EP11 - Sustainability for Contractor ESOPs - Interview With Kevin Birch Regional Manager with CNA Surety

In this episode, we sit down with Kevin Birch, Regional Manager at CNA Surety, to explore best practices for contractor ESOPs. A key theme throughout our conversation is communication—and lots of it. One of the biggest mistakes a contractor can make is surprising their surety with news of an ESOP transaction. Kevin strongly recommends that contractors—whether general or specialty—get their surety agent and company involved early in the process. Doing so allows the proposed ESOP structure to be reviewed and vetted, ensuring buy-in from your surety partner. Throughout the podcast we discuss how critical it is to present models that illustrate valuation, cash flow projections, debt structure, and pro forma balance sheets. These elements are essential for the surety to properly underwrite the transition and help avoid issues with your bonding line after the ESOP is in place. 

Transcript

[0:09] Welcome everybody this is the journey to an ESOP and Beyond podcast where we get into how to Employee Stock ownership plans work.

[0:17] If you are brand new to the podcast welcome and we appreciate you joining today if you're not. Um welcome to or welcome to return to the podcast and some of the different topics that we do um you can find all of that at our website at journey to an ESOP cam. Today we have the opportunity to interview Kevin Birch. And we are going to get into how does an ESOP work after the fact in the sense of third parties and more specifically today we're going to talk a little bit about um maybe a lot more about the idea of your bonding company and how they are going to interpret the way an ESOP works for your company, um so with with me today as Kevin Birch he's AVP with CNA security he's a regional manager and Kevin and I recently met at 1 of the AGC conferences and got to talking about bonding and how it works for contractors and I thought it was a great opportunity for us to invite him on the, uh podcast so Kevin thank you for joining today. Yeah thank you thank you Phil for the for the invite it was very nice to meet you at the national AGC conference and and have uh some dialogue about some industry Trends including and especially esops so this is a very timely topic. Excellent so as we as we introduce you to the podcast Kevin um what is your favorite movie and why, well I you know favorite movie I would say uh Top Gun would be a favorite.

[1:42] Nice um you know first or second yeah I I would say the first um.

[1:47] I would say the the the plot line the speed. Um the uh just the the um the flight of of jet fighters and and all that. Those um trained very very skilled trained pilots do and go through and their skill level is is quite impressive. I had a brother-in-law that was a a a 15 fighter pilot that fought in Desert Storm yeah so I've heard some real live firsthand stories and so I have appreciation for for Top Gun and and what those Pilots do and go through.

[2:28] That's great yeah I love I love the I love both movies so you like the first 1 better than the second I do yeah yeah that's cool, I mean I I mean I'm not actually amazed they made a good second movie too I mean it you know going through all that time I mean it was like what how many years 20 years. Oh the original Top Gun was late 80s I think yeah so way more than 20 yeah that's crazy right to come back 40 years I think yeah whatever yeah long time ago.

[2:56] So cool well well thanks again for joining um as we as we talk about bonding in general what and we're going to get obviously specific to esops because that's what this is all about, um how long have you been kind of working in the ESOP realm in the sense of supporting CNA sharetea around Employee Stock ownership plans.

[3:12] Well I have been with CNA shity for 25 years I've been in the shed industry for for 30 years uh as a shity company we have uh lots of clients construction clients at our ESOP companies some of them are very mature ESOP companies, in fact some of our largest clients are ESOP companies and and uh and very mature they've been ESOP perhaps for you know several decades you know 20 30 years.

[3:40] So the heavy lifting years of an ESOP for them are over, um but certainly the um the recent Trend in U you call it post pandemic even prior to the pandemic was a a trend of uh ESOP companies converting to a to an ESOP so we have uhlots of clients at um. Um are in this space ESOP. Companies I I have personally have I handle region so I I I'm going to estimate I have 10 or 12 construction clients that are in various stages of ESOP conversion and as you all know an ESOP conversion. Isn't done over weekend it's it's it's likely a a 12-month process from start to finish some are longer quite frankly and I've seen um so we have a we have a a fair amount of of experience in the ESOP spaceyeah excellent yeah they um as you as you get into the the.

[4:43] You know the region itself I just want to give people a description like you so you're in a Ohio and you're reaching covers what area I'm just curious sure so I I'm physically located in Ohio I'm considered. Home office employee or home offices located in Chicago but I have an office in.

[5:01] In Ohio and I live in Ohio and I handle it we have 2 regions east of the Mississippi essentially. I handle 1 of those regions and it stretches from Michigan to the Carolinas uh Carolina's Alabama Georgia, and then back up through the call Mid-Atlantic um area Tennessee Kentucky West Virginia Western PA Michigan Ohioso geographically you know fairly large I think there's 9 offices 9 offices in this yeah that's pretty that's pretty large it's a lot it's a lot of geographic area and I'm I'm I'm guess you know just a lot of varieties of contractors so I'm guessing a lot of GCS a lot of trades in in your book of business. Yeah that's correct we uh we handle uh really all types of contractors whether they beuh heavy equipment contractors for instance infrastructure dot contractors or general contractors. Although we handle provide shity credit for a lot of trade contractors whether they be electrical or mechanical or roofer.

[6:05] So we we we have um we we cover the spectrum of of the construction industry when it comes to providing shity credit um and it and because of that we see we see some Trends we see see some things that have worked we see some things that that uh have been failures quite quite candidlyuh but certainly uh, a trend is is ESOP and um we've seen more and more of that activity in the recent in the recent years for sure. Yeah what what do you think why do you think that is happening I mean from your perspective and I and I have of course a billion ideas about it but what do you think is happening with the trend towards that.

[6:47] Yeah good question you know I'll just share you know these my my comments on that are really just based on my experience and having these conversations with business owners uh you know so if there's a company that's considering converting to an ESOP there might be 1 or 2 owners maybe an owner and his wife and these are generally mature companies they've been in business for at least 20 years probably 30 years plusand these are companies that have been um very successful especially in the recent decade these are companies that are consistently profitable regardless of the economic Times even in the the financial crisis of 200789 they were still profitable when times were tougher, and in the recent years when there's been a plentiful pipeline of work opportunities their profitability has essentially quite candidly skyrocketed so companies own owners of these companies are considering ESOP.

[7:53] When the owner is considering an exit strategy a retirement on the horizon. And if they need a very quick um. The exit strategy let's say there's a Health crisis and all of a sudden they now they're forced to make a decisionand to do it quickly ESOP is probably not the right vehicle for that. Uh very quick um urgent. Um transition of ownership because an ESOP transition requires um a minimum of a number of years to to transfer. Ownership because of of valuations and debt to the bank debt seller debtum so the these are companies that are they're very profitable. They um they have a a core team of of the managers Executives that have been in place for uh 10 years or more where they have together have built a company and brought successso the owner of the company. Likely has a desire to reward employees he likely he or she likely has a desire to maintain a culture.

[9:07] Even far after his or her retirement or perhaps when they're no longer an owner that they've built this company and they're interested in a in a a legacy and continuing a culture. Um so those are some I'll say strong characteristics wherewe see individuals considering a ESOP they've been in business a long time they're highly profitable even in in bad times are tougher Economic Times They have a key uh group of Executives and managers that have contributed to significantly contribute to the success of the company and now the owner is is also looking to maintain the culture.

[9:52] To to continue that culture and even to use that culture as a way to incentivize employees and even to attract new Talent so those are those are some characteristics why individuals are are considered an ESOP now those are I'll call it some soft issues but they're real they're all there's also some, Financial, strong financial reasons and 1 of those strong financial reasons for an owner to consider an ESOP is is to the tremendous tax. Uh advantages of converting to an Esauso. However I would I would suggest that would become while it's a driving force. It probably shouldn't be the the singular reason why in the owner would sell this company to an ESOP. Yeah generally what I see is they lead with other issues and they they enjoy the the financial the tax benefits along the way. Yeah makes it makes kind of doable I I totally agree I even as a a CPA firm I think are. Our Creed has always been like make a business decision and then look at the tax implications don't make a tax decision and then look at the business implications it's like it's almost backwards and there I think there's some reasons why that happens within the ESOP World which we can touch into I think some of the trends too I would say is that we're we've an ESOP world we always talk about the silver tsunami.

[11:20] And it just basically means that there's a lot of people retiring at the same time yeah exactly right yeah and it's just true I mean it's a true thing and and there's another thing that I think has compounded it too which you're not seeing as many of the of the generational families like the kids growing up saying hey I'm I'm going to take over this business dad mom and dad and I'm totally excited about it um I've got like 1 Contra we're working with and great guy and he's the son but he's like I got other business interests and and I'm doing this to help out Mom and Dad I'm not necessarily wanting to take it over and so I'm just seeing that as an another Trend it's like you know which is kind of unique to the to the like the last 10 years where um doing management buyouts I've seen a lot of that was typically what we were doing but ESOP has become just a phenomenal way to to keep everything moving a in a sense expand the family you know and say all right you know there's the Family itself from a business perspective is certainly the people that have helped you get there you know and that you've.

[12:18] You know you you've kind of worked through really difficult times with and you know they they know your business really well so I think that's 1 of the reasons to esops are are very popular. Yeah great Point agree completely with those thoughtsso segueing into like the you know 1 thing that that.

[12:35] Is really important I think for us and I know it's important for you is that you have to frame this out quickly you have a long-term. You know ESOP plan right when we just you just mentioned it could be an exit but it's not a quick exit meaning that that the owner or owners are going to have to be paid out over a period of time which means we need a very strong company post ESOP. So 1 of the things I wanted to kind of frame out and discuss with you is just the idea of building they might say best practices like what are you seeing as best practices and some of this is to help companies that are looking at this right now like you said converting over or thinking about converting over. So the they're thinking about the right way to position this for the future so having said that what what are some key things that you think are best practices for a contractor looking to do this um either right now or in the future yeah sure yeah great uh great thought great question you know I would say at the top of that list of we could call it best practices is is communication communicate communicate communicate so in my view, the owners of of this company consuming ESOP cannot over communicate.

[13:49] So their their uh diligence in communicating to uh trusted business advisors and partners, whether that not only is their attorney not only their CPA and tax advisors but also their bank and shyso I'll just say communicate communicate communicate is a is is a high need um the last thing, an owner of of a construction company who would want to do is surprise his um providers of credit whether that be Bank credit or shity credit so in the spirit of eliminating or minimizing surprises communicate communicate communicate so that's you know it's I'm gonna say it's.

[14:35] And that's really easy no matter the business issues at hand uh communication is key I have been in the recipient of of being drastically surprised when a CPA year and financial statements yeah yeah yeah seriously you know although this has been years ago yeah CPA year end statement arrives andthat balance sheet doesn't look anything like. Right it did a year prior or even what was anticipated becausethey converted to an ESOP and the First Time The Surety learns about that is literally through email when the CPA financial statement arrives to me as as the shity so so there's no communication none whatsoever.

[15:24] So eliminating I mean that's at 1 end of the spectrum that that's that's a very very poor practice that the best practice communicate communicate communicate so I don't want to beat the dead horse but communication is key. Yeah definitely I like we're on that as we're on that communication topic I think that 1 of the things that I I've seen is and this is something that you and I have already talked about or shared earlier is the idea that what you communicate is really important and when you communicate like you you know of course we can go to the extreme that sounds crazy right, here you get a financial statement the deal was done the year prior so it's already baked into the you know it's done you can't do anything about that um so what you communicate when you communicate what would you say about those things and and I'll talk about like what I think but you know you're you're the 1 that.

[16:13] We need to make sure they understand what's going on yeah part of that communication is is just an early indication that that business owners are are considering an ESOP and that business owner asking a lot of questions of their shity you know not only them communicating but them expecting. Communication from their shity so they should be asking the owners.

[16:36] Should be asking a lot of questions so that they're sure it gets comfortable with their plan and strategy uh to convert to an ESOP so part of that would be um the valuation process of of of the company and. Certainly a conservative valuation would be preferred compared to a an aggressive valuation um conservative valuation implies that there's going to be probably less Bank debtand less debt overall uh an aggressive valuation probably means there's more Bank debt and and which means perhaps larger Uh current and long-term Bank payments larger and current long-term personal um shareholder loan payments which probably means a longer duration of of those payments debt um bank and shareholder loan payments so conservative um and and modeling the cash flow nowevaluation is based on a perhaps not only the the. Recent past. And The Current financial wherewithal but also the forecastand and I I quite candidly I have not seen. An ESOPfor financial forecastwhere the financial forecast has a decreasing revenue and profit.

[18:04] All of them have been increasing and which is it's a forecast right you know a forecast is nothing more than a forecast right right how realistic is it. To to consider that over the next 5 years revenues and profits are going to consistently continue to climb. Right now we we could say that's been the case in The Last 5 Years perhaps we could say that for many contractors, I'm not sure we can say that for the next 5 years so yeah recognizing that a forecast, we'll we'll need to be call it realistic and if that means revenues are flat or perhaps even decreases in a year so so that would be a best practice of of having a financial forecasts that is yeah conservative and realistic, I've seen many that appear to be in the stratosphere and perhaps unrealistic.

[19:02] Yeah I think I think just to peel that back a little bit I'll give you like what I think on the idea was first off understanding the valuation I mean it's very important. Um and then doing an ESOP what happens is that value is negotiated so at the very beginning of the process, the advisor the sell side advisor usually walks through the the client withsome type of model and the model predicts valuation and it also predicts the structure of the deal with cash flows and at the heart of all of it which which Kevin's getting into is this idea that the forecast itself is really at the heart of it because when you think about an ESOP valuation um I would say. That is going to be cash flow Centric in the sense of like what is the cash flow of the company and it's usually going to Veer towards the discounted cash flow modeling mean meaning that the forecast, we're going to take the present values of those forecasts and we're going to use those to predict the actual Enterprise Value and then the net Equity value. But the issue is is if the forecast is driving up like Kevin saying every year. In a in an unrealistic way because I think what we want we want is a realistic forecasts um and we all know if we've worked with contractors for years and years that that there's cyclical as a cyclical nature to the business it just is what it is it changes with the way the economy changes and it changes can be pretty quick because sometimes be a little bit of a lagger depending on where you are in the contractor process but.

[20:27] Ultimately I I would say that the the deals we put together Kevin the forecast for a contractor is usually more more realistic than it is you know in the unrealistic and I think that, begs the question of of a couple things that I think are important to understand about forecasting is that, forecast is going to be uh a integral part of not only the valuation but it's also going to be integral part of how the companies able to retire the debt and, the bonding company is going to be concerned about as you had already said the balance sheet and so part of that modeling is is how soon does the debt start to burn off.

[21:03] And this is the this debt is there's not a problem with it but is leveraged by out financing meaning that this is not debt that you borrowed money to go raise more get more Revenue its debt to buy out the owners, and it's it's going to be you know debt that's going to get paid off with tax benefits but that's going to look a couple different ways depending on using a c or an s Corporation type of thing so we'll talk a little bit about that as well because we're going to back in on the tax side but we're going to come in with the first part which is how how a contractor ESOP gets set up correctly you know and our best practices so having said all that um what resonates with you regarding the the practice of putting that together for the forecast.

[21:45] Well um.

[21:47] The shity is not a is not a party to the conversations of the of the negotiation process of the forecast our voice is is 1 of uh that that steers to the conservative side so that the balance sheet remains shy credit worthy so uh.

[22:09] Generate now the this is generally speakingit if we see evaluation that's call it 3 times Book value.

[22:18] That it's pretty high it's it's a high valuationum if we see a valuation. That is uh 1 1 and a half times Book value that's that's. Very reasonableso you can begin to see a spectrum of what's considered low-risk with might be considered high risk. And thenyou know we we've seen esops where there are there's no Bank debt.

[22:46] No whatsoever 100% seller financing right right 100% seller financing so that on that spectrum of risk. Mhm 100% seller financing would be considered low risk.

[22:59] Now if there's High Bank debt at the other end of the spectrum this low risk high risk at the other end of that Spectrum high-risk would would imply there's a tremendous amount of Bank debt. Quite candidly howeverthe Spectrum or the the the risk valuation we usually see is somewhere in the middle you know call it on on a football field a 100 yards we see. Evaluation where the where the forecasted Bank debt is we'll call it at 30 yard line. Not at the 80 yard line right okay yeah and that's and that's important to understand and I think there's a there's a Pro there's pros and cons being put together when you're putting together an ESOP deal and you you you have pros and cons for the shareholder and you have pros and cons for the company and they need to my opinion they need to balance you know and so the other part of that is like who prepares the forecast is incredibly important part of it because. As a as a trustee the trustee is looking at that and they're going to ask us the question like who prepared this and if it was singularly just the shareholder.

[24:10] And not maybe the CFO then there could be an imbalance in that and I think more more poignantly is that. Our industry has advisors that are going to get paid a lot more money if the forecast is higher and I think we got to really realistic about that and as a contractor I'd ask that question like who how are you getting paid and and do you get paid if the deals bigger right and I think the main issue there is that we're not talking about, a normal m&a dealyou know we're talking about a regulated m&a deal that is a a retirement plan we're we're setting up a retirement plan. We're we're looking at all the elements of creating a balance so so if the advisor is going to get paid a bunch of money there's no doubt that's 1 of the reasons why you've only seen kind of this incredible you know Miracle happening every year you have this and I and I call it a miracle and again it could happen. But we are coming off 10 years since 0809 we're coming off more than that right a a very bullish time period where.

[25:11] It's in weird like we live in right now in this year it's just been like this tumultuous time but the stock market and everything else so we got to know realistically as business people if we want the right thing right which is the setup a long-term successful company, that we got to be careful with with thatyeah you have very true and and let's face it I would say in like February of 20120.

[25:34] Um I I couldn't even say Co 19 didn't even know what it was yeah right right early 20 January February 2020 No 1 was talking about coid 19 maybe a maybe a few at that stage and in fact I'll even say in February of 2020 I didn't even know what a zoom call was, you know what is and the zoom call right exactly yeah and I would say a year ago. You know 12 months ago even 6 months ago um we we we weren't talking significantly about the effect of tariffs and what that might doto fixed price contracts or costs or. Demand for services and and where that would lead revenue and profit so on and so forth so the bottom line of that is stuff happens and the reality is to have a forecast that is increasing 30% revenue and profits increasing 30% or more every year in a forecast for 7 years is, not likely to be realistic somewhere in that 5 or 7 year period there's going to be a.

[26:43] A plateau or a softening or even a decreasing Revenue profit environment and we just got to recognize the realities and the cycles of this business. That that and that's and that's the reality that needs to be um brought forth in the ESOP process when I call the ESOP processes is you know a plan that starts with hey I understand ESOP and now let's go through the the modeling steps at the very beginning and 1 of the things I see is the other part of this is not just the idea that I'm going to get as an adviser they're going to get paid more money if that it's a bigger deal but they also the 1042 is also a wonderful tool.

[27:21] But it's it's also what I've seen and I've seen this just recently too it's it's like that's the only thing anybody's thinking about so 1042 is a capital Kane's tax deferral you have to be a C Corp to take it and what the advisors are doing is they're basically saying. We're just making the assumption that they are going to be a 1042 I've seen them not even not ever even model the escorp even though the company might be an existing escort in an S corp you should understand that is the company has ex tax exemption versus a cc Corp where you're going to have this deduction.

[27:54] And so the problem with that is that ultimately you could you could put the company in a position where it doesn't have as much cash flow to repay the debt. And that is all in the in the sense or in the intent of selling 1042 which again I think what I'm kind of coming across with is is I think the advisor needs to be agnostic to the point where they need to run every single scenario and every single example and even even within the forecasting like I think it's important to run all right your best case your worst case forecast you know and what's your moderate and then present the bonding company with those 3 examples and then each of those are going to have some impact to the company's balance sheet um but I'm coming back to the 1042 1 of the things I wanted to say is that creates the demand and the need for Bank financing. Because what happens is you have to put some liquidity into that into that 1042 qualified replacement property account and whereas liquidity come from typically from Bank financing so that that's what the people are really gearing towards and that's probably what you're seeing a lot and your your Market.

[28:57] Yeah for sure um anytime we see an ESOP a company convert yourself to an ESOP, liquidity of that company takes a hit so cash comes out of the company and and what's uh what what comes in return is. Is a debt Bank debt seller debt um under an ESOP share so we have a balance sheet is is quite dramatically different than what it was the day before it converted to an ESOP or the year before converted to an ESOPyou know a few other things that you asked about best practices. You know 1 of the best practices that an owner considering selling to an ESOP is to just Ensure. That he has these convers he or she has these conversations with with the home office of the the shity company and and and you know we have great people in the field. But having.

[29:53] The support the communication uh the strategy accepted by the Shorties home office is is important. So having that dialogue at at all of the levels all of the ranks within the shy company. Not only with the locality representative at a local shorty office but ensuring that they have the support of the home office uh because ultimately. My experience is that these companies that are selling or converting to an ESOP are generally larger larger construction companies I'm going to say north of a 100 million in Revenue um some sometimes it's it's you know smaller or less. Um and generally the shy needs of these construction contractors are are are quite large, and and let's face it you know the a construction company is a heavy user of of credit. Whether it be Bank credit or Surety credit so the contractor understanding how they are viewed.

[30:56] In the eyes of their shityso if for example ifif if we say 100% of the revenues are bonded.

[31:06] And they will really need to have a very clear.

[31:10] Understanding review and acceptance by their shity of their strategy.

[31:17] If if their Surety needs let's say our the revenues are are. 10% of the revenues are bonded you know we would call their their a low user or infrequent user of shy credit so.

[31:33] 1 who is a heavy user of shy creditwill will need to I'll suggest their shy needs to be their best friend. So communicate and understand how they are viewed uh from and by the shity1 of the things that an owner of a construction company considering selling to an ESOP is. Is for them to ask the question or have the dialogue with their shity about about guarantees, personal guarantees corporate guarantee in terms of an Indemnity package. And so it might be that The Surety company will say look.

[32:14] During the heavy lifting years of your ESOP we're going to need some level of personal guarantee.

[32:20] Now when are the heavy lifting years it's certainly year 1 it might be year 2 or 3 or 4 it's it's the first. Call the first few years of the the early stages of the ESOP it's certain not year 30 it's not year 10 probably in line with the if they do have Bank financing too is how quick does that bank financing burn off because. The seller notes are a little bit easier because you have the subordination agreement so that's right yeah so so the owners of that company will certainly will need to be prepared to subordinate the seller notes not only to the bank but also to the shity. Uh so that's that's a given the bank will demand it assurity likewise will require it so so there's no surprises the seller debt will need to be subordinated to both. Providers of credit the bank credit the bank lenderand and assurity and and you know 1 of the things that should be noted in that process. Is especially if this is a a construction company that is a heavy equipment contractor a road Builder. Yeah nowfrom a from a bank perspective generally speaking this is a general statement but I've seen itit's easy.

[33:42] For a bank to provide financingfor an ESOP who hasironheavy equipment.

[33:52] The bank is always going to be in a secured position meaning they have physical assets not only. You know the the bank covenants will state allall business assets are collateral for the bank so the bank is in a. In a highly highly secured positionthey have all assets including equipment. And the reality is they also have What's called the cash account they can sweep that cash account if if things went awry the reality is the shity is in a in a second tier or second position to the bank the the shy is not going to have collateral unless they've taken irrevocable letter credit or some form of collateral which is rarely the caseso because these creditors are not on on um in parity with regards to collateral or. Rightit shouldn't be surprising that the shity might at might not not always but. The contractor will need to be prepared for the conversationhow are they going to respond if the shity suggests hey we're going to need some level of personal guarantees during the heavy lifting years of your ESOP, whether that's year 1 2 3 or 4 and then you can have a discussion about.

[35:14] The level of personal guarantee is it unlimited or can it be capped or fixed to a dollar amount those. Those types of conversations are needfulyeah and it kind of it all comes back to the same thing it needs to be planned early you don't want to be surprised by it I and 1 of the things I'll just kind of throw in some details too is like we're talking we're talking about a 100% ESOP versus a partial lease up which I want to talk about the differences in strategies but in a 100% ESOP 2 there's like the sense and I know as an adviser.

[35:46] You you kind of want to help the the owner to get you know sell their they sold their stock and they're thinking like I shouldn't have the long-term risk anymore because I've already capped my um my the benefit I'm going to get you know out of the deal so they're thinking I now I'm taking personal risk to keep the company going yeah meanwhile I'm out as an owner and so there there's going to be a desire and naturally right as a 100% ESOP to say I'm just don't want to do personal indemnities right and um so it's really important to be able to plan that out correctly um I think the worst thing an adviser could do is say don't worry about it because you won't have to guarantee this the bank's not going to need it you're not going to need you know to worry about the indemnity and, but that's not the reality if you do have this this lopsided type of credit you know the bank's in a Better Credit position the shity is a creditor I think a lot of times people don't understand like your business is is similar to banking like in terms of underwriting and understanding the the credit side so I think that's really important you know to do early on but with a partial it may be like look we're and the reason I like partials I like hundreds I like partials but because partials can get things rolling where you can have a manageable level of debt.

[37:05] Um meanwhile there is a bit of like okay give and take on on guarantees because there's still a reason for that shareholder to be part of the company from a guarantee perspective um but it's able to we're able to bite off some of this debt early and then you retire and then show that this thing's happening so how how often are you seeing hundreds hundred percent versus partials and what what's your preference from your perspective you know I I I from a preference perspective I've seen both work effectively I really have um I I suppose if I have a preference.

[37:38] And if there is a a push back on personal guarantees from the owners. A a partial or a phased ESOP is is probably going to be a good or perhaps even right vehicleum so that we. We bite a little bit of the Apple at a time not swallow it at once with a 100% so that that strategy is um is um a way for the shy to to get comfortable with a a lesser amount of debt at least initially in Phase 1, and then once Phase 1 is say 75% complete then we we we move on to the next phase you know that's a that's a way with assurity can get comfortable with the strategy.

[38:25] And perhaps not even require personal guarantees, because the balance sheet isn't as leveraged as it might be with a 100% ESOP or even increased Bank debtso I've seen both work effectively and I've I have clients that are 100% ESOP fresh you know brand new ESOP and I have clients that are, that are in um in a first phase or second phase of an ESOP I've seen both work effectively and I I would say if I have a preference. A phased ESOP is is um it would be a preference especially if if there's sensitivities to personal guarantees, now my response to personal guarantees is sure he's he or she is no longer an owner.

[39:10] But they're they're managing they're running they're controlling the daily operations of the company either he or she and the existing team is continuing to. Manage and run and operate the day-to-day Affairs of the businessso sure why is no longer known or he continues to it be the decision maker and quite candidly he or she is the 1 that has reaped the financial benefit of the ESOP transaction so they're the ones holding the liquidity. That's right yeah all that all those are true and I guess it's just perspective and getting everybody in the right framework of of like what to expect really when when this is putting, together um what about for you um you know of course getting into synthetic Equity a little bit um what and I have I love it I talked to The Binding guy the other day too he's like I hate warrants I hate warrants so what about you know let let me go through real quick like a warrant is a is a synthetic Equity that gets, created at the time of the closing for the seller note for the shareholder to take the risk of the seller note on the interest rate plus a warrant and what they're usually doing is.

[40:17] Taking their interest rate down to a point where um even as low as AFR but then make up the difference at the end when the seller notes paid off with a warrant payment um based on the shares that they get and then out of that we also look at SARS stock appreciation rights for key people that are going to be a big part of the the transaction so what what's your take on the warrants and the SARS and and what what are your. I guess Financial sides like when you're underwriting that in terms of what you're looking for yeah you know great question a warrant is 1 of those topics that we could say on day 1 day 1 of the ESOP No 1 know what the value is. That's right yeah and there there is the and because of that therein is your term of synthetic right the synthetic value the value is it could be X it could be why we've 10 years from now we don't know what that value is today so my my view is is a warrant is is a promise to pay is a liability nowand I've seen and I'm not a CPA, but I've seen warrants represented on the balance sheet in different ways, I've seen warrantsidentified as a long-term liability on the balance sheet now in year 1, that liability is is I'm going to say generally quite small in year 1.

[41:44] That that warrant value is will increase um each year based on the synthetic value or nature of that obligation so it's going to grow that value is going to grow over the 5 years or 7 years and, so in the company does well and that's it's right that's exactly right assuming that company is profitable and and and returning the the profitability that is forecasted right so that generally is going to grow um how so I've seen the warrants, identified as a long-term liability on a CPA prepared financial statement I have also seenthe warrants identified not on the balance sheet.

[42:29] But buried in the notes where becomes a cont.

[42:34] Uh Equity transaction so on the face of the balance sheet you don't see it.

[42:39] It's it's you see it in the notes and it's buried in the the um the net worth or the equity portion of the balance sheet so it it appears to be warrants appears to be 1 of those um. Topicswhere it can be recorded as a liability or, I've seen CPS recorded as a contra uh equity on the balance sheet and I'm not a CPA so I'm not going to suggest which way is right or wrong I know which 1 is more creative than the other. Um I'd like to I like to see the the value on the balance sheet a warrant to me implies a promise to pay which. Which is for me a a liability SARS on the other hand is a stock appreciation rights that's the equity yeah kind of transaction uh and we see both we we've seen esops with no warrants or SARS very conservative and we've seen esops that have uh warrant obligations or promises to pay we we also generally see SARS stock appreciation rate so you can begin to see. What's the duration of an ESOP well the first 5 years let's call it is going to be repayment of Bank debt. The next 5 years let's call it maybe 7 years is going to be repayment ofseller debt.

[44:04] And then either after Bank debt or the payment of the of both those debt obligations now we've got warrant, payments and also we're going to have SARS payments relative to stock appreciation rights so over the course of this call it.

[44:21] 10 1215 I've seen 20 years ESOP. Duration there's going to be a lot of cash come out of this company due to Bank debt seller debt warrants SARS so it's incumbent upon the owners considering ESOP to have. These very candid conversations with the shity so that.

[44:42] There's no surprises and and the the shorty is buying in and agreeable to the their strategy their their valuation their view um getting the shity. On board is most critical with their strategy evaluation and and vision. Yeah I I think that of course that's the underlying theme of of today and I think the main thing is is the way so for instance the way the deals put together the the variable would be hey maybe we really use very conservative forecast.

[45:17] And if you have a conservative forecast that's going to yield lower Bank financing seller financing and then you have this combination of that well yeah we do warrants but what we're doing really is you just kind of like spreading that out a little bit if you have a very aggressive forecast and you do on top of that you know as much Bank financing and on top of that warrants. That's a different that's a different deal you know than I'm a very conservative. Then you know and all those things got put together um the reason I like the SARS too is because um again it's it's how you put the deal together its kind of what I'm getting.

[45:53] Because you're you're getting the key people what part of what we're always we're always thinking about is how do you get the succession plan to be successful right so not just with your rank and file but with with a keep SAR plan at what you're trying to do is say all right I'm going to be working last as the owner for the next 5 years I'm still working but I'm going to start phasing down and this other person is going to start phasing up. The Tsar gives them a sense of ownership but without having to issue equity in in Cloud up all the you know the the potential complexity of equity structures and so, there there should be money there for the Tsar payment and the SARS are usually every 5 years but when you but I guess my biggest point is that it really does depend on all of those pieces and I have had bonding people say well I just don't like warrants I'm like well it really kind of depends on how you build the deal all the decisions you're making and that's why when we do modeling. Exercise will have our model will be in from an entirety from the very beginning valuation through feasibility through the warrant of SARS.

[46:54] And then the ProForm of balance sheets and so what you can do is say all right well these this is the scenario we ran on the the forecast. And you can kind of see with the growth rate you can kind of see that was conservative. If this plays out this is kind of a conservative Financial package all of that I think that's the key is like you've got to have the ability to build models. That helped to predict the outcomes which are again assumptions but at the same time way better than, here's your 10 times multiple and then let's run that through and just assume we're we're maxing out the deductions and everything so so I think that that's kind of where I wanted to land like that's what needs to happen because, as a business person nobody can make good decision without the like the scenarios and the numbers and you guys will be in a place where you can actually you know.

[47:41] You know look at that stuff and actually model out your own numbers right around it would say like you said this is what we're comfortable with right and they come back and say all right now we've got the check of approval from the bonding company and we can all work to the next step to make sure that everything will be um you know succinct and there won't be a surprise like let's just avoid surprises because that's the best my opinion way to go so.

[48:04] Yeah for sure and it would be I'll call it a best practice for the contractor to share their their modeling with the shity you know conservative model maybe you know both ends of the spectrum here's a conservative model here's an aggressive model here's a middle of the road. And you know several iterations of possibilities. And then you know share the vision strategy with the shity and and to your point you know this the bank debt the seller debt the warrant of SARS those are really. You know I'll call it Thor buckets or 4 line items um for components that need to be uh managed and and um.

[48:43] Yeah with a a solid strategy and vision and plan. And I like your thought of conservative Bank debt certainly there's going to be seller debt. And if there's a a way to reward employees for the success and the financial results then maybe maybe there's a a buildup of warrants or SARS that is creates an incentive or reward um, so I I like that strategy um. The the owner who sells the company is is certainly going to want to maximize his his payday the day that. Um that this company converts to an ESOP but you know maintaining discipline. Um and managing those 4 components Bank debt the seller debt warrantsSARS um.

[49:38] So I wouldn't say you know we don't necessarily I wouldn't communicate to you that we don't like warrants I would say that at all uh we see them uh the reality is we don't know what the to your point this is synthetic Equity we are synthetic obligate we don't know what the value is we have a we can see a model of well the potential based on financial resultsuh which we'd like to see we like to see you know the ranges of possibilities, we certainly know that is going to grow as Financial results are expected to be strongso um it's it's a worthy topic you know hence you know we go back to the number 1 best practice of communicate communicate communicate, um sharing strategy. Iterations of forecasts um and getting the shy on board is and really they should spend a lot of time with the shity. Communicating um their strategy and how they're going to get there and I'll share you know kind of a a horror story or War story so to speakso I I've seen a contractor convert to an ESOP.

[50:50] I've seen many actually but 1 in particular. After the first year of ESOP they couldn't make the debt payments right couldn't couldn't make it.

[51:00] Yeah and so yeah then what and then what.

[51:04] And soso that that impliesa couple of things perhaps that maybe the valuation was in the stratosphere. Or something happened with a job or 2 or 3 that created some tougher Financial results in year 1 of the ESOP or a combination of. Of several of those and other factors well the the reality was the seller of the company said look we're just going to add the payments on so we're going to extend ESOP 1 more year so instead of this being a 10 year, you know Bank seller debt repayment is now 11 yearand so the owners of the company. Or or the the leaders the managers and those that have been in place for years helping to build a company and never were owners.

[51:52] You know they're kind of called the second generation they're sitting back thinking and saying.

[51:59] Uh why don't we just leave and and go set up our own company and and build it build it the way we want to build it yeah so on the surface what appeared to be a year or 2 prior creating cities for people. Of the current team has now created an environment where those individuals who helped build this company over, a decade or more are now thinking about leaving and setting up their own company and. Like the opposite of what you what you want to happen and it's probably the opposite of what everybody told them that was going to happen and and it and I think it does Center down to. The the way that the forecast was put together because all of those elements were flowing out of that and um you know this idea that it does matter and I and you want it to be the most successful thing but yeah once you lose that. That excitement from the key people that you got to know that that's going to flow into the rank and file and productive. 1 of the other uh uh experiences relative to Esau now some of these companies are. Our Union some are non-union. Generally speaking my experience is that those companies that are union contractors.

[53:16] The ESOP is for the benefit of the non-union uh labor in that company meaning the office staff not likely for the those in the field. Right because those in the field who are actually um Prosecuting the work in the field are union laborers and so they have a a union benefit. And so my experience is those Union laborers are not participatory in the ESOP. So how the owners or the former owners or the leadership of this Construction Company communicates. To their employees is most critical I've seen very critical Union employees that. Are are are syncing and asking a question well gee how does this benefit me I I'm I'm not, part of the ESOP I mean even and so being careful and strategic and deliberate with real intent.

[54:13] About the messaging from that leadership team to all of their employees.

[54:18] Um and is perhaps a different message to those that are in the office who are not Union, and and and another message to those that are union so I've seen a client that. Had to create an incentive for even Union employees touh to you know pay the path forward that they too participate in the success of this company and so they created an a bonus and incentive a separate from the ESOP separate from the the Union uh wages so there's a there's a lot of moving parts to this where owners should consider. Definitely that's why it's a big decision in in but I appreciate you sharing those 2 things and um just so people can be thinking about like hey it's not just. Zoom zoom let's get this done take your time it's the right way. So we're we're out of time but Kevin thank you so much for for just sharing it I'd love to kind of catch up with you later too down the road um in the Insight is I think really really helpful for contractors to be thinking about this and what your perspective like on that side of the bonding company so thank you again.

[55:26] Yes fit good you're welcome thank you for your time and appreciate the chance to get together and um thank you for all you're doing to help. Educate and and uh bring the awareness to construction clients about the the various moving parts of an Esau. Sounds good so for everybody else thanks for joining today we will see you on our next step on this journey to an Esau.