EP20 - The Negotiation Process in an ESOP Transaction

In this episode of Journey to an ESOP and Beyond, Makenzie breaks down the negotiation process behind an ESOP transaction. From purchase price and seller note terms to governance, SARs, board composition, and fiduciary requirements, this episode explores the key terms that are typically negotiated between the seller and the ESOP trustee. If you’re considering an ESOP or preparing for a transaction, this episode offers a practical overview of what to expect during negotiations and how the process compares to a traditional M&A deal.

Transcript

[0:10] Hey, everyone. Welcome back to another episode of Journey to an Aesop and Beyond. I am your host today, Mackenzie Wirth. And if you are new here, welcome. If you have been a listener for a while, welcome back. As a reminder, our intent is to provide an accessible and understandable resource related to all things employee ownership. If you're new here, you may not know, we have been where we are on season seven. And this year during this season, we're releasing 12, what we're calling 12 foundations of transition on the first of every month. So the first podcast episode of every month is one of the foundations of transitions. And this is geared towards owners who are looking to sell, thinking about selling, thinking about a transition. And of course, we always tie in how that relates or how that what it is in the context of an ESOP transaction.

[1:20] So be sure to subscribe, join in, and listen as we continue through those foundations of transition. But today we're going to take a pause on that theme and going to discuss all things negotiations in an ESOP transaction. So depending on your level of knowledge of an ESOP transaction and the transaction process, you may or may not know that there is a true negotiation process when you sell your stock to an ESOP. So today we'll break down what exactly gets negotiated, who's involved in the negotiation, How long can that take? What does that process look like? So let's get into it. We often tell our clients that the transaction process and the negotiation sort of feels similar to any other M&A transaction. It definitely has its differences. A lot of people use the word it's more friendly.

[2:30] However, it is a true negotiation process because, as part of the Department of Labor requirements and process agreements, there needs to be a, transaction that happens at arm's length and the transaction has to transact at fair market value or no more than fair market value.

[2:57] So the owner that's looking to sell to an ESOP can't just, come up with their own valuation or come up with a number that they want to sell their stock for and sell it to the ESOP and the ESOP trustee just says, yes, sounds good and moves on with life and your transaction is done. It is a true process that follows the, again, Department of Labor process agreements.

[3:22] So first, we'll discuss who is involved in the negotiations. So I did just mention a trustee. So the ESOP trustee, who is the trustee who represents the ESOP trust and represents essentially the employees, the protecting the interests of the employees. This is someone that you as the selling shareholder actually hire. So you would interview a slate of trustees or maybe you already have someone in your network, you hire them, they act as the buyer.

[3:58] It is very common, almost always, that this trustee, the buyer, will retain their own ESOP counsel as well as a financial advisor or valuation firm, essentially one and the same, to help them determine a valuation range to negotiate towards. When they're negotiating with the seller. So you have the selling shareholder who likely or should, we would suggest always having your own ESOP advisor, ESOP financial advisor. You will always also have your own ESOP ERISA attorney. And then yourselves as the sellers represented by these people. So that's everyone that's sitting at the negotiation table.

[4:56] And what is typically different in an ESOP transaction is the seller always provides the first offer.

[5:07] So with that as mentioned you want to make sure you have a good ERISA attorney to, know the terms that to initially offer have a good LOI draft ready to go, with all the different factors that you're negotiating and, So what are those factors and what are you negotiating other than the obvious, the purchase price of the transaction, what the ESOP is purchasing your stock for?

[5:42] So even if you, I guess, don't have everything in your initial offer, the trustee will come back with other items that they want to include as part of negotiation, of course. So we'll kind of just go over what we typically see in the term sheet negotiation process and what items are important to think about as you either think about any sub-transaction or as you are getting closer to the negotiation process. So first, of course, is the purchase price, the enterprise value of the company. By the way, we're going to also speak in this scenario as if it's just completely seller financed because, of course, when there's a bank involved, there's more terms negotiated and other people to negotiate with. However, in this case, we'll keep it simple and stick to seller financing.

[6:37] So first is the obvious the enterprise value the purchase price what the trust is going to purchase the stock for again based on department of labor process agreements the trust cannot pay any more than fair market value so the seller should have an idea of what that fair market value is assuming they have a good esop financial advisor that has prepared them set their expectations. Meanwhile, the buy side, the trustee, is working with their valuation firm to also come up with a fair market value to know what they're negotiating towards.

[7:19] This isn't like in any other transaction. You also have a target networking capital. That is part of what you're negotiating, which may include a caller, so an amount where, say once you figure out all your numbers at close which of course happens, not immediately on the closing date or the day after it takes a month or maybe two or three, whatever your final working capital is as of the close date if it's within that collar then, there may need may not be any purchase price adjustment if it's above that collar or below that caller then there would be an adjustment. So you're negotiating two pieces with the working capital the target networking capital and the caller.

[8:14] So the financing structure is, of course, a term that's called out in the term sheet. Again, in this case, we'll just assume that it's all seller-funded or seller-financed, so trustees not going to typically argue with that. That shouldn't be something to really negotiate, but that's a term that's obviously laid out in the term sheet. However, specific to those seller notes, the terms of the notes would be negotiated. So the interest rate, frequency of the payments, and the terms of that note. How long is that note amortized over? Are there two separate seller notes is there a seller note for the price of the stock and then is there also sometimes well often we see a seller note for a distribution of their basis, is one subordinate to the other these are terms that get negotiated.

[9:22] Another term that gets negotiated is the Aesop inside note term. So if you're familiar, again, this is the same. The value of this inside note is the same as the seller notes. However, the terms are typically vastly different. So if you are not familiar with the inside note, go listen to previous episodes because it is a topic that we could spend a good amount of time on. There's a lot of nuances and sometimes it takes a little bit to wrap your head around it. But typically the ASAP inside note has a long amortization period. So we see 30, 40, 50 year terms. That term is something that gets negotiated along with the interest rate of that note. So we've covered all of the, I would say, big pieces or financial pieces. The purchase price, the working capital, the collar related to the working capital, and then all of the terms and interest rates related to any and all notes involved. This may get a little more complicated if a bank is involved. However, we're just sticking to a seller finance example here.

[10:44] Beyond that, which I think the previous ones I've mentioned are maybe more of the obvious ones, so these may be less known or less understood, especially if you're new to the ESOP world or you're new to learning about ESOPs and the transaction.

[11:03] Synthetic equity is another piece that typically gets negotiated as part of the transaction. So if there are any warrants that will be issued to the sellers as part of the transaction, that is negotiated in terms of a target internal return rate number. So you're negotiating that target IRR related to those warrants. Another form of synthetic equity that we typically see negotiated in ESOP transactions is stock appreciation rights. So there's kind of a few pieces that you're negotiating related to the SAR units. The first and the biggest is what percentage of fully diluted equity are the SAR units going to be? So stock appreciation rights, these don't have to exist with the ESOP transaction. However, since they are dilutive to an ESOP, and most of the time, owners and management like the idea of implementing this synthetic equity plan for their high-performing leaders or their management team.

[12:29] It is necessary to negotiate what percentage of fully diluted equity are these SAR units going to be so that the trustee understands how dilutive they could be to the ESOP in the future.

[12:49] So say you land on a percentage, then you have to determine of that pool of SAR units that you are allowed to grant to your employees, what percentage is retention-based and what percentage is performance-based. When we talk about retention and performance-based, that refers to how the SARs vest. Do the SARs vest based on retention, meaning just the pure fact that the employee is still with the company when they fully vest? And then how many SAR units are vesting based on performance, meaning there is an EBITDA target usually set for the next five years in the year that the SARs are granted. And as long as those EBITDA targets are met, then the performance SARs will vest. So I know that was a handful, but essentially you're negotiating how many total SAR units can I even issue or can be issued to grant. Again, this is synthetic equity. It's not real equity. But of those SAR units, what percentage can be granted as retention SAR units versus performance SAR units?

[14:19] The other piece related to SAR units that gets negotiated is the vesting. And this relates to both retention and performance. So do they vest over five years? Do they vest over three years? What is the vesting period? The last piece is the performance target. So for those performance-related SARs, I mentioned the EBITDA targets that are set in the year of granting these SARs. What is the performance target in order for those performance SARs to vest? Is it 101% of your EBITDA targets that were set? Is it 102% of your EBITDA targets set? Are there any provisions for, let's say, a catch-up provision? So if you don't meet the target in year one, but you meet the cumulative target over the five years, do all of the shares vest, those are other nuances that get negotiated.

[15:36] So now we'll move into maybe some of the less complicated topics or negotiation topics, but other items that are included in the term sheet. So corporate governance is a piece, part of the term sheet that gets called out related to what the trustee expects the governance to look like going forward. So sometimes the trustee will ask for certain committees to be set up, whether you have them set up already or not. They may want to see, for example, a compensation committee set up. And maybe the term sheet will include that this compensation committee needs to be organized within X amount of months from the closing date.

[16:34] Similar to governance is the board composition. So your board of directors, whether you have that organized yet or not, when you become an ESOP, you will need to formalize a board. And of course, the trustee will always want some sort of independent representation, especially in a 100% sale to the ESOP. So whether your board member, your board size is a three-person board member, then maybe don't request that one person is independent. If it's a five-person board member, then maybe they'll request that two people are independent. Again, this is something called out in the term sheet that gets negotiated. With that, similar to the corporate governance, there would be a deadline, essentially, or a deadline after closing that you need to have that board composition. Made up and decided on. So maybe you have six months, maybe you have 12 months to put your board together after closing. Those pieces get negotiated.

[17:49] Another piece that gets negotiated is what's referred to as indemnification. So as part of the ESOP transaction closing, the selling shareholders make certain representations and warranties that basically are saying, hey, we've disclosed everything that is relevant to the transaction, everything we've disclosed is accurate, and we've disclosed all outstanding, litigation, etc. If, for whatever reason, after the fact, something is uncovered that goes against what you had disclosed in your reps and warranties, then a percentage of your purchase price could be essentially pulled back so that percentage gets negotiated as well as what's referred to as a survival period so how long after the transaction could someone say hey, this was found whatever so the purchase price will change um kind of like a statute of limitations.

[19:09] One other piece that gets negotiated is the terms of, I don't know if it's terms of, but repurchase obligation studies. So the trustee will like to include in the terms that the company needs to have a repurchase obligation study done at a certain cadence. So that cadence is what gets negotiated. Is it once every four years? Is it once every three years? And when should that begin? It's typically not necessary to have that done in the first couple years. I would say maybe even in the first three years since your repurchase obligation is so low at that time. However, it's never a bad idea to get ahead of it. But at some point, of course, you will need to have a recurring cadence of these studies done so that you can be aware of your obligations coming in the future. If you're not familiar with repurchase obligation, again, we have some other episodes that discuss that more. That's another topic that we could spend more time on that we're gonna keep moving on.

[20:36] So another piece is the fiduciary insurance trustees will, if it's an independent trustee, especially, they may request you to obtain the company to obtain fiduciary insurance that covers the trustee. So that coverage needs to be obtained within a certain amount of days after closing. That's really, I would say, non-negotiable. negotiable, it's got to be in there, especially if it's an independent trustee. But you may have some leeway with the amount of days it needs to be covered after closing. But regardless, that's just another term in the term sheet.

[21:23] The trustee may also negotiate for employment agreements related to the selling shareholders. So maybe that is the terms of the employment agreement can vary. It doesn't necessarily mean that the employment agreement outlines their salary going forward. It could include salary information. It may just include, hey, you're going to be here for the next X amount of years. But some form of employment agreement could be involved. Finally, one other term that gets negotiated that we see often is the financial reporting. So, of course, all trustees will like to see financial statements, whether that's on a quarterly basis, annual basis. It's probably likely that it's more maybe more quarterly but could be annual and whether you have CPA reviewed or audited financials or not the trustee may want you to begin, receiving reviewed or audited financials or at the very least compiled however it is more likely that reviewed financials at the minimum some level of assurance.

[22:52] So those are probably the biggest pieces that get negotiated in the esop transaction, of course there are other terms that i don't think i mentioned that are probably obvious but are less terms that are to be negotiated because since they're more, Terms of what the seller is, that the company has decided. So, for example, the tax status of the company, if they're an S-corp, I haven't seen a scenario where a trustee is negotiating what the tax status would be going forward.

[23:32] The effective date of the ESOP, whether the ESOP is buying 30%, 100%, what percent is the ESOP buying? These are obviously terms that would need to be called out. However, what I reviewed today was mostly what actually gets, what is negotiated? What are you going, truly going back and forth on and so we discussed a lot but I'll kind of just do a recap the purchase price the networking capital target with a caller the terms of all of the notes involved so seller notes and the ESOP inside note how many years do those get amortized over and at what interest rate, Synthetic equity, so the warrants that may be issued to sellers and the stock appreciation rights, if any, are involved. Governance related to corporate governance and any committees to be organized or put together a certain amount of time within closing, as well as the composition of your board of directors.

[24:47] Indemnification, your cadence of your repurchase obligation study, fiduciary insurance, employment agreements for the selling shareholders, and then finally details around financial reporting.

[25:05] So again, we like to tell our clients it is similar to an M&A transaction in that there is a true negotiation process. It could take, depending on how many turns you're going back and forth, but we typically see it could be anywhere from four to five to eight to ten turns going back until the trustee approves of the terms. and both parties are in agreement. So that is just a summary of the negotiation process and what gets negotiated exactly in an ESOP transaction. I think we have a similar episode from a few seasons ago that may be another source that you want to listen to if this topic interests you more. Otherwise, thank you for listening. And of course, please don't forget to subscribe, share with a friend if you like this podcast. And as always, feel free to interact with us at journeytooneesop.com. Thank you.