Armando (0:00 – 0:57)
Hello, founder. You’ve built a successful business and now it’s time to think about that once in a lifetime exit from your business. You’ve come to the right place.
Here you will hear business exit professionals involved in the buying and selling of companies talk about what you should know before you exit. If you’ve never sold a business before, this podcast can be super helpful to you. I’m Armando, host of the Founder’s Guidepost.
Enjoy. If you like this information, please subscribe and share. This is Armando Romo with Axiom Founder’s Family Office here with Darren Klieman.
We’re going to talk today about ESOPs. So if you’ve got a business and you’re thinking about your exit and looking at the options available to you, you’re going to want to understand what an ESOP is and how this might be a tool or strategy that you can use to exit that business and accomplish those goals you’re trying to reach. So Darren, why don’t you just take a moment to introduce yourself and we’ll have a conversation here.
Darren (0:58 – 1:54)
Absolutely. Thank you, Armando. My name is Darren Klieman and my company is NBO Ventures.
NBO is the private equity arm for CSG Partners, which is the nation’s largest ESOP investment bank. An ESOP, I won’t get into it, but an ESOP is just another way for a business owner to exit. You can exit via private equity.
You can exit via, you know, a strategic buyer, or you can exit by selling the company to your employees via this ESOP structure. And that third structure, this ESOP structure, has tremendous tax subsidies, which makes it extremely, extremely interesting for a business owner. We are the nation’s largest ESOP investment bank.
We’ve structured over 350 of these in the past 22 years, over $22 billion in enterprise value, and we’ve structured over $7 billion in ESOP loans. We definitely know this space.
Armando (1:54 – 2:24)
Wow, fantastic. So Darren, when you think about an ESOP, you know, as you know, of course, many people have never even heard of an ESOP, they don’t know what it is, but an ESOP, E-S-O-P, Employee Stock Ownership Plan or Program, it’s designed to allow that business owner to sell the company to the employees. I know it’s very, very simplified and you can go into all kinds of detail about that, but that’s the basic idea, right, that the owner or owners can sell that company to their employees.
Darren (2:25 – 2:42)
Absolutely correct, Armando, and I’m not going to go into specific details because this will not be boring. I’m going to just go into the overall level of benefits of why one might choose an ESOP. I’m not going to get into the details because details, you know, it’s kind of heavy.
I’m just going to go into and explain, you know, basically what it’s all about.
Armando (2:42 – 3:27)
Perfect. Perfect. So when an owner is thinking of selling, they can, of course, talk to an investment banker or a business appraiser or a broker.
They can look at that traditional, you know, engage the person, go through a whole sales process, and that is what many people will do. But a lot of people don’t know that an ESOP exists. And one thing I really like about the whole ESOP exit is the tax benefits, because when sell an asset, a company they’ve built over, say, 30 years for, say, $30 million, and the tax hit is going to be pretty darn significant.
So the ESOP allows that owner to sell the company and avoid or defer or even eliminate the tax hit. Right?
Darren (3:28 – 12:04)
Yeah, absolutely correct. Let me just go through a slight example and just stop me when I go a little bit too far. Let’s just take your example, Armando.
Let’s say your company has, let’s just say $6 million is your net income. And let’s say the company is valued at around $30 million. Well, if you hire an investment bank or a broker, they’re going to go out and they’re going to try to pitch you to various competitors, like the strategic buyers and private equity and value of $30 million.
They’re most likely not going to get into the aspect that you can take that company and sell it to your employees, because no one ever thinks about that. Well, number one, the employees do not put up any money in an ESOP transaction. Just let’s get that over with.
There’s no money. It’s done by the owner. They’re thinking about it.
Don’t worry about the employee. This is basically a gift to them. But when you sell your company to a strategic buyer or competitor for $30 million, well, great, you get the $30 million.
You have to pay your capital gains tax. Take it around that. And capital gains tax in that example is about $10 million.
So you’re selling it for $30 million, you’re going to end up with $20 million. That’s great. That’s awesome.
If you sell your company to your employees via this ESOP structure, that capital gains, just like you said Armando, that’s deferred, which means you’re not paying your capital gains. If you structure it correctly, the capital gains becomes eliminated, which is a huge advantage of an ESOP. And that’s something that the government structured.
The government wants to incentivize you as a business owner to sell to your employees. And one of the advantages they gave, and it’s back in 1986, one advantage was, yeah, if you sell it to your employees, capital gains will be deferred. And again, like I said, if you structure it correctly, it’s deferred forever.
So the next question, how is that possible? How can the employees, like I said, afford it? Well, they’re not.
Now, I’m also private equity, right? So I buy companies. So how do I go out and buy a company that’s worth $30 million with a net income of six?
Well, what I’m going to do is, first of all, I put up as little money as possible. So I’m going to put up $6 million of my own money, okay? Then I’m going to go to a bank, let’s say a JP Morgan.
And I’m going to get a loan of three times your net income, let’s say that’s 18 million. So I’m going to put up 18 million from the bank plus 6 million from me, that’s $24 million. Well, another 6 million, I’m not going to pay you outright.
What I’m going to do is I’m going to have you take what’s called a seller note, which is like an IOU from the company back to you, or we’ll do something of earn out. And that means that as long as your company continues to produce the way you’re telling me it’s going to produce, you will get your additional $6 million down the line. And that’s how you are going to get that $30 million.
That’s how the deals work. Well, an ESOP structured very, very similar, but the only difference is that there’s no equity in here. It’s all debt.
So what we’re going to do is we’re going to go to that same bank, maybe it’s JP Morgan, and we’re going to get that $18 million. That’s going to go right to you, and you’re not paying tax on that. Now, remember, in the example before you get $30 million from private equity, you got to pay a capital gains tax.
You sell it to the ESOP structure, you’re not paying capital gains tax. So again, we get that $18 million, and that comes from JP Morgan, you get that check, you’re not paying capital gains on it. Well, there’s other $12 million that you should be getting.
That $12 million is a seller note. Okay, that’s remember what I said before, that’s an IOU from the company to you. Well, a couple of things here.
Number one, do you really want to sell a note for $12 million when your company is valued at 30? Yeah, you do. And I’m going to explain to you why, because if you don’t want that seller note, I’ll take that seller note, because it’s very juicy.
And also, the bank, like a JP Morgan, why would they lend $18 million to your company when you didn’t put up any equity, there’s no equity, right? What bank will do that? Banks that understand ESOPs.
And here’s one of the reasons why a bank will do it. Think about your company, you’ve taken out loans before, or Amanda, you’ve taken out loans, you know, so you have a mortgage. When you take out a loan, you have interest, you got to pay back.
Well, you can deduct the interest for taxes, but you can’t deduct the actual principle of the loan. That just doesn’t occur, except with an ESOP. With an ESOP, the government allows the company to take a deduction for the entire principle of the loan up to the purchase price of the company.
So in this example, we have a $30 million company. Well, the company can deduct $30 million, right? They have that $18 million loan to JP Morgan, and they have that $12 million loan to Selenote.
That’s 30 million, the company can take a $30 million deduction, which is a huge deduction that the company can take, right? Big advantage. Now, the next thing is that $12 million Selenote.
Do you really want the Selenote? Yes. The reason why is that Selenote, in general, is called subordinate to the JP Morgan loan.
Subordinate means if the business doesn’t do well, it goes under, JP Morgan is taken over. And that Selenote that is subordinate, they’re getting nothing. So that Selenote is riskier.
By definition, it’s riskier. And if it’s riskier, you as the owner for taking that Selenote should get a higher interest rate. Now, the market rate for that could be 15%, which is a lot to put onto your company.
What we say is, you know what? Don’t put the 15%. Don’t do that.
The company will pay you 5%. But wait a second, you’re owed 15. All right.
Well, in lieu of the difference at 10%, in lieu of that, you’re going to get something called warrants to buy back a piece of your company in the future. A warrant gives you the right to buy back stock, right? It’s kind of like a stock option, right?
But it gives you the right to buy back a piece of your company. So you can buy back, let’s say, 30% or 40% of your company with these warrants. And that’s what that Selenote is going to give you.
So you have a Selenote, which you’re going to get paid back an interest of 5% a year. But you’re going to get these warrants. Now, in this example, it’s a $30 million company.
And let’s say it’s 40% warrants. So 40% of 30 million is what? That’s $12 million.
OK. Well, for the next 20 years, you as the business owner will have the right to buy back. But remember, it’s worth $12 million today.
It’s going to cost you about $1.5 million. That’s, let’s say, $0.10 to $0.20 on the dollar. $1.5 million you would hand in at any time in the next 20 years. And you get back that 20%. I mean, that 40% of the company. Which is a huge second bite at the apple for you or for your heirs and for, let’s say, the management team.
So remember, you’re getting the $30 million. It’s going to take a couple of years to get it. $18 million up front.
You have the $12 million you’ll get back in a couple of years. But when you get that $30 million, again, there’s no cap gains tax on that. Also, the last piece about an ESOP, which is super cool, is that if you sell 100% of the company to your employees, which you don’t have to, you can sell 30%.
You can sell 40%. You don’t have to do 100%. But if you do sell 100%, the company will run tax-free on a go-forward basis.
When I say tax-free, I mean you will pay zero federal income tax. You, meaning the company, will pay zero federal income tax and the company will pay zero state income tax. Which is tremendous.
It really is an amazing, amazing benefit. So you put all these benefits together, it’s phenomenal. So the question that, if you were listening, the question you might be asking right now is, that sounds too good to be true.
Why doesn’t everybody do these ESOPs? And you know why everybody doesn’t do it? Because you don’t know that this exists.
That’s it. It’s the education that this is there. Nobody knows.
It takes me, what I do day in, day out is I just pitch it and I explain to people exactly how this works. And when they do hear it, it’s like, yeah, that sounds pretty amazing.
Armando (12:05 – 12:58)
Yeah, yeah. And I can see why people would say, just as you’re saying, Darren, that it sounds too good to be true. And there are a lot of sections of that tax code that have been around for years that people just don’t know about that are real and valid.
And they’re very black and white. They’re not gray areas at all. They just aren’t known.
And I think that, when I think about the business owners who I know and who I talk with, many, if not all, want to take care of the employees when they sell their company. And if they knew the power of the ESOP, not just that they can transfer for fair value to the employees, but they can also get a tremendous tax benefit, just a tremendous benefit, then it makes you wonder, why wouldn’t I at least explore this option before I decide to sell that business?
Darren (12:58 – 13:18)
Yeah, you go out and you sell your company to a competitor or another strategic buyer or private equity. Why does that private equity firm or a competitor? Do they really need multiple accounting departments and multiple marketing departments?
Do they really need multiple lines of these workers?
[Speaker 4] (13:19 – 13:19)
No.
Darren (13:20 – 13:54)
What they’re gonna do, because it makes sense business-wise, is to start slashing costs. And when they slash costs, what does that mean? They’re gonna get rid of a lot of employees.
So when you structure a regular deal, yeah, they’re gonna fire employees. You have to, because you wanna make it operationally enhanced is the word that we use, operational enhancements, right? If you do an ESOP, you’re not firing anybody.
Not only you’re not firing anybody, but the actual members of your staff all become owners.
Armando (13:55 – 14:58)
Yeah. And one thing I like about that as well, Darren, is that private equity, love them or hate them, private equity has role as many institutions do with this kind of an exit. But private equity, say coming from out of state to buy a company, they wanna get profit from the business, yes.
But when the owners transition that company to the employees, I can’t see a better way where they can really take care of those employees, keep the ownership local, keep all the local people there and keep it still a part of the community that it’s grown to be over time. And the owners of businesses, when they go to sell, they’ve spent years to build this company and make it worth millions. They have a whole corporate culture.
They’re concerned about the corporate culture being destroyed, concerned about a company going in the wrong direction. And they really wanna take care of the people who’ve been with them for years and years and years. And when private equity comes in to just buy it outright, it isn’t always how that story goes.
Darren (15:00 – 15:05)
No, no. And I’m also private equity. I get it.
Armando (15:05 – 15:24)
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Darren (15:25 – 17:12)
And if I’m gonna come in and buy a company in Arizona, yeah, the way it works is I don’t just buy a one-off company. What I’m doing is I buy one company called The Platform. And let’s just say it’s a veterinarian company.
I buy my veterinarian platform and I really like how they’re doing business. Then I go out and I acquire other veterinarian firms and I bolt them on to my company. And as I bolt them on, I remove staff because I don’t need redundancies and staff.
And ESOP is just so much better for the employees. And that’s really why the government incentivized the business owner with all these tax subsidies. When all is said and done, that $30 million company, if you somehow sold that $30 million company to private equity and somehow they gave you a premium of $50 million, you know what?
It’s still financially better for you as the owner to sell to the ESOP. Because when you sell for $50 million right away, they can say, okay, thank you very much. Here’s $50 million.
Well, your tax on that is gonna be 15 million. So you’re gonna be left with 35 million. Sounds great.
And it is great. But with an ESOP that you’re selling for 30 million, remember that 30 million is no capital gain. That’s gonna be deferred.
Plus you’re getting the warrants. Now these warrants, let’s say in 15 years from now, you have warrants to buy back 40% of the company. That company, and let’s say you then had your children starting to run the company.
That’s how you can give it to the children. The company can be worth 80 million now. Once it’s worth 80 million, at that point, if you want, you can now sell the company.
You can terminate the ESOP, hand in your warrants, and now you’re gonna get 40% of that, which is another 40% of 80, another $32 million that you’re gonna get.
[Speaker 4] (17:12 – 17:13)
Wow.
Darren (17:13 – 17:18)
And the employees, the employees at that point will get $48 million.
[Speaker 3] (17:20 – 17:20)
Amazing.
Darren (17:21 – 17:44)
It’s unbelievable. And when the employees get that money, that money doesn’t go into their pockets. It’ll go into their 401k, which is not taxed, which means they literally get it there and it can grow their tax-free until they take it out.
And then once they take it out, when they turn, I think 70 and a half, I’m not sure the rules, at that point is when they’re taxed. It’s a phenomenal, phenomenal structure.
Armando (17:44 – 18:22)
Right. And I’m glad you mentioned the 401k idea or concept of how the money goes in because by and large, employee fees don’t really have any savings. I mean, in general, except for what the employer plan has set up for them.
So if you look across the country and look at where people have their money, the average American, when there is a nest egg, that nest egg came from an employer-sponsored plan like a 401k or like an ESOP exit. And that’s where their money came from, whether it’s forced savings or whatever you want to call it, but it still ends up in the pockets of the employees to their benefit for the benefit of their families.
Darren (18:23 – 19:27)
Oh yeah. The statistics are crazy about this. So a traditional, this is for minorities, it’s crazy.
For a white man, a white man has a median savings, right? A median worker has a median savings of about $29,000. If they’re at an ESOP, their median savings becomes 323,000, which is huge.
Now for minorities, they don’t close the wealth gap, but it gets closer. The average black woman, and I’m reading these statistics here from the Rutgers Institute in New Jersey. I’m reading it right now.
The average black woman that’s a lower income has a median savings of $200. That’s just normal, which is no savings. With an ESOP, their average is $32,000.
For a Latino woman, it’s $100 a median savings. With an ESOP, 143,000.
[Speaker 3] (19:27 – 19:28)
That’s amazing.
Darren (19:29 – 20:15)
Right? The statistics are really insane of how much better it is for the workers. Well, I mean, think about it.
They now become owners. And in terms of the productivity for the firm, once you do an ESOP and you explain to the workers how this works, literally in a couple of months, things definitely start changing. If someone’s slacking off, it’s not the owner that’s getting pissed off.
It’s all of the owners are like, that doesn’t work. We need to be sure. So it turns out that productivity increases by 50% once you structure a firm as an ESOP over a private equity purchase firm.
It’s pretty amazing.
Armando (20:16 – 20:42)
Yeah, that sounds pretty amazing. So for that ESOP to work, they’ve got to have, of course, when the owner steps out, they’ve got to have a team that can run that and keep that company going, of course. And if not, I imagine they could bring in new people or supplement the staff, augment the staff so that the company can continue functioning when the owner or owners step out.
But that shouldn’t be a problem at all. It’s just a new employee for the mix, right?
Darren (20:42 – 21:16)
Yeah, I mean, usually a business owner, you know, to think about it, like, you know, what am I gonna do in a couple of years? I want to get some type of exit. No one really wants to truly exit.
This is a way that they don’t have to truly exit. They can stay and manage the company for as long as they want. So the owner will continue to own or continue to manage.
They can now start to work with other employees to take the reins, or they can bring in another CEO. We acquired a firm, this was about eight years ago. And remember, I told you, we had that seller note portion for those warrants?
[Speaker 4] (21:16 – 21:17)
Yeah.
Darren (21:17 – 22:23)
Well, that owner just wanted to leave. He was 90 years old. He didn’t want the warrants.
So I gave him, we gave him money. And we got these warrants for about, I don’t know, X percent of the company. And we put in a CEO that did a phenomenal job and built that company up tremendously.
So that’s what you could do. But also a lot of people, they’ll use this ESOP structure for, is to get the company from the hands, them managing it to their children managing it, where their children get these warrants. As opposed to normally, if you want to sell to your child or your children, you use like an installment sale method to get it to them because you can’t give it to them.
You’re not allowed. You can’t just gift your company to them. You have to, the whole structure, which is incredibly tax inefficient.
If you use the ESOP structure, well, you sell to the employees, the children get the warrants to buy back 40% of the company. The company runs completely tax free for let’s say 15 years. And then when the children are ready to exit, they hand in the warrants and exit.
It’s much better than the installment sale method.
Armando (22:23 – 22:36)
Wow. Wow. It does sound pretty darned amazing.
So Darren, when someone is going through this process, start to finish, what is it? How much time typically to go start to finish on that?
Darren (22:37 – 22:55)
Yeah, what we do is someone will come to us and like, all right, yeah, what do we do? We think you want to do this. All right.
So what we do is we call it a phase one analysis. And the phase one analysis, we open up what’s called a data room. And that’s where we can go out and we can get access to their balance sheet, same as tax returns.
[Speaker 3] (22:55 – 22:55)
Okay.
Darren (22:55 – 24:50)
We open the data room and then we pour through it. And we go out and we say, all right, well, this is how much money you’re going to be paying in tax over the next five years by doing nothing. Most business owners, it’s really against inertia because they don’t know what to do.
So they do nothing. So we say, look, the next five years, this is how much money you’re paying in tax by doing nothing. Then we say, if you sold to a private equity, this is how much money you’re going to get.
And this is how much money you’re going to get after taxes. If you do an ESOP, we do a valuation of the company as an ESOP. And ESOPs are valued different.
So we know exactly how it should be valued. So we’re going to give them a range and we’re 95% accurate on that. We’ll know what it’s going to be valued at.
And this is what they’re going to get after tax. Then what we do in this analysis is we go out to our lending stack. And we’re pretty broad.
And we go out and we try to find out, okay, how much money can we borrow so we can pay the owners their money? And we go out and we find out, okay, we can borrow, X times their earnings plus some assets. And we go out and we can borrow for the $30 million company.
We can go out and get probably $18 million. And the cost is going to be about 5%. And we’ll know that.
We’ll be pretty good. So we go out and we do a presentation. And we walk them through exactly what I just told you.
And they have that document. And that means they don’t have to do anything. But from that, they know at least, yeah, we know that we can be able to get $30 million for this.
We know we’re not going to go taxes. And they have a pretty good idea of what they’re going to do. At that point, they can engage us or not engage us.
Now, that process takes about three, four weeks. Now, when they engage us to actually do and structure the ESOP, that can take anywhere from a traditional private equity deal, anywhere from four to five months. So if someone did it now, and today, let’s say it’s July 1st, we could have a ESOP in place by the end of the year.
Armando (24:50 – 25:10)
Wow. Wow. What are some of the, other than the big tax impact, of course, what are some of the surprises that along the way that maybe the business owner who is learning about this, any surprises that maybe they’re just shocked about?
Other than the tremendous tax benefit they can gain from it?
Darren (25:12 – 26:09)
They will be shocked by the employee retention now. And employee engagement. If they want to have more employee engagement, this works.
Because employees do have pretty great ideas. And a lot of times in a traditional company, we just let the employee do what the employees do and the managers manage. This is just an opening.
If you want to get the employees to get a little bit more involved, they can. And this is usually a great opening for that. And you will find that these employees have some pretty phenomenal ideas because they’ve been working there for many years.
So that’s number one. And number two, though they’ll hear the tax benefits and I’m saying it, they’re not going to remember it. People just don’t remember these things.
But the additional amount of money that they can make from selling to the ESOP is just so much better than private equity. That’s something I think it’s always in someone’s mind that, wow, wow, that’s phenomenal.
Armando (26:09 – 26:44)
And I imagine what they would likely want to do is take a look at those numbers from your phase one, get together with their tax CPA, just validate that what they’re being shown is in fact what the CPAs agrees with. And the CPA may or may not know what ESOPs are or how they work. It might need a little education himself or herself to get on board.
But then once that validation is done and that business owner understands, wow, this is real. And I imagine getting to the phase two is probably a lot easier now that they’re more on board with this whole concept.
Darren (26:44 – 27:29)
Absolutely, Armando. We definitely need to speak with the CPA or their attorney quickly because it sounds too good to be true. And so we want the CPAs and the attorneys to right away speak to us because they probably don’t know about an ESOP.
They think an ESOP is some type of pension plan that sounds complicated and we don’t know what to do about it. They don’t worry about that. So we wanna get that right at the beginning and explain it to them, right?
And then we can explain them a little bit more technically than we are going to a business owner, which is great. And then we’ll get them on board and put everybody tied up in a bow so everyone understands it. But yeah, we’d like to get the CPAs and the law firms right away.
Armando (27:29 – 28:36)
Yeah, and Darren, you mentioned about tax elimination or tax deferral in that code section that I saw in somewhere in papers that you gave me before our conversation today. You mentioned a code section 1042, which is real similar to a 1031. And people might be more familiar with the 1031 when they sell a piece of real estate and if they reinvest those proceeds, then they can pretty much defer 100% of the gain on the sale of that real estate.
So the code section used for this ESOP, it’s the same idea. You reinvest the monies and you don’t have the money to pay the tax. Therefore, IRS says, hey, you don’t have to pay this tax.
And just like with the 1031, when you die, there’s a step up in basis and that’s where the elimination can show up as well. But all that gets a little bit, maybe a little bit too much in the weeds for this conversation. But I wanted to mention that because I think that at least here in Arizona in the Southwest, there’s a lot more familiarity with the 1031 exchange in real estate.
And that would be the way to show how this kind of gets to the same place because it’s the same basic concept.
Darren (28:37 – 29:13)
Yeah, it’s almost identical. You have a $30 million piece of real estate. You sell that and buy another piece of real estate.
That capital gains goes away. You sell your $30 million business. The code actually says you need to go out and buy another U.S. operating business. Well, what does that mean? Well, that means that you can go out and buy stocks. You can buy bonds, right?
You need to, that’s like a U.S. operating company. If you go out and you make this acquisition, as long as you hold onto it for forever, you don’t pay taxes.
Armando (29:13 – 29:48)
Right, right. And that’s where the CPA is so critical when the owner is thinking about walking down this whole step. So you mentioned warrants and let me ask you, Darren, about making some notes here on my yellow pad so I can make sure to ask you some questions.
So you mentioned warrants and it sounded like what you said is that use that example of the 90-year-old seller. He said, I don’t want the warrants, just give me the money. Is that how that worked?
He got paid up front versus not taking that money and in exchange getting warrants, which later he could cash those in to get more value.
Darren (29:49 – 32:34)
Yeah, so for him, he’s 90 years old, but take that same exact example we have. It’s a $30 million company. He’s got an $18 million.
He gets an $18 million check from JPMorgan and he has a 12, he can’t get any more loans. He’s not gonna be able to get more loans. $12 million that he’s taking back is that seller note.
So then we looked at it and like, you know what? I think it’s a pretty good deal. Even though we are now gonna be subordinate, it’s a little risky, but I’ll take that.
So we would write the check, the $12 million and it goes to the owner. He now has that $30 million and he’s 90 years old. He has that 30 million.
We now put in our own CEO into that company and now we got the warrants to buy back a chunk of that company into the future. Wow. So that means that the company has that debt on the books.
It paid down the debt, right? So because you’re not paying any taxes, we structured as 100% ESOP. So the company did not pay any taxes.
We had a lot more money to pay down the debt. So we paid down that, this example, that $18 million got paid down in about four years, three and a half years. Our debt that we had, which is $12 million, we got paid back very quickly because that same bank that JPMorgan, they saw that this works.
So they then wrote us a check to $12 million and they took over that $12 million note. So we got paid back pretty quickly. Now they had that $12 million debt.
It took them another maybe year and a half to pay back because now we’re generating more income. And then this thing just generates cash and not paying any tax. So what did we do?
Well, we went out and we started to, we used our money to acquire more. We would lease out these bins to the oil industry. We bought more bins.
We had thousands of these bins. It was great. And we literally just took it private about a month ago, this company.
And each of our employees did supremely well, supremely well. Money that they would never, ever have had. Now they had into their 401k.
So it worked out tremendously for everybody. I mean, it’s exactly what the government envisioned. This is, ESOP is the government gone right.
And you know what’s cool about with an ESOP? There’s nothing else in this country, think about it, where the Republicans and the Democrats agree. They both agree on the ESOP scenario.
And so on the Rep side, you have like Bernie Sanders. He webs the ESOP for all the amazing things it does for the employees because it makes them these owners. And then on the right side, you have McConnell.
He likes it because of all the tax deductions and all the incentives that the business owners get to sell to the employees.
Armando (32:35 – 32:35)
Right.
Darren (32:35 – 32:39)
It really is phenomenal. They both love it.
Armando (32:39 – 33:45)
Right, right. And that makes me think of, in general, qualified plans like a defined benefit or cash balance, because it’s the same idea that the government allows for an enormous tax deduction when the owner of the business puts in a pension plan in that company. And they can reward themselves, the owners pretty handsomely.
But the government says, you’re allowed to do this and get a big tax deduction for it when you include all the employees and bring them along with you in this plan. Right. And when that works, it can work, same idea just beautifully because you get the tax deductions, the employees win, the business owner wins.
And it’s just a good story overall for the company and everybody who’s part of that company. So the ESOP has that same idea. And I love that the people who are all working, who have helped build that company, all those employees, they can still contribute and get their own exit from that at some point because the ESOP has been put in place by the owner who then sells that company to the employees.
Darren (33:46 – 34:07)
Right. It’s a phenomenal option. The employees are rewarded for work that they’ve done.
The owners, the legacy remains. And the owner not only does supremely well financially, but becomes a hero to the employees because these employees will obtain substantial wealth.
Armando (34:08 – 35:27)
Yeah. So let me ask you, I think I described to you, I had a conversation recently with someone who had bought his company from his father years ago. Not too many years ago, but did it just as you touched on earlier in the traditional way where there was an installment note.
So son bought the company from dad. There was an appraisal done on the business. They determined it was worth X dollars, whatever that was.
So then there was a note that went to dad, you know, I owe you. And son has to pay dad off that note over, you know, say a 10 year period. The company has done really well.
And son was able to pay off that note a lot earlier than expected, than anticipated because he’s just grown the company. And now it’s just doing even better. There’s a whole management team in place with this company.
And now son is, when I spoke to them recently, son is looking at his kids, you know, his next generation and thinking of his own exit and wondering how that might work. So he’s been through that traditional installment note process, but he’s not been through the ESOP. But it sounds like the next conversation that he and I need to have are how an ESOP can really make sense and explore that a bit to see, will that get him where he wants to be?
Darren (35:27 – 36:39)
Yeah, so the process that he went through, let’s say, you know, take the same example is, so the dad wanted, you know, $6 million in income, dad wants 30 million bucks. Okay, so what happens is, okay, son, pay me out in installment sales, whatever we can. And that’s probably the agreement.
You know, they have some type of term, but okay, the company makes $6 million. That’s a lot, right? Well, you gotta pay about $3 million in tax.
You have the Arizona tax, you have federal tax. So the company has $3 million. The son now has $3 million.
So now he takes, I don’t know, 2.8 million and gives it to the father. The father now takes that 2.8 million and has to pay his capital gains tax, right? And that’s now all of a sudden you’re taxed twice.
And that makes you repeat over 10 years. The father gets his money and maybe early if the company does better, but there’s so much tax in that. You know, it’s a difficult proposition.
The son now could do the same ESOP structure that we talked about earlier and save so much more tax. And he would end up getting a lot more money sooner and his children would end up with those warrants.
Armando (36:41 – 37:11)
Yeah, and this particular owner has a management team that really runs the company. And so the owner is there and just keeps the company or keeps the team working together as a team and keeps harmony in the team, in the company, in the management level. But basically the owner is not nearly is involved as maybe many owners are.
So for him to step out, the company will continue to function and run very, very well, even when he’s not there.
Darren (37:11 – 37:48)
Yeah, and he could do a quasi management buyout that he can implement himself. So remember, if we get warrants of 40% of the company, what he can do is he can give his children, he can give to his children, let’s say 20% of those warrants and the other 20% of those warrants, he can sell to the management team. So now the management team is really incented by the additional 20% of the company, right?
And that’s how they would do a management buyout and he can implement that entire thing, which is phenomenal for the owner, phenomenal for the children and phenomenal for the management team. And then of course the line workers, well, they’re gonna own the company.
Armando (37:50 – 38:08)
So this owner was talking about possibly setting up trusts for kids and grandkids and that, but it sounds like the warrant could help accomplish or maybe is one of the tools in the tool chest for that owner to transfer part of his wealth to the next generation.
Darren (38:09 – 38:51)
Yeah, that’s correct because the warrants on day one when they do the transaction, a warrant is not worth anything. So you can take a warrant that’s worth nothing and you put it into a trust. As the debt gets paid down, the value of that warrant significantly increases, but it’s increasing inside a trust.
So to your audience, think of a trust as just a person that never dies. And if a person never dies, well, then that person never has to pay a state tax because when you die, you need to pay a state tax. But if you have this trust or this person that never dies, well, you never pay a state tax.
So if you put these warrants inside this trust that’s valued at very little and it grows inside the trust, well, since it never dies, you never have to pay a state tax.
Armando (38:51 – 39:39)
Right, and I can also see how that trust can be very helpful because a lot of times the founders of a business and or the parents are concerned about their adult children getting married and getting divorced and trying to protect that adult child’s wealth that they pass on. So if that money is passed on in a trust, then that helps keep it cleaner and simpler. And that divorce, ugly divorce, sticky divorce that may happen down the road, that wealth still stays isolated as parents intended for their adult kids and their grandkids.
So a lot of benefits can happen by having that trust in place and the warrants growing tax-free inside them. Just a lot of benefits there that somebody can really reap from the right using that ESOP the way it can be used.
Darren (39:39 – 39:54)
Right, and then using trust law correctly, as you said, and setting up that generation skipping trust, which is fantastic. It works. And now the grandchildren will end up with the money and you are protected from a nasty divorce.
Armando (39:55 – 40:11)
Yeah, no, that sounds amazing. So Darren, the ESOPs are federal, not states. So they work in all the states all over the country, right?
And you have clients in different states, of course, but you work with people all over the country as well?
Darren (40:11 – 40:21)
Yeah, as I said, we’re the nation’s largest ESOP investment bank and we work in every state. I mean, we’ve done ESOPs in Hawaii, in California, in Arizona, we’ve done them everywhere.
Armando (40:21 – 40:22)
Okay, fantastic.
Darren (40:23 – 40:36)
It’s such a small part of the tax law. And as we said, not many people know about it. So no one’s really working on it in every single state.
And that’s why we’re here. Our headquarters are in New York and we go everywhere.
Armando (40:36 – 40:46)
Okay, Darren, anything that we didn’t touch on in this conversation that’s relevant to that owner who’s never sold a business before and now they’re thinking, should I think about an ESOP or not?
Darren (40:47 – 41:59)
I think it’s pretty relevant. I mean, if people that actually are continuing to listen, yeah, I think we’ve gotten to every bit of it and then they should go back. Because yeah, I mean, we covered the top points of it, which is a phenomenal way to exit your company.
Oh, here’s one little piece. So when you sell a company, you don’t have to sell 100% to the employees. You can sell 30%.
So if you want, in that example, it’s a $30 million company. What a lot of people do is they’ll do it in two stages. They’ll sell 30% for $9 million.
They get a check for $9 million. So you take some chips off the table. You’re not paying cap gains on that $9 million, right?
And now you still are managing, controlling, doing whatever you want with that company. You’re still totally in control, but now you’ve sold 30%. So the employees are rolling with you, but you were able to cash out, which a lot of people like.
And then usually let’s say four years down the road, they’ll go to the next stage in the transaction and they’ll sell the other 70%. And that’s how people will usually go out and sell 100% of the company. That phase one, that stepping into it makes people feel very comfortable.
Armando (41:59 – 42:03)
Okay, so they can try it without giving up control of the company.
Darren (42:03 – 42:06)
That’s right. And even, yeah, exactly, exactly.
Armando (42:06 – 42:15)
Like what you said, taking some chips off the table. So Darren, if somebody wants to get ahold of you and ask you questions, what’s the best way for them to reach you?
Darren (42:17 – 42:36)
Best way right now is to contact you and then contact me. Or if you can contact me directly, great. I am, my email is dgleeman at nboventures.com.
I don’t know if you’ll have that up there somewhere, but yeah, yeah, yeah. Okay. Or you can just text me at my phone number, 646-734-2035, which you’ll have there too.
Armando (42:38 – 42:41)
Repeat that number please. You said 646-734.
Darren (42:43 – 42:45)
646-734-2035.
Armando (42:46 – 42:47)
3035.
Darren (42:48 – 42:50)
I have my New York accent.
Armando (42:52 – 43:01)
Well, that New York minute is pretty quick, isn’t it? Yeah, yeah, it’s good. Yeah, we’re on the other coast.
We’re on the other end of the scale, I think.
Darren (43:01 – 43:09)
Yeah, I’m a fast talker. You know, it’s like I have a lot of thoughts going through my head. I’m very animated and I get very excited by ESOPs.
Armando (43:10 – 44:04)
Well, good. Well, Darren, thank you so much for the time. I hope that, you know, the business owner thinking of selling is able to look at, listen to this and watch this, learn from it and reach out and ask the questions that they should be asking so they really make that best decision when it comes time for them to exit.
Really enjoyed this time with you, Darren. Thank you so much. Appreciate it.
Thanks, Armando. Glad to help. All right.
Thank you now. Thinking of exiting your business? You may have only one chance to get this sale right.
Your family depends on it. Come hear experts who plan and negotiate successful business exits for a living. Bring your questions.
Live panel discussion followed by Q&A. Join us Thursday, April 27th, 2023 at the next Scottsdale Founders Forum, a biannual live event for the founder considering exiting in the next five years. More information available at ScottsdaleFoundersForum.com.
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