Armando (0:00 – 1:00)
I’m Armando Roman, host of the Founders Guidepost. You’ve built your business over decades, and now it’s time to think about that once-in-a-lifetime exit. You’ve come to the right place.
Here, you will hear business exit professionals talk about what you should know before exit. Besides hosting the Founders Guidepost, I’m CEO and founder of Axiom Founders Family Office, a Scottsdale wealth management firm helping founders and their families preserve their American success story. We oversee and coordinate a network of vetted professional advisors to help maximize their probability of achieving everything that is most important to you.
And we host the Scottsdale Founders Forum, a biannual live event for the founder considering exiting in the next 36 months. Here’s to your hard work and your American success story. Enjoy.
Hello, Armando with the Founders Guidepost here this morning with John Chionchio of WealthPoint. John, how are you?
John (1:01 – 1:04)
I am well. Thanks for asking, Armando. I hope you are too.
Armando (1:05 – 1:20)
Good. Yep. Very, very good.
So John, we’re going to have a conversation about ESOPs. And for those business owners who have never sold a company before and have no clue what an ESOP is, in a nutshell, what is an ESOP?
John (1:20 – 2:21)
It’s a very good question. And most owners know a little bit. And if they Google it, they’ll probably end up with more questions than they got answered and confused as ever, because ESOPs are very complex, but very configurable tools that are an exit and succession strategy for business owners.
It’s one of a pretty large handful of tools that are in the toolbox to create the outcomes owners want through a transition of their business. And it’s probably one of the least known tools in the box. Everybody’s heard the word, but they don’t know much about it.
And having just returned from the National ESOP Convention, even though it’s a qualified plan that’s been around for several decades or more, the community of people who serve the business owners around ESOPs in this country is very small. It’s amazing how little known the tool of an ESOP for transition and succession is.
Armando (2:21 – 3:06)
Yeah, yeah. And that is a great tool. We’ve worked a lot with qualified plans over the years to understand the tax benefits and just so many good benefits about that.
And John, I think it’d be really helpful. And I realize I didn’t ask you to say more about you. You owned a business and have had your own rounds with business ownership and sales.
And I think that one thing I think about with you is because you have that experience, it puts you in such a better seat to talk with that business owner and really relate to them because you’ve been through that yourself. So maybe you could spend just a minute or so talking about your own background and then come into how you use that in this new phase of your life with the ESOP exit for business owners.
John (3:06 – 6:23)
Well, I really don’t want to bore people very much, Armando, but the cliff notes of it. And I know you understand that very well. Also having your past with your family business and so forth.
So, yeah, I mean, all of us partners at Wealthpoint are ex serial entrepreneurs. Basically, I’m an electrical and computer engineer by schooling. Never really wanted to write code or design circuits.
Always loved the people part and the business part. And, you know, from the time I was 11 and no one told me I had to have just one paper route. And I ran a team of kids doing paper routes and things like that and put myself through school, running my own businesses in the summers and with my parents help and, you know, worked for the man for 18 months and didn’t really fit with me.
So I quit and started an electronics company with another guy who figured out that he needed to do his own thing to accomplish his goals. And so we built that company into several related companies and, as you know, eventually sold to Rockwell Avionics and Communications into Westinghouse. And so that experience of not just having been through exit with those companies as a founder owner for the first time, but just living and breathing every day, growing and running a business and knowing what that’s like and trying to use outside resources, whether they be tax or legal.
And you know how it went. And always wondering if there were things I should be paying attention to, I wasn’t aware of. And waking up in the middle of the night with that pit in my stomach because something wasn’t right at the business and all these people were depending on me and my two partners for their livelihoods.
You know, if you don’t live that and breathe that, it really doesn’t prepare you to do what we do with just helping owners around exit. It’s just invaluable. And in fact, as the firm grew in the early years, there were some missteps to try to build the partners at WealthPoint with people who weren’t serial entrepreneurs, but just had a wonderful business resume.
And it just didn’t work. And it was for that lack of connection with the client. There wasn’t that deep understanding.
And we had been there and known the frustrations of building a business and the founding partner, managing partner, Tim Young, his whole goal was to say, what would I want to have had access to and the types of relationships I would have wanted to build my business that the financial services industry really fell kind of short on. So that was the whole motive behind building the company. And the fact that we do just one thing with a real intense laser focus, and that is succession and exit planning and execution.
And we do that in a comprehensive way that includes a lot of other parts, because it’s not just how is ownership in a transition, but we’re trying to make sure the future success of the business, which is always required to achieve the outcomes around exit, is built into that process as well. So leadership and management and culture and relationships that all have to go along with ownership transition and have to also transition with the business for the future success. You get those types of things when you’ve been there and done that and maybe not got it that right and learned a whole lot.
Armando (6:23 – 7:14)
And so now as you focus on one specific area, like we’ve talked about ESOPs, and that being an exit tool, let’s dive into what that really means for that business owner. And you have conversations, of course, with people who’ve never gone through this, never sold the company before, and they don’t know what they don’t know. And they don’t understand often, I’m sure the tax benefits are only one component, but there are a lot of reasons why an ESOP should be considered.
And it may or may not fit, but it should at least be considered before that owner decides to exit the business. So when you have those initial conversations, John, let’s talk about what are those initial conversations and what should that business owner really know and understand to know if they should take more than one step in that path, or should they really walk down that entire path with you to get that done?
John (7:14 – 13:11)
Yeah, that’s a fantastic question. And it’s really about education in the beginning, because it’s a tool for transitioning ownership. Yes, but it’s a tool to accomplish so many other things around exits.
It can be designed to service so many outcomes besides transfer of ownership and monetization of a business. And those outcomes are very diverse in nature. I mean, with an ESOP, you can monetize 100% of your business and not lose control of your business.
What other tool allows you to do that and to continue to not just be involved somehow, but really, by choice, however you choose going forward. That’s an amazingly powerful thing for owners who don’t just want to cut the rope, but want to continue to be involved in their business in some way, but still take some risk off the table and accomplish things for themselves. So that’s a wonderful nature of it.
It’s very, very flexible regarding future inclusion and involvement in the business by selling owners. Another one is, of course, the tax efficiency is very nice. Because if you, for example, are an S corporation, and you do 100% ESOP, you become a tax-free business.
You won’t pay taxes anymore because the business is actually owned by a qualified plan that ESOP trusts, which is an exempt entity. So that extra cash flow and cash flow flexibility, and having that extra profit to grow your business for capital expenditures, for equipment, for hiring, and just growth in general, bonuses, whatever you might want to do with it. It is a really unique thing about this transition tool.
Another unique thing is just how impactful it can be for your employees. Every employee, from the C-suite right down to the shop floor, or the rank and file, everyone is going to have a retirement account that builds relative to the growth rate of the business. If you look at the stats, you’ll see that all ESOP-owned, privately held businesses as a group, way outperform non-ESOP-owned businesses.
And it’s mainly because of the owner mindset that gets instilled in all the employees. They now have a way to build a retirement account where they don’t have to put a nickel of their own money in it. And unlike their 401k or other investment accounts that might grow at market rates, if the company grows significantly faster than the market, their retirement account will grow significantly faster than the market.
And so all of a sudden they realize, wow, my buddy’s in an ESOP over here, and the average increase in his account value over the last 10 years has been 14%. That’s incredible. I’m not getting that anywhere else.
And then they realize, wow, if I do my job better, if I use one less paper towel in the bathroom every day, when I wash my hands, it’ll go to the bottom line and increase the value of the company and my account along with it. And that’s a silly example, but they really do begin to start thinking like owners where they start getting better at their own jobs, collaborating better with their teams, having more of a big company focus where it’s like my company now. And that owner mindset is enormous in its value to get the most out of the most valuable asset most companies have, which is their human capital, right?
The human potential that’s in every one of their employees. And that’s an amazing benefit. And there are so many more benefits that you can design an ESOP and not just the ESOP, but ESOP in conjunction with things that you might choose to surround it with a stock appreciation rights plan or some sort of phantom equity plan for leadership, because it is an ERISA plan with formulas for how many share allocations go to each person based on their comp and things.
So it can’t be discriminatory per se, but it’s the foundation. And then the things you can surround it with and integrate it with your 401k and other benefits that you have to really do things for your employees is very powerful and it’s complex. And so most people don’t really have the level of education they need to fully understand the impacts and the outcomes they can achieve with the tool.
And as you know, business owners are so busy. I mean, exit’s a perfect storm for these owners because first they’re so busy building their business. Secondly, they see exit as this thing at the end.
I’m so busy now. Why would I put time now into working on something that might be five years down the road or more? And they don’t realize the runway required.
And then thirdly, they don’t know what they don’t know about these tools like an ESOP. And if they did, I’ll give you an example. I have a current engagement with a very great group of owners, two owners, and they have a wonderful business and they’re just planners and they wanted to educate themselves about exit.
So they engaged us with a 10-year runway for exit. That was about nine months ago and we’re nine months in. And now that they’ve learned all their options and got fascinated with the ESOP option, that 10-year runway turned into a two-year runway.
It’ll give so much extra time to their people that they care about to build those accounts and they still get to run the business. And there are many technical aspects of an ESOP we could discuss such as warrants, which allow them to also participate in the future growth of the business. If you sell 100%, you can participate in the ESOP yourself if you remain an employee.
And you can also have warrants related to the transaction so that at a future date, you can cash in those warrants and continue to take advantage of the increase in value. There are so many ways to use the tool to accomplish outcomes you want that people don’t understand. And sometimes it’ll change your runway from 10 years into two.
Armando (13:11 – 13:12)
That’s amazing.
John (13:12 – 13:21)
That perfect storm of busy and it’s later and not knowing what they don’t know about the tools, they just, they miss out on opportunities.
Armando (13:21 – 13:40)
When you’re talking with the owners who are going through an ESOP and they’ve decided to do it, are there things that you’re hearing over and from them that are the resounding why? Why they chose that versus sell to a private equity firm, sell to a competitor? Why did they want to choose the ESOP?
What are you hearing from the business owners?
John (13:40 – 17:38)
Yeah, that’s a great question. Most of the time, the initial interest is either tax efficiency or employee impact. They really want to do something for their people, their loyal employees.
So those are the two original ones. But as they learn more and more about the tool, it often expands from there to say, I didn’t realize how I could design my future involvement. I didn’t realize that the company is still going to run according to the board of directors and they’re going to be the chairman of the board and so on and so forth.
So some of these other possibilities to achieve outcomes for themselves and their families or their employees and their families emerge. One of our current engagements. So we closed one ESOP a week ago yesterday for over 125 million.
And that was a very unique design of that ESOP based on what that owner wanted to achieve with his business for his family and his employees. And then we’re going to close another one on Monday, actually. And that one was also a very unique design where we one thing you learn about ESOPs is to really max out the benefits toward the outcomes you’re trying to achieve.
It takes a lot of analysis and design work on the front end to explore all the avenues and potential of the tool. Do that all up front. Because doing it later can have negative impacts on that owner mindset and on some other things, right?
That upfront design and analysis thoroughness is really important. And as we begin to take owners through all those things they should be thinking about, the lights go off and they end up realizing other things they might want to achieve they didn’t even know were possible or think or thought weren’t possible and that sort of thing. One owner, for example, in the one we’re going to close next week, he had a whole bunch of very, very loyal employees that were highly tenured, some of them 25 plus years, but they weren’t executives.
These were line workers and people that were so loyal and he knew them all like brothers and their families all these years, the owner, and really wanted to do something for them, but they weren’t highly paid and they’d been there so long that their runway was pretty short. And so the ESOP would do less for them because they weren’t going to be there for 20 more years. He really wanted to try to figure out how to use that tool to do something special for them.
And so, it took an extra month on the front end to figure all this out because we had to, first of all, understand what he wanted to do. And then we had to look at the census of those people and know how many there were and so forth. And then we could start to dive into the rules and regulations of ERISA to figure out the definitions of compensation limits that we could use to do special things for those people.
And then we had to do all kinds of financial analysis and compliance testing that a TPA might do years down the road to look at 404 and 409 and 45th section limitations to make sure we weren’t going to design future troubles into the plan and so forth. And it took a long time, but in the end, we got that all done and we were able to put a scaling factor in the definition of compensation so that based on your tenure, you would not just get share allocations based on your comp, but you’d get a scale factor based on if you’d been there for more than 10 years or more than 15 years or more than 20 years so that their allocations would actually be greater.
And that kind of design work is really important to really put the tool to use. And I think unfortunately when ESOP is a transaction and a lot of companies who do formations get pretty focused on that transaction and getting that across the line and maybe don’t put as much energy on the front end to take the time to do all these special things. And that’s one of the downsides in the industry, I think just by nature, like any transaction oriented situation where there’s a bit of a conflict of interest there, but tell themselves I’m doing that really well because our business model is different than that.
Armando (17:38 – 18:16)
I was going to touch on that, that you can find a cookie cutter models out there for just about anything, but to really make it impactful for that business owner, for that founder, it really takes understanding what are they really trying to get to? What do they want? What outcome do they want to see when it’s all said and done?
And then is there a way to customize and tweak and work within the ERISA code, et cetera, to get as close as possible as you can to meeting that outcome? And it sounds like that’s what you were able to accomplish with that example that you used where on the surface, it looks like it might’ve been a little difficult to get there, maybe not possible, but with a little more homework and digging, you found a way.
John (18:17 – 19:53)
Yep. That’s where the real benefits lie in that upfront thoroughness of design and analysis. And then we were in that part of that plan also was the leadership team was very important to the future success of the business.
And he wanted to do more than he had done in the past to keep them around. And so we ended up designing a stock appreciation rights plan in conjunction with the ESOP to do special things for those top four or five people in the organization that really needed to be there long-term to create the growth and everything he was looking for. And so that’s the sort of thing I’m talking about.
And that’s not a part of an ESOP. That’s a totally separate non-qualified deferred comp, which is, I don’t like the word, but it’s discriminatory. You can do it for a single individual.
It’s not an ERISA plan. So oftentimes to really be focused and remain focused on those outcomes, you need to have more than just third-party sales and leveraged non-leveraged buyouts and owner investor models and generational transfers and ESOPs on your list of tools in the box. You need executive comp strategies and other things to accomplish the outcomes.
And you’re right. Our process is very unique. And the first phase of it is to take the time and include all the players that will influence decision-making in a transition and really find out what’s important to everybody and crystallize those outcomes because they become the true drivers of everything we do when we do a comprehensive succession plan for an owner, especially one who is a founding owner who hasn’t been through exit before.
Yeah.
Armando (19:53 – 21:03)
And so with the ESOP, you hear often about, John, about the tax benefits of ESOP. You hear about sometimes, like you mentioned with the desk corp, it can be a non-taxable entity going forward. And you’ll hear often that there’s a runaway.
The owner needs to stick around for maybe three, five, 10 years or so before he or she can really leave the organization. So that’s what you hear. And you’re talking about the customization, of course, other add-ons that are not really, they’re not ESOP, but they are add-ons that really help the owner get to what they’re getting to.
Let’s talk about just the general mechanics of an ESOP. Owner has a company and they’ve got, say, they’ve got 50 employees on board. Owner wants to exit the business.
They want to, they realize they need to retire or move on or do something different. And they want to exit the business. And now they’re talking with you about this tool and they don’t have time.
They need to kind of get to the chase kind of quickly about, is this something I should pursue more or not? And they want to know the high points of it. Just walk through, if you can, conceptually from start to finish, what is that ESOP really doing?
What does it look like?
John (21:04 – 25:20)
Okay. So from the mechanics point of view, you have the company and you have an ESOP trust, and the trust buys the business and puts it in the trust. And then all the employees become beneficiaries of that trust.
So some of the misconceptions about ESOPs are that, like I talked to an owner the other day that was interested in one. And he said, but you know, I just don’t see my employees being able to read financial statements and understand them and all this sort of stuff. And he was under the impression that because the employees were going to be owners, that they would get full financials and all this.
And that’s not the case. They get financials that you choose to share with them. But there is a team around the trust who are fiduciaries in the game to, in the best interest of the employees.
So that the trust always acts in the best interest of the employees. And that team around the trust is a trustee, a valuation firm, and a trust attorney. And those people collectively are watching out for the employees through the transaction and the operation, the ongoing operation of the ESOP.
And so the trust purchases from the owners, but the trust has no income of its own per se, it can’t borrow money or anything. So if it’s a leveraged ESOP, and then the company borrows money from a bank based on the bank will do. And then it loans that money to the ESOP trust.
The ESOP trust uses that money to purchase the shares from the sellers. You can’t fully leverage a company. So let’s just say that’s half of the purchase price.
There’s then an internal note between the company and the sellers for the remainder. So they carry a note on the balance. And then there’s an internal note from the ESOP to the company to pay back the money they borrowed to buy the shares.
So you have one note between the company and the bank with covenants. And then the other two notes are internal. And of course, they’re subordinated to the primary commercial debt to the bank.
But it does create a very flexible situation relative to cash flow for the company, because the only note with covenants is to the bank. And so if there’s a good year or a bad year, you can adjust the cash flows from the other two notes, they’re totally internal run by the board of directors, and what to do on payment of those notes. And so you have that very flexible cash flow situation internally for the other two notes that allow you to prioritize growing the company and so on and so forth, if that’s what makes sense, which is a very nice financial flexibility to have.
Right. And so those are the basic mechanics of it. And then as an ERISA plan, the company will make contributions to the ESOP like they would to a 401k.
And then as those contributions are made, and shares are actually paid for, that money goes right back to the company, and no taxes on it in any case, to pay back the note to the company that the ESOP has. And then now that there are some shares that go into a suspense account that have been paid for in full, those shares must be allocated according to the ERISA formulas to all the participants. So that those are the mechanics.
And then as the notes get paid down, more and more shares are paid for and allocated and so forth. And then just like a 401k, there are there’s vesting of the shares, and there are triggers for monetizing those accounts, whether it be death, disability, retirement, etc. And then as the shares all get allocated, then as people leave, their shares come back into the ESOP, they get reallocated to current participants and so forth.
And we could go into lots of technical detail, but about the flexibilities you have to concentrate shares with employees and that sort of thing. But anyway, those are the mechanics. So it gets a little complex in the end.
And the complexity, if you understand it, and you’re a specialist at these things, then it becomes the flexibility you want to achieve the outcomes you’re looking for, and how to put all those capabilities together and get the puzzle right.
Armando (25:21 – 26:11)
Yeah, it does sound like a puzzle, and it does sound complex. But that really gets back to getting the right provider, the right team on board that understands that space. And most importantly, understanding what is that business owner really trying to accomplish with this?
Yes. So that you and the other folks who are working with you can really tailor that and put the add-ons in there that really need to be there. Yeah, part of what you described sounds a lot like a 401k with the forfeited, you know, the forfeited shares and that and the annual requirements, et cetera.
I guess a question for you then with an ESOP, is the owner, when the owner, when the ESOP is done on day one, how many years beyond that is that owner typically staying? Is there a minimum requirement or is that really up to that owner, what they want to do?
John (26:13 – 28:28)
Good question. It depends is the answer, of course. And so if it’s a minority ESOP say, oh, we want to do a 40% ESOP and the owner still has, the owner still have 60 equity in the company, those requirements are very different because those people clearly have a lot of skin left in the game.
And so the trustee will perhaps be much less specific about the requirements for owners to stick around because they know they’re going to stick around because they want the rest of their equity, right? Their equity monetized. So everything’s very well aligned.
But in the 100% ESOP or majority ESOP, and those owners are then monetized and have the ability to exit, that’s a whole different situation. And the trustee will typically, of course, looking out for the employees, the trustee may require certain executive sellers who are executives in the company to stick around for a period of time. And what is that period of time?
It really depends on the business, on the strength of the leadership team, on how well that owner understood that they can’t be a key player in their business anymore when they want to walk away if they care about the future performance of the business and so forth. So some owners have a leadership team where they could go on vacation to a deserted island for a month and never get a phone call and everything would be just fine. In that case, the trustee may require them to stick around for a year in a certain capacity or something like that just to make sure the transition is good.
If that owner is a really key player and they really haven’t replaced their core values to the organization in the rest of the organization, and it would hurt the organization if they left abruptly, then the trustee may say, no, you need to stick around for at least two years or maybe three, but the comments you made about five and 10, no, that would be very, I say rare, I don’t know if it ever happens.
So usually it’s in that range of a couple years, maybe a little more if it’s an extraordinarily unprepared situation to lose a seller, so the talents of a seller. But yeah, the lens to look through is if you’re the trustee and you’re looking out for the employees, the longevity and future success of the company is what’s really required to be a successful ESOP. So you’re always looking through that lens.
Armando (28:29 – 29:12)
So you mentioned the longevity and future success of the company and some companies are cyclical, others are in new space. I’m thinking of AI right now that is in a new space. Some companies will skyrocket to the top and others will disappear.
Maybe those are not the best ESOP candidates, but companies that are more stable, more secure or their long-term prospects are better, more secure, maybe those are better. Can you talk about the typical, I don’t like to use the word profile, but when you’re thinking about that ideal ESOP candidate, what does that look like? What founder, what type of business fits into that ideal ESOP category?
John (29:12 – 31:45)
You’re full of good questions today, Armando, as usual. Yeah. An ESOP is a long-term play.
It’s not a short-term thing. You don’t form an ESOP with the idea that three or four or five years from now, we’re going to disband it, take it out. That’s not really the motive.
It’s a long-term play that is designed to reward employees and create longevity in privately held businesses. That’s why the government is so supportive of it right now, because if you look at what’s happening to social security, the government’s pretty interested in employees having better retirement accounts built up. An ESOP is just a wonderful tool to help all employees do that, not just executives.
There’s a lot of support for it all the way around right now. And really what we’re looking for is a company with stability and the potential to be around for a long time. So you will sometimes see ESOPs put into companies with 10 employees, because they’re in a market and an industry that’s so stable and so solid with long-term contracts that they expect that to be a very consistently stable company.
And that’s a safe bet. But if it is a company like AI startup or something like that, no, then if they could disappear tomorrow, not a good fit until they know that they have a niche where they are probably capable of performing for the long term and being around for a long time. So it really depends.
And then there are certain metrics you look for, certain level of payroll, because payroll dictates contribution limits and things like that. So there are a few financial metrics. And the real answer to the question is there isn’t a cookie cutter there either.
It’s based on a very focused feasibility analysis as the very first step when someone says I’m interested in an ESOP. Then we go into heavy analysis mode to look, get all the past financials of the company, do a whole bunch of modeling, look at best case and worst case scenarios going forward for projections and model an ESOP out to say, are we near the limits of this thing or, and maybe we should wait or no, this looks great. And then we can model it to say, okay, how bad do things have to get before it just breaks right before the cash flows don’t make sense or kill the company or something.
But that upfront analysis is absolutely key to make that go, no-go decision about, yeah, this is a viable option in the toolbox or no, I need to focus on other tools in the box.
Armando (31:45 – 31:59)
And so the payroll and contribution limits again, makes me think about profit sharing plans and maybe 401k contributions. Is there a minimum payroll or minimum number of employees? Use the example of 10 people in a company and that, that works.
John (31:59 – 33:16)
Is there a minimum number of employees that- There’s not a minimum number of employees, but there’s kind of a functional or practical limit, I would say, and not on number of employees necessarily, but on revenues and profitability and so forth, because ESOP, like you’ll hear metrics out there of a minimum of 2 million in payroll. So there are certain guidelines that are out there, but really what you’re looking at is the financials and the stability going forward. And if you wanted a rule of thumb, if companies have been around for a while and they have a decent look into the future and expected longevity, 40, 50 employees, usually companies that are stable and have 40 or 50 employees, I mean, definitely on the list.
It really just depends though, on the type of company, the level of profitability. If it’s a small company with long-term government contracts that aren’t going away anytime soon, and they’re real profitable, I mean, that might be one of those 10-person examples or something like that. But really you just have to assume that the tool is there for you, unless you’re a startup or some company that really hasn’t been around long enough to even do the feasibility analysis.
And just assume that’s a tool in the box and we need to figure it out and do that upfront analysis. Okay.
Armando (33:17 – 33:51)
When you’re meeting with companies and having those initial conversations, sometimes you probably hear or see things where they’re just not at this point, not a viable prospect for really having an ESOP as their tool. And some of those, you meet them and you think, wow, this sounds phenomenal. This is going to be great for them.
Can’t wait to dig in and show them and validate with numbers. So those that get weeded out, what is it that gets them weeded out from really being not the right fit for them, or maybe not the right timing for them to do that?
John (33:51 – 36:33)
I would answer that question by saying totally depends on who you choose to help you do your formation. Because as you see 401k plans all the time that aren’t designed best for the client and you fix them up, right? And ESOPs.
Yeah. And so I ran into a situation where one of the more transaction oriented providers of ESOP formations out there put one into a client in a business in Tucson for 6% of the company. I mean, it made no sense whatsoever, but that company got their feet into the formation.
So we see stuff like that. That’s an extreme example, but stuff like that happens a lot where it’s just pushed through. It’s an ESOP in a box, it’s a cookie cutter process.
And it’s really just about the transaction. And those situations are just inappropriate in a lot of times. So it depends on who you’re dealing with.
But for us, it has to be someone who cares about their employees predominantly and really wants to see their business go on without losing its culture, its legacy. So as an example, PE would be a very bad choice for them because their company would go on a platform, their culture would disappear. A lot of their management employees that helped them get there would be redundant and probably lose their jobs.
And the legacy of what they built would just kind of disappear into the platform and that sort of thing. So it really depends on what those outcomes are that they’re looking for. And I don’t know if you saw it, but a few months back, the IRS actually put out an alert, a warning, if you will, to the world that we are scrutinizing ESOP formations a lot now.
So beware. And the reason is because a lot of owners, not a lot, but some owners and some formation entities will do ESOPs for the wrong reason and for the tax benefits. For example, I know of a case where someone wanted to put one in place to monetize the business.
They were going to use the tax efficiencies to pay bonuses to top level executives. And then when all the notes were paid off and the debt was gone, they were going to disband the ESOP. So it wasn’t going to do anything for their rank and file employees at all.
They wouldn’t even be vested. Those people doing things for the wrong reasons are out there. And the IRS has put the flag up that we’re cracking down on that because it’s not just a tax efficiency strategy.
And if those are the only motives, I would say probably not the best fit.
Armando (36:34 – 37:25)
IRIS has, you’ve mentioned ERISA and we’ve talked about ERISA mentioned a few times this conversation. And ERISA oversees, it’s an acronym of course, and it oversees employee benefits, 401k plans to find benefit plans, ESOPs, health insurance benefits are part of that category as well. So it’s really how do you take care of the employees?
So one of the tenants that IRS says with these types of vehicles is business owner, we’re going to let you do this, but you have to bring employees with you. It’s got to benefit them as well. That’s why this tax benefit is so generous for you.
And those are my words, but in my interpretation, but having worked with qualified plans for over 30 years, that’s what it seems to me as IRS comes out with its different employee benefits, along with business owner tax savings, and it pairs those together.
John (37:25 – 40:11)
Yep. You nailed it. The fit has to be good.
And for us, if someone comes with a bad fit, and they’re just trying to use it as a tool for some ulterior motives than the ones it’s designed for, that’s not a good fit for us. That’s not what we do. We’re not succession planners to get a phone call down the road from an employee of a client or an executive of a client to say, Hey, why did you do this to our company?
If we’re going to help advise someone on how to make a successful transition to their company, they have to go through our process where we not only have taught them all their options and so they can choose best, but we have to convince ourselves that we’re advising them to take advantage of the best options or it’s not a fit for us. This one, this ESOP is a classic example of how there’s a right way to do it. And there are lots of wrong ways you can do it.
Anything this complex with so many moving parts and management, ongoing management that’s required to really get it right and keep it focused on those outcomes as the plan matures, you need to do it right, or you’re going to set yourself up for some issues down the road. This ESOP, we’re going to close next week, took us nine months to do that formation. A lot of companies will grind them through in four months.
And you can do a very simple one in five months thoroughly, but if you’re really focused on those outcomes and maxing out the capabilities of the tool to achieve those outcomes, you just have to be willing to put the time and energy in on the upfront design phase to be thorough and get that all right and do all the analysis and all the future testing, you know, projections and testing of future limitations to make sure you’re not designing future problems into that plan design.
It’s an amazing tool. It’s incredibly powerful. But as the movie industry told us with great responsibility, with great, great knowledge comes great responsibility, right?
So you really do have to do it right. And we take that very seriously. I mean, you know us, we’re all a free enterprise system in America.
And what gets us out of bed and truly drives us every day is to help owners get it right in the end around succession and exit because you can pump decades of your life and your heart and soul into building this asset. And if you get exit wrong, you can get a tiny fraction of what you deserve and achieve a tiny fraction of the full impact of what you built could have not just on you and your family, your employees and their families, but your vendors, your clients, the communities you serve and the giving back that you do. And add that up times the six million businesses in this country that we’d love to see stick around for the long term.
And now we’re talking about very significant things to our country in general.
Armando (40:12 – 40:49)
Right. And I’m glad you brought that up because it sparked the thought of my mind that one of the benefits that I like so much about ESOPs is that if it’s, let’s say, a local company here that has 50 employees and it goes through an ESOP and the owner is now out of the business, sold to the employees, that company remains local. It’s not a company from somewhere in Europe or China or some other state that owns it.
It’s owned by the people here who helped build the value and provide service every day to that company. It still remains a locally owned company.
John (40:49 – 41:30)
Yeah, that’s huge. I mean, I was in the gym this morning and I met a guy who told me about his company, the company he works for. And I asked him, is that a private company or public?
And he said, well, it’s public. We got bought by a public company a few years ago. It was private.
And then he went on to say, yeah, it was a lot more fun working here when it was private. As we got absorbed now, it’s a lot of corporate stuff and a lack of focus on what we knew grew us. And even if it’s not an ESOP or whatever, the business staying locally owned, privately owned, I believe is very important.
And so I couldn’t agree with you more, Armando.
Armando (41:30 – 42:10)
So let me ask you, you mentioned warrants. And let’s use an example of a company that has, say, 50 employees that say the value of the company is $20 million. The owner goes through the ESOP.
ESOP is now done. Five years later, the owner has received all of her money from that company, but is still there in that business. And you mentioned warrants.
What might that mean for that owner who sold for that amount of money and got that money tax-free and now has warrants? How could warrants affect that sale or affect her now?
John (42:10 – 44:22)
I want to correct one thing. They might not get their proceeds tax-free. ESOP doesn’t guarantee that.
It’s possible with a 1042 exchange. If you’re a C-corp, you can take all the proceeds from monetizing your stock and you can roll it into what’s called QRP, which basically allows you to defer any taxation of those proceeds until later. And then if you leave those as an asset for your kids upon your death, they get a step up in basis and the taxes will never be paid.
But that’s a unique thing for C-corps only, not available to S-corps. And there’s obviously a lot of analysis to go through to determine if that makes sense. Because if you’re a C-corp, you have to remain that way for five years.
And so you’re going to get taxed at the corporate level as a C-corp, taxed at the corporate level. And so the benefits to the corporation versus the benefits to the exiting seller need to be weighed and so forth. So I want to make sure we don’t mislead anybody about that.
But no, no problem. But the warrants are a wonderful tool to basically get a second bite of the apple, even if you’ve monetized 100% of your stock. And that’s usually when they’re used.
If you still have ownership, then you don’t need warrants. You still have skin in the game, right? But if you monetize 100%, and as we discussed a little bit, one of the cool things about an ASAP is it allows you, and this is a motive of a lot of our engagements, ASAP or otherwise, many owners want to have a successful transition, but then have the option to continue to participate and contribute by choice, not necessity.
So they want to do what they love and keep giving to build it, but they don’t want to go into work every day or that sort of thing. And an ASAP gives you that potential in a hugely flexible way so that you can continue to be involved in your company, even after you’ve monetized 100%. And if you are involved, then you want to be rewarded for that.
And if you do monetize 100%, then you can be an employee of the company with an employment contract and participate in the ASAP actually, but you can also get warrants as a seller. And warrants allow you to basically get a second bite of the apple relative to the growth that happens between the time you get the warrants and the time you exercise the warrants.
Armando (44:22 – 44:23)
Just like in any company.
John (44:23 – 45:45)
Just like in any company. And how significant can that be? It can be very significant for owners.
I mean, there are a certain number of warrants that are okay, according to IRS. And so you can’t get warrants for 50% of the company, but 10, 20, maybe up to 30%, you can have warrants. And so those can be extremely significant and be worth millions to owners at a future point, if they’re going to continue to contribute or not.
And so anyway, warrants are something that always should be on the list to analyze and talk about as part of the upfront design and analysis to say, what outcomes are they achieving for you? And they can have a significant effect on the timing of an owner wanting to basically begin working less or semi-retire and so forth. If they know that they have this potential out in the future, they might not feel like they need to wait around for the company to grow to a certain point before they design their transition and so forth.
So yeah, warrants are a very significant tool that should always be on the list to analyze and quantify and design into the plan design. It’s just one of those tools in the box of an ESOP that should not be overlooked.
Armando (45:45 – 46:21)
And that’s part of the customization, whether it makes sense or not, whether you’re going to have warrants. Again, getting back to what is that one you’re really trying to get to? And that affects, of course, or directly impacts the plan design that you and your team are looking at for them.
Yeah, many things. Are you wondering if you’ve missed anything in your planning? We hear that a lot from very smart, very successful people.
And that’s why you may be interested in our founder stress test, even if you’ve already sold your business years ago. For more information, go to axiomcorp.com.
John (46:21 – 49:36)
Should be that are not often included in the upfront design, but should be happen in a more transactional process. And the reason you have to do all that stuff upfront is because anything that affects the valuation of the company will have an impact on the ESOP. Because the way ESOPs function is every year, the team around the trust, which includes a valuation firm certified to do valuations for you, does a valuation.
They get the financials done. They do a valuation every year. And based on that valuation, they know the share price per share.
And so when a contribution that year is made to the ESOP of X dollars, then we know the formula for allocations based on compensation. And we now know the share value. And that’s how the allocations get made.
And so when that valuation is going to affect account balances every year to get the maximum owner mindset and other benefits from an ESOP, you’d love to see the value of the company start out here right after the ESOP and as a trend grow. And we all know that, you know, it might be a little lumpy, but growth overall, because then as if I’m an employee and I want to max out my account, that’s motivation for me, right? I see my first year statement and wow, I got 6,000 bucks in there.
I didn’t put any of my money in there. That’s pretty cool. And then the next year, wow, I got 10,000 or 12,000, whatever it is based on the valuation of the company, the faster the company grows, the higher the valuation, the more rapidly those account values grow.
And that’s a huge motive for employees to really dig in and say, how can I do better? How can we do and so forth? But if you say, put a SAR plan in after the ESOP that should have been done up front, that’s a future cashflow obligation to the company and it devalues the valuation.
It lowers the valuation. And so if you’re the employee and you get a statement the first year and you got 6,000 in your account and the next year it goes down to 2,000, you look at it sideways and go, oh, I thought this was going to be really cool, but I guess it’s just all hype or whatever. But the point is the impact, one of the big benefits and the reasons if you study privately held ESOP owned businesses in this country, and you look at the performance metrics, whether it be longevity, profitability, talent retention, performance through COVID, I don’t care what stat you look at, ESOP companies are significantly above non ESOP owned companies.
And it’s that mindset that creates an owner out of every employee that is largely responsible for that. And so if you just want to shove the transaction through and get the structure in there, which is what many owners are told is the most important things, not necessarily true. Then you do all these things later.
Each one has an impact on the value of the company, account values stagnate, owner mindset doesn’t happen. You’ve lost an enormous benefit of what you did it for. So that’s why it’s so important to really figure out those outcomes and do the right design and analysis in a very thorough way up front and just make sure that all those things are included.
And then you can maximize the impacts of that tool.
Armando (49:36 – 50:14)
So John, as business owners go through and bring in people like you who are suddenly walking through the building and having meetings, and they’re seeing you around, employees might wonder what the heck is going on. They might get nervous, might get uncomfortable, rumors might start, which is not what you want, of course, but that is part of human nature. And obviously, for this to be successful, employees need to stick around, they need to understand this is a benefit for them.
Talk about that communication to employees that needs to happen during this process or when it’s unveiled so that the owner understands what that looks like for his or her employees.
John (50:14 – 54:34)
I’m really glad you brought that up. It’s an important thing. So there are really two answers to that question, pre-transaction and post-transaction communication, right?
And the pre-transaction case is the same communication we have in all of our engagements, ESOP or otherwise, because if you really look at exit, the future success of the company is absolutely required to achieve whatever the outcomes are, even in a third-party sale, which is the one kind of exception. Unless the owner says, I just want to get everything I can get at transaction and I don’t care about holdbacks, clawbacks, warrants, and reps. If I lose all that money, I don’t even care.
I’m just gone. That might be an exception. But even in a third-party sale and certainly in a generational transfer or leverage or non-leveraged buyout or recapitalization or an ESOP or an owner-investor model where achieving anything depends on the future cash flows after the transaction for all that to come true.
Somehow that gets missed in succession planning many times and the focus becomes, how are we going to transition ownership? And that’s what gets left there. But if you don’t transition leadership and management and culture and relationships, internal and external, that are required for the longevity and future stability of the company, the company will suffer for that.
If owners want to disappear and they’re the visionaries guiding the company through the economy and the market, and that’s going away. If they’re the ones who make it tick from an operations point of view, like a Swiss watch and they’re going away. If that culture is, they’re the keeper of the culture and that’s what keeps talent around and allows them to attract good talent.
Or if they have relationships with key clients or key vendors or city officials or whomever that are vital to the success of the company, all that stuff has to go with the company through a transition to ensure the future success and really achieving those outcomes at the highest level. That gets missed. And so as we help owners plan for succession or exit, the communication to employees isn’t, we’re selling the place.
The communication is, we’re building longevity into this company. So it’s going to be around for a long, long time to come, even after the stressor of key founders, leaders, owners disappearing, because that’s a whole different stressor on a company than a down market or a economy that they may have experienced surviving through in the past. This is a whole different kind of stress.
And so if you’re really a true succession planner, your client isn’t the owners, your client is the asset. And so we’re looking at the asset and what does it take to make it around for the longterm? And then we can achieve anything.
All the options are available at that point. And so that’s the communication pre-transaction ESOP or otherwise. Post ESOP, it’s very important to have an ESOP committee you form and to have an ongoing strategic plan for usually quarterly company meetings and communication strictly about the ESOP.
It is complex. People have lots of questions and there needs to be an ongoing venue to get together to continue the education process about the tool and how to best achieve the outcomes for everyone so that they know how to participate best as an employee to grow the company and so forth. They understand thoroughly the impacts it can have on them and all those sorts of things.
And to be able to answer all their questions that come up to really max out impacts from an ESOP, the post-transaction communication to employees is very important. And so one of the steps in our ESOP formation process, step number six is an ongoing relationship to make sure they get that right until it’s established and rolling. Because again, we’re focused on outcomes.
So that is super important with a tool this complex.
Armando (54:34 – 55:17)
Well, I like what you said, building longevity into the business, transitioning the asset, you’re focused on that. And I can see how from an employee standpoint, that sounds like what they would want. They want that company to be there.
They want that culture that they become accustomed to and those relationships with the people they work with. That’s what they want. I can also see that when a business owner is about to exit or having those conversations, it can cause the employees to feel uncomfortable, to wonder what that really means.
So having longevity in that company is critical for them to really understand that their second home where they work, the second home is going to be there for them.
John (55:18 – 56:35)
Yeah, well put. And they won’t talk about it very much, but employees who work for privately held businesses that are run by a founder owner, and they see that owner looking like me with this much forehead and gray hair, they’re thinking about it. Whether they talk about it or not, they’re going, man, what’s going to happen to this place when this guy disappears?
And they’re concerned for their futures as they should be. And so, I mean, to us, it’s not something we need to combat, some attitude that, oh, they’re selling the place. No, it’s some comfort we need to give to these employees to let them know that they work for a very elite business owner who is thinking about the longevity of the company after they decide they want to move on.
And they’re fortunate to work with somebody who has the forethought to spend some energy, some time and some money at this point to make sure down the road that all happens well. So it’s often perceived exactly opposite of how it should be perceived if you’re truly focused on outcomes and not just that transaction where you get your fee and you go on and you move on to the next one. Those types of things, then it is a legitimate concern.
You know, who are these people? Oh, they sell businesses. Oh, yikes.
You know the story, right?
Armando (56:35 – 56:54)
John, what have we not touched on so far in this conversation as you think about those initial conversations you have with business owners about the concept of transitioning themselves through an ESOP with their company? What comes up in those conversations that we, maybe that we haven’t touched on in this conversation?
John (56:54 – 59:10)
Good point. I would say a couple of things. One, exit in general, that perfect storm of busy and later and don’t know what you don’t know.
So causes runways to get so short that outcomes are compromised, options are limited. That’s the first one, just exit in general. The best time to educate yourself about what it takes to get exit right is today, no matter how long down the road, unless you’re a startup or some business that’s not established, right?
And this is an example of the 10-year runway that turned into a two-year runway. I mean, if you don’t know what you don’t know, how do you know what you’re missing? So education now about exit is the first goal.
And when it comes to, I think is especially true, learn about ESOP sooner rather than later, because once you understand the capabilities, the flexibility, the configurable nature of an ESOP towards so many outcomes in that, and you learn that, wow, I don’t lose control of my company if I sell a majority percentage and all these things, it will probably change your thinking about exit and the timing of it and so forth.
So we just don’t want to miss opportunities to do what we want to do with this asset we’ve built with big chunks of ourselves and our lives around exit because we didn’t know what we didn’t know and we waited too long. And within ESOP, that’s especially true. So I would say runway is everything when it comes to getting exit right, particularly within ESOP.
And so you and I have had this conversation where I’ve said that, look, I’ll have a conversation with any business owner, whether they’re a potential client for us or not, to have that wake-up call with them to say, hey, let’s talk about exit just so you know how that should be involved in your thinking, because it may change the fabric of how you operate your business on a daily basis starting tomorrow to do some of these things that take years to get right. So you have all your options available to you.
And at some point in the not too distant future, you’re ready. Your business will then also be ready. And now you have all your options and timing flexibility to achieve what you’d always envisioned with this asset you’ve built.
So timing and runway is everything.
Armando (59:10 – 1:00:11)
Yeah. I’ve heard you say many times that planning ahead, that founders will see exit as a project, not realizing that you really have to spend a lot more time with it and understand what options are available. And that when they don’t understand and they make a choice, maybe because they’ve waited too long, maybe a health issue came up, maybe they’re just burnt out and tired and they just want to be done.
But whatever, the reason to really have the most flexibility, the most choices available, they really have to plan ahead and think about it. And as you said, thinking about it sooner so that it helps them understand more and put systems in place. What have I missed?
Yes, I’ve got X, Y, and Z. I’ve done all these things, but what are the gaps? What have I missed?
And they don’t know what they don’t know. So glad that we had this conversation, John, about ESOPs. And any final thoughts that you want to share for the listener who’s wondering if they should be thinking about an ESOP for their company as they think about transitioning and exit?
John (1:00:12 – 1:02:23)
Yeah, I do have something I think is valuable to share. And that is like any industry, there are different players who serve the industry in different ways. And ESOPs are amazingly capable tools.
They are complex. To do them right, as we talked about, requires a whole bunch of work. And anybody who has experience forming ESOPs is probably capable of doing that work.
But as we’ve heard so many times in life, you get what you pay for. And there are vendors out there who will give you a fee of half of what it is to do it right. And they may nickel and dime you along the way.
And anyway, my point is, it’s not the time to be penny wise and pound foolish. And to realize that you get what you pay for. And doing it right is way more valuable, multiples, orders of magnitude more valuable than the difference in any fee you might perceive up front to install the ESOP.
And the tax efficiency of an ESOP is pretty great. If you’re an S Corp paying 40% tax state and federal, and now you pay none, you’re going to have more cash flow to play with. And the return on the investment of forming an ESOP will be fast, measured in months often.
And so focus on doing it right is the message, even if it costs a little more to go first class, as my grandfather used to say. And the point is that that means being focused on those outcomes. So if you get nervous that you haven’t fully clarified those outcomes, that there isn’t a process in place to fully understand those outcomes of all the key players and stakeholders in your business, that should be a huge red flag to say, yeah, maybe I’m going to shop around a little bit.
So it’s important to get it right the first time. And so that’s my big message is it’s the normal world out there in the ESOP vendor space and shop wisely.
Armando (1:02:24 – 1:03:20)
Excellent. Thank you for that summary there. And from our perspective, when we’re talking with that founder, we want to make sure it’s the right time for them.
Are they ready with themselves, with their family, with where they are financially? Is it really the right time? We don’t want anyone to go through a sale and then regret it as most people do.
We want them to make sure that they feel like they’re in the right place. And then when it is the right place, then let’s have a conversation with you, with John, and let’s see, well, what do those options look like? What is going to be the best thing for them?
So John, thank you so much for this conversation. Really helpful. I appreciate your experience and what you bring to the table when you’re talking with those owners.
And you can, like I say, you’ve been there, you’ve been in their shoes, you had your own exit, you know, use that business experience to really help them as a colleague, as a consultant, help them walk through and navigate in the best outcome for them, given whatever they might want to accomplish at that point.
John (1:03:20 – 1:03:40)
Well, thank you, Armando. I appreciate the opportunity to get the word out because it’s just so important to our cause, our purpose in life. And I enjoy working with you because you’re like us.
You’ve been there and done that with the family business and you get it. And so it’s just a great connection. I appreciate the opportunity to get the word out and help more people.
Armando (1:03:41 – 1:04:07)
Certainly. But John, great. Again, enjoyed the conversation.
Anybody has any questions, then what we’ll ask them to do is reach out to us and then we’ll have them, you know, we’ll set up a meeting with you. And you are based here in Phoenix, the Metro Phoenix, but you’ve got folks in different parts of the country as well. And just I appreciate what you do.
I appreciate the approach that you take. And I hope that the right ears hear this conversation so that we can have another conversation with them.
John (1:04:07 – 1:04:10)
So do I. Thanks again, Armando. I really appreciate it.
Armando (1:04:10 – 1:04:46)
Hope you enjoyed this episode of the Founder’s Guidepost. Whether exit is on your immediate horizon or maybe 10 years down the road, there’s something here for you. And remember, we all have an expiration date.
We just don’t know when that will be, which is why planning ahead is critical. And if you’re wondering if you’ve missed anything in your planning, contact me to schedule your founder’s strategy call. You may call our office at 480-367-9000 or schedule a call at axiomcorp.com.
Here’s to your American success story.
Leave a Reply