EP36 - Ghosts of ESOPs Past, Present, and Future

In this episode, Jason and Makenzie let three “ESOP ghosts” guide us through the employee-ownership journey. They revisit the origins of your ESOP, take a candid look at how things stand today, and discuss how to intentionally choose its future. They highlight how the decisions, habits, and culture shape long-term ESOP success.

Transcript

[0:12] Hi everyone and welcome back to another episode of Journey to an ESOP Beyond I am your co-host today Mackenzie worth.

[0:22] I'm Jason Millerand today we are going to be of course tying in esops to. The time of year we are approaching the holidays um no matter what you celebrate its kind of everyone's most people's favorite time of year everyone's filled with cheer um and we are going to be. Discussing something that you may be familiar with um a little play on a movieand that will be the ghost of the esops past present and future.

[1:01] This is going to be a lot of fun umI I think. Everyone's familiar uh at least many people are familiar with uh Charles Dickens at Christmas Carol uh they've been countless movies my my favorite interpretation is the Bill Murray movie uh Scrooge uh that that was that was pretty interesting uh back back in the day I think it was late late 80s or early 90s um we'll have to pull that up and see and and make sure but I think we've all seen A Christmas Carol number of different times um and when McKenzie brought up this idea of, uh you know what what could this look like alongside esops if we think about the the past present and future uh I I I think it's it's going to give us some interesting perspectives and for the main line of this we're going to address ESOP existing ESOP companies uh and kind of what ghosts they may have that could influence them. And we're going to take a little bit of an aside at each of those and talk about where some of you may be. Uh as as a founder and what you would be bringing to a potential ESOP transaction.

[2:12] So in in true Charles Dickens fashion we will start in the beginning um I don't know that we have a vignette of of Tiny Tim that that we want to share um but we can at least jump right into the the Ghost of Christmas past or ghost of ESOP pass um so what what do we have on the the the docket to be able to to chat about that today McKenzie, yeah so a couple a couple of things that the ghost of the ESOP pass brings um, R1 the Founder's motivation.

[2:48] And 2 deals are decisionsum. Deal structure decisions uh so let's again keeping with the theme of if we are addressing existing ESOP companies um we're in in standard operation uh things are are moving along the business is is great it's an employee-owned company uh and the these these deal decisions that were made let's let's talk a little bit about those um what. What ones in particular um do do we want to address first that may have a an outsized impact that could uh be considered haunting for an existing ESOP company. I think uh a couple of the big ones or or maybe 1 of the biggest is how leveraged was the deal.

[3:45] Another could be um did the company choose an s-corp or Corp structureso I think maybe we can start with. Tackling those and I think thehow leveraged was the deal is a decision that could.

[4:02] Definitely hotyou saw companies and the presentum. So maybe let's peel that back a little bityeahandwhat I found is that many. Companies that transition to an ESOP before the transaction are completely unleveraged there's there's zero operating debt um or if there is it it's a line of credit that's rarely tapped uh except for bringing on large projects maybe some seasonalityand it it, the management team uh and the leadership team and ownership are all comfortable with that Arrangement right we kind of chart our own destiny we build in our own flexibility uh we know that leverage companies are riskier because if macro factors impact us negatively then we are less Nimble because the weight of debt that's on the company. And whether it's intentional or explicit it's at least understood that you know that's kind of the way that that it, it manifests over time is or as likely leveraged as we need to be to continue operating uh to give us the breathing room that that we need toum.

[5:18] And then we get to this uh the ESOP transaction and as as we've expressed before it's an basically an exchange of of the owner's equity for debt. Whether that's with a bank or without a bank um but regardless. It is now new debt on the balance sheet that doesn't help the company grow it doesn't help the company become more profitable. The financial instrument it's just that weight or that that burden and so um that.

[5:52] The structuring through feasibility on the front end um that creates the design of of that debt uh can certainly um, create a a haunting scenario umso what are your thoughts about that. Yeah I think ummaybe let's touch on what so. Most of the times that leveraged esops are the most common so what about the leverage and the structure itself. Could lead to haunting the companies in the future is it the percentage that isBank financed is it. The percentage that is versus seller financed um is it the the terms that get negotiated maybe kind of.

[6:43] Um help our listeners understand what decisions onLeveragecould yeah negatively um.

[6:53] I think we all know that no no 1 know the future except for the the ghost of ESOP Futures uh in in our scenario today um and there's something really important that that you said there and and we use the term Leverage esopsand, uh I want to be very distinct in in this that a leveraged ESOP uh is a a company and an ESOP that has an inside note so Shares are held in suspense to get released over time that's when we say leveraged ESOP that's that portion it does not mean that the company is leveraged it just so happens that again at the time of transaction because we're taking on debt the company the operating company is now also leveraged where they weren't, before right um in our employee ownership uh month podcasts with uh Kimberly Inn in week 3 Kimberly mccourtney from the nceo um sometimes uh management, uh the while they do influence decisions and do you have influence on owners they don't always get to make the decision about how this occurs uh but they do have to after the transaction. Live with the the uh the outcomes of of the of it.

[8:09] And if the the company is not used to leverage not used to debt in any fashion or form it's a learning curveum. And it comes on pretty suddenly because of the magnitude of of what that the the debt looks like because the transaction is is significant um.

[8:30] And thinking about money flowing out of the company even though it's going to the owner to to service debt or it's going to the bank and and then to the owner uh you have to be very careful about how that that is structured is the amortization long enough is there enough flexibility in the payment terms uh and then who do we want as a Capital Partner as a debt Capital Partner and this gets to your question around the the bank financing, um The company cannot afford to jeopardize its access to debt Capital if it needs debt Capital to accomplish its goals right. And specifically in an ESOP to accomplish its forecasts so then we kind of tie in forecast was the forecasts accurate was the forecast reasonable, um we always say the forecast is going to be wrong but it can be more reasonable or less reasonable and more achievable or less achievable. And that's why it's crucial for um the approach and and uh, how close can we get to we think we can accomplish this that the value gets derived from and therefore the debt gets generated from.

[9:43] I think that uhkind of emphasizes why that. 1 of the valuation and feasibility steps are very important so thatyour. Whatever ghost is haunting you is notas.

[10:01] The impact isn't as bad yeah and Leadership teams and management teams um again they the more that you are able to incorporate them or include them in the process as it makes sense for you as as as a Founder as a selling shareholder um I think this is probably the biggest panic button for them, uh when they realize that this is going to be a debt transaction and again they've never had to to deal with it before but some tools that. You can Implement to provide some guard rails is even if you're not doing Bank financing.

[10:40] In becoming a creditor to the company rather than an owner or a partial creditor if you're selling a part of your company is thinking about like or thinking like a bank. What is a bank need in order to uh to deploy capital. Um they need to know that the company is healthy that the company has the capacity to repay um and that there's a little cushion there's a little more um and defining that for management uh and if the bank doesn't if again if you're not including a bank then you have seller nodes um thinking about it and here are some here's some guidelines here here's some some guard rails of what's considered healthy operating and how this debt layers into that to give the team confidence, on hey we can do this and not only can we do it but we we have a little bit of a cushion here before we have to start worrying about it impacting our our operations right.

[11:36] I think that's that's super helpful and super valuable insightfor our listeners.

[11:43] Shall we move to the presentumyeah we can move to the presentokay.

[11:55] So we've touched on the goop the ghost of esops pass now to touch on the ghosted esops present um.

[12:04] This ghost will show you what your ESOP looks like right nowso what are your. Operational realitiesand. Maybe what is your current culture look likehaving taking a pulse on your current culture how does the organization feel.

[12:27] We like to say that communication is is is key.

[12:32] Uh and this is a theme that never goes away for for esops uh if only evolvesum and how you first set out those initial kind of blasts of of communication in the roll out meeting here's here's what we we've done this is what we've decided on um this is the new Financial reality of uh of of the ESOP and of the company and what it means to you and employees may have some past experiences of their own and their own their own ghosts uh that that they bring to the the news of a company becoming an ESOP.

[13:12] Uh but they may be just as excited about the future but in the present in that moment immediately after a transaction um it's still not quite real it's still some somewhat dreamlike it's still somewhat Charles Dickens like uh for for them as they go oh what do we what do we do and how do we how do we assimilate this information right umbut a a structured communication plan um establishing your communication committee and then making sure that you as a leadership team are continually injecting life into that committee and into those people those Champions that are are super excited about uh being employee owners and and what what they're going to take doesn't doesn't go away, right and the more investment that you can make in communicating to.

[14:07] The the employees the new employee owners the greater the returns you're going to see in really every area of culture. Right.

[14:18] I agree I think um kind of a common theme amongst what's what you said is that it's not the ESOP is not just a 1-time announcement 1-time communication it's something to constantly. Bring up and remind your your leaders and employees um to kind of reinforce the behaviors and like the ownership mindset. Of an employee-owned company.

[14:47] Those other operational realities are this doesn't substitute anything that you were doing before right. Uh and that.

[15:01] From a uh a a limited ownership perspective like a limited share number of shareholders that have been bearing the risk and the burden of of leadership and decision-making um. That they've delegated appropriately to roles within the organization to make the organization healthy. Um is is 1 thing but now is the the greatest opportunity after an ESOP transaction and really ongoing is thinking about a Cascade of responsibility.

[15:29] Because now you have everyone willing uh to to Bear some portion of the risk they're taking that that risk and that responsibility on because they're they're getting a direct Financial benefit, in in the future from from their efforts and from stepping in and stepping upum and I use the word Cascade pretty deliberately because delegation kind of goes down, but the concept of of risk and responsibility for the future of the company again Founders and Executives have borne that, mostly by themselves and that may be 1 of the hardest things to transition, uh is is that that mindset and really it's being cultivated uh through communication, um but it's a layer on top of what everyone was responsible for before so an ESOP is is an ad it's it's not a subtract. It's kind of a a divided um in order to multiply. Does that make sense yeah I would agree with that and I think there's also an element of. Accountabilityand maybe discipline that that comes with that um.

[16:42] I think we hear many times from our clients maybe the the leap of faith that they're taking when they're when they go through with an ESOP transaction is. Yes based on feasibility this will work but. We have to meet the projections we're saying we're going to meetand so I think there's a piece of accountability that comes in where we leaders. Well if they are not already making sure thatthe employees understand. The forecast or the budgets relative to them and their department and are they being. Held accountable to it or are they being measured up against it and providedkpis to achieve or is. Umlike tangible goals that they are aware ofand are constantly um reaching towards.

[17:37] This is a great place to talk about um opening up uh more of what you as as, leaders and have found as Founders have always had access to to more of the population um and and 2 uh what's the word that I'm looking for um like symbiotic approaches to helping you transition and be more transparent are like EOS and and traction you'd mentioned kpis. Uh McKenzie are great tools for um it transitioning that responsibility and making it clear to the responsible parties um and then our friends at the great game of business have taken that a step further and you have you know different layers of open book management, so that there's a uh everyone has some insight into some portion. Of the the financials so that they can directly see the progress that they're making or the progress that they need to make uh in order to to to kind of Thrive um.

[18:42] And that that evolution is is alsoprobably different than the way it was before uh however you'd mentioned in the ghost of ESOP pass it's like for what what's going to survive and and maybe create some issues for us and we talked a lot about debt and and Leverage everyone knows that there are things outside of your control and outside of our control that could create a a bad year or bad run of years after the transaction No 1 saw coid coming.

[19:16] Right right um and being nimble, as Nimble as you can be is impaired by the amount of of debt and then it goes back to that that structuring and if you're not communicating with the leadership team and not giving insight further down in the organization again either through kpis or through transparency or through some some type of communication um the what gets communicated by not communicatingcan be a story that you don't want to tell. And that could get to the owner sold at the high or uh you know kind of left as high and dry and then we're we're now responsible for for all of this and then the the opposite of what you wanted to communicate. Comes out in the gap of of not expressly saying it and and staying on top of it does that make sense absolutely and I think another. Another topic that kind of weaves into all of thisand maybe it's kind of an overarching.

[20:22] Umpiece here is the governance landscape of the company. Um what does the governance look like before and after the transaction and why is that so important. For these operational realities and culturecurrent culture status um and how can thatimpact those.

[20:47] An ESOP is such a great opportunity to get more people willingly involved.

[20:54] Uh and their administratively within the ESOP like not everybody's going to be a board member you don't want to grab people and throw 35 people on a board uh and put them above manage or Executives and management um but there are plenty of committees that have to be established and there are others that should be established that give people a sense of not just responsibility um but uha a an opportunity to. Help influence how this is going to look for everybody and the and I think I I may have shared this before but like not not everybody um you don't have to have.

[21:39] Uh Finance people on a specific you know the administrative committee and then you don't have to have marketing people on the communications committee, you can grab anyone from anywhere that's willing to raise their hand and say I I want to do something for the ESOP because they're saying really I want to do something for myself and I want to do something for everyone else and I want to know more, right and the further down in the organization that you can embed that willingness that that opportunity for them to to step into it committees are a great tool for that that's just going to enhance culture from from the ground up, and I think those. Those tools kind of tying in the ghosts of the past in the present you can't control what decisions have already been made or were made in the transaction but having these um. Committees in place can allow you to.

[22:34] Address or maybe not fix or correct but at least um react to or manage the decisions that were made.

[22:43] Bettercommunication all comes back to what what you say and who you say it to uh and and how you say it, and I would look atevery month every quarter every mid year every year end as an opportunity to even reset.

[23:04] Uh and communication has to be honest uh for it to be most effective. Um it can be couched to and still be effective uh but the the more open and transparent that you are then the the better the the message gets communicated um and so those arethat's some encouragement that that I would would use for everyone just just like kind of jumping ahead to the end right so Scrooge obviously went through this and then changed his heart toward Bob Cratchit and Tiny Tim and life in general but it wasn't all about wealth and it wasn't all about just showing up and working on Christmas day um, that an event this event occurred uh and it provided for him the opportunity to change his mindset. And you really have that with, uh every instance you can you can change today if you don't feel like you've done a great job um you can resolve to be better today than you were yesterday uh in moving forward and think oh this is the time for us to address this and. The beauty of an ESOP company is everyone is tied in.

[24:17] They're they're in uh it's h how do you utilize that energy uh and that recognizing that that fact of of reality they're already in, right so how how now do do we we we make the most of that and if we need to make small changes today we canand I think that's a great segue into how.

[24:40] Your current today's actions can shape. Uh the future of the company that the company's future valuation um and overall organizational health. So now we may have a visit from the ghost of the east on the future what what is he gonna say uh for for us today McKenzieum.

[25:08] 1 thing thatstood out to me or has stood out to me is that um. ESOP companies have an advantage in that they cansee future challengesand course correct.

[25:26] Early or today umand I guess what I mean by Future challenges are umfuture repurchase obligation.

[25:37] Uh maybe youyou're obviously aware of your your day-to-day operations and. Hopefully you are staying on top of a forecast and so you're aware is this is this a good year or is it a bad year if it's a bad year you know it's going to impact evaluation so what steps do you need to take to make sure that you don't continue to go down that path in the future.

[26:00] There is unique accountability. When a valuation on a stock is done every year or with frequency I would say but um and you're you're absolutely rightit's not just accountability, and wanting to make sure that that stock price continues to appreciate through your efforts and through your strategy and through your people and all of the things that we've we've already talked aboutum but it it does set a benchmark uh and it it does have implications whether if it goes down or if it goes up, and why uh those changes were were made everyone wants to know why.

[26:44] I would want to know why if it's going up so that I could do more of what we did this year.

[26:50] I'd want to know why it's going down so that I I don't keep doing the things that may have happened or I understand that it's temporary right. Uh but that insight into I know we're going to have the the valuationand based on that I know my people. And I also that that provides for us the framework when we look into the future um you know how how are we going to honor the promise of the ESOP and what impact is that going to have on the choices we make today. Right.

[27:25] And not every company uh has that level of responsibility accountability or insight. With all of it being shared amongst everybody at at the company.

[27:43] And the view into the future or the forward-looking with accountability I think is is the key in that but you're you're right that is a a a very distinct advantage that that esap companies carry. Could or should be doing relative to repurchase obligation in in the present moment.

[28:14] Uh many ESOP advisors will tell you it is wise to get a read on repurchase obligation, um and through the process of the ESOP being set up it's a word that you're going to hearuh and the impact of that in the early years of most plants is negligible. Uh for various reasons uh the the vesting schedule that gets chosen the length of the inside note the volume of of your population if you have a young population uh that that's not going to be nearing retirement anytime soon, um you measured steady growth over a period of years and there's uh in the early years. Uh you you can fall into this. Uh false sense of everything's going to be okayand this is why trustees will encourage you to get a repurchase obligation study every couple of years. And that. Activity um and then that product that deliverable from a reputable sourceis going to say oh here's what it is today and then here's kind of based on the assumptions of the future this is this is what it's going to look like for you um

[29:30] As you get closer and closer to certain events so in in year 10 of every plan there's mandated diversification so diversification is a term that come that's embedded in in the plan. It's a 10 year old plan if you've been in the plan for 10 years and you're 10 years out from retirement or 55 or older. Um then the the you have to be given the option to diversify out of the company stock, uh and then the the company that creates repurchase obligation so if I have thousand dollar balance in the company stock and I've been in the plan for 10 years uh and I'm I'm 55 or older, then um I can put back 25,000 of my account to the the ESOP sell my shares out and then I can put that into my my 401k so I'm diversifying out of Company stock, so I'm not not concentrated its elective, um but the option is is mandated right and if I don't choose to do that this year but our stock price doubles next year, I might start looking at that as a a broader piece of or a larger piece of my portfolio and I might want to take it up next year. Um and if that continues at some point I might say hey this is great and so the the obligation of diversification kind of rolls forward based on that choiceum.

[30:56] Likewise not everybody retires at retirement age especially for companies they love working for, uh and they they want to stick around so you there there are a lot of elements in in that but plan triggers like diversification the other 1 is understanding how many shares are allocated, and how many are not, and as you get closer to more shares being allocated and less available that in in suspense that are that are unallocated in the leveraged ESOPum then you you should have a read on how you're going to be able to continue offering a benefit to the in the ESOP to current and future employees, um this is a great 1 that kind of ties all that together so we we can take it aside and talk about the Haves and Have Nots.

[31:47] Yeah I think that's that's very important andkind of highlights the emphasis on, why planning is so important and having visibility into these studies and understanding what the studies are even looking at and what what they're considering you know like the demographics of of your um. Employee base and age Etc all the assumptions thatuh.

[32:18] Result inthe obligation. Estimateyeah and I think um the bottom line for for repurchase obligation is don't ignore it um don't forget it, and get get your finger on the pulse of what it could be and as you come up on a on a plan event, like diversification for the first time in your tenth year um or as people start retiring um get it more frequently and then true it up. Because uh some ESOP companies will do 1 every year um and we are going to have a guest on very soon to talk about all all of the implications around what what you can do strategically as an ESOP company uh to help with repurchase obligation. And honoring that promise of retirement to employees so more more to come on that uh but for for today yes looking into the future you can uh do it more frequently as the the ESOP matures. And then understand what your options are and think strategically about those.

[33:33] Let's see sowe've touched on the past we've touched on the present we've touched on the futureum.

[33:43] Anything else that comes to mind relative to. The futureyeah I I think I'd be remiss in not. Addressing what the future of a company could look like if there's not intentionality. Toward changing or preparing or readying yourself for an exit if you're not an ESOP company today. Um my my favorite is uh you know using Hallmark as the the target 1 of these days when we get enough listenership they might tell me to cease and desist and using them as an example. The the Hallmark movie of the the the company that the main company in town um that that sells out or shuts down for for whatever reason that leaves everybody in a bad spot. Um and then the itinerant investment banker that flies in and meets the young lady who owns the the bed and breakfast and then at the end of the day everything kind of magically works out as the company gets reinvigorated and everybody gets hired again right but no 1's to go through the pain um. Andyou get to decide what your future can look like and as long as you have time. You can prepare yourself individually to become more ready for that emotionally intellectuallyuh and it it's a it's a crucial process.

[35:13] And I'd encourage everyone who's not yet. Made a transition of your company uh to take the time and figure out what do you want your future to look like, consider employee ownership as part of that future I think you are because again you're listening to an ESOP podcast so uh that that part's awesome and I'm glad you're here to do that but I want to encourage you to stay down that path, and figure out what it means for you and what it could mean for your company um so that you're not rushed because of an event that's outside of your control that you feel forces your hand to something that you wouldn't prefer.

[35:55] If you feel you have time take the time be intentional and then think, through what those implications could be not just to you and not just to the company and really not just to the employees but to your community. Uh to your city to your town and to all the businesses that depend on your workers living there, um and for many of you you might not be in an urban area and you may be that company in in those Hallmark movies that has sustained a town uh and it's its environs for decadesum. There's there's a a a different level of not not responsibility and I don't want to put that on you I don't I don't want to say like you you should absolutely do this because it's going to avoid all the complications of ending up in in that homework scenarioum. But there is a path for you that preserves everything that you've built and preserves the culture of not just your company but your communityum. And then I I think the the other part of looking into the future is what if you don't do anything.

[37:07] What if you what if you don't make a change to invigorate your cultureto be capable. Of carrying on the company without you or into the next evolutionum and then I've I've got countless notes on a Herman Melville um aside that 1 of these days I'll I'll do uh but uh if you're familiar with um, uh her amount his Herman Melville his his big thing was moving dick wrote a ton of other books and the other 1 has a character in it called Bartleby. And Bartleby is a worker who shows up to work um at a at a scrivener's office a kind of a lawyer's office um and his his tagline whenever he's asked to do something is just. I'd prefer not to.

[37:59] And that becomes a problem uh to to the point where the only person left in the scriber's office is Bartleby, uh because he didn't want to do anything um but the owner didn't do anything about him or his culture or his response and ended up moving to get away from him.

[38:19] And you don't want to find yourself in either scenario rushed too much because of things outside of your control to take an option that you feel is an option of Last Resort or just what you need to do, and you don't want to end up in a spot where in investment and action in people can prevent, take a dead culture inside your company at the expense of the the kind of the paycheck or the financial return in the meantime right. So when you look ahead just like Scrooge did in A Christmas Carol the future that he saw if he didn't change was not 1 that he wanted to do.

[38:58] And he was able to be absolved somewhat of the the past. And understood the impact of his life in the present and then he said I'm going to change I'm going to make I'm going to be intentional. And I'm going to go out and and be different because that future is not 1 that I want to see for myself or for Bob or for Tiny Tim. Overall as as you have the visits from the 3 ghosts um you're reminded that. 21 honor and understand the the origin of your ESOP companyum allow.

[39:51] Leaders and management but also employees take responsibility for your present situationum and then as you said choosing your future intentionally with the information that's. Available to youum todaywell listeners thank you for for being here and for indulging us on our our Christmas Carol Adventure uh and the the ghosts of of ESOP past present and future uh we'd love to hear from you about what you would like to hear from us and so you can't communicate with us at journey to an esop.com uh and we will see you next time uh here on the journey to an ESOP and Beyond podcast thank you thank you.