so compared to you know just pure joy I want to be just a joyful person right and so it's the combination and the mix of these things that that can come about in the humans development, some people you can say yeah that person's really more anxious than they are joyful or some people are more embarrassed or you know more envious or all those things which which I really like about. When I think about the the what they did with these character developments within this um this teenager who is going off, in the story line she's going off to Hockey Camp and her friends are a big part of her her life and because anxiety takes over now here's where it segues into the ESOP stuff so um 1 of the reasons I like doing this for the for the.

[6:15] To convey the inside note outside note is that when we get to the outside note um 1 of the things that I would say first off is that there's anxiety related to putting debt on someone's balance sheet, especially when I say someone I mean the companywhen you have a company and I would say a lot of clients that I work with. Throughout the countryare closely held companies that have gone through you know a lot of these companies have been around a long time they've gone through these these these, certain points now this isn't true for every company because sometimes companies are absolutely Capital intensive meaning that they have to borrow money and they have debt already on the balance sheet and there are some, some issues related, to that that are important to understand when you actually do the transaction and understanding the amount of debt that you can put on the books as we go so that'll be something we can we can get into but, for the first part of this is really understanding that anxiety is going to play a big factor.

[7:14] In the leveraged buyout scenario for the company now within that let's talk about like of course who are the people that affect right.

[7:24] The first the first person I would say in a company that this is going to be directly affecting probably more than anybody is the is the person, our persons responsible for the for the finances so that could be the CFO the controller, the county manager anybody that's paying the bills and it could be for the person like who's responsible I've had owners right shareholders they're responsible for that function so whoever's responsible for the for the checkbook and they're looking at the debt and all the things that are going to come about which of course is payments on the debt right so it's it's the debt that is going to be on the balance sheet. And that debt of course is going to come with Debt Service as we call it like so where is Debt Service come from on the outside note it comes from directly the amortization of that debt. That as we talk about what the debt is going to look like it's going to be in a couple different formats when we look at it so in a very straight vanilla type of deal. You're going to have some level of say senior debt financing which is going to come from a banking institution the banking institution could be, a a normal conventional bank that is just your banking relationship that you have it could be a bank that that the advisor helps you find. That is willing to do the deal in a way that's that's advantageous which we'll talk about you know that in a minuteand.

[8:49] The debt behind that or the capital stack behind that is okay the seller note now so what happens is the mix between the outside note. Is going to be in this very very normal standardized ESOP transaction a portion will go senior debt and a portion will go seller note.

[9:07] And so some of this is going to be pretty fundamental for some people that have already kind of done this so so keep in mind I'm I'm really kind of gearing this around some some foundational things that we're seeing and then we'll kind of gear up towards some things that are that are. Um important to be thinking about sowhen we think about the senior debt what happens is the bank has to come in and say hey we think we'll do this amount of of credit now when we think about the ESOP process, where should that apply in the process so if I if I just kind of laid out the ESOP process the beginning part of the process is, what we what in the industry what everybody's going to call feasibility what we call that is valuation model. If that works we go to the feasibility model so that can all be inclusive in a feasibility model that really lays out the the road map of the ESOP.

[9:55] So in in as we go through the process once that works and everybody's good with it then what happens is that typically normal ESOP transaction processes are hey now we're going to bring in the outside parties which include of course the trustee the independent valuation firm you know the attorneys and all the different people to start putting the deal together from a sell side and a buy side team so in some cases the outside note becomes for the senior debt portion becomes something that some advisors will put to the push more towards the end of the processand. They're going to end up you know process wise they're going to end up grouping up you know hey this is the the lenders we're going to send it to and we're going to get their proposals and we're going to review this proposals and you know all that sounds great at the end of the day but.

[10:43] On our side what I would say contrary to that as we really do like to put that more upfront. We do like to work with the incumbent bank first to see if that really works so that they so that the company doesn't have to make a major. Disruption to other things so so the CFO and the controller and the people that are used to working with the bank that they've worked with, is it's so much easier just to stay with them now it's not always the case that the senior debt bank is going to be the same 1 it's not always the case, what why well sometimes the senior debt like lender would be. Not maybe experience with esops not comfortable with the approach to even like thinking about not a re not a non-recourse type of loan they may not even give enough financing or they may be um they're just not competitive you know for for whatever reason you may rule those out so when we do this what we're going to want to do and my advice is rule this out early in the process the worst thing I think in in terms of anxiety in some cases now what is this new banking relationship look like.

[11:47] Because there's a lot of work to be done you know and I would say that when I when I compare the relationship versus the transaction and these are 2 separate things right the relationship and the transaction overlap but, the banking relationship is going to have other elements to it so for instance if my company that's going to the ESOP process is, whether they're doing a 100% sale or whatever partial saleobviously there might be a need for the company to continue its line of credit, and there might be a need for the company to borrow other types of term financing for maybe equipment purchases or whatever else they have going on they may be scaling up they may need for some growth Capital as well so we need to know that the partner that we've decided on the banking side knows and understands the business plan. Understands the forecast understands you know what what is going to happen after the war afterwards so so things like preform a balance sheet and ultimately areas where they're going to really need to understand to be a big part of the future I'd say that's really important and that's why I would say do that all upfront as you go into the feasibility model, at least start the process with who whatever banking institutions you're going to be thinking about.

[13:00] Super important now ultimately because we're thinking about this post-closing what this banking relationship is going to look like in addition to relieving all the anxiety around the amount of money that's going to be financed by the company. Now1 of the things that is important and I had a call today with a client that 1 of the um major issues that, they're thinking about is how do I maximize liquidity at closing so when we're talking about this. Outside note right we're we're really talking about how much liquidity that the seller is going to be able to get at the closing. And in sometimes you know when you look at the like the goals and objectives that we're talking to the seller about the very front end of the ESOP process.

[13:48] When when you start talking about like I want to get as much liquidity out of the deal as possible.

[13:55] Then totally makes sense to me why why would you want to take on the risk and there there are some reasons to take on some risk when it comes to an ESOP transaction. The first thing to say is that in general it's very difficult for the senior lenders to take on, if it's a 6 times multiple to take on the entire multiple and finance the whole the whole thing at the front end. It's very difficult for them um number 1 because they are underwriting this around a non-recourse structure meaning there is no personal guarantees. Number 2 is that there is a. You know for the banks if they're going to do that there is also for the banks wanting to know that there's some type of skin in the game meaning that the sellers have some level of risk going into the future so that they're not just going to completely like eject right.

[14:43] 1 of the major business risks in doing a transactionfor whether you're an ESOP. Or you're a selling twist strategic buyer is is the risk of the person or persons that have been responsible to build the ultimate part of the value.

[15:01] And in some cases a lot of work is done to build in valuation is to build that that part and and separate by by using business processes separate from the influence of 1 or 2 key people in the in the businessso that you can say hey we can we can go ahead and just. Believe tomorrow and everything's going to run like a clock right so that's always going to be something we're going to be assessing in the valuation and then also also in the feasibility model and thinking about like what would be really important for the company so and that can be in a spectrum of things like, some companies have completely completely exited the person. Even though they're still the owner out of the day-to-day and even managerial or oversight functional responsibilities of running the company so and that can be like on the other side can be like nobody's done anything on that and so keep in mind if the bank perceives for the outside know for the senior debt portion of the outside notes.

[16:01] That the person who is really responsible is going to leave they're going to be a lot less likely to do more financing right because they want to know that that person is going to hang around and have some incentive to do that which their incentive is directly to get paid the seller note.

[16:15] So I know I've said this in the last 1 but I wanted to continue to stop you know stop myself and say the inside note is relative to the trust and the company and it moves the payments of the inside note are non-cash in that they're funded by this represents the contribution of the companyto the. ESOP plan by moving the money on the payment for the inside note into the ESOP bank account and then moving it right back in what we call the round trip so so that's what the Insight note is and the difference is that, it stays the cash flow stays inside the company right it's not moving outside, so so to delineate that between that and the outside note as I kind of digress real quick over there I wanted to make sure I didn't get too far down the road. And not address that the outside note is when cash is moving outside of the company to pay off these seller notes. Our senior debt financing and the seller notes so that's what the outside notes are so it's important to understand that that.

[17:13] Differences between those 2 things I say that partly now because I wanted to kind of also segue where I've seen people get super, more anxiety kicks in right and they get super anxious about oh my gosh we have this outside note with the bank we have the outside note with the sellers and we have this other Insight note and they start adding on all this. This this sense of debt service and you're like no okay hold on you know let's calm down for a second let's look at what we really have. And so keep keep that in mind that's why this is this is part of the reason I'm doing the title of this of this podcast and to kind of break up these 2 different things is because I want to really make sure that there's not a lot of anxiety when it comes to the inside note.

[17:54] I also had a call today with another client who has been a Nissan for several years now and his his questions were really about. Um the confusion behind the inside note and they've been an ESOP for a few years and just in that how does this payment for the inside note.

[18:11] You know what does it really affect and 1 of the things about the the inside note is is the value of the inside note and the starting period can be significantly different and depending on the way the structure of the, ESOP transaction goes so again we're jumping back on that side a little bit just to say um the principal and interest payment for the inside note.

[18:31] Are really relative to the payroll of the companyin terms of how much the payroll is so in the IRS code section 404 allows for 25% of your total payroll to represent a retirement plan contribution that includes the ESOP contribution and the 401K match. In combination those cannot exceed 25% of your payroll in any given plan year, so what what happens is the inside note can be a value at the front end that it either can match say for instance the value of the deal depending on how you've structured it or it can be much lower like the day 2 value when we when we talk about the valuation and go from day 1 which is what we negotiated the value for the company is and then day 2 which is the value that got impaired with the new debt that got created in the balance sheet that we're talking about the new debt we're talking about is the outside note debt right so, a little bit of a digression there on the inside note but I wanted to make sure in context we come back to the outside note and we're really able to kind of delineate to find what this is as we as we get into it and the implications of of all that.

[19:45] So thinking about the outside node again back to the senior debt piece so as we go through that process we're we're most of the time you know we're going to settle in on on 1 banking institution except their proposal in the ESOP transaction process they're going to usually start off with a term sheet, that term sheet usually could start and move into a commitment letter some banks don't like to do commitment letters I like commitment letters because there's a commitment legally but for the bank and you can kind of put the deal away right and it's like all right I know what they're going to do. Um there's a lot of variances to structuring an ESOP transaction so I can say. Hey this could work this way this could work that way but in general for the senior debt. They're going to structure an amortization because when we say senior they're getting paid first an amortization schedule that works for the cash flow of the company generally not more than 7 years.

[20:41] And if it's you know conservatively 5 years is probably a pretty normal amortization so it's it's typically p and I principal and interest term loan financing the companies obligated to pay that that note on a monthly basis. The interest rates are going to be what they are you know from a market perspective and and then as you evaluate all the different outside note proposals when you look at the senior debt proposals you know you're going to see things like.

[21:10] You know the interest rate the loan fee. Um you're going to see things like the loan covenants that are going to apply to Shoring up the risk of what we're going to call Cash Flow financing so they're what they're doing is they're underwriting the cash flow. What that means is that really not on a conventional cni or commercial and Industrial loan what the banks are doing is they're they're usually underwriting a couple different primary or different repayment sources as we talk about underwriting. The the the most frequent 1 that that gets analyzed the most right is what we call the primary repayment Source this is the the repayment source which is the cash flow of the company.

[21:52] When we talk about cash flow we're always going to mean in this regard normalized cash flow which is synonymous in the valuation model that we talked about. Normalize cash flow is truly cash flow we could call it adjusted ibida we could call it free cash flow adjusted ibida is the ibida earnings before interest taxes depreciation and. Plus your interest plus your depreciation plus the taxes. If you're a Corp plus the amortization expense so some of the non-cash expenses some of the the actual cash expenses like interests that are going to be added back because we have a cash-free debt-free type of transaction so that's IBA, adjusted EA is when we actually add back all the other normalization entries so um could be um.

[22:41] A discretionary expense that didn't doesn't occur in the future it could be a non-recurring expense that happened in another it's never going to happen again it could be um a change in owner comp so all those are normalized cash flow that's important to to know that the banks what the banks using to underwrite the primary payment source is normalized cash flow.

[23:03] And what they're doing is they're trying to figure out from a, um a fixed charge coverage ratio which becomes a covenant in the in the senior debt. Which basically used to be called a long time ago debt service coverage now it's called fixed charge coverage the difference is that the debt service coverage was, um more about the uh just the bank obligation so the actual loan that they're they're lending on and then the cash flow to cover the loan. Of course you're looking they're looking for an above 1 number so 1.2 1.25 the fixed charge is everything that the companies obligated to pay so the the the 1 thing I would say about coverage covenants in any kind of Covenant first is, don't get confusedask the bank to give you their math and make sure that you can calculate what they're calculatingso.

[23:55] Then as we look at this it's like okay we need to make sure that we understand what the bank is actually saying when they're when they're doing the underwriting so primary payment source is going to be evaluated, from an underwriting perspective on the strength of those cash flows.

[24:11] Now in a normal loan we're going to also have secondary payment source so secondary payment Source typically is liquidation of collateral. Now here's where the issue is with ESOP transactions for the senior debt is that there normally isn't enough collateral. There's usually some kind of shortfall of collateral so you're not going to get some primary secondary repayment Source that's substantial enough to weigh out all those factors and on top of it we're not going to have guarantees so because of thosefactors. Um the bank's going to say hey we want to make sure that we have these covenants to make sure we're on top of what happens a lot of times those covenants can be core tested quarterly. There are cases where we've had lenders look at those more on an annual basis to make sure that there's there's some kind of Rhyme or Reason to that but the banks aren't going to want to know what's happening soon sooner than later if there was a change in those cash flows because they are primarily relying on those cash flowsso. 1 of the things about this process of working with the bank I think is if there's a positive here which I would say that the banks are very.

[25:18] They can be very difficult because they're going to be asking a million questions and they're they're focused on things to really underwrite and mitigate their risk that can feel like you're driving us crazy kind of thing especially if you haven't borrowed money in the past.

[25:32] But there is a good part of that which is is really to help that out. In our models that we do for feasibility we're going to be testing that cash flow like crazy because we do want. We want to come out of the deal for the company to win we want to come out of the deal where the company has significant, um ability to pay off this debt. And so if we if we don't test the cash flows you know the right way then it can be um you know obviously we could miss something big time and the structure and the development of the um. Sustainability of the company to go through the process and sell their sell the shares and now have all this debt on the books this leverage financing now I will say that I've had many deals.

[26:19] Not many deals I've had deals where we get to this point where we start really thinking through the structure of the financing and we have determined it is too soon to do the ESOPbecause we do not have enough, strength to those cash flowsto make sure that there's enough. Wiggle room in the event that things change where we're like hey we we don't feel like it's a good time for you to do it so we'll we'll be the ones to first to call it out if if it's if it's true the case and I I think that's important um of course in your internal team. There are clients that are you know the company's Financial people are very um, super conservative and they're really really wanting to make sure and so in that case we don't really need to step in and and play that role for those companies but there are companies where, they're not as extreme on that and they're willing to kind of bite off more than they may be able to chew so our job is to. Is as advisors is to kind of like lay out that from the standpoint of um what happens if your cash flow forecast goes down by 20%, or 40% or 50% at what point is there going to be a major issue for the company to to make sure that they've paid off the debt obligation for the for the banknow.

[27:35] Sometimes when we get into that conversation it can feel like I've had clients, that look at this and again this is the context here is that they haven't had a lot of debt on their books before and so we're their context is anxiety itself like I don't really want to deal with the bank if we get into a downturn.

[27:54] For that very reason some of these clients have said you know what. And maybe we'll refinance this piece later I'm just going to go 100% seller financingso your outside note can be again 2 things it can be senior debt and then the seller note. Um but in some cases they may and not process of evaluating it they may say you know what it's more than we want let's just do seller note financing.

[28:18] And. I'm trying to be as we go through it I'm trying to measure and 1 of the reasons people decide that is they start off with the concept of I think I really want to some I want some liquidity or I want a lot of liquidity or whatever they're saying like they want something right out of that and so, emotionally part of that is because they're managing their own anxiety with the risk of what happens in the future and rather. Be able to just walk away and do something else sometimes they do want to take the money and invest it in something else so there's a lot of good reasons to get liquidity out of the deal so so all of those have to be considered as you go through the process of. Evaluating it. But for the most part I've seen that happen where people look at the senior debt they look at first off the cost of it the bank's going to be getting all this money on interest rates and then the fees and then, dealing with another attorney and the closing and the fees related to that are all going to be kind of part of the process of thinking about it so um again and if they do or don't it doesn't matter it's just an analyzing those 2 different pathways, in some cases they converge and B and the seller says all right I'm okay with the seller know I really want that.

[29:27] The advantages under the seller node as we as we think about it let's just talk about what it is again it's pretty straight forward at the closing the seller or sellers would take their respective portion of the of the purchase. And that would translate into a promote back to them that's going to include principal and interest payments. Now we don't have the senior debt anymore right so now we have just the their left their their note left over for the company to finance so the company's going to be making payments to them on a principal and interest basis like they would with the.

[30:00] Um senior debt right so instead of having the ba the bank first they're going to get to go ahead and start paying their own debt now here's where in an s-corp environment here's where it kind of becomes a little bitnuanced.

[30:14] And specific to an S corp where the shareholders generally will have what we call in tax as AAA. AAA stands for accumulated adjustment account and So within that the AAA represents the tax basis that the shareholder has in the stock that they own for the escort. AAA is is as simple as it can be but a little more complicated than this is basically the resultof the company's income that is. Because it's a pass through entity that is basically going to go to each individual shareholder once a year on their K1 from the 1120s, over to the K1 so all the income goes over there now the AAA balances will go down every year by the amount of distributions that that shareholder has received out of the company so simplistically the AAA balance is at the time of closing. Will be affected by income and distribution so it's kind of a flow to your it's a floating concept. We won't know truly what AAA is until we close the deal and we have the final monthly balance sheet income statement for the company to True up AAA.

[31:30] 1 of the things about aaa2 is it isn't always exactly income minus distributions there can be a effects to AAA or basis based on the Buy in of new individuals or the associated um.

[31:45] The associated um amount of um. Uh Capital that they put in so you you will have to work with their CPA to um try to come up with the um. The amount of what the AAA is going to be at the closing but ultimately what happens is is sometimes we reduce AAA right before closing so sometimes we'll distribute out the company has a lot of cash already we may distribute out that cache reduced the AAA down to something very nominal other times we don't do that and we keep the cash on the balance sheet really kind of depending on.

[32:20] You know the amount and and structure of the balance sheet with the required working capital that we that we're going to have. In the negotiation and so from that there is going to be um. A balance there and so when I'm getting to is that the structure of those promise notes within the outside note concept is going to be partly seller note financing with the um. AAA being carved out of the of the total purchase price so either we have senior debt financing with seller note financing and then we have a AAA note which basically takes, um whatever AAA is owed carves it out of the purchase price so there's not going to be a loss for the purchase price but it just separates it. Now this is specific to an S corp so keep that in mind it's not a CCP, as we talked about this but what happens is the AAA note is a promissory note with generally the same terms as the seller note but it can be it can vary it can have a shorter am. Um generally we want the same interest rate there as we had for the seller note.

[33:24] And all we're doing all we're doing there is we're as we collect the money off the AAA now as the seller. We are not paying capital gains tax on that part of the transaction so again escorp not a C Corp we're not doing a 1042 here so it's as simple as as as really defining those 3 potential promissory notes the senior debt the seller note. And the uh AAA note and those this is where that becomes kind of like. You know maybe confusing the AAA know and the seller note are subordinate to the senior debt meaning that those principal payments still are going to be subordinate to the senior debt because the bank's going to get paid their money before those so, because of that there might be a strategy that just really eliminate as much AAA before you close the deal as possible, now in conjunction with the outside note because we're talking about the seller Note 1 of the 1 of the other major things we have to talk about which we've done entire podcasts on, and I can say that we need to do more of those is just the the warrant like what is the warrant we talk about warrants. Um the warrant itself is synthetic Equity shares that are going to be awarded at the time well through negotiations and at the time of closing.

[34:41] To the selling shareholders respective to the amount of their seller note and then the interest rate on that seller note. Into the negotiated internal rate of returnso that they are technically being compensated to hold a what we would call more like mezzanine type financing and not get paid that warrant payment, or that interests the full interest amount until the end of the deal is done so because they're subordinatingthey're operating as a lender to the company, that has the um.

[35:16] The rights to get in a sense a double-digit return on their internal rate of return internal rate of return is a finance um. Mathematical ratio that shows how much the investor got from their investment. And so without a warrant the investment return is going to be simply the interest rate. With a warrant it's going to be whatever ends up becoming part of that targeted internal rate of return so it'll include the interest payments for the Target internal rate of return plus of course all the other payments and then finally the warrant payment.

[35:52] So what happens is and this is 1 of the major advantages to more of a seller note financing in addition to having a lot of flexibility um which we'll we'll talk about in a second this is 1 of the major parts of having the, um the company. Um Capital stack as we talk about the company's borrowings be shifted more towards seller notes because we can maximize the warrant, shares and ultimately the seller could of course because of the way the warrants are going to be paid which which will go into as we go through this, because they're going to get um. The payment of the warrant at the end they're going to get the opportunity if the company grows in value to participate in that value for the portion of Warrant shares that they get. So the way it works is that the warrant will would be exercised when the seller note is completely paid off, at that time what happens is the future value of the company is going to be calculated minus the day 2 value that they started with which is their strike price, so the differential is the appreciation of stock so if the company does grow a lot in value in the future then that shareholder is going to participate in that. If the company goes down in value then they're going to lose they could potentially lose you know that potential part of their reimbursement. They're still going to get the interest rate on the Note as soon assuming the company's cash flows you know work with all that.

[37:20] So having said all that those are important elements to to really understand the outside note and the structure of that as it relates to the inside note. And and 1 of the things I kind of touched on and I'll just kind of just touch on a little bit deeper is that there is like a tremendous amount of flexibility when you have more seller Note versus Senior debt.

[37:38] And in some cases you might have a say a contractor who's looking at. Maybe a a 3-stage transaction the 30% and they go to the next and they go to the next they finally you know over 10 years they sell the whole company stock. And they're they're looking at that primarily because they want to um. Make sure that the company has the ability to manage all the cash flow and all that and it and it really is important for them um to. Go through this process of being.

[38:08] Playing devil's advocate thinking about the cash flow um there could be other Industries where you know they have a lot of like even contractors they have a lot of capital, intensive types of debt involved in their balance sheet so so with all that you know you really do have to structure the capital around the the the senior debt seal and the seller notes and all that around creating as much flexibility in the process in the event that something does happen, if your industry does is subject to you know maybe critical downturns without a lot of notice then my advice is to be as flexible as possible. Um if it isn't and you have a very predictable cash flow where the economy is you're very inelastic in a sense from an economic standpoint then you probably don't need to worry about as much flexibility.

[38:55] Um I will say that the the worst thing that can happen is the is that the company's debt structure is so horrible.

[39:04] And the companies you know ability to pay that back is so dependent on the company hitting these hockey stick projections I I would feel sick to my stomach if I jumped in and I'd have a lot of anxiety for that deal so ultimately you know it's a balance when you're planning these things out and you really do want to, evaluate all the things that we're just kind of looked at as part of the ESOP process as part of the transaction planning. And you know part of that is to make sure as you do this you are working with people that understand.

[39:34] Um underwriting banking financing cash flow taxes of course I didn't even mention the whole point of the outside notes is that. The and the main thing when you start underwriting them isn't just the way the banks look at it is that the company gets this tax exemption from federal and state income taxes that get to add on to their cash flow. That didn't exist before. So part of the way that the bank is comfortable or the selling shareholders are comfortable is because the company now is in a preferential tax position not paying income tax and using that what I would say the IRS subsidy to we know re basically reduce status fast as possibleso, a lot of information there on the um as again part 1 inside note and then again part 2 the outside note if we come if we combine those this really gives us the the overall promise that are going to that you're going to deal with in an ESOP transaction thanks again for listening to the podcast please share it with a friend give us a 5-star rating if you if you can and um thank you so much for listening today we will see you on our next step on this journey to Nissan.