The Hard-Nosed Business Case for Employee Ownership
Introduction:
This week, Jay Goltz explains how he got interested in selling a percentage of his business to his employees and why he quickly lost interest once he started reading books, attending seminars, and talking to accountants and lawyers who specialize in employee stock ownership plans. To Jay’s ear, they all made ESOPs sound expensive, complicated, and risky. This was not something he needed to do. So why go to the trouble? Why take the risk? But he kept asking questions, and over time, he sensed that many of the problems he was being warned about didn’t have to be problems. As of now, he’s pretty much concluded that an ESOP could help him secure retirement for his employees while generating more profit for his business. In fact, he says, “I’m confident I can make more owning 70 percent of the company than I am now owning 100 percent.” But he still has a few lingering questions, which is why we invited Corey Rosen to join the conversation. Corey helped draft the legislation that created ESOPs, he’s the founder of the National Center for Employee Ownership, and he literally wrote the book on how the plans work. All of which led to an inevitable question for both Jay and Corey: If ESOPs are so great, why are there so few of them?
— Loren Feldman
Show Notes:
Here’s Corey Rosen’s most recent book, written with John Case: Ownership: Reinventing Companies, Capitalism, and Who Owns What.
Here’s a previous book Corey wrote with Scott Rodrick: Understanding ESOPs.
And here’s a book written by Jack Stack and Bo Burlingham: A Stake in the Outcome.
Guests:
Corey Rosen is founder of the National Center for Employee Ownership.
Jay Goltz is CEO of The Goltz Group.
Producer:
Jess Thoubboron is founder of Blank Word Productions.
Full Episode Transcript:
Loren Feldman:
Welcome Jay and Corey. It’s great to have you both here. Jay, let’s start with this. You were hot. You were cold. What got you hot again? What triggered your interest most recently?
Jay Goltz:
Well, frankly, first I was hot on it because I recognized there was a problem with two things. One is my employees. I never looked at my 401(k) balances. And I was frankly horrified when I saw how little money most people have put away. I care about my employees, and that was concerning.
Loren Feldman:
You’ve got a lot of employees who’ve been with you quite a few years, right?
Jay Goltz:
I’ve got 100 and some employees, and many of them have been with me over 20 years. When I say many, probably 20-25 people have been with me over 20 years. And I’m concerned about that. And secondly, I’m not planning on going anywhere, but who knows what happens? I’m thinking: What can I do to make the business more solid going forward? And I frankly have no interest in selling it. So the ESOP seemed like a good solution.
And then I embarked on going to seminars and reading books, and I went from the joy of ESOPs to the oy of ESOPs. And I said to myself, “Yeah, I don’t think I want to deal with this.” And I threw in the towel. And then I was talking to someone about it again, and I started to do some more research. And in my mind, I figured out that I think the things that were giving me the oy are not really problems. I think.
Loren Feldman:
But that’s what we’re here to talk about.
Jay Goltz:
That is what we’re here for.
Loren Feldman:
Corey, what would you want to know about Jay’s business to know whether he’s a good candidate for this or not?
Corey Rosen:
There are a few baseline questions I ask every company. The first one is: Are you profitable enough so that you could—even though it’s on a tax-preferred basis—use future deductible profits to buy out your shares over time and still have enough money left over to run your business successfully? If you don’t have both of those, there’s really not a way that you can do this. The second issue is, if you’re leaving—
Loren Feldman:
Let’s stop there for a second. Jay?
Jay Goltz:
I understand you have to be profitable enough for this to work, which probably takes out 99 percent of the businesses out there. I got that part. So so far, so good. One is you have to be profitable enough for the math to work.
Loren Feldman:
Are you?
Jay Goltz:
I don’t know this year, but certainly in the short run. Yeah, I should absolutely be. I mean, I’m big enough that I think, frankly, I’m a prime candidate. I’m big enough to pull this off. So I think so. Yeah, that should be fine.
Loren Feldman:
Sorry, Corey. I interrupted you. What were you going to say?
Corey Rosen:
Sure, no problem. The second issue is, if you’re leaving, do you have successor management? Same kind of question, really, that a bank would ask. They want to know if you’ve got successor management in place for obvious reasons.
Jay Goltz:
I have a very solid management staff. This is not the Jay show. I barely deal with customers. I barely deal with vendors. I have done the proverbial work on the businesses instead of in the business. So I’m solid. I’ve got half a dozen key managers here. I plan on hanging around, but if I’m not here, I believe I have a key management staff to pull that off. So, check.
Corey Rosen:
The third one is: Are you big enough? Now, you’ll get lots of different feedback from advisers on this. The big enough question is: It costs money to set up an ESOP, and it could cost anywhere from $100,000 to $500,000, typically, for businesses that are the typical ESOP candidates. It depends in part on the complexity of the transaction, the size, and other factors. Now, realistically, if you sell your business to anyone else, it’s going to cost probably as much money, and often more, because when you do sell to someone else, if you’re using an M&A advisor or a broker, they’re going to charge a success fee. And most ESOP deals don’t involve a success fee. Some do. But that’s a percentage of your transaction.
So if you’ve got a $5 million business, they might charge you $200,000 just as a success fee, plus the lawyers and all that. So it isn’t necessarily cheaper. In fact, it’s usually not cheaper to sell to another buyer. But if you’ve got 10,15, 20 employees, that may be hard to absorb. And you want to look at some other option, if you can find one.
Loren Feldman:
When you’re talking about size, Corey, are you talking about revenue?
Corey Rosen:
Well, I think really the best way to look at this is to say, “If we did an ESOP, and we paid,” let’s say, $150,000. If you’re a real small company, that’s maybe what it would cost. “We paid $150,000, and we still now have to pay off the loan to purchase the company, do we still have enough money leftover from the profits that we make and reserve that we have so that A) we could do it, and B) given the enormous tax benefits of an ESOP both to the seller and the company, would it be worthwhile? And so typically, the break point is somewhere around 20 employees. There are some ESOPs that are smaller than that, but that’s a reasonable rule of thumb. Obviously, you’re bigger than that.
Another important issue is—and I think you’ve kind of answered this, Jay—What do I want to do with my business, in terms of the alternatives of selling? Do I want to get out really quickly? I want to sell to somebody who can give me all the cash upfront, and I want a price that’s as high as possible. Well, after taxes—because there are a lot of tax benefits to selling to an ESOP—it turns out maybe 15 percent of the companies that end up selling to an ESOP could have gotten a better net value for the seller by selling to, say, private equity or some other consolidator.
So if you’re in that situation, is that your preference? “I want to get the most money possible.” Or are you more concerned about legacy and maybe also—and this is, I think, relevant to what Jay is saying—that you want to get out some now, some later, or maybe you even want to sell 100 percent now, but you’re not ready to retire? You’d like to stick around in some capacity in the company. Selling to an ESOP lets you do that. Selling to a consolidator or private equity usually doesn’t.
Jay Goltz:
Am I obsessed with getting the maximum money out of it? Absolutely not. I’m not selling the company. I’m just not. I have no interest in watching some private equity or anyone else come in and destroy what I built for 43 years. No interest whatsoever. Don’t need the money. I’m not doing it. So that’s easy. I don’t need to cash out at all. I mean, I could keep the money in it and lend it to the company.
I’m thinking about it for two reasons. One is, I absolutely want to do something to help my employees put retirement money away. And two, I’d like to help the business down the road, so that on the day that I’m not here, it’s a little more solid. And it seems like this could do it.
I have a friend who sold his business for tens of millions of dollars. And I told him that I’m concerned about my employees’ 401(k) balances. He turned to me, and he just said, “Why is that your problem?” Okay, I can’t argue with that. I’m not about to tell any business owner that they should worry about it. That’s everybody’s own business. I’m not making any judgments whatsoever. But the answer is: Maybe it’s not my problem, but it is my concern. And I do want to do something about it. So he obviously didn’t doesn’t care. So he’s certainly not a candidate. I do care about the employees. I don’t need all the money out right now, which is why I think I’m an excellent candidate for this.
Loren Feldman:
Let me ask you, Corey referred to the likely price for doing this. He put it between $100,000 and $500,000, I think. I know you’ve been doing a lot of your own research, Jay, going to all kinds of seminars and reading books. Does that square with what your expectations are?
Jay Goltz:
I have to tell you, at one of the seminars I went to, at the end, the person said—and I don’t exaggerate, this is exactly what he said—“The cost can be 1 percent, 3 percent, 4 percent. But don’t hold me to that.” Great. I mean, like, really? So, okay. In my case, I believe that the math has to work. And that doesn’t just mean what your profit is, how many employees you have. In my mind, as an entrepreneur, it’s about, “Okay, what’s my return on investment in doing this?” And I believe that a little bump in marketing, just a little, you’d get 1 percent more business because of this.
Loren Feldman:
Let’s hold that conversation for later. I do want to get to your hopes about what this would mean for the business. But first, you’ve got to get there. You’ve got to do it. Are you comfortable with that price tag that Corey mentioned?
Jay Goltz:
I’m not comfortable with half a million dollars. I don’t know what drives it that high. So, no. One hundred and something? Okay. I don’t know. I have to say, I haven’t gotten that far. I’m certainly still in the process of figuring this out, which is why I’m glad to be here today. Because I still have some key questions that I haven’t gotten the answers to.
Corey Rosen:
Well, when you’re looking for advisors, of course, you want to shop around. And if you go to our website, there’s a service provider directory. And what we encourage people to do is talk to a lot of people, because you’re going to get very different pricing. But here’s where you’re going to see the big difference. There are some service providers who charge success fees. And their argument—and it’s not a bad argument—is, “We could also sell your business to someone else. And we want to give you advice on what all your alternatives are. And if you end up selling to an ESOP and not to some consolidator, we get less money. So we don’t want to have that incentive, and you don’t want us to have that incentive. And so we’re going to charge you a success fee. And that’s typically in the range of 2 percent to 3 percent of the transaction. Plus, you’re going to have some other costs as well.”
On the other hand, there are a lot of service providers who work like any other attorneys and trustees and valuation firms. And they either work on an hourly basis, or they have a fee based on the particular service they’re providing. That’s going to cost you a lot less than the ones who charge the success fee. But they’re not going to be thinking about how else you could sell the business. So if you’ve decided you want to sell to an ESOP, you probably should focus on those. And that’s going to get your cost in the lower range, rather than the higher range.
Jay Goltz:
Okay, that was very insightful. I didn’t know that. The idea that someone’s going to make an argument—the meeting would have been over the second I heard about the concept, because that’s just revolting to me. Oh, so you could have gotten more money out over here. And since you didn’t, you still want to get that money. So I should pay you for something you didn’t do? Like, yeah, I don’t buy that at all. So all right, well, that explains that. Yeah, I’m not paying a success fee. Not happening. So, okay. That’s good.
Corey Rosen:
There’s one other consideration that people should understand when they’re making the decision, which is that ESOPs come with rules about how the stock gets allocated to people. And I have talked to people over the years who say, “I want employees to own the company. I love all the tax benefits. But I am not comfortable with not being able to pick and choose who gets how much stock.” And it’s a small number of people who feel that way, but there are people who feel that way. And if you feel really strongly about this, this isn’t going to work. If what you really want to do is have seven people become the owners, then you’ve got to do it another way.
Jay Goltz:
No, no, that part I got. I got the whole concept of discriminatory blah, blah, blah. No, no, I got all that, because in my mind, this doesn’t replace if you have some kind of bonus plan or whatever. I get that this is not a one-size-fits-all. This is a supplementary retirement fund thing. I’m totally good with that. That fits fine. I do have some questions about the core of how that works, though.
Corey Rosen:
And by the way, while there are all those rules for ESOPs, that doesn’t preclude you from how you pay bonuses to people. Or some companies give key people something like stock appreciation rights. That’s pretty common. You can do that.
Jay Goltz:
Okay, no, that part I got down. The person who’s just standing there framing pictures that makes, whatever, $42,000 a year, I’d like to know when they retire, they’re also gonna have some money, too. So this isn’t just for key people. I want it for everybody. So that’s why I say, so far, so good. It seems to fit where my head’s at.
Loren Feldman:
All right, I want to try to run through a bunch of the issues that have come up. Jay, you’ve heard from a lot of people that this is just hard to do. How big a concern is that for you?
Jay Goltz:
What I’ve learned lately is that everybody’s definition of what hard is is different. When I look at this, I think, “Wow, what a great thing. I can give people a good retirement plan.” And I would think that the ideal candidate for this, which I think I am, is already a collaborative kind of company working with their employees. I don’t know why—and Corey, you said it in your own book in three different places. You talk about how this is hard work, this is hard work, this is really hard work. And I’d like to ask you: What’s the hard work part of this? Because to me, it sounds like a joyful thing: “Hey, everybody, I’m gonna sell you 30 percent of the company, and it’s gonna cost you nothing. And we’re all gonna make more money together.” Where’s the hard work?
Corey Rosen:
So, of course, I would say that hard work isn’t necessarily unjoyful. Hard work can be very joyful indeed, as probably anybody who’s an entrepreneur can attest. But what I’m referring to there is that once you set up your ESOP, the expectation that, “Well, now everybody’s just going to get it and they’re all going to act like owners and everything’s going to be wonderful,” doesn’t really work that way. Like anything else in companies, if you want to achieve results, you have to work at achieving those results.
And what the research, in our experience, shows is that companies need to commit to things like setting up an internal communications committee with employees who are going to be in charge of helping explain not just how the ESOP works, but how the company works. That means, ideally—and these aren’t things you have to do, but these are things that make it work a lot better—becoming more of an open-book company, starting to share key metrics with people. And it’s not really just focused on the income statement. It’s about all the metrics at the particular work level that make that work contribute to the company’s success or not. It’s things like creating high involvement management systems, work teams, and employee committees, and ideas teams.
I wrote a book called Beyond Engagement, and the first line of the book is, “It’s simple. The best companies are the ones that generate the most ideas from the most people about the most things.” And that concept, Beyond Engagement—and the rest of the title is How to Make Your Business an Idea Factory—that concept comes from the notion that if you just give employees the opportunity to share ideas and information, if you have an open-door policy, nothing’s gonna happen. Everybody has an open-door policy.
You need to have a structure for how employees can identify problems and identify ideas. So one of our members, Hypertherm—about 1,800 employees, 100-percent ESOP company, one of the most awarded of our members—generates about 4,000 usable ideas per employee per year. Imagine if you have a company that generates two or three usable ideas per employee per year, how much better you’d perform. But this doesn’t just happen by magic. This happens because you have people spending time figuring out how to do it and allotting the time for employees to participate in those things.
Jay Goltz:
Okay, that totally makes sense. And to me, it sounds like it’s just good business, which is why I’m getting excited about this. I’ll tell you the three big things that most people are being dismissed by, that say, “Oh, ESOPs….” Here are the big three that I think you hear if you talk to the accountants or the lawyers who maybe aren’t as familiar with it. The first one is, “There’s a problem with the valuation with those things.” Okay. My answer is, “All right, you get the valuation. If it’s not what you thought it was, abort mission.” Okay. I mean, am I wrong?
Corey Rosen:
No, that’s right. So that people understand, when you do an ESOP, you’ll have a trustee, and the trustee will hire a valuation firm who determines what a financial buyer would pay for your company—not a strategic buyer. A lot of business people, maybe most, have this idea—and frankly, unfortunately, for most, it’s a fantasy—that there’s a buyer out there, who is a strategic buyer, who will pay this substantial premium for your business.
And as I mentioned, maybe 15 percent or 20 percent of potential ESOP candidates have a buyer like that who can offer them more money so that, after the tax benefits of selling to an ESOP are taken into account, they would do better. I think this is probably true for a lot of feedback you get from advisors. Remember, a lot of the accountants don’t know how to do ESOPs, and they’re afraid that if you do one, they’ll get somebody else.
Jay Goltz:
Absolutely, that’s one of my big breakthroughs I had in my head, that yeah, they don’t want anyone else at the party.
Corey Rosen:
Yeah, and mergers and acquisition advisors will make more money selling you to someone else than they will to an ESOP. And so they definitely will tell you, “Oh, that’s a terrible idea. It only works for this or that. And most of them fail.” ESOPs have a default rate on the loan used to buy the company of two per 1,000 per year. So the notion that they often fail is just not true.
Jay Goltz:
No, and I’m telling you, I really believe that that conversation with the accountant or lawyer, it lasts about 20 seconds, and it’s done: “Oh, you don’t want to do those. Those are a pain in the ass. Hey, where do you want to go for lunch?” That’s what I’ve seen. So the valuation is one. Two, “Well, a lot of people could retire at once and you’ll have a payout crunch.” Correct me if I’m wrong, because I think I figured it out. If you don’t take out a big bank loan to finance it, that really shouldn’t be a problem. Is that true?
Loren Feldman:
Hold off for a second. Let’s explain that, Corey. I think Jay’s referring to what happens at the time of the sale where the employees are purchasing the company. The employees don’t actually lay out any of their own money. Money has to be borrowed. Correct?
Jay Goltz:
Right. But the problem I’m talking about is if it’s 10 years from now, and they want to retire.
Loren Feldman:
No, I understand that. But I want to start with the basics.
Corey Rosen:
Sure. So there are a number of possibilities here. One is, if you start soon enough, you don’t have to borrow any money at all. You just contribute cash each year and the ESOP buys more and more shares over time. That process might take 10 years or so. But most owners want to get more money upfront. And so how do you get that? Well, you borrow it. And you can borrow it from banks. You can borrow it from mezzanine lenders, if you can find those. There are those people in the ESOP space. They will charge more than the bank, of course. Or you can do a seller note.
The typical transaction where the owner wants to get out all at once, or at least very quickly, is you get as much money upfront as possible from senior debt. And then that depends, of course, on the collateral you have to offer. But let’s say that’s 40 percent of the company—I have heard some companies get as much as 60 percent or 70 percent, but let’s say it’s 40 percent of the company. And so the other 60 percent is paid with a seller note. So you’re saying, “Pay me off over time.”
And typically, the term of those seller notes is five to seven years. So you won’t get everything upfront. You’ll get a significant amount of it in the first couple years. But if you really feel like, “I’ve gotta get all this money upfront, right now,” then it may be that you need to sell to somebody else. Unless you can get this mezzanine debt, which will fill that gap. But the mezzanine debt is pretty expensive.
Jay Goltz:
I met with my bank. They have a division where all they do is lend money to ESOPs.
Corey Rosen:
There are quite a few of those.
Jay Goltz:
Yeah, all this guy does is—and I have to tell you, he’s part of the reason I’m talking to you today. He said he just loves his job. He loves what he does. He doesn’t see a lot of problems with these. And I go, “Is this going to impede my ability to get a credit line?” He goes, “We’re not lending money to the company. We’re lending it to a trust, and there’s no collateral. Like, we’re doing a hard”—I think he called it a “hard loan,” meaning they’re gonna look real carefully at everything to make sure it’s safe.
But in my case, I don’t even know that I’d bother doing that. I don’t need the money. I would just go ahead—which is why that potential problem, in my mind, doesn’t exist. If in 10 years, somebody wants out, there should be money sitting in that account.
Loren Feldman:
Corey, is Jay right about that?
Corey Rosen:
Yeah. Well, banks that do ESOP loans do love them, because why wouldn’t you love a loan that has a default rate of two per 1,000 per year? So yeah, and a lot of banks figure, “Well, if we can do your ESOP loan, we’ll also get all your other loans. And we can get your line of credit and whatever else.” So banks have been very favorable toward ESOPs.
The seller note, there are a lot of people who say, “Don’t even bother with a bank. And if I can get paid off over eight years, that’s fine. I don’t need all the money upfront. I’m gonna get some of it each year. And that’s fine, that’s plenty of money for me. I don’t want to bother with a bank.” And seller notes are kind of an attractive investment, because they’re gonna be priced in today’s market, probably 8 percent to 12 percent on the interest rate.
Jay Goltz:
That’s exactly what he said. And this is what made me realize, “Boy, the math works very nicely on this.” I think to myself, “Wait a second. So what if you said, ‘Well, Jay, your business is finally getting to critical mass. You’re gonna get much more profitable for the next three, four, or five years. Boy, you could be giving away 30 percent of your profits.’” But then I say to myself, “Wait a second, getting 10 percent of that note is going to chew up half of that money right off.” So I did my own little analysis: The math works. I believe—and I think I’m right—this might be the only time I’ve actually seen a situation where I can have my cake and eat it too. I can both make more money and take care of my employees at the same time. I think I can pull that off with this.
Corey Rosen:
Well, that’s how typical ESOPs work. And there’s even another wrinkle, where some owners—about 20 percent or 30 percent of the seller notes—the seller says, “Well, it should be 9 percent or 10 percent interest. Give me 4 percent interest, and give me the present value of the 6 percent interest I have forgone in the form of a warrant.” And a warrant is the right to buy stock at the transaction price for, say, six years into the future. And so if the share price goes up, I’ll go to the company and say, “Hey, just redeem this warrant.” So I’m actually going to benefit from the share price going up. So that’s a deal that can be structured and needs more advice and more lawyers and appraisers getting involved, but it’s not uncommon to see that.
Jay Goltz:
Okay, that leaves me with the third one. These are words right out of an accountant’s mouth: “Oh, the administrative costs for that are really high.” Okay. Now, I’ve gone to enough webinars. I’ve talked to enough people. It sounds like—correct me if I’m wrong—the administrative costs of getting the appraisal and having the trustee of $50,000 to $75,000 a year?
Corey Rosen:
Or less.
Jay Goltz:
Okay, good.
Corey Rosen:
The administrative cost is just the people who keep all the records, and that’s going to cost in the range of $100 to $200 per employee. That’s not a big cost. Trustee’s gonna cost—and you don’t have to use an outside trustee after you’ve done the transaction. About half the companies don’t pay for that. I think it’s a good idea. That’s going to cost you $20,000 or so per year, and the valuation is going to be another—which you have to do annually—$15,000 to $20,000, probably $15k. And then if the law changes, you need a lawyer.
Jay Goltz:
Okay, so you just gave me $10,000 and $20,000, so it’s $45,000. Okay, so we’re in the same neighborhood. Here was my revelation—and this is only personal, this is how I feel—I am absolutely going to stop my 401(k) matching plan that has always made me sick. I don’t like it. I think it’s completely wrong. 401(k) matches benefit the people who make a ton of money or have spouses who make a ton of money, and have no children. They can max it out, and the rich get richer. And the poor guy who’s making $62,000 a year, and has two kids, who can save very little, he’s getting nothing. So my 401(k) match this year is going to be about $30,000. So right off the bat, instead of $45,000, I’m going to take that 30. So now it’s going to cost me $15,000.
Corey Rosen:
So a number of companies do that. Most companies don’t fiddle too much with their 401(k), because taking something away from people, they might not be happy about that. ESOPs are just an add-on. But you can definitely do that. I should note, by the way, for anybody out there with a 401(k), the typical match is based on what the employee defers. But you don’t have to do it that way. In our own organization, we have a 401(k) for our staff, and everybody gets the same. Everybody gets 3 percent.
Jay Goltz:
Okay, in my company, I have an unusual situation, perhaps, unlike an accounting firm or a law firm. I’ve got people making everywhere from $35,000 a year to a six-figure income. So it’s all over the place. For me to just give everyone a number, it wouldn’t be very much, so that really wouldn’t work. And in this case, the higher-paid employees are going to be coming out real well with this, and I would show them, “Lookit, you’re going to lose $4,000 here, but you’re gonna make $10k.” So I’ll just explain it to them. And like I said, that’s gonna finance a lot of the administrative costs.
Loren Feldman:
Before we forget, I want to go back to the issue that Jay raised before, Corey, in which he was talking about the concern that I know a lot of ESOP owners have with: What happens if you have a bunch of employees leave one year and you have to buy them all out simultaneously? What do you need to do to be prepared to do that? How big of an issue do you think this is?
Corey Rosen:
What you need to do is plan for it. And it’s not an issue much in the early years, because, first of all, you don’t have to start paying off these distributions till your acquisition loan is paid. And there’s a lot of in-the-weeds stuff here, because the loan typically goes to the company and then is re-loaned to the ESOP. And the internal loan is on a longer term, so that the shares are allocated over a longer period of time. But you can probably wait typically 10 years before you start paying people out, unless it’s because people are retiring or die or disabled. So there’s some flexibility on that.
But after the first several years, you really need to start carefully planning for this repurchase obligation and making sure that you have a really practical, solid way to pay for it. We’ve done extensive research on how many companies end up in trouble because of this. They can’t pay it, and when that happens, they typically have to sell the company. It’s a really small number where that happens. So successful companies are able to put aside the money to do this. Part of the reason that happens is, if you become a 100-percent ESOP, you don’t pay any taxes. And that’s not a loophole. It’s not something some clever lawyer figured out. It’s a law passed unanimously by the Congress in the late 90’s.
So you don’t pay any taxes. That’s a lot of money to save the deal with the repurchase obligation. And by the way, it turns out that 100-percent ESOP companies are on a real acquisition binge. Once they’ve paid off their initial debt, they start accumulating a lot of cash. And because they’re typically successful companies, they’re going and buying a lot of companies. In fact, one of the things that we’re going to start providing more resources on is for companies that say, “I really like the idea of an ESOP, but I just don’t want to do it in our own company.” You can sell to an ESOP company. There are a lot of companies looking for companies to buy, so that’s an alternative, too.
Jay Goltz:
I would say the word I would pick for myself and many other entrepreneurs looking at this is, they’re apprehensive. I mean, how could you not be apprehensive? You’re not sure what exactly it is. And then when you start to get more information, that apprehensiveness could turn into anxiety, which then turns into, “See you later! Don’t need to deal with this.” Because I simply don’t need to deal with this. That’s the point. I don’t have to do this. But I’m back in the happy mode now of thinking this is the greatest thing ever. So let’s see if you can get me out of that.
Corey Rosen:
I think the best advice that most companies in your situation can have is: Don’t just talk to advisors. They have their own interest in what they want you to do, which may or may not coincide with yours. Hopefully they do, but they may not. Talk to other companies that have done it, and we can help with that. And see what their experience has been. How’s it work? How much did it cost? What were the pitfalls? One of the great things about this community is that it’s incredibly sharing. Even your competitors will talk to you about it.
Loren Feldman:
Corey, I’ve talked to a lot of people who’ve done ESOPs, and one of the interesting concerns I heard from a couple of owners was that they were surprised to find out that the employees were not completely sold on this idea. They were very skeptical. I’m wondering, is that something you’ve heard? Is that something that comes up?
Corey Rosen:
Well, you’re always gonna have skeptics who wonder, “How can this really be free? What’s really up here?” And I think a lot of that depends on what kind of culture you had in your company to begin with. If you have the kind of culture that I suspect you do, Jay, in your company, then it’s going to be, and you say, “I’ve got good news and bad news. The company is being sold. The good news is that you’re the new owners, and it didn’t cost you anything.” Some people are going to react to that and say—in some companies—”Something’s up their sleeve.” And I suspect in a company like Jay’s, they’re gonna cheer: “That’s great!”
Jay Goltz:
Yeah, let’s move from corporate culture to just simply: Do they trust their boss?
Corey Rosen:
Exactly.
Jay Goltz:
Which in my case, I think I’ve demonstrated many times to them. They know that I never screw them around, and they know that I’ve gone way out of my way, and they talk. So that’s why I don’t think I’d have that problem at all.
Corey Rosen:
But the two things that cause what you’re talking about, Loren, most commonly: One is, companies start off communicating the ESOP—and you really have to spend time and resources doing this. Companies start off communicating it as a retirement plan. That’s a mistake. That’s a hard thing for people to relate to, almost at any age.
What you really want to do is say—and I’ve done this with meetings with employees—”Close your eyes. I want you to spend 60 seconds thinking about what would have happened if Jay decided not to sell to an ESOP—because eventually, Jay’s gonna want to sell—and decided instead to sell it to some private equity firm or to one of our competitors. What would that be like for you? Now think about what would happen, because we have an ESOP instead.” That’s the most compelling thing about an ESOP right upfront for people.
The second problem is, you say, “Well, now you’re owners.” And somebody has an idea about something they can improve, and there’s no way to do anything about it, because you’re still treated like an employee who doesn’t have any particular reason to have that kind of involvement. And you’re not given any information about how the company is doing, because that’s private. You can see how people might get skeptical in that. If you want to run your company like Elon Musk wants to run Tesla, maybe not. Maybe an ESOP’s not right for you. [Laughter]
Jay Goltz:
Good example.
Loren Feldman:
Jay, do you have other questions for Corey about how this works?
Jay Goltz:
Yeah. A couple of just basic ones—which, again, I’ve gone to numerous seminars, and no one’s really talked about this. I understand that you’ve got to architect this, and there are some basic questions. So the easy ones I’ve got—like: What percentage am I going to sell? What’s the vesting thing? Very easy. What is the pay cap you’re going to use for your percentages? Okay, again, easy.
Loren Feldman:
Explain what that is, Jay. What do you mean by the pay caps?
Jay Goltz:
The way you figure out the share is divide the salary by the payroll, but they cap the salary for purposes of their percentage. So they’ll say, “The most somebody is going to be in there for is $200,000 or $150,000.” And there’s a limit, right?
Corey Rosen:
The legal limit is $305,000.
Jay Goltz:
Okay, so I don’t have anyone making that anyway. But I would say, “Okay, your cap is going to be X dollars.” So that’s all very easy. My question is, what else is there? Because I don’t understand. What else is there? It seems like that kind of covers it all. But are there 50 more questions you have to ask yourself?
Corey Rosen:
Well, you have to decide what your board is going to look like. It’s up to you. Most ESOP companies end up with outside board members, because they find it useful. It’s not required, but 75 percent of ESOP companies do that. You have to decide whether you want to have internal trustees, so employees who would be responsible for the various things that have to happen in an ESOP, or if you want to hire an external trustee to do it. You have to decide on when you want to start distributing stock. You have some options about that. Of course, you have to make all the decisions about communications and culture. So those are some of the key things that you want to decide upfront.
There are a number of sort of procedural things that go on in an ESOP that you need to be aware of, and we’ve tried to make that easier. We have a documents library on our website. We have checklists of, “These are the things you need to do this month,” sort of thing. And that typically is handled through HR, for instance, of what information needs to go to the plan administrator. So there’s a lot of that just sort of nuts and bolts stuff, but good advisors will walk you through that.
Jay Goltz:
Okay, here’s the one question I really don’t have a handle on. I understand that you take their salary, divide it by the total payroll, and they get that percentage. My question is—and I just was told this—you can’t give any credit for, “Oh, they’ve been here for 20 years.” Okay, that made it a lot easier because, frankly, I was struggling with that.
Corey Rosen:
That’s wrong.
Jay Goltz:
That’s wrong? You can give credit for how long they’ve been here?
Corey Rosen:
Yeah. Well, credit in terms of, there are two different things here. One is how much their allocation is. So to explain that, simply, the ESOP, let’s say, buys a thousand shares, and it pays for 10 percent of the loan. One hundred shares get allocated, and I make 5 percent of the covered payroll. I get 5 percent, I get five shares. So you can use relative pay or a more level formula. You could say, “I’m gonna give you one point for how many years you’ve worked and one point for your salary.”
So you can do that. If the effect of that is that what are legally defined as highly compensated people, which I think is people making over $130,000 a year this year, they can’t get more than what this straight relative pay thing was. So yeah, you can do that. But what most people are talking about is, “If I’ve got an employee who’s worked here for 20 years, and I’ve got an employee who’s worked here for one year, when we start the ESOP, are they both zero-percent vested?” And you can give credit for prior service, for their vesting. You can give them year-to-year, or you can say every three years, you get one year. So as long as you do the same for everybody, you can do that.
Jay Goltz:
So okay, I got the vesting part, but this person wasn’t a lawyer, so he’s just got this wrong. He’s involved in the ESOP industry, but he made it sound like, “No, the person who’s been here 20 years can’t get any more than the person that’s been here five years.” You’re telling me that’s absolutely not true.
Corey Rosen:
There is a way to give credit for prior service as part of the allocation formula. Again, you just have to have it tested so that the effect of that is, if somebody who makes $200,000 a year gets—in our example, let’s say they have 20 percent of the payroll. They can get up to 20 shares. If this formula would give them 25 shares, five of those go back to everybody else. But if you’ve got an employee who makes $50,000 a year, this would probably work for them. They get more. So yes, there are some constraints on it, but it’s not impossible.
Jay Goltz:
Okay, so how does it work going forward? Let’s assume, obviously if you hire more people, it’s going to dilute their shares a little bit. But let’s just, for the purposes of looking at this, assume that you don’t add any people. Does everybody keep the same amount every year?
Corey Rosen:
Well, each year, you get another allocation based on the same formula. And you might decide, at some point, “Let’s change the formula to straight pay,” for instance.”=
Loren Feldman:
Corey, is that true, even if Jay stays at 30 percent?
Jay Goltz:
Let’s assume I am, because that’s my plan.
Corey Rosen:
The percentage of ownership is not related to this. This is what happens internally with an ESOP.
Jay Goltz:
All right, this sounds complicated, too complicated for this, but okay, that’s good to know. I got it.
Corey Rosen:
It’s not impossible to do what you’re talking about. There are some constraints, but it’s not impossible.
Jay Goltz:
Okay, that’s fine.
Loren Feldman:
Corey, the rules that you’re referring to, are they all national? Or can this vary by state?
Corey Rosen:
No, this is all part of the Employee Retirement Income Security Act. So state law has virtually no impact on ESOPs.
Loren Feldman:
Jay, are you still with us?
Jay Goltz:
No, that’s fine. I’m telling you, the things that turn me off, I have learned, are really not problems. So far, so good. I haven’t seen anything that’s gotten me to think, “Oh my God! Wait, this isn’t gonna work.” Like I said, I did the math. And I figured out this should be a net gain for everybody involved.
Loren Feldman:
Let me ask this question, Corey. What if, for some reason, Jay’s business turns? What could go wrong involving the ESOP if he gets it off the ground, but then because of a recession, or whatever reason, the business doesn’t do as well?
Corey Rosen:
So a couple of things can happen. Of course, if you have a loan, and you can’t pay off the loan, then it’s like any other situation. The creditor’s gonna say, “Okay, I need to do something about this.” And so, typically, what you see when a company runs into trouble is one of two things: If it’s really in trouble, you look for another buyer, and you get whatever you can. And the ESOP is bought out, and if there are other owners, they get bought out as well. Fortunately, that doesn’t happen very often. Obviously, it doesn’t happen never. But it’s rare.
More common is the business goes through a downturn, but it realizes it can come out of it. And so if they have enough reserves, then they can do that. If they don’t have enough reserves, then maybe if you have a seller note, then this note is renegotiated to pay it out over a longer period of time. Or maybe some of the interest is exchanged for warrants, so that the company has less debt. So you’re restructuring the debt so that the company can survive through this. In some rare cases, the seller is just forgiven some portion of the loan. But fortunately, that doesn’t happen very often.
We know, just from all the research on ESOPs, the number of companies that faced these kinds of scenarios, even during the pandemic, was really, really low. And of course, the PPP program helped, and some of those companies that might have had trouble got rescued by that.
Loren Feldman:
All right, we’re running short on time here. There are a couple of things I want to hit. We’ve talked a lot about the challenges and the issues and what can go wrong. I want to make sure we talk a little bit about what can go right. Jay, at one point, you said to me, after doing your research, you told me, “I’m confident I can make more owning 70 percent of the company than I am now owning 100 percent.” Explain that. What were you thinking?
Jay Goltz:
Simple math. Here it is: I’m taking the 30 percent of the profit, whatever that number is, and then I have to back out of that the interest I’m being paid on the note that I’m holding. So that eats up probably half of it. Okay. And then I figured—you can’t prove any of this—I’m in the retail business. People have relationships with my employees. How could being employee-owned not get sales up 1 percent? Just 1 percent. Well, 1 percent is a lot of money, gross profit-wise. So that’s going to be a big chunk of money.
And then, again, even with motivated employees—and Corey I loved in your book when you said, “Lookit, half your employees are going to work hard no matter what. And the other half might work a little harder.” Yeah, sure. What if my efficiency just went up 1 percent? Well, I have a big payroll. One percent of that is tens of thousands of dollars. So if you add up the little bit of cost savings, a little more business, and the fact that I’m getting interest, all of a sudden, I made more money than I would have made without selling it. On top of the fact I now have retirement funds for all my employees. So like I said, I see this as a win-win-win: Win for the customers, win for me, win for the employees. It seems too good to be true. But I think it’s true.
Loren Feldman:
Corey, is he deluding himself?
Corey Rosen:
No, we actually have a lot of research on this. And it should be mentioned, just to be clear, that when you sell to an ESOP, if you meet certain criteria, you can defer taxation on the gain by reinvesting in stocks and bonds of other companies. So that’s a pretty big deal. If you are an S corporation, the percentage of your profits attributable to the ESOP is not taxable. If you’re 100–percent ESOP, no taxes. If you’re a 30-percent ESOP, 30 percent of your profits are not taxable effectively. So there are some big tax advantages that add to the financial benefit of an ESOP.
But when we looked at the data, we found that ESOP companies grow about two and a half percent per year faster than would have been expected if they did not have an ESOP. And the companies that combine an ESOP with this high involvement management system grow about 6 to 11 percent per year faster than would have been expected.
Loren Feldman:
How can you determine that? How do you know?
Corey Rosen:
Yeah, so this is called, in social sciences, a matched sample, quasi-experimental technique, where what you do is we took a whole bunch of ESOP companies randomly. And we said, “Let’s compare these companies to companies that are otherwise just like them for the five years prior to the ESOP. And then let’s compare them for the five years after the ESOP.” And what we’re going to do is say, “Well, if Jay’s company was growing 2 percent a year per year faster than its competition prior to the ESOP, but it was growing 5 percent per year faster post-ESOP, then there’s a 3 percent difference attributable to establishing the ESOP.” So this quasi experimental technique is the kind of social science gold standard, and that’s what the research showed.
Jay Goltz:
And here’s the key for me figuring it out: Let’s say that the social scientists are off. It’s half as good as they say it is—still damn good! Even if it’s half, even if it’s a third of what they’re saying, it more than pays for itself. So I’m not suggesting you’ve got to hit all those—I mean, that would be unbelievable if a company grew 6 percent more because they went ESOP. I’m not even suggesting that. I’m just suggesting, bare minimum, if they grow 1 percent more. That’s all, just 1 percent more.
Corey Rosen:
It’s a modest target. And the other side of that is that there are a lot of surveys that were done. My favorite one was comparing ESOP popularity to apple pie and baseball. And it actually came out better than both.
Jay Goltz:
Well, being a Cubs fan this year, that’s not a hard thing to imagine.
Corey Rosen:
That’s true, but maybe the apple pie. Part of the reason Publix is so successful—there are a lot of reasons—but part of the reason is that it’s employee-owned, and there’s some percentage of their customers who just prefer shopping at an employee-owned company, because they figure it’s good for more people.
Loren Feldman:
All right, all of this leads to one obvious question, Corey, which is: If it’s really as good as Jay is saying, why don’t more companies do this? Because we know the percentage is tiny.
Corey Rosen:
Yeah, of the companies that are big enough to do it, there are maybe 150,000 companies that fit the criteria. Because most companies are really tiny, of the millions of companies—under 10 employees or under one employee. But I think it’s exactly what happened to Jay. They go to their advisors—first of all, they don’t even know you can do it. There’s a large percentage of the business population who don’t even know what it is. There’s another large percentage who says, “Oh, employee ownership. The employees have to buy the stock. That’ll never work. End of story.” And then there’s the remaining percentage of Jays who go to their advisors who say, “Nah, you shouldn’t do that. Let’s go to lunch.” And that’s a big problem. A huge problem.
Jay Goltz:
You’ve kind of hit my three. One is, absolutely, they don’t know. There’s no question. I talked to lots of business owners. Most don’t have a clue how it works. So that’s for sure.
Loren Feldman:
Remember, when I told you that the profits were not taxable?
Jay Goltz:
And I said, “Loren, you’ve got this wrong. That can’t be the case.” No. Absolutely. Okay, so number two is—and I think this is huge—they talk to their accountant or lawyer, and it is completely dismissed immediately with, “Oh my god, they’re a pain in the ass.” And that’s the end of the conversation. Because most people are going to think, “Oh, well, I can trust my lawyer or accountant. They know what’s going on.”
Okay, and then the third one—sorry to say—I’ve gone to these seminars, and they’ve managed to unsell me. They say things that are so… they unsell me. I could give you lines they said.
Loren Feldman:
Give us an example. What are you referring to?
Jay Goltz:
Okay, here’s my favorite one. I’m watching a seminar from a well-known company, and the speaker says, “It’s like building a house. Well, nothing’s perfect.” And I think, “That’s like taking your kid to a babysitter and on your way out, they go, ‘Oh, by the way, I just want you to know, I’m not the perfect babysitter.’” Like what the hell does that mean? I still don’t know what that means. That was one.
Another one is, both of these companies—and these are very big companies that you know extremely well—the person speaking, they both said the same thing: “It’s basically like a 401(k) plan.” The other one says, “An ESOP is simply a benefit plan.” That’s simply not the case. That’s like saying, “Going to the Cubs game is like being the manager of the Cubs.” No, you’re in the same stadium. You’re wearing a hat, but one of them is being paid to be there. And the other one, you paid. It’s certainly got an element that’s like a 401(k) plan, but it’s not their money, for God’s sake. You can’t just go ahead and summarize it with that to say it’s like—because then I say to myself, “Well, then what the hell do I need this for? I’ve got a 401(k) plan.” That’s underselling it by about 80 percent.
Corey Rosen:
One of the difficulties—I used to be an academic. And when I first started teaching, the thing that occurred to me right away was, it’s hard to remember what I didn’t want once know. Things that were concepts that were so familiar to me, I didn’t even think about them, that I didn’t know where the audience was. And that’s true of lawyers. They’re experts. And it’s hard for them to remember where the audience is.
The second problem is, often the people who are the worst at explaining something are the people who know too much. They want more and more and more detail. And you don’t really, at first, need to know all that detail. And I had a lawyer tell me once—I said to him, “You’re really intimidating people, giving them all these things that could happen and all the details.” And he said, “That’s the point. If they thought it was simple, they might not feel they need me.” I said, “Dave, if they think it’s as complicated as you just described, they don’t need anybody.” [Laughter]
Jay Goltz:
No, right, I think you’ve hit it on the head. They put up a screen with a bank and trustee and with arrows and dots and arrows going around, and I’m thinking, “Do they seriously think someone’s looking at this and going, ‘Oh, I understand how it works now.’” They don’t speak entrepreneur. They’re not speaking to me.
I want to hear two things: I want to hear, “This is a great way of making sure that all of your employees end up with some retirement. And two, this is going to be great for your company. And you’re going to be thrilled you did this, because everybody is going to be happier, including your customers.” Wow, there’s the sales pitch—instead of, “Let me show you how this works.”
Loren Feldman:
Corey, have we missed anything?
Corey Rosen:
Well, thousands and thousands of things.
Loren Feldman:
Jay, are you still hot on this?
Jay Goltz:
Absolutely. Here’s exactly where my head’s at. My head’s gone from, “If you fit the criteria, you’ve got a management team in place, you don’t need all the money upfront, you’re not worried about getting the last dollar out of the business, you’re big enough for the math to work, you care about your employees.” I feel like I’ve gone from, “Should you do this?” to “Why wouldn’t you do this?”
Loren Feldman:
My thanks to Corey Rosen and Jay Goltz. And to our brand new sponsor, the Great Game of Business. You can learn more at greatgame.com. Have a great week, everybody.
