EP33 - Common Myths Associated with ESOP Transactions

In this 15-minute episode, Jason and Makenzie take on some of the biggest misconceptions that keep companies from exploring an ESOP. They break down why ESOPs aren’t the overly complicated, out-of-reach structures many assume they are and why owners don’t suddenly lose control the moment they sell. They also dig into the fear that employees won’t understand the benefits of an ESOPs hurt bonding capacity or borrowing power, and the belief that only large companies can afford them.

Transcript

[0:13] Welcome back to the journey to an ESOP and Beyond podcast where we seek to make all things related to Employee Stock ownership plans both accessible and understandable I'm your co-host Today Jason Miller and I'm here with. McKenzie worth. And today uh I thought that we thought that it would be a good idea to break out some of the topics that we've covered in our our previous podcast throughout employee ownership month. In those conversations out of their unique contexts and address them as. Just a highlight of common myths associated with ESOP transactions and we're just going to have a conversation about what we think those top 5 are. There's there's always more uh and then there's urban legends and we won't get into that today but uh we're we're just going to address these 1 at a time and just pull them out and and talk so McKenzie where should we start with these common ESOP myths.

[1:16] All right well today we're going to try to. Try to debunk these 5 top 5 myths in 15 minutes kind of a a bit of a crash course here. Um might be a little difficult for Jason and I but we'll we'll keep an eye on the clockso first myth esops are 2 complicated for most companies. Esops.

[1:39] A retirement plan they're a trust you may need a certain number of employees people think um there's a lot of tax implications they're just too complicated for most companies. What do you think about that Jason. I I I don't disagree with that they're complicated uh I I never want to put someone in a place to assume that it's too complicated for them, and you just laid out I don't know how many I was trying to keep track with with my notes but let's call it another 5 items that are all very relevant again retirement plan tax benefits uh the the number of of employees it's an m&a transaction type um and I I think. It's important for each person considering things to to build the idea of the ESOP around what context they have for each of those elements and just like we we talked about. Um Pretty pretty often just take it 1 bite at a time and then build your education foundationally through resources like the podcasts like the nceo. Uh like the ESOP Association and whatever you you can find about about that um what what would you add to that.

[2:55] I think that's a great summary I would say what matters most is a good team of advisors and providers as you mentioned um. Claim financials andand a good stable leadershipleadership team.

[3:12] Ready for the next 1 let's do it we got uh time on the clock. All right myth number 2the owner loses control after selling to an ESOP we only have 15 minutesum. Th this is uh1 of. If not the most pivotal question and it it's delicately answered and we have to think. Through what words are being used by the asker of the question and, really what what they're thinking about life after the the ESOP so let's address that first uh the the thing that I like most about ESOP transitions uh is you still have to show up the work the next day at the same company that you were the the day before with all the same people in place.

[4:07] And that functionally doesn't change for a lot of people very few owners are using it as an exit to immediately leave uh their role and their operations and so there's this continuity from before uh to after uh and then you'd mentioned something important in the last 1 around having a great leadership team uh as a key piece of um, the just the idea of complexity kind of sharing the load of the burden of that so decisions for how the company operates. Are going to continue as they were before. And you've heard me use the term imposed governance uh if there wasn't a a formal board before in an ESOP transaction a board gets established and then the particulars of your your deal and then if it's a majority sale or a minority sale who's who sits on that board um but most uh most of our Founders and owners like the idea that afterward on Day 2 uh it's going to feel like every other day they've shown up to work and they still get to do what they're doing uh what they did before and so this idea of control um is is is separate from do I do I still get to retain my influence in my leadership.

[5:25] Greatand I would also just add that when you think about.

[5:31] Owners losing control or you in an ESOP transaction you understand there's a trustee that is. Representing the new ownership and just keep in mind that ownership. Control versus operational control are2 distinctive things that ESOP doesn't Force you out.

[5:55] That's a really succinct distinction I wish I could have said it as eloquentlyall right myth number 3. Employees won't understand it or won't value itthis is a good 1 um. Never underestimate peopleuh that that's that's the first place that I would start and then.

[6:22] How to how to address that and um.

[6:28] I think at every roll out uh that we've either been a part of or have have heard of the questions that come are really really good questions around what is this what does it mean to me what are you trying to tell me and back to myth number 1 the the all of the items the retirement plan that the tax benefit the m&a piece all of those kind of roll into the employees perspective, and just like for owners and the complexity piece delivering that message and communicating that message to the broader populace is is important.

[7:06] How you say something matters what you say also matters. But they're going to be thinking about it like oh I have a new retirement plan am I going to be taxed on that and then is is anything changing we have this huge announcement uh am I going to be working for someone else what's going to change for me uh how are you going to address that that anxiety and we uh we espouse communication as the key, and then the second part of that myth was they're they're not going to Value it and the beauty of an ESOP statement is that there there is an explicit value for that particular employee and it is small in the beginning in in most cases but that does grow over time and so their appreciation of the value of what the ESOP means to them individually is going to appreciate alongside their their stock value and their their statement balance in my opinion.

[8:03] Rightand I think a big piece too is that um.

[8:10] What is a good kind of reminder is that it's that no cost to them they don't have to do anything different other than maybe the mindset mind mindset shift that happens just from. The the roll out or the announcement of of the ESOP um.

[8:28] But it's at zero cost to themit is a shift in in mindset uh that that's such a great way of putting it because before the expectation of of a worker that works for someone else is is a paycheck a little bit of stability responsibility and opportunity for growth professionallyand I I think the Gap there is, is filling that expectation of I never knew that ownership was an option for me I don't know what ownership means it wasn't in my plans I didn't want to be an entrepreneur, so I I shelved the idea of ever owning a business so I never explored what that would mean to me uh where now it it is it is being given to them in this structure um some people hesitate to use the word gift because they do they earn it through through their their Blood Sweat and Tears as I often say um but the it's suddenly A New Concept that they have to pull into their their own mindset, and then re-evaluate and then what it means what it could mean to them like how how is this different than another way and then what am I going to, do with that how am I going to think about that and it's going to take some time for for that to uh to kind of ruminate uh and and produce some fruit. Right won't happen overnight but it does happen.

[9:50] Myth number 4esops destroy bonding capacity or borrowing power. Cool that's a strong word destroyum it it really isuh, thereyou've probably heard me talk about the iceberg and I mean we're we're on a podcast and then and and YouTube and there's always Iceberg videos like the very top and I. Often said that you can tell how far uh certain people go by what they say when you say ESOP and uh inevitably it's oh well it inverts the balance sheet all right we're at the tip of the iceberg um or you you're going to destroy destroy uh the the debt capacity of the company and uh that that may be a step lower so there there is a financial impact on the company. And there's there's no doubt about it because functionally in an ESOP transaction the owners are exchanging their equity for debt.

[10:53] And that debt gets represented on the balance sheet by itself and that could be Bank debt or seller debt. And then there's that fun thing uh that unearned ESOP shares portion uh that magically shows up on the balance sheet as well and a, person at the tip of the iceberg that's worked maybe with 1 or 2 esops or has heard about them or or understands what what conceptually they are when they look at the financials they go whoa, this balance sheet is upside downum and uh shy agents and and carriers make their decision for uh for bonding, a lot on this the strength of the balance sheet of the company it's not the only Factor but that's there and then the company's ability to uh generate uh and a creative balance sheet meaning that their payments on their debt is less than what their cash flow is so that they're stable.

[11:50] And we get to this idea of stability Bankers look at it similarly right how am I going to get out from underneath of whatever it is that I'm extending and then I look at your balance sheet and there's if I just see it at the tip of the iceberg there's. There's nothing here uh that gives me Confidence from an asset perspective uh that's that's going to make me feel comfortable with your debt and so I don't want to give you more. Uh and it it does create some limitations all of that goes into structuring you know is it Bank debt and seller debt to finance the ESOP what's the Right Mix, can you hear me talk about productive Capital versus unproductive Capital uh in in that decision-making so that the company itself has what it needs to continue to generate Revenue that the value is derived from so destroy is a strong word uh but I can see how a lot of people would use it if they first look at financials after a transaction and go whoa. And a big way to maybe avoid that reaction there is is transparency and communication upfront with your lenders and your your charities. Takes a village you don't want your shirty finding out the day you close on an ESOP no no absolutely.

[13:06] All right myth number 5 esops are too expensive for midsize companiesum.

[13:15] How would you answer this 1 McKenzieI would sayit's likely less.

[13:25] Expensive thenother exit strategies for example selling selling to private Equity maybe um.

[13:34] I would also say.

[13:37] The savings the tax savings that result frombecoming an ESOP companyhelps you recoup the costs quickly.

[13:48] I also think finding the right provider.

[13:54] The provider that's a right fit for you of course there's so many providers in the industry at different levels that can helpdifferent size companies um. Depending on on the size of your company and the complexity of your company the structure of your company you may not need this. Um more expensive provider you can have another provider that provides the same quality of service but. Is maybe less it's more umit's within your budget for the size of your company.

[14:30] I think my. My take on this we we could we could talk for another hour we don't have an hour we only have a few minutes with our our self-imposed time limit we'll see how close we get we get to that um. Not every company has every option to exit and we talk about that too right not every company can become public not everyone has a a strategic uh that's interested in them not everyone is large enough for for private Equity so when we say it's too expensive for a mid-sized companyum. My thought behind that is there's a cost individually to Founders that don't plan their exit. And give thought to that when they can and plan for it they might decide I never want to do an ESOP but if I don't know what options are available to meuh then I'm not going to know what I need to grow to or go to, uh from a financial perspective to become attractive to a different type of of buyer or option um. And the other gap that we could talk about is if if an ESOP isn't an option that management may not have the ability to uh to create the the.

[15:49] The their purchasing power, to buy from a Founder to buy from owners uh and there's more risk to an owner in that than there would be in an ESOP you not simply because of but certainly those tax savings that you had mentioned could facilitate a deal at fair market value so that 1 1 element of cost is um it it should be explored I think we encourage people to explore the idea of how affordable it could be from a um.

[16:20] From a a process cost from the transaction costs um because really what it's preserving for them is is uh the value of of their company at fair market value uh rather than having to accept a different option and the earlier that they plan for that the better the other umthing that I wrote wrote down uh for this is, the that access to to advise and get getting the right teams in placeto have a, create an objective mechanic conversation about what I what I just talked about and I I I see that there there are a lot of great providers um in in the ESOP spacethat, so I would say that exploration is key don't don't just go to the first 1 and be like ah this is too this is too expensive um really vet that out and and find good good providers for the transaction uh for for your particular company.

[17:35] Okayvery insightful. All right well I think we did itis it's a miracle um. Well this this was this was kind of fun for me um I I hope it was for for you too uh and our our listeners uh thank you uh again for tuning in uh we hope that you found this valuable not just for yourself but share this with a friend that you've had a conversation with about esops when when you and you're talking over dinner or or over a beer and you're saying hey I'm listening to to these folks on this esot podcast and they give you a weird look uh say no no no here's here's an episode I want you to listen to this is why I'm listening hopefully this is 1 of those. Uh but thank you for your your attention like subscribe share all all the fun things and then we will see you next time here on journey to an ESOP and Beyond.