Bonus Episode: The Long Journey to Really Understanding ESOPs

Introduction:

If you’ve been listening to this podcast, you know that we’ve been taking periodic dives into the world of employee stock ownership plans. We started down this path because Jay Goltz was thinking about his own succession issues. In a series of podcast episodes and conversations and seminars over the course of more than a year, Jay progressed through the three stages of ESOP discovery: First, he had his eyes opened. (“Wait a second. If you’re an ESOP, you don’t pay taxes?”) Then he got a little euphoric. (“I think I can make more money owning 70 percent of the business than I do now owning 100 percent.”) And then he confronted what I’ve been calling the ESOP industrial complex—the big firm lawyers and consultants who sometimes seem inclined to make ESOPs as complicated and expensive as possible. (“They want to charge me a ‘success fee’ for finding a buyer even though they didn’t find the buyer.”)

That introduction to Big ESOP occurred at a conference that Jay and Shawn Busse attended in Portland and that left Jay convinced that ESOPs are probably right for a lot of people but not for him. And yet, it was also at the conference in Portland that Shawn and Jay met Phillip Hayes, who takes a decidedly different approach than the industrial complex gang. What immediately stood out about Phil, who calls himself The ESOP Guy and who has his own podcast, Journey to an ESOP, is that he doesn’t view his mission as selling owners on ESOPs. His goal is to help owners figure out which solution is best for them, whether that’s an ESOP or something else. Which is why Shawn and I decided to sit down with Phil and have a conversation—brought to you by our sponsor, the Great Game of Business—about his approach.

— Loren Feldman

Guests:

Phil Hayes is The ESOP Guy.

Shawn Busse is CEO of Kinesis.

Producer:

Jess Thoubboron is founder of Blank Word.

Full Episode Transcript:

Loren Feldman:
Welcome, Shawn and Phil. It’s great to have you both here. For the past year or so we’ve been presenting a variety of perspectives on ESOPs. And we’re eager to get yours, Phil. Can you tell us first how this became the thing that you specialize in?

Phil Hayes:
I just love the ESOP concept. But I think the greatest reason I got into it is I saw that there’s definitely a gap in the industry. And what I mean by that is that there’s a need for companies, first off, to be really well-educated in the correct things of: What is an ESOP? How does it really work?

Secondly, I think that there’s a problem in the industry—it’s not like this huge problem—but I think some people don’t realize that the ESOP transaction doesn’t have to cost millions and millions of dollars. And so, looking at that, I had a lot of clients at a CPA firm that were being approached by these types of sell-side advisors. And I decided, “You know what, I’m getting questions from my clients from this. I might as well just jump in and start helping them.” And I found I loved it, and I love ESOPs. And so I’ve kind of just pivoted my whole career towards doing this full-time.

Loren Feldman:
You mentioned that there’s a certain lack of understanding about what an ESOP entails. Are there particular issues that you think are most misunderstood?

Phil Hayes:
Yeah, I think there’s a host of issues that are misunderstood. I know we kind of hit on the cost side. That’s definitely one of those areas. Some of the things that are just commonly misunderstood is the structure of an ESOP, and how it works with your employees, what the employees’ part is in the ESOP, what your part is. I think that’s definitely a misunderstanding. There are misunderstandings related to valuations and how a fair market value would work for a company. I think, overall, a lot of people look at an ESOP as my lowest valuation alternative, and I don’t think that that’s true.

So as you start talking to people, one of the reasons there is a lot of misinformation is because there are different hotbeds, or geographically, there are different places in the country that are, I would say, ESOP-friendly. And then there are other geographic areas that are not. And so, what I mean by that is, there are a lot of advisors, whether they’re CPAs, attorneys, bankers, insurance people, all of whom are great at what they do, but they may not understand ESOPs very well. And so sometimes they either give misinformation or they guide somebody away from it. So a lot of the education that needs to be out there needs to kind of penetrate the advisory areas so that people are more educated, especially in these markets that you’re seeing. They don’t have a lot of good information for these companies to think about.

Loren Feldman:
That’s really interesting, especially thinking about it in geographic terms. That had not occurred to me. What are the most ESOP-friendly parts of the country?

Phil Hayes:
Yeah, I’d say for sure, like Chicago, Illinois, is very friendly for ESOPs. Ohio has a strong ESOP chapter in Columbus and Cincinnati. California is a very strong ESOP state, in general. They’re very, very geared towards that. Then there are parts in the Northeast, and there are probably others I’m missing. But I just think in general, those are probably the biggest ones that stick out.

Loren Feldman:
Diving into this issue over the last couple of years, I’ve gotten the impression that there’s something of a choose-your-own-adventure aspect to ESOPs. I don’t know if this is a fair statement or not, but it almost seems like no two are alike, that there are a lot of decisions that owners have to make, and that maybe that’s part of what contributes to the misunderstanding—because there are different ways to do it. What’s your sense of that?

Phil Hayes:
Yeah, I think the first thing I would say is, as an advisor, and going into it, one of the premises I start with is: At the very beginning, I’m not saying you should be an ESOP company. And I have a process that basically proves out the ESOP concept, and as we get through it—the first step, the second step—then I think the actual, like you say, adventure, how we actually structure the ESOP, starts to come to light. Because there are some things that the shareholder can choose to do, for instance. They could choose bank financing with a seller note or all seller note. They could choose to use warrants in the transaction and SARS. And they could even choose to do what we call a non-leveraged ESOP.

So there are different ways to build it, but they’re all going to start with the same building blocks. And if you do the process right, in some cases, it’s gonna lead us to the right place, for sure. I’ve had people refer me business, like, “Hey, help this company with an ESOP. They definitely want to do a partial ESOP.” Well, we don’t even know if they want to do a partial ESOP yet, because we haven’t really worked through: What are their goals and objectives? How are we going to structure this? And there are things that will get flushed out in the planning process in the very first two steps that will contribute to how we actually build that ESOP for them.

I’d say the other side of that is that there are some things that are just going to be standard for every ESOP. First off, it’s a retirement plan. It’s like a 401(k) plan, but it’s a retirement plan. And it’s built under the regulated guidance of the ERISA, and the Department of Labor, and the IRS. So no matter what you do, you’re always going to be within the regulations. And your ESOP has to conform to that. So however we pick and choose the way that we structure it, it’s not going to deviate from the way the regulations are.

Loren Feldman:
Phil, you said you have a process that you take people through to see if they’re appropriate for an ESOP. Could you walk us through that a little bit?

Phil Hayes:
Let me start with the size, too, because it can kind of get all over the place when we’re thinking about what size of a company should even think about this and contemplate it. Honestly, I’ve done ESOP transactions for companies that have somewhere between, say, $800,000 to a million dollars in net income, or if we translate that into EBITDA, cash flow. So the revenue isn’t as important as the cash flow itself, because the cash flow is going to give us a really strong indication of what we think the transaction value is going to be for the company.

And it’s going to help us also to build out the models for: How do we structure the debt? So that’s the first thing. So size is going to be, you can even go down, I would say, as low as that. Something lower than that is going to be problematic, even with the way we structure the costs, just because the cost benefit may not be there for somebody. On an employee size, I will say that if it’s an S corp, we’re going to feel really comfortable with anything over 20 employees, because we have to work within the 409(p) guidelines, which is the disqualified persons test. I have done and I am doing an ESOP right now for a company that only has 10 people. So that’s kind of the general idea of the sizes.

Loren Feldman:
That example you gave, you said they only have 10 people. Can you tell us what their EBITDA figure is?

Phil Hayes:
Yeah, their EBITDA is around $1.5 million.

Loren Feldman:
So that’s pretty small.

Phil Hayes:
Yeah, relatively small. And this is why when we think about the cost as well, we can build a transaction for a company that small and still be very, very successful at making it work for everybody—the company, the owners, the other advisors, and putting the whole thing together.

Shawn Busse:
But they’ve got margin. Like that 10-person company. That’s an amazing margin for a 10-person company.

Phil Hayes:
Yeah, obviously, and that’s one of the things you have to look at with the employee roster, too. Because when we do the allocation of shares to the employees, in that case I’m talking about, there’s going to be a very strong benefit to those employees, because there are so few employees. So when you’re dividing up the allocations for stock, to me, there are going to be 10 people in that company who are going to have a tremendous opportunity to get the shares, and grow that company, and have a very strong retirement plan going forward.

Loren Feldman:
So besides the size, what else are you looking for?

Phil Hayes:
The first thing I would say is, I’ll spend several meetings with people, and I don’t charge them for this. I just conceptualize. Let’s just conceptualize the ESOP. And what I’m trying to get into is like, “What are your goals and objectives?” And I’ll tell you kind of some experiential things that happen.

Like, I can just tell when I talk to them, some people are so geared around trying to maximize the valuation that my advice to them is like—and I don’t mean to be demeaning or derogatory, but—“If that’s all you care about, then I think you’re better off just pursuing a strategic sale.” Because when you try to say, “I’ll try a strategic sale, and I’ll kind of look at that in combination with an ESOP,” your heart isn’t really in the right place for an ESOP.

So I’m just kind of really being candid and transparent about that. Because they need to see the big picture. Like, they love this company they built. They love the employees. They want everybody to have a future. And they also do care about a fair market value, so that’s not going to be not important, but it’s going to be part of the whole equation.

So a lot of times, I’ll just try to give them some guidance. My job is not to make every company that calls me an ESOP. I mean, I don’t necessarily talk them out of it, but I’m going through and filtering, to help them to save some time, to be like, “You know, is this really what you want to do?” So the process really starts there.

If, conceptually, it works, and they get all the things that we’re talking about, then the very first thing we’re going to do is we’re going to create a valuation model. Now, the model itself is going to be mimicking the model or the valuation work that’s going to be done in, say, step five with the trustee and an independent valuation firm. And there are a lot of parts and pieces to that model that are important. In my experience looking at other advisors’ work—because this happens from time to time, where I’ll be hired after somebody else—I don’t think that people put enough emphasis on the parts and pieces of that model. They want to go from the evaluation model into the feasibility piece, which I’ll talk about next.

But the key is that the owner and the key people need to understand the connecting points between their financial forecast, their cash flow, their cap rate—so the risk rating of the business—their target working capital. They need to understand the mechanics and the correlation of all of these, and how they actually translate into an actual real number. Instead of, “Hey, this is your EBITDA, and this is the multiple of EBITDA.” It doesn’t tell people a lot of information.

And so that’s the first piece. And then going into that, I really stop everything. I don’t do anything before we nail that down. Because I don’t think it’s really helpful for people to get thrown into this process. And then suddenly, they realize they’re so deep in it, they really don’t even understand what they’re doing with it, which is something I’ve experienced with clients that have hired me after the fact.

Shawn Busse:
Yeah, if you don’t mind me pausing for a minute, I think a lot about decision making. You know, how businesses, often, they’re started by an owner/founder, and that owner/founder is really a big part of the decision-making organization. How do you evaluate that?

Phil Hayes:
The main thing is—and this is what I love about ESOPs—we have time to work through that individual. They are the decision maker. And what we have to be thinking about, whether we do an ESOP or we’re transitioning to—sometimes I’ll do a management buyout. You know, your key people just buy you out, instead of an ESOP. Or we’ll do some hybrid. But either way, whether you’re doing an ESOP or not, the key decision maker has to start transitioning their role, and functionally, that needs to start taking place, I think, as early as possible.

So the ESOP gives us a lot of room to do that. Like, let’s lay out the roadmap for how that’s going to function. And every company has a different culture. And one of the things I always kind of look at is: What is their existing culture right now? And you know this, Shawn, and I’m sure you know this, Loren: A lot of the culture in a business is going to reflect the leadership. So if that decision maker is maybe more autocratic, or just very bossy, then that culture is going to reflect that.

And so one of the things I’m always thinking about is the sustainability of the culture of the future. Let’s just say it’s the opposite, that the owner is more of a democratic kind of person who gets everybody involved as a team-oriented person. Obviously, we can work a lot with that. But the key is that we’ve got to transition to something. And so the decision maker has to kind of want to do that as well—and not be in that place forever.

Loren Feldman:
Why do you have to, Phil? I ask because I’ve heard different versions of this. Obviously, this is a point of great interest for any owner who’s contemplating this. Will it still be their company, in some sense? Will they still be in charge? Will they still be making decisions? And I’ve heard some owners who’ve been through this, who have ESOPs, say, “You know what, you control who goes on the board. Ultimately, it’s still your company. You can just run it the way you always have.”

Phil Hayes:
Sure. No, it’s a good question, Loren. And it gets to the control aspect of ESOPs and how that really works. I think that they do because it’s healthy for the company. Let me just throw out one thing that I think is so important for companies to consider as having maybe one key decision maker—before you even do an ESOP or anything else—is thinking about their continuity plan. And so if something were to happen—disablement or they passed away for some reason suddenly—what’s going to happen to that company? What’s going to happen to the value of that company? And what’s going to happen to their estate, in terms of transitioning the value into their estate?

One of my first ESOPs I did was with a good client of mine, and I’ve known him forever, before we even did the ESOP. I think we did it four years ago, and he’s a 100-percent ESOP company. He’s 76, and he’s still president. He works 12 hours a day, five days a week. He loves working. And when we first set it up, he was like, “Can I still do this?” I said, “Yeah, you can still do this if that’s what you want to do.”

So he’s got a board of three people. So it’s a 100-percent owned ESOP. There is an independent board member who used to work for the company, but they passed the independent standards from the trustee. Then his son actually is on the board as well. So his son is kind of taking over everything. His son didn’t want to buy the company, by the way, in this situation.

But I would say if you asked him, from a control perspective, it would kind of align with what you’re saying, Loren, and with what other people have said. The day-to-day decision making is completely the same as it was when he first started. And the only thing, when I think about the changes that have happened, is he’s accomplished what he wanted to, which was to transition of his ownership. He didn’t want to be holding on to that stock, and he’s been able to kind of move through that. So I would say that’s the majority of the time. You’re not going to see a major shift in control, even if you sell a controlling interest, which is a 100-percent ESOP.

Shawn Busse:
I’m kind of curious, from an industry perspective, what are industries you’ve looked at where you go through this process and you’re like, “This is a really good industry for this type of thing,” and, “This is an industry that it’s really tough”? Or maybe any at all work? It’s more a matter of ideology and structure of the organization.

Phil Hayes:
Yeah, I think that a lot of people who do ESOPs, we all want to talk about industries that really work well. And the reality is, there are some industries that are just going to be better for ESOPs. I would say architectural and engineering firms. I’ve got several I’ve done in my history. I’ve got more coming into the future. I just closed, actually, one Friday—a new ESOP company that we did. And it works well because the individual employees get it pretty fast. The owners get it. There’s a very strong teamwork environment in those types of entities. I’ve seen and I’ve done several construction companies. And they work pretty well, assuming all the pieces are there, and culture is there, and it works with the decision makers.

I would say though, I’ve done distributors and manufacturing companies and retail companies, and we’re doing a retail company right now. So, I don’t know. For me, if I really look at it, it’s not as much to the industry. It’s much more, in my opinion: Is it culturally a good fit? And I look for things like: What are they working on right now?

I’ve got several clients that are Great Game of Business cultures, so open-book management. I’ve got some that are EOS Traction cultures. So those are interesting to me, because they’re working so much on the business already, that ESOPs just make sense, because they’re not just building business processes. They’re getting people involved. So I think it has a lot of ideology and culture.

I would say the other financial part of it is, the company really does need to have a source of predictable cash flow. If some company has this erratic behavior of cash flow, then it’s hard to build a model where we can put a lot of debt on the books and have this tax benefit, if they’re gonna lose money in it next year, and they’re gonna come back up. So I’d say that’s definitely part of it. I’m going to go towards more the specifics of a good ESOP candidate, as opposed to just good industries.

Loren Feldman:
Phil, have you done any ESOPs or seen any ESOPs that just haven’t worked, for whatever reason?

Phil Hayes:
No, no. I actually have never done one that hasn’t worked. And, in fact, before I did ESOPs in our firm, we’ve been doing ESOP work—not the sell-side piece, but the consulting piece on tax advisory—since 1985. And we’ve had ESOP companies go through the ‘08-‘09 downturn and they’re still fine. So we haven’t actually seen any companies go through that. But I think that the main thing that I’ve seen with companies that do go down is—not from our experience, but the people I talk to in the space—is the structuring of an ESOP transaction, I think, is critical in how you go about it.

So I talked about the valuation piece, and we get into the feasibility models. We’re going to want to play out some scenarios to protect the company, meanwhile, making sure that the owner is getting what they should get from a cash-flow standpoint. So structuring debt is really important. Understanding that the actual quantifiable tax benefits and building that into the model is going to be important. Stress testing cash flow is going to be important. And then creating backstops. Like, “What happens if this happens?” So some of this is just good business planning. I mean, when you think about any company that’s thinking about their future, any company can fail tomorrow, right? It’s a matter of how they’re going to adjust toward changes in the marketplace.

A lot of times, when people look at not selling their business to a strategic buyer, one of the reasons they don’t want to sell is because they know their people don’t want to work for a company that’s only focused on profits. Especially nowadays, I think that the new culture, the new generations are thinking much bigger than, “Hey, I just want to make a lot of money.” And so there are a lot of things that we’re now getting into that are post-ESOP services, that I would call ESOP-implementation services, that help design workforce development, employee engagement surveys, how do you recruit and build people?

So when you think about what we’re really doing with an ESOP is we’re leveraging one of the greatest assets they have, which is their people. And at the very beginning, when we asked the question, “What do you want to do this for?” And the owner’s like, “I really want to do it to help my employees,” that’s part of the answer, because they already care about their employees enough to consider their future and the quality of life that they have. So like I said, I could go into a lot of the things like that. But I think those are, to me, very exciting when we do an ESOP company, or create an ESOP company, because they get to use all those benefits to create a very strong business.

Loren Feldman:
I want to address some of the issues about why there are so few businesses that have chosen to do this. I mean, we can all point to lots of examples, but as a percentage, it’s a very small percentage of the businesses that exist in this country. And I’m curious why you think that is.

A couple of things have come up. I think part of it is, we started referring to what we’ve called the ESOP industrial complex. And you get a sense that some owners are kind of turned off by the bureaucracy that exists. And I think part of it is, they talk to people who are in the business, and two things: One is, they get a sense that a lot of it is aimed more at the employees than at the owners. It’s like, “Okay, great. I understand it’s wonderful for the employees. Why is this good for me?” And the other thing we’ve heard is that it almost seems like they think it’s in their interest to make this sound as complicated as possible. Does that resonate with you at all?

Phil Hayes:
Yeah, I mean, if I had a very clearly stated mission statement on my podcast, it’s to really help in that situation. Because I do agree. Unfortunately, I think that there are a lot of ESOP professionals who make this sound way more complicated than it really is. And I can’t really know what the motivation is. I mean, we can always speculate. You know, “If I can make it sound really complicated, then I can charge more money for this.” Right?

Loren Feldman:
That was Shawn’s guess, I think. Right, Shawn?

Shawn Busse:
Yeah, call me cynical.

Phil Hayes:
I think, culturally, the ESOP industry does suffer from a little bit of that. Instead of just saying, “Let’s just be straightforward. This is how it works. It’s not for everybody.” Because at the end of the day, I just want to sleep at night. I want to make sure I’ve done the right thing for people who we’ve worked with. If it’s not the right thing for them, let’s do something else. You don’t help people by bringing them down a road where maybe you can make money on them, but that’s not really worth it.

So I think part of it, too, is that professionals kind of congregate. And so the attorneys and the trustees and the valuation firms, they like to talk about a lot of the complexities, which is fun. And I think that’s engaging. But I always tell this, as a new professional who comes into our firm: “Your job is not to know everything about tax. Your job is to be able to take, say, for instance, tax, and explain it to your customer so well that they understand it.” Because that’s how you become, I think, a very good service-oriented professional. And that applies to ESOPs.

Shawn Busse:
I think some of this, honestly, is just a cultural shift. I have just seen a massive change into what employees expect when it comes to work, what owners are trying to do, in terms of making something meaningful—you know, actually create a place where they both enjoy showing up for work and they enjoy being around the people who they work with. And that idea has been expressed, I’d say, in the last five or 10 years as this idea of purpose. And more data is coming out showing that businesses that start from a place of purpose, ironically, often outperform financially those that don’t have a sense of purpose. And so I think an ESOP is a much more natural extension of that idea of living a life of purpose.

Phil Hayes:
I do think I see a change in people’s anticipation of what their career looks like, what they want to do with their life. So you do see a new generation coming into the workforce that has some different ideas, some of which play better in an ESOP, because everybody’s sharing into not just the ownership but the responsibility of the future, as opposed to maybe the older generations who were more keen to, “I want to make a lot of money.” And again, there’s nothing wrong with making money, but their main focus was the ambition of building wealth. I think that people are broadening their idea of what a successful life looks like, and I think the ESOP plays well into that cultural shift.

Loren Feldman:
How about the idea that these things seem to be marketed more along the lines of, “This is great for the employees,” and paying less attention to what it means for the entrepreneur? Do you think that’s an issue?

Phil Hayes:
I will say, it needs to be a holistic plan as you kind of build it all. So, eventually, we need to understand how the employees will be affected. But at the very front-end, my idea behind the process itself and proving out, “Will the ESOP work?” is you’ve got to nail down what the individual owner is looking to accomplish. And that’s outside of all the other parameters of employees.

I’ve got one right now—we’re going to do the meeting next week—and it’s a single owner of a really nice company. And he asked me, like, “Should I have these people on the phone?” I said, “Let’s just you and I talk. Let’s just go through the first valuation model. I want to hear from you, without bias. I don’t want you to tell me what your people want to hear. I want to know what you want.”

And my goal there is to be able to have a very concrete conversation about: Can we accomplish what he wants out of this transaction? Because then as time goes on, if we accomplish that, then we can start adding on all these elements. And eventually it becomes: How does this affect the employees?

Loren Feldman:
Let me ask you a very specific question that came up in our previous conversations. We have a regular on the podcast named Jay Goltz. He hit upon something that confused me, and I’d like to see how you respond to it. He started to think about it in these terms. He was thinking about selling 30 percent to his employees. Because he doesn’t really need the money, it wasn’t about getting the money off the table for him. He would do it by a loan and let the employees pay him back directly.

But then he started to think about it. And it occurred to him that they would basically be paying him, in his opinion, with his own money, because they would be using profits earned by the company that would have been his if he hadn’t sold. So he came to the conclusion that if he did this transaction, he wouldn’t be selling the company to his employees, he’d be just giving it to them. Was he right about that?

Phil Hayes:
Okay, if I generalized everything first. And I said: “Okay, the cash flow that is going to be used to pay Jay out is generated by the company,” is a true statement. Now, if the owner is looking to transition the ownership into whatever—whether it’s a sale to my employees as an employee stock ownership plan, or a sale to my key persons, or I’m going to sell it to a strategic strategic buyer—ultimately, the owner’s trying to get their money out of the business. Like, what’s the valuation? And how are they going to get their money out of the business?

A typical structure of an ESOP transaction—I would say most of the ones I do—will have some bank financing and some seller financing. Which means the owner at closing is going to get a liquidity event—as much as the bank can lend on that ESOP transaction. So they are getting something that’s out of the company, like say in that structure immediately that the company now has borrowed and is now in debt to pay back. In addition to that, they’re also going to get the seller note. But he’s right about the cash flow. It has to be the cash flow that pays him back.

Now, I think the idea is like, “If I just hold on to this, then I’ll keep the cash flow no matter what.” And I think that’s where Jay went with it. And that’s true. And the question for every owner is going to be: At what point are you willing, from a risk-reward standpoint, to hold on to that cash flow? And then, when you are ready—now, this is why some ESOP transactions are partials, because they’re not ready to release the ownership transaction or the ownership stock right now—but maybe they are a little bit, because they want to have some chips off the table. And they feel like the valuation is enough to benefit them to make that really work. So generally speaking, he’s right, but it’s really in how you structure it. If there’s a lot of bank financing, for instance, then he or she is going to get their money at the closing. And now they’ve been paid some percentage of the total valuation.

Loren Feldman:
There’s another issue that I’ve heard come up from time to time, which is: What happens when employees leave the business, whether it’s for retirement, or if they just choose to change jobs and go somewhere else? It can, I gather, put a company in a bind of having to come up with a chunk of money to pay out. How big of an issue is that?

Phil Hayes:
There’s not a concern. What I’m trying to do with a client is work through the anxiety points. There’s really not going to be, because we’re building models that really will work. We’ll go back and forth on those several times to make sure that it works for everybody—the company, the individual shareholder. So by the end of our plan, we know where we’re going to be. We know we can weather a downturn. So I think that’s really important too. If your advisor is doing that work, they need to get into the numbers really well. And everybody needs to understand what is going to be paid out.

So we’ll burden the company, for instance, with all the compliance costs of an ESOP. So you have to have an annual evaluation. You have to have a third-party administrator. You have to have fiduciary insurance. You have to have possibly a trustee involved. So those costs are going to need to be in the cash-flow models, anything else that we’re anticipating that is going to come up. I have a client, we’re doing a deal right now, and we know we’re going to invest in two new stores. That’s built in the cash-flow model. So I think that’s the key part of getting to the next step. If we get through cash-flow valuation, then getting through the feasibility model.

Loren Feldman:
Shawn, has this affected your thinking at all? Is it as attractive as before, more attractive, less attractive?

Shawn Busse:
I mean, what I appreciate about Phil’s way of working is, it’s methodical and one step at a time. And there isn’t a foregone conclusion that you become an ESOP. And what I contrast that to: Let’s say you hire a business broker to sell your business. They want you to sell your business, because they get paid on that, a percentage of that deal. And I think anytime somebody comes along and says, “Let’s see if this is the right fit for you,”—and I assume, Phil, you get paid by the step, as opposed to by the completion. Is that correct?

Phil Hayes:
That’s absolutely correct. And that’s one of the things—like, I don’t charge a success fee. So it doesn’t even matter what we end up selling it for. We’re gonna do the best job, and I’ve had where we get to a point where we’re not going to go forward. And I think what I’ve helped him with is: At least you didn’t go into the whole big old nightmare of spending a bunch of money on this and realizing it’s not for you. And that is predominantly in the ESOP industry how it’s done, by the way, is firms charging a success fee.

Loren Feldman:
Explain that, what’s the success fee?

Phil Hayes:
Well, so an investment banking firm, in doing an ESOP transaction—like they would do a sale for a strategic buyer—they’re going to just like in a normal, what we call an M&A transaction. They’re going to have it look like that, right? We’re going to go through the due diligence process. They’re going to make an offer. The trustee’s going to counteroffer. So they’re gonna go through all of that. It feels like an M&A deal, but it’s really a regulated M&A deal.

If they sell the company for more money, their percentage, their fee is based on the sale price. And they’re going to include in that, if they do source bank financing, they’re gonna get a fee off getting the bank financing. And there’s a dollar amount connected to the amounts that they’re securing for people.

And so, on its surface, it looks kind of normal, because people are so used to an M&A model where I’m gonna go get these guys to help me sell my business. But when you think about an ESOP transaction, the problem I have with that is that it’s a regulated transaction. The Department of Labor is going to have jurisdiction over the transaction, over the valuation, and at any point can go investigate that deal.

Now, if you look at case studies where companies have been sued as ESOPs, the number one thing they’re being sued over is being overvalued. Now, who is going to pay the price in that situation? Not the investment banking firm. There is no jurisdiction the Department of Labor has over them. They’ve done their work, they’re objective advisors, whatever. But it’s the selling shareholder and the trustee who are going to have to deal with that. And essentially, the company, because if they’re found guilty of that, they’re going to have to pony up some money to rightsize it. And it’s going to be disruptive. It’s going to cost the company legal money.

So I think there are problems with the whole model. And going back to some of the original things, that’s one of the reasons I got into this. Because I do think that the way these transactions are being done is philosophically misaligned with the purpose and the mission of being an ESOP. I also disagree from the ethical standpoint. There’s nothing wrong with making money, but they’re bolting this whole M&A thing in here, and they’re making a lot.

Loren Feldman:
Isn’t that the argument that they make, Phil? They say, “Listen, you have options. You could sell it to a strategic buyer, or you could go ESOP. If you sold it to a strategic buyer, we would get a success fee. So we should get the success fee, even if you do the ESOP.”

Phil Hayes:
Yeah, definitely. They’ll come in and say, “Well, at least we can help you provide both paths.” And that sounds really nice. But when you really look at the conceptual side of things, I’m going to say, hands down, either somebody is really an ESOP candidate, or they’re really not. So that whole running down two paths, to me, is a very good way to manipulate the situation to get them to realize, “Oh, well, I’ll just spend the money on an ESOP transaction.” But all you’ve done is taken their hard-earned retirement money.

You know, Shawn owns his own company. I own my own company. What does it take to build a company? It’s hard. So I would not want somebody to take advantage of me like that, because it’s wrong. And so, anyway, that’s why we’ve built a model that’s purely advisory. It’s budgeted, and we get our costs out on the front-end. Like, this is what it’s going to cost. Now, it’s never perfect, but it’s going to be pretty close at the end of the day before anybody gets involved in any engagements or getting things started.

Loren Feldman:
So do you think we have the right number of ESOPs in this country? Or do you think that there are people who are looking at this and walking away for the wrong reasons?

Phil Hayes:
When I first started getting into ESOPs, doing podcasts and things, I realized the statistics are really low. Like, there are only 7,000 ESOP companies in the entire country. So right off the bat, you’re like, “There should be more ESOP companies.” So I do think, and it’s hard to prove out exactly why people don’t veer towards this. I think there are probably multiple reasons. Right off the rip, I’d say there’s not enough good education—and I’d say unbiased education. If you go to a conference, and you think that the cost of the ESOP is 10 times what it really costs, you’re probably going to walk away from that thinking, “I’m not going to do an ESOP. I’m too small, and it’s not going to work for me.” So I think that’s contributing to it.

I’d say the second thing is what I noted before: The people who they listen to the most are going to be their advisors at home. And if the advisors at home are intimidated, or they don’t really understand it, they’re not going to advise it. So I don’t think that there’s a strong—in the United States—I still don’t think the CPAs have trained well on this.

Then I think the idea, too, is that there are companies that do become ESOPs, and they do sell. And the reason that happens is they become so successful at what they’re doing, they become such a great target to be acquired by a bigger company. And it’s kind of contrary to the whole idea and mission of, “Hey, let’s build this legacy.” But it does happen enough.

So if you talk to trustees about their book of business, probably every one of them is going to have some number of their ESOP clients selling that year. It’s just the truth. And so you have this input of new companies, and you have this output of ESOP companies selling. So I think, just to answer the question simply though, I do believe that we should have a lot more ESOP companies throughout the entire country.

Shawn Busse:
That outcome you just described: A company becomes an ESOP. It performs really well. It grows a lot of wealth for the employees. And then it sells. Is there any way you can mitigate that, in terms of the structure of the organization? Or is it just like, it’s just a risk? You know, it’s part of the deal?

Phil Hayes:
Yeah, I think that’s a good question. I’ve thought about that a lot, too. And thinking and discussing this with other trustees. Because it’s a retirement plan, there’s a fiduciary responsibility that is going to hang over somebody. And that’s typically the trustee. They’re going to have the responsibility to manage the trust.

Loren Feldman:
In other words, if they get a great offer, they might have to take it.

Phil Hayes:
That’s it. That’s kind of where I was going. If they get a great offer, and the trustee’s a fiduciary, then they have to think about the benefit of the employees. And imagine having some nice retirement plan at $20 a share that you’re waiting for, and then a company comes in and makes an offer at $50 a share. You’re like, “Okay.” It’d be hard for the fiduciary not to take that. I think that’s the main issue for these types of things.

So partly, it proves out the concept of what I was saying: ESOP companies outperform non-ESOP companies, because they do become good targets. But there’s nothing that I know about that can restrict that type of thing happening. It’s going to be a fiduciary decision.

First off, it’s going to be a board of directors decision. The board of directors is going to be solicited by a buyer. The board is going to have to review that, and they have fiduciary responsibility. If it goes deeper and deeper into it, and it’s a real deal, then they’re going to get their trustee involved. And they’re going to have to make a decision. So I would say that if the board of directors is not interested, from a good business perspective in selling, then I don’t think that those deals are going to kind of penetrate, unless you just have a very aggressive buyer that wants to get in there and push it really hard.

Loren Feldman:
I’m not sure what you mean by that. Are you suggesting that there is a way to turn away a deal that maybe financially looks good, but there are other issues with?

Phil Hayes:
Yeah, I mean, if the board of directors looks at it and says, “This is not the best timing for the company.” Being a board director, I think you wear that hat of being a good business person for the company. So you have these governance rules or guidelines that say the board is really there to do what’s best for the company. That’s their job. And the trustee is there to do what’s best for the ESOP. They direct the plan, according to its governance.

So they kind of work in tandem. The business decision itself rests with the board to entertain the offer. If the offer gets entertained, then the trustee is going to have to review it. It has to go through the board first. So I’m not suggesting that the board, if they had a really legitimate offer, could just circumvent the trustee completely. But I’m saying that if they have a business plan that says, “We’re not really ready to go out in the market yet, we’re doing these other things,” it needs to make sense from a business perspective for them to not maybe take an offer.

Loren Feldman:
So it does leave the possibility that you have a business owner who creates and builds a business and decides to go the ESOP route—with the goal of creating a special place to work, a great company where people enjoy being employed, that does good things, and makes money, pays people well, and they sell it 100 percent. And then one day in the not too distant future, the people who are at the company decide, “You know what, we’d like to take the money.” And that special place to work goes away.

Phil Hayes:
That’s right. That’s always a possibility.

Loren Feldman:
My thanks to Shawn Busse and Phil Hayes, and of course to our sponsor, the Great Game of Business, which helps businesses use an open-book management system to build healthier companies. You can learn more at Greatgame.com. Thank you both.