EP12 - Step-by-Step Guide to an ESOP Transaction

In this episode, Jason and Makenzie walk listeners through the step-by-step process of an ESOP transaction, breaking down what can often feel like a complex and overwhelming journey into a clear, approachable roadmap. They cover common questions business owners often ask at the start of the process, including: How do I know if my company is a good fit for an ESOP? and who should be involved? From evaluating readiness to understanding the key players involved, Jason and Makenzie share practical insights on who to engage first, what steps to expect, and how to navigate the early stages of exploring employee ownership with confidence.

Transcript

[0:11] Hi everyone welcome back to another episode of journey to an esop and beyond, i am your co-host today mckenzie worth and i'm jason miller and today we will we will be discussing, mostly how what it looks like to go step by step in an esop transaction we've spent a lot of time over the last few weeks discussing owner preparedness which will will continue over our our series over the next um nine months for the trans foundations of transition however if you kind of put yourself in the position where okay you feel prepared now you feel ready to move forward with an esop or maybe you're ready to move forward to start speaking with an advisor or getting more information on what that means for your company. We're going to walk through that step by step. And I'm going to ask Jason some questions that he's not aware of yet. It's going to be fun. What that looks like.

[1:28] So I kind of want to start with before just before diving into what the transaction process looks like. Starting with an example client, kind of like we all we deal with pretty often clients come to us and just have initial questions on ESOPs in general. So. If a client came to you and, you know, they've they've listened to our podcast, they have an idea, a basic understanding of ESOPs. Their main question, or maybe first question would be, is my company even a fit? What would you say, Jason, kind of rules companies in or out of an ESOP off the bat, if there's anything? That's a loaded question, Mackenzie.

[2:18] I can give you a time limit on your answer. Yes, that would be great. We can do the time limited one. You know, what I would say to an owner asking that question, what I normally say to owners asking that question or other providers of different services that work with us that, you know, have a client that's thinking about an ESOP, is really for the individual, What have they thought about what the company looks like after the proposed transition? So they've gotten far enough in your example of, I want to consider an ESOP. What's the quick and dirty on us being eligible for an ESOP? What are the things that we should look out for?

[3:11] And so I'll try to limit my answer to just that, understanding that don't take it as an absolute if the qualities of an ESOP are things that you desire. And then all kinds of different constraints after that. But on the surface, an ESOP itself is a 100% debt-financed leveraged transaction, meaning that you as an owner are exchanging the value of your equity for a debt instrument of an equal amount. So in that, there are already some constraints. And the way that people boil that down is you have to have some mass to your EBITDA, which is what all debt structures relate to in a couple of different ways, both leverage and the ability to cover debt payments that are incremental to how your company is operating. So that's the first one.

[4:16] And is there a hard and fast rule in that? So there's obviously a relationship between the value and then how that value gets monetized for you in the debt instrument, which leads to amortizations and rates and preferences on how quickly you want to get repaid for the value of your company. And that bears more investigation than, hey, it's got to be $2 million of EBITDA or $1 million of EBITDA or $5 million of EBITDA. But there does have to be some mass there you can't have a break even um and and have that be the same afterward uh and so that that's where i would start with that the the other i'm going to pause it real quick would you would you throw out an average even a number that is kind of a, Maybe a general rule of thumb or something we see most often is what works. I would say seven figures is a really good starting place. So a million or more. And a million could be tight depending on the value or, again, how quickly you want to get repaid.

[5:35] And I think another question related to, I guess, something that's quantifiable is number of employees. I feel like that's a big question we get is, is my company too small from an employee perspective? What are your thoughts on that? Yes. That was my next thought in that. Because the other constraints related to how an ESOP gets established do have guardrails that are derived from payroll.

[6:18] Your employee base matters and then what they get paid how they how much they get paid and how many of them there are all factor into that and so are there scenarios where there are small numbers of employees that allow for an ESOP to work the answer is it could be but we we do like to see, again, if we're going for really quick, hard and fast rules in a lot of ways, 25 or more, 20-ish, depending again on the size of the company. So the smaller the value of the company and the smaller number of employees that it would require in order to make all the mechanics work.

[7:06] I think that's consistent with what we see.

[7:12] Kind of branching off of that, are there any traits or, yeah, I guess traits of companies that people perceive as being a red flag or kind of like, oh, I can't become an ESOP because of this, where that's just not the case or it's like a, it's a myth. Is there any kind of trait or situation you can think of where we can kind of debunk any myths where people think that they can't become an ESOP because of XYZ? That's a really good way of putting that question. What came to mind is most of your sitcoms that are around having terrible workplaces. And they can't wait to get out, but they can't because the story that follows their life forces them to show up to work every day in order to make things happen.

[8:12] The softer side or the qualitative side of a company does matter. If there's really high turnover, if things are really seasonal, if there's no reason for employees to stay around for a long time, then it's going to create a lot of churn and there's not really going to be a benefit or there's potential for there not to be a benefit. So those are some of the things that I would answer as red flags. Is there anything that you would add to that?

[8:51] Um, I guess in terms of debunking myths or people may think, oh, my company is too volatile. For example, I guess I'm thinking of construction contractors where maybe they have a hard time projecting the future. Or obviously there's good years and there's bad years, which there are in every company, but in some industries it's more specific to that industry rather than it being due to macroeconomic factors. And I think if a company has that perception that, oh, I'm too volatile to sell to an ESOP, that can be something that is not necessarily true in order to kind of qualify for an ESOP. That's a great point.

[9:43] I'm sorry, I cut you off. No, no, no, no, that was it. Oh, and that's why I keep kind of defaulting back to the word investigate. And if the alignment of what you think an ESOP would bring to your company makes sense, then these are questions that you should ask to us, hopefully to us or to your advisors related to the ESOP transaction. What came to mind as you were talking with that is maybe you have a great workplace and employee turnover has been either an issue or a concern.

[10:27] Many clients look to an ESOP to create a reason for people to stay longer, and it does create a reason for people to stay longer. And the employee retention within an ESOP company is greater than that of those that don't have ESOPs objectively. And that's one of those qualities that it brings in a way that bears out numerically, but you can't put on a spreadsheet and say, here's a guarantee that this is how this is going to play out for you. It gives you as leadership and then your management team the ability to say to frontline workers, here's another reason for you to show up to work tomorrow and next week and next month and next year and next decade. Right.

[11:18] All right. So we've knocked that out. Is my company even a fit? So now they're ready to get started. And there's always multiple parties involved, whether that's an advisor, a CPA, an attorney. And maybe if you are not in tune with our podcast or you're just kind of Googling about ESOPs, there may be the results you get may be pointing you to different places and people to start with the process. What would you say is the best place to start in terms of with who and what? Yeah.

[12:04] I'm going to get shot for one of my answers. I have two answers to that one. Just remind me about the second answer. So the first one is I would encourage you to start with your most trusted advisor. For some people, that's your CPA. For some people, that's your financial advisor. For some people, that's your attorney. Start with whoever it is that's not going to give you the answer that you want to hear, but that's going to encourage you to investigate the answers that you need to make a decision that's best for you. And I always think about ESOPs in this, because it touches so many different facets of industry. And like you mentioned, all these different disciplines and then different people and companies. And I think about it like a carousel, like it doesn't matter where you get on and then which horse or carriage that you're going to be riding in, you're going for the same ride. And there's a lot of people and there are a lot of places to choose to start to get on and it's going to rotate around, right? But you're going to go for the ride.

[13:13] And I think that's very true in this scenario. Which advisor should you start with? And how do we investigate? And the real answer is find the answers that are meaningful to you that encourage you to stay on the path until you know you want to continue or you need to branch off and do something different.

[13:36] The really short, my second answer, the one that I'll get shot for is competition is healthy for clients. Okay. And don't, unless it's us, right? Don't pick the first one that you talk to. But wherever you start, again, with your most trusted advisor on this journey, when you go to interview or go to take the next step, choose someone who will help you through the process. You know, we say quarterbacking the process, ESOP advisory, sell side advisory, however it gets communicated to you and choose the right partner. And how are you going to know that you're going to choose the right partner?

[14:23] You'll get a feel for the way that different organizations operate. You'll get a feel for if they're going to speak to all of those things that you said are important to you along the way. And demonstrate that they can execute. And that's another way of making sure you have the right team because they're going to influence who else comes on board throughout your ESOP journey. And one other part of that, in addition to the fact that, again, competition helps you see differently and it's only good for you as a client. Uh the the next element in in that is um man I lost my train of thought where was I going with that Mackenzie this happens to me far too frequently recently um I guess I was thinking about where I was gonna branch off what you were speaking I just think that's a really good point in that don't go with the first person you speak to. And as advisors.

[15:37] As us as advisors, I think, of course, selfishly, we hope we're selected and we hope we get to work with you. But it is so true that you should essentially interview many advisors to understand the different processes that are run, how they run their process, the type of communication you're going to get, even just like personality mesh. Because to your point, that does influence who else comes along in the process because you're relying on these people to bring you the other players that you need for assembling the team. I remember. Thank you for where I was heading with that. The comfort listener that you'll have in this is likely this will be your only ESOP transaction or it will be one of a couple if you do a partial versus a full and all the things that we can get into on other calls.

[16:30] You don't have to second guess yourself on could it have been better, could it have been a different experience, and just know that when you make the choice, you're not going to know the difference whether it was a bad choice between one advisor or the other, even though you could have a great or a negative experience with it. That goes back to why are you going through it, what really is happening throughout the process. How could it feel differently? What's going to make one advisor different from another? And which of those things are most important to us to select? At the end, you have one transaction. It's the only ESOP transaction you'll go through. Or again, one of a couple very strategic reasons to do that. But you'll get where you need to go.

[17:20] So once you find that advisor that you're looking for and knowing that the process can vary, a little bit from each advisor generally where do where do advisors like to start, um everyone needs to know how to approach the the process for for the esop and what i mean by that is expectations always get set in the beginning.

[17:54] The goal is to transition your ownership to that of a trust that represents your employees or set up for the benefit of your employees. And there has to be a value ascribed to the stock of your company. And you should, in the beginning, have an indication of what you expect to receive for that in the negotiation with the trustee and the buy side team later. So it's a great place to start. What's my company worth? And then the next step logically is how then do I get that? And then who becomes part of the team? What are my expectations? And I think it's important for our listeners because I think We sometimes hear this from clients or maybe they don't fully understand it until we get past feasibility, but I mean, ideally they should understand it from the get-go, but when we're looking at valuation...

[18:59] We want to be sure that the client understands that the value we're calculating is not us telling them what they're going to get in the transaction. They have to understand that there is a buy side team that is coming up with their own value. So really what we're doing is setting their expectation for what they can receive in the transaction, as you said. But it's not guaranteed. There still is a negotiation process like any other transaction.

[19:30] I say about many things in business that, uh, the, the client advisor relationship is 90% managing expectations. And then it's 9% education and then 1% a combination of hard work and luck. And it may be a little skewed um but that that helps with uh alignment and room for error and not error as in hey someone really messed up here uh but there's to your point there's there's probability uh and how if something were to go in a different direction than we expected um how much of a hard line do we want to take on that? And how do we evaluate that in the greater context? So the under promise over deliver mentality kind of covers that, but there should be in the beginning stages, very, very clear expectations of not just what do we think we can help you achieve in this transaction, but how confident are we that we can support it objectively if there's a difference of opinion between the sell side and the buy side.

[20:54] So kind of going out of order here, just to an aside, real quick, I wanted to point out something you mentioned. You said only 9% is education. And I think that is something that's interesting but important to touch on because with ESOPs, they're obviously super complex, very nuanced. There's so many, if this, then that, different scenarios. There's so many things that you can learn and understand about ESOPs and going through the process you're having to absorb all of that but to your point that's only a small percentage of the process because most of it kind of falls on your advisor which is kind of the point of having an advisor you need to trust them that they know what they're talking about and that they are looking out for you. And even though you may not understand everything that you're learning and maybe you want to be fully educated, um, you have to trust your advisor.

[22:01] Well, would you add anything to that? Or what are your, what are your thoughts on that? I love, I love that. Um, as you were talking, what came to mind for me is the, the, where you landed in trusting your advisor. And then listeners, you're going to be like, well, how do I know I can trust the advisor? And I need to know that they know everything that they should in order to advise me in accordance with not just my expectations, but my desires within the transaction. And then be honest about that throughout. What I would advise is you don't need to know everything before you move.

[22:49] And one of the things that you're trusting your advisory team with is that, first, when you ask a question, they will give you an answer and a complete answer that satisfies what's underneath of whatever is prompting the question because you're entitled to those answers. The second part of that is trusting them to educate you in sequence.

[23:16] You do have to have enough concrete information to make a decision and then you need enough to make the next decision and you need to trust your advisory team that that you have everything that you you should need to to make that in accordance again with with your expectation and your desires, And if you don't get how it ties into something in the future, or you had a question, or chat told you something, or you're doing your own Googling, which you should, and then you ask that question, don't make the decision until the advisor can tie it together and say, here's how, this will pan out in the future and why this is something that is in the next step or three steps down the road. And we're not behind. We're not making an irrevocable decision today that impacts this negatively tomorrow or next year or 10 years from now. It's just not important for this decision to be made to keep moving through the process. But you are entitled to complete answers that tie through your curiosity at this stage to get you comfortable with making the next right decision that your advisor is recommending. Right.

[24:33] So tying that back into you know after valuation and that that naturally leads to feasibility, being able to move forward with not knowing everything what is kind of the i don't want to say bare minimum but the at minimum decisions that have to be made and understood you have to understand what you're deciding on um what are those decisions in in the feasibility phase, And maybe these aren't your final decision, but at least kind of you have an idea where you're heading. So we have the number from valuation team is confident that that's that's what our targets are. That's what we're going to move toward in feasibility. It's how does that translate to to dollars and cents per person, per stakeholder. And that's company and sharehold selling shareholders and employees what is this gonna look like for everybody if this is what we do and that could be very eye-opening.

[25:44] This is the kind of trade-off season of, does it, if I wanted to be 100% ESOP company and do all of it at once, can I?

[25:56] And when I see that number and how it's structured, is that palatable to me as a selling shareholder? Is it reasonable for the company and does it provide the benefit to the employee? And this is where everything shifts. And if you think about like a sound engineering board with all the different, I'm not a sound person, just in my head, like all the little things that move up and down to get the right sound. And that's what you're calibrating for in feasibility. and it should be a very interactive process because you are going to have so many different questions and you are listening for what sounds right. The inputs aren't bass and the percussion and all the different elements of music, but it does create a symphony. And that's what you're targeting as your advisor calibrates that soundboard to go, okay, bank or no? All seller financing, some. Partial or whole? What percentage? And then of that percentage, how much bank, how much seller? Warrants or no? Is it even possible in a partial?

[27:20] What interest rates? Over what period of time? How long should the inside note be based on the things that we know with the compliance things that we talked about earlier?

[27:34] 1042 or not, C Corp, S Corp, what's it look like to the company if we revoke to do the C? What does it look like for us? How does our state impact that? So many questions. And when you're Googling at this stage, hey, what are my options for an ESOP? What are all these tax advantages? is this is really the stage where those should get demonstrated to you. And you are listening and your advisor should help you calibrate all of those until you hear the right note. And then that's when you know, this makes sense. Now we can move forward with this because I have confidence that the company can do it, that it makes sense for selling shareholders, and it's going to be a meaningful benefit. it. And when we play with, you'd mentioned volatility earlier. What if we have like a terrible year and this doesn't, what's a terrible year to you? Let's throw that in and then see what would happen under the structure. And then you get to tell us whether or not you can live with that. And we get to tell you that the company can or can't or how it's going to feel. Yeah, I think the feasibility stage is very telling. And also that, that sound that you're kind of the analogy you're you're making here, that sound can be completely different than the sound that the owner thought they were going to hear.

[28:58] It may kind of flip your decisions, or maybe going into feasibility, you were kind of set on doing 100% ESOP, but then you see how things are now. And you're like, maybe I want to do a partial. or maybe you were set on getting bank financing and then you realize well I can take this all back with the seller note and still get paid out in x amount years so I think it's it's a very telling process and for our listeners for all the all the decisions that Jason laid out there which, as it sounds it's a lot of decisions if some of those topics sound sound foreign or you're you're confused or whatever, just know we have a podcast, at least on all of them for you to understand more. All right. We're past feasibility. Now we're ready to really move forward with the transaction. The next step typically is assembling the deal team so let's hit on who are the the players involved who is the buy side team and what does the process of assembling them look like.

[30:11] Your buyer is is a trust and that trust is going to be represented by a trustee not just any trustee. I mean, technically it could, but you're making a fiduciary choice as the current owner of the stock. And then on behalf of your employees, your choice is choosing who's going to represent that trust to negotiate against you.

[30:40] And that process should follow diligence and it should contain trustees that have done ESOP transactions before, are familiar with the process agreements and the rest of how an ESOP gets formed, that have their own relationships with the support that they need as a buyer. And you get to participate and choose who that representative is going to be. And then they get to choose who's going to support them on their team in order to assemble the dynamic tension that's required for an arm's length transaction. Normally, your advisor will set up a series of interviews with qualified ESOP trustees, transactional trustees. And then through that interview process, you will select who's going to represent the trust and its negotiations and purchase of your shares.

[31:51] And so aside from hiring the trustee, who else from, well, I guess that's by side, but is there anyone else on the sell side that comes in the picture for this process? You're going to need someone who's familiar with ERISA law. And so a good ERISA attorney with a specialization or experience with ESOPs is going to be your concurrent step with this in assembling the rest of your team.

[32:22] I'm not going to get shot twice in the same day, so I'll reserve a comment around that. But yes, on the sell side team, you're going to want legal counsel for the generation of the documents, the creation of the plan, and then all the things that are required to get your intention behind how the benefit will be established, all done in compliance with ERISA. Mm-hmm.

[32:45] And so we've selected the trustee to represent the buyer, protect her on behalf of the employees. Who all does the trustee hire for their, for the buy side team? Well, when you have an attorney on one side, you need an attorney on the other side. Um, so, uh, the, the trustee will, will hire a legal counsel. Um, and then the trustee will hire an independent. It's so funny. The industry calls it independent financial advisor, their evaluation firm. That's doing the valuation work to provide the trustee with the range of value that they determine is fair market value so that they can negotiate within that range. and then that's what becomes documented as part of the transaction. Everybody operated inside the right parameters and that can be proven. But they do provide the financial advice to the trustee on that range and the terms of the deal as it gets negotiated, that at the end of how everything gets assembled together, that it's going to work based on all the information that was shared and given and assumed. Mm-hmm.

[34:02] So throughout that process of them determining the value and providing the advice to the trustee, what can the selling shareholders expect from that due diligence process?

[34:20] Um, not too much pain. It's not, it's not that painful. Uh, and I, I, I, you hear me say this all the time, but the process is really rather friendly in comparison. Um, each side does have to do it. It's, it's fair bit of due diligence. It's a legal structure. It's a legal transfer of property. Uh, there's the retirement plan element of the ESOP that are the mechanics, how the benefit of the trust gets to the employees or to its beneficiaries.

[34:51] And so the history of the company, its financials, its legal status, the shareholders and their particular rights, any other parties that have rights or claims to property or are in relationships with the seller. So for your construction company, think about your surety. Uh, for any company that has outside capital, think about your bank, um, think about your landlord if you're renting space, right? So there's, there are a lot of relationships, uh, that affect the financial wherewithal of the company or are part of the capital consideration. And all of that, uh, documentation is going to be filtered through due diligence, um, And will be examined. The intent behind the examination is discovery for awareness is the way that I'll phrase it. And then curiosity to the extent that it could be material or meaningful. Mm hmm. It is not discovery for the intent to negotiate the price down, down, down, so that the financial benefit favors the buyer more than the seller.

[36:19] And it's a subtle difference between what could transpire in a different type of transaction because the buyer and a financial buyer is looking for a financial return and every time that they could get a better price on the front end then there's less risk to their ability to generate that return in their period of time afterwards and so the feeling of the diligence process is different, but the functionality is the same. Is there anything here that we as a buyer need to be concerned about that's going to alter what we're perceiving the value to be? And if so, we need to address it. And if not, then we've done our diligence and we've accepted that that's going to fall within our range to negotiate with. Right. So as you said, definitely a lot of similarities with any other transaction, but still some differences as well. And probably everyone's favorite in the fact that it's a little friendlier. Yes so when there is bank financing involved at what stage does that.

[37:40] Get tied in? And could there be different stages that that gets tied in? And does the trustee have any role in that?

[37:54] Brave asking me a bank question.

[37:58] This one, I might have to cap you. That's fine. I'll be really brief. You phrased it in a great way. So the first thing I can answer is that the trustee doesn't doesn't really get a say in who you select as the vendor. Where there could be contention or conflict in that is if the financial advisor, the valuation firm to the trustee says that the terms of this debt are not reasonable or feasible. I haven't seen that happen, thankfully, knock on would. That's the only place where these terms need to be a little different because in order to achieve this value or this payback, but I haven't seen that at all. Just something I think could be there. Where do you start? Always recommend starting with your incumbent during the discovery phase. And what I mean discovery in that is valuation and feasibility. You don't know what to take to the bank until you have a number and you say, whatever, it's going to be $100 million. My company's worth that. That's what we think we're targeting. We want to see what it is that you're willing to participate with us if we want bank financing. So if we've chosen that we want to do bank financing, it should bear out in feasibility because that should get structured in all of those decisions on that soundboard. This is what the bank can offer.

[39:25] I'm just going to pause you. That's regardless of whether you want the funds from the bank at closing or after closing. Yes. Great distinction. You don't have to close with bank financing. Sorry, bankers.

[39:45] At the same time that the ESOP closes, it could happen afterward. It could happen immediately afterward, or you could stagger the timelines if it's going to be a drain on resources or time, or you could just kind of get a feel for how things happen after the transaction. And then know that you have capacity to get bank lending a year out, two years out. If you change your mind and everyone's comfortable with the change, it's already coming to your financials because of the transaction. Great point.

[40:15] All right. Now we've gotten to the closing of the transaction. First, I want to touch on how long can a selling shareholder expect this entire process to take till you get to the closing, and then what does the closing look like? Uh, we, we say typically it's, it's three months if everyone is doing, if that's the intent, it could be as, as quickly as three months post feasibility, because you don't know until you know what you're, you're dealing with, um, the structure of the deal until you structure the deal on paper. Um, it could be as quickly as three months. Uh, again, sorry, bankers, uh, if there's funding involved, lining up the funding at the same time is likely or could likely extend that period, or it's going to compress the amount of additional lift on each team in the timeframe. Can you do it faster, sooner?

[41:15] Possibly. Can it take longer? If you like. And I think listeners, you've heard from us before about how crucial it is for us to communicate that you've got agency in this entire process all the way through. And you shouldn't feel rushed or pressured if you don't have all the information required to make the next right decision for you. And if that requires holding off or something material happens in your business or in your life personally, take take a beat or two or ten whatever is required don't don't let the inertia of the transaction lead you to complete it if things have changed that require a different thought process or create different circumstances um i don't think there would i mean there are obviously worse things. But in light of an ESOP transaction, completing something that may not be what you need it to be because of those events is likely worse than just delaying until the air clears on whatever's occurred. Right.

[42:30] So that final day, the closing day, a bunch of documents get signed, everyone's together on a call, likely, or there's often many calls or weekly calls leading up to that closing date. Is that kind of it? And then it's just an ESOP. You are now an ESOP. That's kind of it. I think it's somewhat more anticlimactic now than it would have been 20 years ago, where people likely were in a room with documents, with pens. Now it's Adobe Sign or DocuSign or whatever we're all using these days in all of our various places, which is very convenient. And after everything is, again, negotiated and walked through and agreed to and then documented and then signed, then typically there's a signature release. And all the shareholders, all those documents are held until they authorize the release of those signatures. And then the ESOP is born.

[43:45] Right so we've we've discussed the entire transaction process from starting with it might even a good fit in the discovery phase which we're kind of referring to as valuation and feasibility and then moving along through the actual process of assembling the buy side team, um and during the the due diligence process going through negotiations and then and then finally closing. We may have set ourself up here for a future episode of what happens next, which we definitely have episodes out there on that. Even just last week's, we kind of touched on once you are an ESOP, what does that look like from frontline management's perspective? What are the kind of responsibilities there? So we can, we have, we have room to expand on, on what happens next as, as there's always more to discuss with Aesop. So if you liked today's episode, um, feel free to share with a friend, like subscribe, interact with us at journey to an Aesop.com. Let us know what you would like to hear. If there's anything you want us to dive deeper on, if there's a certain episode you want us to point you to, um, don't hesitate to reach out. And as always, thank you for listening.