Decision Vision Episode 41: Should I Sell My Company to an ESOP? – An Interview with Andre Schnabl, Tenor Capital Partners
Is selling my business to employees through an ESOP advisable? What kind of businesses are the best candidates to sell to an ESOP? In this edition of “Decision Vision,” host Mike Blake discusses this question with Andre Schnabl, Tenor Capital Partners. “Decision Vision” is presented by Brady Ware & Company.
Andre Schnabl, Tenor Capital Partners
Tenor Capital Partners is financial advisory firm focused exclusively on the design and installation of Employee Stock Ownership Plans (ESOPs). These transactions use employee ownership as a platform for business owners to realize the value of their businesses through the sale to an ESOP.
Andre Schnabl is a managing partner of TCP and leads the firm’s debt placement practice. Prior to joining TCP, Andre retired as Managing Partner of the Atlanta office of Grant Thornton LLP in 2012. Prior to his retirement he held a variety of positions within the firm in the firm’s offices in Zimbabwe, Montreal, Canada and Atlanta. During his career, he has consulted with mid market companies on a variety of matters, including mergers and acquisitions, debt and equity financings including public offerings. Since joining Tenor in 2013, Andre has been advising companies and shareholders in business succession using ESOP’s, including shareholder advocacy, structuring and leading the financing raises. Andre has a Bachelor of Science degree in Chemistry and Geology from the University of London and is a CPA. He serves on a number of corporate and not-for-profit boards.
For more information, visit the Tenor Capital Partners website or call Andre directly at 404-372-2759.
Michael Blake, Brady Ware & Company
Michael Blake is Host of the “Decision Vision” podcast series and a Director of Brady Ware & Company. Mike specializes in the valuation of intellectual property-driven firms, such as software firms, aerospace firms and professional services firms, most frequently in the capacity as a transaction advisor, helping clients obtain great outcomes from complex transaction opportunities. He is also a specialist in the appraisal of intellectual properties as stand-alone assets, such as software, trade secrets, and patents.
Mike has been a full-time business appraiser for 13 years with public accounting firms, boutique business appraisal firms, and an owner of his own firm. Prior to that, he spent 8 years in venture capital and investment banking, including transactions in the U.S., Israel, Russia, Ukraine, and Belarus.
Brady Ware & Company
Brady Ware & Company is a regional full-service accounting and advisory firm which helps businesses and entrepreneurs make visions a reality. Brady Ware services clients nationally from its offices in Alpharetta, GA; Columbus and Dayton, OH; and Richmond, IN. The firm is growth minded, committed to the regions in which they operate, and most importantly, they make significant investments in their people and service offerings to meet the changing financial needs of those they are privileged to serve. The firm is dedicated to providing results that make a difference for its clients.
Decision Vision Podcast Series
“Decision Vision” is a podcast covering topics and issues facing small business owners and connecting them with solutions from leading experts. This series is presented by Brady Ware & Company. If you are a decision maker for a small business, we’d love to hear from you. Contact us at decisionvision@bradyware.com and make sure to listen to every Thursday to the “Decision Vision” podcast. Past episodes of “Decision Vision” can be found here. “Decision Vision” is produced and broadcast by the North Fulton studio of Business RadioX®.
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Show Transcript
Intro: [00:00:02] Welcome to Decision Vision, a podcast series focusing on critical business decisions brought to you by Brady Ware & Company. Brady Ware is a regional full-service accounting and advisory firm that helps businesses and entrepreneurs make visions a reality.
Michael Blake: [00:00:20] And welcome to Decision Vision, a podcast giving you, the listener, a clear vision to make great decisions. In each episode, we discuss the process of decision making on a different topic, rather than making recommendations because everyone’s circumstances are different. We talk to subject matter experts about how they would recommend thinking about that decision. My name is Mike Blake and I’m your host for today’s program. I’m a director at Brady Ware & Company, a full-service accounting firm based in Dayton, Ohio, with offices in Dayton, Columbus, Ohio; Richmond, Indiana; and Alpharetta, Georgia, which is where we are recording today.
Michael Blake: [00:00:53] Brady Ware is sponsoring this podcast. If you like this podcast, please subscribe on your favorite podcast aggregator and please also consider leaving a review of the podcast as well. Our topic today is, should I consider an ESOP? An ESOP is an acronym for employee stock ownership program. And, you know, this is a topic that sort of comes and goes. You kind of see waves of ESOP’s popularity in the marketplace. And I don’t frankly know for it a crust or a nadir of waves right now.
Michael Blake: [00:01:31] But what I do know is that ESOPs are interesting. They are complicated. They can be accompanied by some risk, but I also am convinced, in certain circumstances, they are, flat out, the best way for an owner to exit their business. There are tax advantages to doing so. In some cases, the ESOP is in a position to pay more for a business than any other buyer. And also, there are business owners out there who have an interest in giving their employees an opportunity to share in the wealth that the business has created will generate.
Michael Blake: [00:02:18] And that may be in the ongoing role of the owner or even after the owner sort of drops off the keys and retires some place to Costa Rica. And, you know, I don’t know if this is still true, there’s not tricks have emerged since, but for a long time, I think the largest ESOP in United States was United Airlines. And for a long time, they are an employee-owned company, merged I think with Continental. I can’t keep track now. They’re just all, in the United States, making airlines anyway.
Michael Blake: [00:02:55] But, you know, it’s probably a topic that at least some of you have had arise either as a business owner or an advisory capacity. And once you start getting into regulations, the mechanics, it can be dizzying. And I am far from being an expert on this, as I am with just about every topic that we bring on the program, which is why we do the program. And so, instead of my trying to fumble my way through it, I have brought on my friend and colleague, Andre Schnabl, who is a principal and managing partner of Tenor Capital Partners, a financial advisory firm that is focused exclusively on the design installation of employee stock ownership plans.
Michael Blake: [00:03:38] Prior to joining TCP, Andre retired as managing partner of the Atlanta office of Grant Thornton in 2012. And we’ve known each other long before then. We were sort of friendly quasi-competitors. Prior to his retirement, he held a variety of positions within the firm and the firm’s offices in Zimbabwe, Montreal, Canada, and Atlanta. During his career, he has consulted with mid-market companies in a variety of matters including mergers and acquisitions, debt and equity financings, including public offerings.
Michael Blake: [00:04:10] Since joining Tenor in 2013, again, a very busy retired guy, Andre had been advising companies and shareholders in business succession using ESOPs, including shareholder advocacy, structuring, and even the financing raises. Andre is a bachelor of science in chemistry and geology from the University of London and is a CPA. I did not know that you’re a scientist. He serves on a number of corporate and not for profit boards. He has the passionate belief that the advancement of women into leadership positions is not only the right thing to do, but also a business paradigm. I strongly agree with that.
Michael Blake: [00:04:44] He partnered with Women in Technology to help create the Women of the Year Technology Awards that began 17 years ago. For those of you who are not in Atlanta, that is a big deal. I think it is one of the two or three most important awards ceremonies on the Atlanta tech sector calendar. And I did not know that you helped start that, so good for you. And thank you for doing that. Andre continues his unwavering support for diversity and has been a frequent guest speaker for corporations and associations on the critical importance of diversity within leadership ranks. Women in Technology recognized Andre’s contributions in this regard with their legacy award. Andre, thanks for coming on the program.
Andre Schnabl: [00:05:22] Thank you, Mike.
Michael Blake: [00:05:24] So, let’s start with very basic—this first question I ask in almost every interview, it’s probably the most important interview for which I’m asking this question so we can set the vocabulary. What is an ESOP?
Andre Schnabl: [00:05:37] The acronym literally means employee stock ownership plan. I would like to say that the acronym unfortunately connotes a number of different things for different people. And to some extent, maybe it’s the press that it’s received has been unfortunate. What an ESOP essentially does, it creates a platform for employee ownership. So, this is a mechanism by which a shareholder, a founder, somebody who basically has built a business, it’s time for them to consider a variety of options on how to exit. They can either take it public. They can sell to a competitor. They can sell to a supplier and/or other strategic buyer or they can sell to a financial buyer, such as private equity. They seldom think about this other potential exit strategy, which is selling to an ESOP. And therein I guess is the basis of this conversation.
Michael Blake: [00:06:44] I’m glad you brought that up because in my line of work dealing with many companies, I hear people use the term ESOP in connection with stock options, right? And they’re calling it employee stock option program. And it’s descriptive but factually incorrect, right? So, it’s important because those two things are about as different. In fact, later today, we’re recording a podcast on stock option programs, but that’s not what we’re talking today. So, we’re selling to an ESOP. When we say selling to an ESOP, I mean, what exactly is ESOP? I mean, we talked about, you said that it is a vehicle for employees to own a company or a portion of a company. Can you expand upon that in terms of what the mechanics of an ESOP actually are?
Andre Schnabl: [00:07:34] Yes. Basically, what happens is one creates a trust, an employee stock ownership trust, and you sell all of the shares of the business from the selling shareholders or a portion of the shares to that trust. Can be anything from 1 percent to 100 percent into the trust for the benefit of all of the employees. And so, over time, the trust releases those shares into employee accounts. A little bit like a company’s match on a 401(k) plan. And by releasing those shares into employee accounts, over the years, those employees enjoy the benefit of the equity appreciation of the company.
Andre Schnabl: [00:08:27] And on their retirement, they can essentially sell back those shares at fair market value and have created value for themselves. And on the sell side, here is a way for selling shareholders to sell their shares at full value. They’re not leaving anything on the table or be it that they are doing something wonderful for their employees, they’re going to get full value. And they get paid out over time and the employees ultimately get ownership over time.
Michael Blake: [00:08:59] And the thing that strikes me over the head about an ESOP, one of the things that makes it so unique, is the fact that, in effect, you create your own buyer, when you think about it, right? And that just struck me. When you say you create a trust, you are, in effect, creating a vehicle that is going to be the buyer of your own company.
Andre Schnabl: [00:09:23] That is-
Michael Blake: [00:09:23] I cannot think of any other scenario in which that exists.
Andre Schnabl: [00:09:26] Well, you’re absolutely right. And let’s just think about this. I cannot tell you how many times we get a knock on the door and get brought into a potential ESOP opportunity because the potential selling shareholders have been let down or disappointed or left at the altar by a third-party buyer. There is enormous transactional risk when you start talking to a third party about buying your company. You have risk about whether it’ll ever close. You have risk that the original promise of price is actually met. You have a lot of warranties and reps and escrow.
Michael Blake: [00:10:12] In fact, the price probably won’t be met.
Andre Schnabl: [00:10:14] I was-
Michael Blake: [00:10:14] If we’re really honest about it, chances are that LOI price ain’t going to get paid.
Andre Schnabl: [00:10:18] That is exactly correct. In a case where you’ve created your own buyer, nothing in the business from an operational standpoint changes, whatsoever. So, employees don’t get unsettled that anything negative is to happen and you know the deal terms before you pull the trigger. So, there is no transaction risk. There’s no integration risk. It’s not as if a third party now has to integrate the buy, the business that they’ve just bought into their own business. And as a result, the trustee is prepared to pay total and full value in spite of the fact that the employees get a wonderful benefit over time.
Michael Blake: [00:11:02] And, you know, that last part, I don’t know how relevant it is to the podcast but it does bear highlighting. And that one of the greatest gifts that you can give I think anybody is a functioning operating viable business, right? And I say that I do a lot of work with succession planning and I strongly encourage people, whatever they can, if they have a business that they can keep it in the family to do so and maybe that’ll be a—and we’ve had a topic on succession planning.
Michael Blake: [00:11:38] But anyway, you know, giving that same thing to employees, especially in a time where retirement is very uncertain, right? Depending on your ideology, you may or may not think that Social Security and Medicaid/Medicare are going to be out there in 30 years. I’m not going to go down that rabbit hole. But one thing we do know for certain is that most of us are going to live longer than we ever thought we would, right? And one of the best hedges against that is ownership of a viable going concern.
Andre Schnabl: [00:12:14] Absolutely correct. And in addition to having ownership in a viable concern, there is significant empirical research that supports the fact that employee ownership, as opposed to selling to a third party and in particular, selling to private equity, will in fact create a business that outperforms a business owned by private equity. Productivity, employment, wage rates all move in the wrong direction when purchased by private equity. And I don’t want to be disparaging about private equity. There is a wonderful place in our macroeconomic equation-
Michael Blake: [00:13:02] Sure.
Andre Schnabl: [00:13:02] … for private equity and capital formation. But one of the negatives is that private equity, in order to enhance returns, do things, sometimes, that are very much negative for the performance of that business and the experience of employees.
Michael Blake: [00:13:20] You know, it brings up an interesting point. I’m going to take a little sidebar here. One of the things I’ve been studying a lot is business holding periods and one of the things I’m learning is that basically, the longer you hold on to a business, the better it performs. In fact, there’s data suggest that at a 20-year threshold, the average stock has less risk than the typical bond over the same period. And that’s St. Louis Fed data. And the thing that has struck me about private equity, and this is where this is relevant to the ESOP, is that private equity has a structural problem and that it has a countdown, right? Private equity must sell in some period of time. Very few private equity funds have more than a 10-year vintage.
Michael Blake: [00:14:12] You’re starting to see some 20-year, but those are very much kind of unicorns, which means that depending at what point in the firms, the PE fund’s life cycle the company’s been bought, the holding period may be somewhere between three to seven years. And that creates distortions, as opposed to an ESOP, which is definitionally a long-term owner, a buy and hold structure. If you accept my premise that the time horizon is meaningful to the business outcome, by definition then, the ESOP is structured to build that better outcome not because they’re better, smarter, more noble better motivated, but simply because they have more time.
Andre Schnabl: [00:14:57] Well, I wonder if I could provide a specific data point-.
Michael Blake: [00:15:02] Please.
Andre Schnabl: [00:15:02] … that takes that broad conceptual observation and brings it down to earth. We happen to be in a bank building. I have done about 10 transactions with this bank. This bank has provided the senior debt on a leveraged ESOP transaction. I don’t know the total number of millions of dollars that those 10 transactions aggregate. But the lead ESOP lender for this bank gave me an interesting statistic a few months ago. If you can consider 10 borrowers because essentially, these 10 companies that shareholders sold their stock to a trust, the company borrowed money to pay off the selling shareholders.
Andre Schnabl: [00:16:00] And so, we’ve got 10 companies who are 10 borrowers of this very bank. Of those 10 loans, each quarter, the bank measures covenants. And so, they are acutely tuned into the performance of these 10 companies. One of these borrowers had a covenant breach in one quarter. And so, over the six years that I have been doing this with this particular bank, those ten companies, they have ten performing loans and they are performing not only in accordance with the prescribed documents, but in fact, in every case, they’ve accelerated the delivering process because of this structure that an ESOP provides.
Michael Blake: [00:16:48] So, ESOP sounds great. Why is not every company an ESOP? Should every company be an ESOP?
Andre Schnabl: [00:16:58] No. I think that we design each transaction based on the priorities and strategic objectives of the selling shareholders. And not every company is either performing at the level that one needs in order to accomplish those objectives or the balance sheet of the company may not be strong enough to support the structure that we design. The growth rates may not be appropriate. There may be a number of reasons that a particular business is either not ready or not suited to this particular exit strategy. So, I’m not saying that there are an enormous number of hurdles to jump over in order to be eligible, but there are companies that are far more suitable for this transaction than others. But what I can tell you, for those that do fit nicely into this model, there is nothing that comes close to competing with it.
Michael Blake: [00:18:06] So, let’s dig into that because I think that’s really kind of the main course of this interview. Profile for me the characteristics of a great ESOP candidate, please.
Andre Schnabl: [00:18:20] A great ESOP candidate is a business that employs at least 20, 25 employees, these are general guidelines, is profitable, has been around for several years, so that they are an attractive borrower to a bank. And finally, the value of the business tracks with the business’s ability to throw off cash. In other words, if we have a business that is worth $100 million but isn’t profitable or is worth $100 million and throws off $1 or $2 million dollars in cash, it’s probably not the best candidate for an ESOP. So, we are looking for businesses where the enterprise value of the business is tied very closely to the cash that it throws off.
Andre Schnabl: [00:19:21] Generally, in this market, valuation somewhere between five and 10 times EBITDA, those are the kinds of businesses that really fit very, very well into this ESOP model. I’ll give you an example of something that doesn’t fit. If you’ve got a software company that has built an enormous amount of intellectual property that it hasn’t yet monetized. In other words, it’s early in its market cycle. I don’t think that’s a good ESOP candidate. A business that is a multi-generational manufacturer of widgets that has been profitable, that has got a very strong balance sheet, a perfect example of a wonderful candidate for an ESOP exit.
Michael Blake: [00:20:10] And so, you touched on valuation, which, of course, is a topic near and dear to my heart. And I want to explore that just a little bit with you because what you’re highlighting that I think is very important here is that not all values are alike. And your example I think is very apt. For example, that software company, if I were to perform an appraisal, may very well exhibit a value of say $20 million, right? But the thing may very well be pre-revenue, certainly pre-profit. And the value of that company is derived primarily from a strategic fit for a, you know, potential strategic buyer.
Michael Blake: [00:20:54] Basically, Google, Microsoft, Oracle, Facebook decides that they just sort of have to have it. And there’s nothing wrong with that value but the thesis of that value is inconsistent with the thesis of the ESOP because in effect, that market-based value, this gets in so many interesting questions, I got to keep my mind on topic, that thesis of value is sort of the flipper value, right, as opposed to an ESOP where a cash-driven value implies, again, a buy and hold strategy. And it must be able to support and sustain a buy and hold investment and ownership thesis.
Andre Schnabl: [00:21:33] And that is all correct. There are two elements within it, most ESOP structures and ESOP design transactions. The one is that the selling shareholders get paid over time, but they want a down payment. That down payment generally represents somewhere between 30 and 50 percent of the entire value of the business. And where does that money come from? It comes from a lender. The lender may sell to a software company pre-revenue, but it’s unlikely to. They would love to lend to a business that is cash flowing.
Andre Schnabl: [00:22:17] And so, with the added tax benefits, banks love to lend to ESOPs and that money goes into the pockets of the selling shareholders. And then, the remainder of the selling price will come from the profitability of the business going forward so that the selling shareholders are paid out in total over, let’s say, a five to seven-year period. There are a number of bells and whistles that we haven’t touched upon here that make the transaction even more attractive to the selling shareholder than them getting full and fair value over a multi-year payout.
Michael Blake: [00:22:58] And I want to touch upon that. But before I forget, I want to clarify or bring one issue into the characteristics of an ESOP to your attention or for your comment really. And that is that although the ideal candidate, as you said and I agree with this, certainly that, you know, multigenerational manufacturing company, lots of fixed assets is an ideal candidate, you don’t necessarily have to be that to be a viable ESOP.
Michael Blake: [00:23:25] For example, there is a stereotype that architecture and engineering firms seem to make very good ESOP candidates. And they’re unlikely to—they don’t manufacture things, they’re a professional services firm. But for whatever reason, they seem to find ESOPs as, there seems to be a match there with ESOPs. A, is that true? And B, why do you suppose that is? And then, C, if you can remember all these questions, is can that be applied to other services firms, maybe even accounting firms?
Andre Schnabl: [00:23:56] First of all, it is true. Secondly, the reason is why are ESOPs attractive to professional services? Professional service firm’s primary driver of growth, in addition to market conditions, is the attraction and retention of talent. And ESOP provides a unique opportunity for a future employee to look at two offers and say in one situation, “I’m simply going to get a paycheck”, in the other situation, “I’m going to get the same paycheck plus ownership over time”, which is more attractive.
Andre Schnabl: [00:24:41] And so, ESOP-owned professional service firms have got competitive advantage in attracting and retaining talent, which is the lifeblood of professional services. Now, in terms of what kinds of professional service firms work, in our firm, Tenor Capital, we’ve done architects and engineers, we’ve done general construction, we’ve done intermediaries, and consultants, marketing consultants, for example. And as you may recall, we’ve done one for your firm.
Michael Blake: [00:25:19] Yeah.
Andre Schnabl: [00:25:19] And they were a professional services firm themselves. Whether this would work for an accounting firm or for a law firm for that matter, the answer is yes. But there’s certain regulatory hurdles that one has to consider when you consider a law firm or an accounting firm. Because the regulators of those professions generally require that the shareholder or a principal in an accounting firm is an accountant. In an ESOP, everybody, including support staff, including the person at the front desk who answers the phone will be a shareholder and one has to navigate the regulatory environment, which one certainly can do before one can actually execute an effective transaction for professional services.
Michael Blake: [00:26:18] Now, why are banks interested in lending to such ESOPs? Because the fixed assets are not going to be there, right? The traditional collateral, as we would think about it, is not there. How do banks get comfortable with that?
Andre Schnabl: [00:26:35] Well, the fixed assets are not there in professional services.
Michael Blake: [00:26:39] Right.
Andre Schnabl: [00:26:40] The fixed assets are certainly there for other kinds of ESOP transactions. Banks become comfortable because they lend on collateral, yes, but they also lend on cash flows. And an ESOP transaction, the cash flows are actually enhanced when the owner of a company is an ESOP compared to a traditional individual like you and me. Most smaller businesses in the United States are S corporations.
Andre Schnabl: [00:27:19] And that means that the company itself is not a tax-paying entity, but the shareholders that own the business are. In order for those shareholders to pay their tax liability each year, to make a distribution of cash to those shareholders. Well, if instead of those shareholders, you replace those shareholders with a tax-exempt trust, which is what an employee stock ownership trust is, then overnight, you are no longer required to make tax distributions to your shareholder because your shareholder has no tax liability.
Andre Schnabl: [00:27:58] So, all of a sudden, 100 cents on the dollar that you make, you keep and can be used to pay off the bank as opposed to only 60 cents on the dollar or 70 cents on the dollar. So, you have immediately enhanced the borrowing power of a company, which is obviously very attractive to a lender. And that is why they look at these things and enjoy the possibility of lending to an ESOP, even if it is a professional service firm that doesn’t have hard collateral.
Michael Blake: [00:28:33] Okay. So, let’s say by now, we’ve convinced some of our listeners that an ESOP is a viable vehicle. What’s involved in setting one of these programs up?
Andre Schnabl: [00:28:47] Well, we’ve talked about the formation of a buyer, which is the trust itself.
Michael Blake: [00:28:52] Right.
Andre Schnabl: [00:28:53] And one needs to obtain a trustee. Now, the company itself could nominate an executive to be a trustee. It’s not something that I would recommend, but it can be done. So, let’s assume that you follow my recommendation and get an independent trustee. So, you need a trust and you need an independent trustee. And on an ongoing basis, you need a third-party administrator, who is the person that does a lot of the day to day mechanics, so that an employee, when they want to see how many shares they have in their account, they need an annual statement.
Andre Schnabl: [00:29:38] That annual statement is produced by a third-party administrator. So, those individuals have to be put in place. And there is an annual cost associated with those individuals. The cost is very manageable. And I will say that quite frankly, this is more a misconception than reality that this is a complicated affair to set in place. There is certain costs for a small business, let’s say, worth $25 million and less, the average annual cost is somewhere around $50,000 for all of these activities combined.
Michael Blake: [00:30:25] So, pretty reasonable, right? That’s-
Andre Schnabl: [00:30:27] Pretty reasonable.
Michael Blake: [00:30:28] … a junior employee, basically. And one other feature that I want to bring up, a tip also is that an ESOP, when it’s formed, is typically accompanied by some form of third-party appraisal, right, which is, in effect, a fairness opinion. And the role of that exercise is basically, in effect, to prove to the bank that the asset they’re buying is worth what they’re lending against, I think. And second, I think it also has something to do with communicating to the shareholders now what it is they’re actually receiving, then there’s an ongoing need for that as well. Can you talk a little bit more about that?
Andre Schnabl: [00:31:08] Yes. I apologize that I didn’t bring up the valuation firm at the outset as to their annual running costs. But you’re absolutely right. The trustee that is essentially representing the trust as the buyer, from a legal standpoint, cannot pay more than fair value for the shares. And so, they get a valuation firm to give them a valuation to ensure that they don’t overpay for the business. On an annual basis, that valuation is updated so that the employees know the value of the number of shares that they hold in their account. So that when they retire, they know the value that they’re going to get for those shares, so that they can then take that cash and use it to put bread on the table. So, yes, a valuation is required for the transaction itself, the sale. And it is required on an annual basis to maintain, essentially, the efficacy of the plan.
Michael Blake: [00:32:13] And that valuation on an ongoing basis will also serve as the basis for setting the price at which shares will be repurchased or, in fact, redeemed, correct?
Andre Schnabl: [00:32:24] That is correct. Yes.
Michael Blake: [00:32:25] So, you know, it’s a big deal in my experience that the valuation part is among, if not the most expensive part of the ESOP.
Andre Schnabl: [00:32:36] Well, I can give you some numbers and you know this business better than I do. The cost associated with giving the trustee what they need, that fairness opinion is heavily dependent on the target company. Generally speaking, the larger the transaction, the more expensive the valuation. But also, the complexity of the valuation may be driven by the kind of business that the company is in. The valuation therefore can be anything from $25,000 up, depending on the size and complexity. However, we haven’t talked about all the savings associated with this transaction-
Michael Blake: [00:33:24] Yes.
Andre Schnabl: [00:33:25] … which generally funds all of these expenses. And without getting ahead of myself, when we get to that point, you will very quickly see that selling to an ESOP is less expensive than selling to a third-party.
Michael Blake: [00:33:39] Well, you know what, it’s Friday. Let’s go ahead and get ahead of ourselves. So-
Andre Schnabl: [00:33:43] All right.
Michael Blake: [00:33:43] … let’s talk about what those cost savings look like because they are significant, but they’re also a little bit complicated. So, let’s walk through that a little bit.
Andre Schnabl: [00:33:52] Okay. Well, essentially, an ESOP-owned company gets a unique set of tax deductions that no other entity gets. We’ve already talked about the fact that if it’s an S corp, you don’t even care what tax deductions you’ve got because the company is effectively a tax-exempt entity. But let’s assume that it’s a C corp, the C corp gets a tax deduction equal to 25 percent of its payroll over and above its payroll itself.
Michael Blake: [00:34:31] Wow.
Andre Schnabl: [00:34:31] So, essentially, they get a tax deduction which represents 125 percent of its payroll. So, if a company is a professional services firm, where its primary cost of delivery is salaries and compensation, you can imagine that it’s very easy to drive down your taxable income to zero when you’ve got that tax deduction which represents 125 percent of your primary cost. In manufacturing, same thing, labor cost is huge. So, you’ve got a huge tax deduction. So, what is the value associated with that 25 percent tax deduction? It usually exceeds the cost of that valuation that you were talking about. And so, effectively, it is a very tax-efficient and cost-efficient way of selling your business.
Michael Blake: [00:35:29] Now, do all employees participate in ESOP? Is there an option to exclude some employees either from the owner side or from the employee side, if they choose they don’t want to be a member?
Andre Schnabl: [00:35:40] No, there is no choice.
Michael Blake: [00:35:41] Okay.
Andre Schnabl: [00:35:41] This is a qualified plan and you cannot discriminate. Everybody has to participate. Now, their level of participation is dependent on their personal compensation. So, not everybody participates at the same level, but everybody is required to participate at some level.
Michael Blake: [00:36:04] Okay. So, one of the other features of an ESOP that makes it so different is that it is a government-regulated entity, right, by the Department of Labor, if I’m not mistaken, under ERISA from the 1970’s Employee Retirement Income Security Act, if I did that correctly.
Andre Schnabl: [00:36:25] Well done, Michael.
Michael Blake: [00:36:25] Oh boy. So, what are the implications of that external regulation? Do they add a level of risk? Do they interfere in the business? Is there a lot of activity of the Department of Labor as taking actions against companies? How do you see that environment?
Andre Schnabl: [00:36:45] And let us consider the Department of Labor as you might consider the IRS. As a company that is a taxpayer, you’re always subject to potential audit. And if you’ve been doing something that is untoward or potentially illegal or irresponsible, you may get sideways with the IRS. The same thing with the Department of Labor. The Department of Labor has the right to audit the filings that an ESOP is required to file every year. But in the event that that filing doesn’t raise any questions, you don’t hear from the Department of Labor. If you’ve been doing something a little strange or something that raises a number of questions, then it is true, you’re subject to a Department of Labor audit.
Andre Schnabl: [00:37:37] And if they believe that there is something that is being done that is inappropriate, you are potentially subject to legal risk as a result of that. So, I don’t consider the risks to be enhanced any more than somebody who doesn’t pay their taxes and they should. So, there have been court cases brought against trustees and selling shareholders as a result of litigation brought by employees and third parties, but that is infrequent. And when you look at the history, the chances of that happening is as remote as you being thrown into jail because you were a bad boy by the IRS.
Michael Blake: [00:38:26] Okay. And I actually could touch on one question that I want to make sure we get back to, which is the ongoing role of the trustee, right? And for our listeners, you know, that the trustee’s role in ESOP, as I understand, is that of a fiduciary, meaning that the trustee is there to represent the interests of the employees who are the participants in the ESOP. How involved or engaged is a trustee in the business of the ESOP? Do they effectively serve as a board member? Do they have veto rights over certain corporate actions? What does that role look like?
Andre Schnabl: [00:39:03] That’s a great question, Mike. And we get that question a lot from selling shareholders. The reality is that the selling shareholder, although they have sold a part of their company or potentially 100 percent of their company, they still control the board of directors. The trustee has absolutely no interest in being a board member or in running the board or participating in running the business.
Andre Schnabl: [00:39:32] They know as well as anybody that the people who built this business are the best people to run this business. Having said that, there are certain items where trustee approval is required and where a vote of the shares held in the trust is required. An example would be if an ESOP-owned company is approached by a third party to buy the business, then the board of directors has to consider whether that offer would be good for all the shareholders, which includes the employees who are represented by the trustee.
Andre Schnabl: [00:40:15] And so, in the sale of a business to a third party, the trustee needs to support the transaction. Generally, what would happen, the board would evaluate the transaction, would conclude that this is a deal that they’d like to do and then, they would approach the trustee and show why this is good for all shareholders and the trustee would sign off. But on all operating decisions and most strategic decisions, the trustee has absolutely no interest.
Andre Schnabl: [00:40:48] In the absence of something nefarious occurring, if the trustee became suspicious that, for example, the selling shareholders had granted a bonus or a distribution to themselves outside of the agreed upon deal terms, then the trustee would have a right to demand an explanation. But they are, quite frankly, from a practical standpoint, invisible other than once a year reviewing the annual valuation that we talked about previously.
Michael Blake: [00:41:31] Okay. So, we’re running out of time. We have time for a couple more questions. One question I want to make sure I get out there is how permanent is an ESOP? If I decide, you know, I have a company that decided, “Can we go do an ESOP?” But I’m concerned, maybe five years from now, maybe I don’t like the ESOP so much. Can an ESOP be canceled, terminated like a benefit plan sometimes is or once it’s there, is it pretty much there, carved in stone?
Andre Schnabl: [00:42:07] The answer is once you’ve decided to sell your business to an ESOP, they are now the owners. And in the event that you want to buy back your business, which is absolutely within your power, you need to cut a deal with now the seller who is the trustee. Just as selling to a third party needs a trustee approval, if you want to buy it back, you need trustee approval. So, it is cast in stone in the sense that you can’t just tear up the documents and pretend it never happened. But you can very much reverse it by buying it back or selling to a third party.
Andre Schnabl: [00:42:54] In fact, an ESOP-owned company is a wonderful vehicle for an intermediate step in a roll up. For example, if you were a professional services firm, sell it to an ESOP, you now have a tax-exempt entity that has a lot of cash and a very attractive platform to be a buyer for other professional service firms. So, you can build a business, you can grow your business through acquisitions before you decide to sell the entire shooting match to a third party. So, it is a wonderful way to build wealth and then, flip it out to a third party using an ESOP platform to accelerate that growth because you preserve cash because of the tax efficiency we talked about.
Michael Blake: [00:43:47] So, in effect, it’s really no different than if you have another shareholder in your company to say, “Hey, I’d like to buy your share.” “Okay. Let’s talk” or “I’m not interested.” Same kind of conversation.
Andre Schnabl: [00:43:57] That is correct. That is correct. There is one thing that we haven’t talked about and because we are getting to the end of our time that I want to bring up, that the selling shareholders, they sell their company for fair value. But there is also an opportunity for them to get an amount over and above fair value. And that sounds a little bit too good to be true. Let me tell you how that happens. Because selling shareholders are waiting for all of their money, they get compensated for that wait. And they get compensated by being issued warrants in the business.
Andre Schnabl: [00:44:39] And a warrant is the right to buy shares in the business at a price that is agreed upon. And so, as the business grows after you’ve sold the business, their warrant position becomes more and more valuable. That warrant position can be as much as 20 or 30 percent of the entire business. So, if you just think about this, if you’ve got a growing business, that 20 or 30 percent will grow in a business that is no longer paying taxes. Very often over a decade, that 20 or 30 percent is worth more than the entire business was worth the day you sold it. So, that warrant position should not be forgotten. It is something that is unique to these ESOPs.
Michael Blake: [00:45:31] I’m glad you brought that up because candidly, I did not know that. And you’re right. It does sound too good to be true. It sounds very much like, you know, you’re literally getting two bites of the apple.
Andre Schnabl: [00:45:43] That’s right. This is-
Michael Blake: [00:45:43] You sell your company but you still maintain a foothold in the company so you participate in the upside.
Andre Schnabl: [00:45:49] Absolutely. It is the second bite of the apple. But you’re financing a transaction that is for the benefit of employees, you deserve compensation and you get that compensation through the warrant position we’ve been talking about.
Michael Blake: [00:46:04] Well, we’ve covered a lot of ground here. And thank you, Andre, for helping us work through what is a very technical and complex topic, a lot of moving parts. I suspect a few listeners will find that they want to learn more about ESOPs to see if it’s right for their company. How can they reach you to learn more about this topic?
Andre Schnabl: [00:46:24] Well, my name is Andre Schnabl and my telephone number, 404-372-2759. And pay tenorcapital.com a visit on the web and you’ll see how to get a hold of us by email and you get to learn a little bit more about our firm.
Michael Blake: [00:46:44] Okay. Well, that’s going to wrap it up for today’s program. I’d like to thank Andre Schnabl so much for joining us and sharing his expertise with us. We’ll be exploring a new topic each week. So, please tune in so that when you’re faced with your next business decision, you have clear vision when making it. If you enjoy these podcasts, please consider leaving a review through your favorite podcasts aggregator. It helps people find us so that we can help them. Once again, this is Mike Blake. Our sponsor is Brady Ware & Company and this has been the Decision Vision podcast.
