EP34 - Feasibility is not Just a Math Exercise!

In this episode, Jason and Makenzie dive into the real purpose of ESOP feasibility and why it’s far more than just another spreadsheet. They break down what “feasibility” truly means in an ESOP transaction and walk through the key factors companies should evaluate, from existing debt to entity structure (S-corp vs. C-corp) to long-term sustainability. They also dig into how feasibility helps determine whether an ESOP will genuinely benefit the company, the owners, and the employees.

Transcript

[0:11] Hi everyone welcome back to another episode of Journey to an ESOP. Where we speak on all things related to esops to make them accessible and understandable. And I am your host today Mackenzie worth co-host ratherand I'm Jason Miller thank you for coming back.

[0:31] And today we will be discussing how feasibility is not just a math exercise.

[0:39] Feasibility that isthat is explored and the early stages of. An ESOP transaction and whether you want to follow through with an ESOP transaction is much more than just a spreadsheet calculation. So we're going to break down the elements that truly determine whether an ESOP can succeed or or whether your company can sustainum. An ESOP transactionI really like this topic. Uh I'm I'm glad that this is what we we've been talking about we spend a lot of time with our clients in in feasibilityand I I do think that there may be some. Um That's the right word that I'm looking for like me Miss misconceptions or maybe just a different expectation of what what it means when we use a word like feasibility it's like oh Is it feasible is can can it happen uh is the the broader topic um I think it might be really important for some of our listeners to understand what. Is really being decided on. Uh throughout the feasibility process um what what are some of the big topics that that get covered or should be covered during feasibility.

[1:58] Some of the big topics includethe can can your company. Pay off the debt that comes from the value that that the ESOP is paying for. The shares of the company um what what kind of capital structure.

[2:21] Is is comes or issustainable to make the transaction happen umwhat doesdo you. Stay in escorp do you become a C Corp what are the tax implications on their under under the different scenarios.

[2:40] What am I missing I know I'm missing a lot. That that's a a great way to to look at it there is a lot that goes into to feasibility right so we're we're talking about the the, debt structure let's back up just a moment so our particular process and really probably most most advisors processes start with is is there value here in the company.

[3:04] Um what value are we going to use to operate all these assumptions on uh so we take a number from from valuation stage or we we we begin that and then we we roll this into this feasibility now that we have a numberwhat does it mean and then what do we what do we do with it. And your comment are on is it sustainable can the company uh. Pay this value to the selling shareholders and then the other questions that.

[3:35] Follow in that chain arewhere where's the money coming from where where is the money going um how is that money coming to the the selling shareholders uh and then what what implications are there of uh I guess what options if you want to say options what optionality is there in determining thatum and you'd mentioned escort and and core so when we we think about corporate structures and their their tax implications to the company is is 1 item and then to the selling shareholders is is another item and isolating out the benefits of of an ESOP. Uh ownership structure um is is kind of a big key to that because that's the can can the company survived uh can the company Thrive and is it going to be workable in in the future. The 1 piece I guess 1 1 of the the elements during this stage is is it going to be a meaningful benefit to the employeestalk about that for a minute.

[4:42] Yeah what what does itand feasibility what does it look like for the employees and how many. Let's say years does it take for their statement to be something that's meaningful to the employees um. How do employees receive shares and how many shares are getting allocated to them on an annual basisum.

[5:09] We've had some and for our listeners we're talking about these pieces we all of this should be through the lens of you know are you deciding onuh you know Bank debt and seller debt and warrants and they assumed interest rates and and all of that that that's kind of granular I I I like how we're we're talking about this it's what what other decisions are are being made uh by these choices these these options that you're really unaware that you're making for the long runum.

[5:49] In some ways we've had some some clients that have expressed what Mckenzie was just talking about and very clever ways and I remember 1 distinct was like well how how long would it take. For someone in the ESOP plan under the way that we're thinking about it uh to basically have have their annual salary as a. Um as a balance in the ESOP with all the assumptions based on you know projections and future values and we all all know about how unreliable those things really are unpredictable I think is the best way to put that uh with with the caveat but hey if all this kind of pans out uh I want it to be meaningful for them what I think would be meaningful is a balanced equivalent with their pay how long is that going to take.

[6:41] IsI guess cool about feasibility is you're not just looking at what does this mean for the company you're looking at it for. From the company's perspective the shareholders perspective and the employees perspective because as part of feasibility we want to make sure that it's a win-win-win scenario for all all parties involved we're not just making sure that the company is going to survive we want to make sure, the shareholders arereceiving you know the liquidity they would like upfront or the value that they're looking to.

[7:12] To get as part of the transaction andfor it to be meaningful to their employees.

[7:21] I think every client asks when do these go wrong.

[7:25] Under what circumstances do esops would my ESOP breakum we hear uh stories or anecdotes um around uh things that didn't work out like they were supposed to or like they were intendeduh so what what makes that happen um and we routinely respond with this is the stage, where we test all of those so that we can get those wins the board as as you mentioned it should be a meaningful benefit to the employees it should make sense for you as a selling shareholder. Has to make sense for the company. Uh to to be able to repay the the debt that's being created in in the transactionand all of those are are choices in the moment. For the transaction but what feasibility highlights in the future is well me as as the selling shareholder. While my my role my leadership role may not be changing um.

[8:30] And on Day 2 after the transaction uh I I do need. My intention is for the culture that we've built for this company to exist all the way into the future and now the ownership is shared through the the ESOP with all of the employees um but if if they're not winning if that's if that's not a meaningful benefit. Uh the the gap between what you brought as a Founder to the success of your company uh to their uh incentive. To pick up that mantle and distribute it across your your entire population of employees that the Gap is going to be pretty wide if it doesn't work for them and those are the things that we're evaluating uh in in feasibility so that it doesn't show oh this is just a minor additional benefit on the side um it is a benefit plan but ultimately this is the um Catalyst for everyone to grow into their best selves within the culture of your company and then take on that mantle of ownership. It's maybe difficult to grasp or justconnecting the 2 pieces may may not be simple but um.

[9:54] The annual contributions that are made to the ESOP and why that how that amount is determined and why why determining that amount amount is important.

[10:05] And what what um rules do you need to comply with that you may not even know you need to be complying with when looking at feasibility.

[10:15] Who who dictates that compliancethe IRS.

[10:22] And you're you're right so the the retirement plan element of the ESOP it is a defined contribution plan uh does have limits um and restrictions uh kind of guardrails around all of that uh in in order uh for the employees to get again a meaningful benefit in a way that's um that that isn't, prohibitive on the company uh and isn't outside of of those guidelines 1 of the things that. Feasibility helps uh this this scenario analysis right what what what am I deciding on um and again capital structureuh is is a big key to that but also well what what if I wanted to sell less than 100% of my company. And this analysis that you just mentioned is even more key in that scenario uh because of the split ownership between individuals and and the ESOP and so there is strategy around that term of the inside note that dictates the amount of the contribution in light of a a partial sale for for your ESOP. And for any of our new listeners um the uh 1 concept I want to pull out is you can sell a portion of your company to an ESOP.

[11:47] Uh and the you never have to finish selling your company to the ESOP so isn't a path where you you get down and go I want to sell 30% of my company to the ESOP but then I've got a ticking clock on how long it's going to take for me to sell the remaining 70% um it there's a lot of flexibility in ESOP structure and then in in that structuring in that analysis this feasibility is really where you get to see the impact of that to help inform you to make the best decision for yourself do we include an ESOP do we not do we do a partial ESOP sale. Do we not um and all all of the the the things that McKenzie just mentioned are should be examined or during that time.

[12:34] Jason how would you describe.

[12:39] What to consider when you are an owner is interested in incorporating Bank financing and combination of Bank financing and seller notes what what is the balance that needs to be considered there what what do you need to consider. Oh that's a good question um I could talk about this for a long time as you know and I've heard me before umthe. There's so many different facets during a transaction that are on your mind and the first 1 is what works for the seller when I make this transition do I need cash upfront. From the transaction for myself or for my own personal financial plan or just because it is my company I have sold my company and I I want to have cash at close uh to make it whatever feel real feel right and only you as as a selling shareholder can answer that that question on what what's important to you if it is important to you to examine that the first is going to be understanding what the market has available to you.

[13:45] For your company for an ESOP transaction and those are very very distinct layers if your company requires debt. Uh operating I call operating debt so you you have uh a lot of capex you finance Machinery you have a facility uh that needs maintenance or you're looking at expanding your facility um you have seasonality and you need a line of credit to get through that that seasonality anything all of those are what are called productive capital, and they are necessary for your business to continue operating as it was before so you always have to have access to that capitaland that. Is kind of the the base level of debt Capital that has to be included in your debt capacity so part of feasibility is understanding the debt capacity of the company uh and then within that debt capacity what the market would have for you in that differential between. What you can pay which we figure out if these ability and then what uh is above your your operating Capital need. That could be available for an ESOP transaction to fund liquidity at close, um it would be disingenuous for anyone to say up here's a blanket uh amount of debt that a financial institution would be willing to give you for this this transaction just because.

[15:09] Uh and you know they're they're gonna provide that to you above and beyond whatever your company is debt capacity is debt capacity how much can you affordand layering that in it's not just paying the bank for all of those operating uh uh debts but then for whatever their funding for the ESOP transaction and as we've mentioned you're going to have even with bank financing you're going to have to take back a note if you sell a 100% of your company suspect the partial thing but if you sell 100% of your company no 1's financing that uh to an outside lender is not financing all of that, so how how does that get repaid to you and so all of those considerations are does it work for for you as the seller um what is the market have for me and can I continue operating the company as profitably as I have before because I have access to equipment lines and Facilities loans and uh and lines of credit to to operate. Just just some of those did I miss any. No I would think the only thing that um keeps popping in my head that is something we look at in feasibility and is important to consider when you're pulling in Bank financing is. Looking at how quickly can you pay well first off let me back up when you have both pieces your seller note is subordinate to the senior lender meaning you cannot.

[16:31] The company cannot pay the seller note before or until it pays off the bank debt. So the seller is only going to be receiving interest payments until that Bank debt is paid off. And So within feasibility we explore how quickly can that Bank debt be paid off so that you could start chipping away at the principal on the seller note.

[16:52] That's really important I should have mentioned you think I'd know better by now um. There's too many too many areas there are and that's that's really what I was going to get to and and listeners when we talk about all of this I don't want you to get too bogged down in the details at at this stage and we're just talking about feasibility the concept uh that I I want you to hang on your framework as you're evaluating this uh this term cash flow mapping mapping is is a great word.

[17:23] Uh not just because we're a journey to an ESOP and Beyond podcasts and and like the idea of of maps and directionality but uh you you have a a path that you are charting out in relation to your cash flow, and you kind of know where you want to go and then you're taking the steps to get thereand in doing that you will arrive at your destination. Uh and you you might have a circuitous route you may have to go off the beaten path just if you hang the concept of cash flow mapping and apply that to feasibility for your company. Before you individually that gives you something to to hang your questions on and then gives you context for oh now now I can take that and go ah subordination and interest payments and productive capital and not don't don't worry about all of those just think big picture uh and then use that to help drive your your decisions.

[18:25] Jason how could we tie in I think. 1 of our last couple episodes we've discussed forecastinghow does that tie into feasibility and why why is forecasting important when we're looking at feasibility. Um

[18:45] If weproject what we think is going to happen. Uh this is that idea of of of that of the journey right we we have to kind of know where we're where we're going and it's it's not just a guess I mean it is a guess but it's an educated guess based on your company's performance and what you know about your company and and all of thatand those future, cash flows are what is going to be repaying.

[19:19] The seller for the debt that they take on in exchange for their equity in the ESOP transaction, so it has to be um reasonable and it should be heavily scrutinized um I think I use the term often you know we're going to beat it up with you when we we talked about forecasting is this real uh do you think this is achievable is this everyone working 100 hours a week at your company um is this making an assumption that you're never going to need a new facility or you're never going to need new equipment what what goes in into this and so that that we say accuracy on a forecasting knowing that it it's going to be wrong um but it should be reasonable and under the reasonable kind of test then could this structure or this value um hey be uh are you able to repay it is it sustainable for for the company but in that it creates.

[20:19] Um The optionality of oh okay so now that I see what my forecast my my revenues and my profitability what I think they're going to be. Uh and now I I see how that's going to repay me for my the sale of my shares now I can really start dissecting how do I want to receive the funds uh do I want to include a bank uh do I want to carry back the note uh in its entirety do what kind of split feels good for me um and more often than not um. We use that forecasts and those assumptions is what I call the governor on how we approach negotiation and structuringbecause every owner wants to see the company Survive and Thrive and they don't want it to be choked out by a bad year. Um and so that sensitivity analysis on that forecast is going to be key so that they can breathe and so the company can breathe and that everybody uh back to your comment earlier everybody wins even when uh the economy or circumstances make it feel like No 1 can win in that scenario.

[21:33] I think you mentioned a good point when we you were discussing the the future cash flows and of course in feasibility we're looking to make sure that the company can pay off the debt that is a result. Of the transaction but you don't want to forget about the other.

[21:49] The other demands that are required like cash flows are not just covering your debt you got to look at Capital expenditures that was something you mentioned um. You need to consider what if you're very equipment heavy vehicle heavy what capital expenditures do you need to make sure your baking into your. Uh forecastin determining your future cash flows to make sure that you have that covered as well you're not just making sure you're covering the debt you want to make sure you can cover Capital expendituresand also any working capital. Incremental working capital needsI think this touches on um a topic that we see pretty often uh in our our clientele we work with a lot of construction companies we work with a lot of of companies that require bondingum and have very very healthy balance sheets, um and that that creates a lot of that's a result of of a high basisin the company.

[22:54] And the philosophy of ownership leading up to a transaction has often been uh the only distributions that I take are those that are required for me to pay my taxes and then everything else gets reinvested inside the company or remains inside the company for the inevitable uh cyclical shift uh that may not be going our way um and there are a lot of choices to be made around what to do with that basis in light of a transaction. In light of your shity company in light of your debt capacity and your your borrowing capacity for for Bank debt. And all of that should be considered in this too but again the big concept is thinking about what has been our our distribution philosophy uh leading up to this and why did we do it that way, feasibility gives you a mirror. To look into and say huh maybe we should consider a change or we had a really good reason for doing it this way and now we we validated that reason and that's going to influence structure. 1 of the key things around basis in feasibility in structuring and you had mentioned S Corp or C Corp earlier uh is the the tan the benefit of exploring. Uh ah ah CC Corp transaction.

[24:16] Uh for the potential to defer the capital gain on the sale which is a 1042 Exchange um which basis influences the uh the impact or potential benefit to you as a shareholder in that and what we do with bases at what what structure. All of that gets back to what what's our what's our philosophy what has it been and what should it be in in light of the transaction and the changes that are going to be made on the balance sheet.

[24:45] Right and being able to model that out in feasibility with the numbers and showing you what that looks like under those different scenarios. Is key and kind of follow suit with the wholeum mappingprocess and decision-making that results from. What kind of mistakesdoes feasibility helpowners and companiesprevent.

[25:27] Being overleveragedand.

[25:36] Preventing.

[25:39] When you're looking at the inside note and when you're looking at the annual contributions that you're you're making to the ESOPpreventing um. The acceleration ofthe repurchase obligation.

[25:54] You are looking at how can I allocate shares over a certain amount of time in a way that I'm not allocating too many shares up front. Which then accelerates or pulls your repurchase obligationumsooner.

[26:11] And maybe I may not be articulating thatperfectly you got it umand I I.

[26:20] Think that again going back to Big Concepts and what does this mean to the employees so we've talked about this in relation to the company and to the the selling shareholder so the company that kind of that cash flow mapping piece um and then for the individual shareholder philosophies around why we've done business like we've we've done business in in a financial context and is this the right time for a change since change is coming with the with the transaction and you're touching on something else that weaves into all of this and that's to the employee perspective everyone would like to have more shares sooner.

[27:03] Um but having more shares sooner uh in a a growing company May create some unintended consequencesand this idea that, when we we talked about, uh sure we can make this particular structure work and it's going to be somewhat tax-neutral to allow you to to do do a 1042 uh the only thing you have to do is just prepay the inside note um okay well that's that's going to have it its own consequences not not to say that they're terribleum but it it could alter the way that the capital structure for the company uh it is needs to be in in years 5 or year 7 or year 9 or year 11 and the further out we go the less reliable we are on data but if you treat that up then use uh the feasibility the initial feasibility as a a map as a guideline and then true up as you go you're going to see how close you got to your assumptions and whether or not there have to be other changes or considerations.

[28:06] I got off topic again but back to you uh the the benefit level and you know thinking about this is a benefit to employeeswhat's a meaningful benefit and how do we plan as much. Structure and stability around I guess consistency around that benefit to to them so company cash flow um. Owner philosophies on on finances and and the the company and then the the benefit the meaningfulness of the benefit to employees is kind of the way that uh I would encourage people to look at what's really a complex topic uh and apply that and go oh how does this fit into our philosophy how how do we map this this cash flow out how what what is the meaning of this to to my employees and that that might provide some um, some structure to the thought process of really what's being decided on outside of, what are the dollars to and from uh and then how are we going to handle thatall right.

[29:09] Perfect summary of how feasibility is much more than just a spreadsheet and and a mathematical. Exercise. Very good any other uh questions comments concerns or things that we could share about what what really is a um. A multifaceted part of the process and probably the most pivotal part of the process.

[29:41] I would say ummaybe the only piece that we haven't touched on whichwithout getting too in the weeds isanother.

[29:52] Piece to explore and feasibility is um synthetic equity and how how that impacts.

[29:59] How that kind of all weaves into feasibility specifically I'm thinking about warrants andhow that kind ofeases the burden on the company.

[30:10] Relative to the seller notemaybe just touch on that a little bit sure uh and and listeners I know that Philip has recorded a handful of of podcasts specifically on warrants and then also on stock appreciation rights which is another form of synthetic Equity that's often included in ESOP transactionsum but we'll touch on a high level of of that and I I would look. 1 of the ways that I would look at warrants so uh in in in an ESOP transaction is a a pressure release valve for the company on its interest burden. As it relates to the seller noteand the way that uh I I routinely explain this to clients is when we.

[31:00] When you get a mortgage at a bankyou can buy down the rate of your mortgage by paying points or paying cash upfront to to lower the the rate on on your mortgage to a certain extent. The company is taking on debt from you so you as the selling shareholder are a creditor in the capital stack with your seller note and then you are entitled to a market rate of interest on on your seller note for the risk that you're continuing to take in its new format um and so if the rate is whatever the rate is let's call it 10%um that's the the market rate of interest the company may not like, uh paying 10% interest so I I don't know about you I don't I wouldn't like paying 10% interest but that that's what you're entitled to and we talked earlier about using the feasibility as a governor for these uh different parts of the structure and so you could say as the founder I want this to be feasible I want this to be sustainable I want the company to win as we're mapping out cash flow um but I'm entitled to 10 um I'd be willing to take 6.

[32:11] And what the company compensates you with is called a warrant in this scenario uh that. Makes up the Delta and there's some math in in there but functionally you're giving the the company a break on the debt that it took for you at 6% when market rate is 10 and when all the debt is paid off those warrant shares that are given to you it's kind of again the company's paying points in the form of of an synthetic equity. Then you're you're going to be entitled to the growth in in the those warrant shares so. It's still risk if the company is flat they may not be worth anything they might not be worth much when the debt is paid offif the company does everything that that you project that it's going to do and more than there is potential for a lot of upside on those warrants which makes it really attractiveum and that's 1 way to give, the company a break this pressure release on monthly interest payments by deferring this and taking on some some Equity risk and exchange.

[33:28] Another another piece of feasibility that kind of probably makes all this sound maybe overwhelming there's there's so many. Someone need moving parts that we look at and feasibility but I think that speaks to why the feasibility phase is super important. And it's a phase that you shouldn't necessarily speed through or um.

[33:50] You should spend the time to truly understand your your options and I think that's a big key here too is looking at the options you have in the the different scenarios that you canum.

[34:01] Play out and model within feasibility.

[34:07] Very good well I think we'll probably have to do another 1 of these and maybe break down uh each of those 3 areas the cash flow mapping concept the philosophies that we bring into a transaction sounds like a great topic for for a podcast for for us to cover. Uh and and then on the employee benefits side making it it meaningful and sustainable to them listeners thank you for for joining um, share this episode with a friend uh send send us interact with us on the journey to an esop.com uh and provide any of your feedback good bad or indifferentum would love to hear from you and also on topics that you want to hear us cover and what level of detail but we really appreciate you listening in. And then we hope that you join us next time on the journey to an ESOP and Beyond podcast thank youthank you.