007 | Utilizing Employee Stock Ownership Program (ESOP) to Maximum Benefit with Brad Ethridge

Ever thought about how successful entrepreneurs prepare for selling or transitioning their businesses? Today, we’re discussing the benefits of selling to an Employee Stock Ownership Plan (ESOP) with podcast host, Patrick Lonergan and seasoned business professional, Brad Ethridge.

Brad Ethridge is well known in the business landscape with a career spanning back to 1985. With experience in individual financial planning, leading international sales and marketing, and launching several successful businesses, including multiple Insurance Marketing Organizations (IMOs), Brad’s entrepreneurial prowess is unparalleled. He is recognized for his expertise in Business Exit Strategies, particularly with a focus on ESOPs. Brad’s dedication lies in structuring ESOPs aggressively in the best interest of the owner.

In this conversation, Patrick and Brad unravel the intricacies of Employee Stock Ownership Plans (ESOPs) and the art of crafting effective exit strategies for business owners.

Key takeaways:

  • Strategic exit options
  • Tax benefits of ESOPs
  • Employee involvement and retention


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Sponsored by Vital Wealth

Music by Cephas

Produced by BrightBell Creative

Research and copywriting by Victoria O’Brien


Episode 007 | Utilizing Employee Stock Ownership Program(ESOP) to Maximum Benefit with Brad Ethridge

Welcome back to the Vital Strategies Podcast. I’m your host Patrick Lonergan and today we’ve got a great conversation looking at the amazing benefits of selling your business to an employee stock ownership plan with Brad Etheridge. Brad brings over 38 years of financial services experience in the area of corporate tax efficiency, asset protection and legacy and business transition planning.
Brad works closely with business owners to define and meet their objectives. Brad is here to dive into the world of employee stock ownership plans, otherwise known as an ESOP, as an effective exit strategy. In this episode, we cover the tax benefits of ESOPs, valuing your business and the perks of involving key employees.
Stick around as we uncover how businesses leverage an employee stock ownership plan. into a competitive advantage in the marketplace because of the tax efficiency that the structure creates. This episode is for any business owner that is considering what the next chapter in their business looks like.
Let’s get started with today’s guest, Brad Ethridge.
Brad, thank you for joining us. I’m excited to get into our discussion today. So I’d like to just hop in and, and have you talk a little bit about an ideal scenario, both from a financial perspective and then long term goals that aren’t financially related in relationship to the entrepreneur and how and how an ESOP can fit into their lives and how that would work out.
Brad Ethridge: Well, that’s a, that’s a lovely softball. You’re lobbying over the net here. So I’ll hit it back nice and slow. So thanks for not starting out with all the tough questions to start with. I mean, in ESOP, for those of you not familiar as an employee stock ownership program, and it’s one of really three legitimate options that a business owner has when they’re looking at, an exit strategy and, you know, we work with business owners and employees and in it spans the spectrum. I mean, from folks that are ready to sell their company as an example or contemplate it, and they just don’t want anything to do with it. They want to get out. They, maybe they don’t have as much of a concern. Of course, they care about the employees, but they just want to be done with it and walk away.
We’re, we’re not a real good candidate for that type of person. More for the person who’s saying, look, let’s give it, let’s give you a great example, and it’ll probably lead into it. You know? If most of the entrepreneurs listening to this podcast are like the ones I’ve worked with for the last 40 years, because that’s basically what I’ve done in my professional career is, is tax advantage strategies in that type of, of structure.
When you, when you’re looking at it, you got a few options and you’re saying, okay, look, I’ve spent the last 20, 30, 40 years building the business. I haven’t given a lot of thought to an exit strategy, because that’s very difficult. It’s also very difficult because you spend most of your time building it.
You know, nobody takes a lot of time to think about what’s that next step. And maybe the kids aren’t going in the business because they went a different direction, or maybe they’re not capable of running the business at the level it needs to be run at. So, you’re looking at me and say, okay, Brad, what are we going to do?
Let’s talk about my options. Well, option one may be. Selling your business, getting it valued, and then selling your business to, you know, private equity or to a competitor, just like in any other sales, pretty much like even selling a house. You know, you’ve got comparables based on your industry. And let’s say that comparable is, you know, five or six times your last year’s EBITDA.
And you look at the number and you say, okay, great. It’s not a bad number. I’m all right with it. A couple of issues that go along with that is a lot of you are going to end up paying a lot of capital gains, especially if you built that business from scratch, based on what state you’re in. Uh, but between capital gains and state and federal, if your state does have that tax, you can lose a third of that value that you built back on everything above your basis.
The other problem with selling to your competitor is there really isn’t any protection for your employees. So, I mean, if. I was one of your competitors, Patrick, and I looked at your business and I had one that was similar, maybe a little bit bigger, or you’re going to make me bigger. I can afford to buy you because of economy of scale.
I mean, I’ve already got my CFO. I’ve got my marketing team. I’m going to eliminate the one that you have because mine’s better or you’d be buying me. So, a lot of those employee issues can be kind of a concern, especially for your long-term employees. I mean, yeah, you can always throw money at them on the way out, but that’s at the end of the day, that’s your money.
The other thing I think a lot of owners don’t think about when they’re selling their business that they really need to think about is, you know, I’m going to end up having to go to work for whoever buys me for two or three years. It’s ultra common and usually required that they want a nice transition from the old leadership to the new and they require a working contract and they usually have that tied into some earnouts or buyouts or potentially some paybacks or clawbacks if the numbers aren’t hit that you said the company was going to hit.
And even if you’re right about your numbers for a couple of years, you got to have some pretty big concerns about the fact that, most of the clients I worked with, they are entrepreneurs, they don’t do real well working for somebody else. And now all of a sudden you’re punching the clock on money you’ve already earned and received.
It just usually doesn’t end very well. Yeah, so no protection for those employees, which is tricky and working for somebody else, which is no fun.
Okay. So, another option. Hey, I’ve got some really good key. People have been with me since day 1 and I’d really like to see them take the company over. So, I’ll sell it to them and over time they can pay me. Well, you’re taking 100% of the financial risk and doing that. Number two, most of those people do not have the money to give you to do the buyout. So when you actually physically sit down and you look at the risk that you would take in doing that and the lack of reward and the amount of time that it would take to pay you off on top of paying them for being owners and they won’t be making much more money because they’re giving it all back to you, they usually get scrapped.
So the third option that may make sense for the right type of business is looking at an ESOP. On employee stock ownership program, where you’re selling over time, the value of the company to the employees. Now, there’s some really big tax advantages and there’s some big financial advantages to the right kind of seller.
What that really requires just to give you the quick thumbnail sketches, you know, you need to have at least 20 eligible employees, because you got to be able to spread those shares out over time to a group of people. The range that we work in at BTA Business Transition is a company valued at $10 million or close to $10 million up to about $600 million.
So, our sweet spot is that $10 to $600 space and that’s where we’ve done a majority of the ESOPs we’ve put in place over the last 15 years. By the way, if you’re wondering where you fall in the company, you can talk to Patrick and you can get numbers on the company. And, you know, we’re, we’re more than happy to sign an NDA and do a quick valuation, uh, you know, without an engagement agreement.
And we do it all the time, because if it’s a good fit, great. We want to show you what the numbers will look like. If it’s not a good fit, we’ll show you what you need to do to change them or where you may want to go to get better numbers. Outside the ESOP arena. So, let’s just assume we’ve got 20 employees and the ESOP might make sense.
Patrick: And I think one thing that may be undervalued and what you’re talking about is just having the life of the entrepreneur, you know, then, then being able to, Continue to be involved in the business. Most of them don’t understand what retirement looks like. You know, like they, they, they’re, they’ve been high energy their entire lives.
And so, you know, when our, when our listeners here like selling, then what am I going to do? Right? Like I almost need to have something else in the queue to, to keep me going. And the thought of being able to continue to be involved in the business, uh, maybe hand off some of the day to day operations to some key people, but to be involved, I think is the, I think the financial aspect of this is really valuable, you know, and I’m, I’m excited about getting into the tax efficiency that you touched on, but really this, this component of like, what does my life look like after the business that I have my, oftentimes a ton of identity tied up in that can be a scary piece.
So I appreciate you bringing up that point.
Brad: Such a key point. I mean, look, if, if we were running a one on one class on what succession strategies look like and what the responsibility of the entrepreneur is to the continuation of the business, the first thing we talk about is, hey, you know, what have you done to build your bench?
Is your bench in a position to be able to take over if you get hit by a bus tomorrow? So those employees have continuation. Well, that all is great if you’re in a classroom, but in real life, you’re scrambling, building the business and now to stop what you’re doing to start doing. And not having the additional finances to do it or the time to do it is very difficult.
So a lot of times with an ESOP, it’s that owner who says, look, I’m kind of interested in what my options are. We’re happy to show those options either through an ESOP or through the other options. And we can run the numbers and show you what the company might be worth under those conditions. But the cool thing about the ESOP is the owner’s DNA is what we refer to.
So, I mean, you built the business or maybe your dad built dad or mom built the business or you took it from scratch and build it up. And the reason it’s successful is you and your DNA is all over that company. And the minute you sell it to a competitor, that DNA gets wiped off the table. And that legacy aspect in the responsibility to the employees goes along with that DNA disappearing.
So even though you may have a profitable venture, that doesn’t mean it’s going be there after you, uh, after you sell out. So, with an ESOP, you’re giving your employees on an annual basis a certain number of shares. And those shares are beneficial interest shares. That’s a really important key point to remember.
If you gave shares to an employee, they’re going to get, W2 on that value of the stock, but they can’t touch the stock. They’re not usually real happy about having less money out of their pockets. I mean, it’s a nice piece of paper. So what an ESOP does is that it generates beneficial interest shares in each year based on when we help the business owner design the best way to give the shares to the employees, it could be based on compensation, could be based on some performance criteria, could be based on longevity with the company. There’s a lot of different ways to slice and dice how those shares are given out, but what we’re looking to do is what’s in the best interest of the company over time. In the best interest of the employees, so these shares, these beneficial interest shares also don’t allow the 5 of your employees to get together over a couple of caffeinated drinks in the break room and vote you out because they have no voting interest or shares.
In fact, the only time that there. Stock or their beneficial interest has value is based on five triggers, and we’ll talk about that a little bit further in the presentation. I mean, this, in essence, Patrick, this is the ultimate retirement plan. And that’s how this is regulated. So, this isn’t anything that’s new.
It’s not anything that requires an opinion letter from a lawyer. It’s black letter IRS law. It’s been around since the fifties. But what was really interesting to me and why I came on board with BTA and became kind of a zealot to the ESOP movement is the fact that, you know, the private equity money is drying up.
It’s not like it was back in 17 and 18. Um, you don’t see as many ridiculous offers against, uh, EBITDA that you used to. So, you know, we always were kind of a pretty girl at the dance, but we, we’ve become, you know, a 10 because not only can we deliver more money than private equity and overtime. But it’s also that very key point that you brought up.
The owner keeps the DNA. The owner continues should they become an ESOP. We’ll talk about the structure. It happens over a 7-10 year period on average. Each year the employees get shares. The owner. The company, the minute it becomes an ESOP, no longer pays state or federal tax. That’s a massive key point.
The company’s profits no longer are taxable and we can use the money that was going to pay those taxes to buy the owner out over time. And once the owner has been paid off, then there’s a second bite of the apple, which is another set of dollars that goes to the owner once all the other funding has been put into place.
So, if I laid it down side by side, and I was looking at a $10 million company as an example, let’s, let’s just do a really kind of a simple math one. Um, I sell my $10 million company to a competitor. I get my $10 million. But it’s $10 million minus brokerage fees, whoever put the deal together. It’s also minus state and federal taxes and capital gains against my million dollar basis.
So, I might have, you know, $6.5, $6.6 million dollars to work with. Then I’ve got to figure out how to create an income. And then you just lay on the bed and help your wife with the jewelry because you don’t have anything else to do for a while. The ESOP is, we’re going to get the money that was going to taxes.
We’re going to get a nice down payment, uh, that will be financed. They get some money in the pocket at closing for the owner. Then the owner is going to take a seller note and receive some interest on that. And eventually receive interest and principal payments over a 7-10 year period, they’ll get their money out.
If you added up the total amount, and I’ll show you an example a little bit later in the presentation, but if the total amount, we’re going to way outperform any of the offers that are on the market. But that owner continues to run that business, continues to earn his or her salary and still continues to earn bonus.
I mean, you can’t do anything ridiculous like go buy your niece, uh, an Escalade. Um, you know, it’s got to follow normal business, but. You’re continuing to run the company in, as you had mentioned earlier, you start to hand off those duties to the second line, help to develop the second line doesn’t mean you’re there eight hour, 80 hours a week, but it means you can start doing that a handoff.
And then, you know, once for 10 years into it, the employees now have the stock, you’ve got 2 times, in most cases, the money that you thought you were going to get for the selling of the business. And then if you want to stay on the board for the rest of your life and keep control of the company.
Patrick: So if you don’t mind, I’d like to step back and just talk through a few things you mentioned there. So, one of the first things is, okay, if I’ve got a, let’s just say the market value is 10 million. Okay. And we’re going to do a 10 million sale to the ESOP. How much down payment is typically coming in in that scenario?
Brad: Okay. Usually it’s, it’s two, two and a half times EBITDA. So, a $10 million company is probably going to have anywhere between two and a half to a three and a half million dollar loan that we’re going to take from a bank.
So let’s stay on that one for a second. Banks love EBITDAs, or the banks love ESOPs. And the reason they love ESOPs is the outrageously low rate of failure. Um, you’ve got the same management team in place. The only difference is the company is no longer paying state or federal tax. So. They’re a good risk.
So, if your bank, as an example, doesn’t understand the strategy, we can explain it to them, but we can put 10 banks to compete for that ESOP loan. So, what happens is we go to the bank and help structure it for you. The company you own borrows the money, not you, but the company, because the company has cash collateral and credit.
They do a five-year note, for two and a half in this case, probably two and a half to three million dollars and banks right now are charging 8% on a five-year note. That’s today’s rate a year ago is, you know, three and a half who knows where it’s going to be in a year from now, but it’s all kind of proportionate to the structure of the deal.
So, what’ll happen is the company becomes the board agrees. We’ve structured everything. We put a trustee in place. Um, we’ll go through the structure. I’ve got a grid. I can show you that might make that a little bit easier, but I like talking through it first, makes more sense to me that way we’ve established the trust.
The company now is no longer paying any state or federal tax. And by the way, I mean, there’s only two for profit companies in the entire US that don’t have to, that are for profit that don’t pay state or federal tax. I mean, one is a credit union, which is why they’re propping up on every corner. And if you think about it, it kind of makes sense.
I mean, credit unions work with a lot of blue-collar workers, provide auto loans, mortgages, that type of thing at favorable rates. And if a, you know, a chase bank doesn’t want you on the corner, they could wipe you out by, you know, taking you out of the market. So the Feds said, we think it was a good move.
The Fed said, look, the credit unions are not subject to state or federal tax. The only other for profit in the US is an ESOP. So it’s the same thing. It’s, it’s going to be something that’s for the long term benefit of the employees, but the nice thing is, uh, is from an employer or an owner’s perspective, you’re not giving up anything.
In fact, you’re going to see you actually do very, very well. If you’re willing to stay engaged through that, uh, selling process.
Patrick: I love it. You know, we, we think the, the tax code is actually designed to. Create incentives, you know, and you just highlighted a couple of them, right? The credit union is incentivized to go take care of the working person.
The ESOP sounds like it’s doing the same thing. Like, hey, let’s, transfer all of this wealth from the owner to the. Employees and let them have, uh, a slice of the pie that they maybe wouldn’t have otherwise.
Brad: So, and I don’t know that, and I don’t, I don’t know the, uh, the political bent of the folks that are listening to this, but they own businesses.
So they’re 1 of the other usually, um, I mean, the Democratics, Democrats love this thing because it’s, you know, it’s giving the power of the company and the wealth back to the working man. So, yay, good, more government intervention, more money for the employees. And the Republicans like it because you did, you did all your sweat equity and all your risk to build the business, and here’s a way for you to get a substantial amount of money out of the business at a very favorable tax rate. Um, everybody wins.
Just to be clear where we are in that relationship, meaning business transition advisors. Is we are all about the getting the top dollar for the owner. I mean, that’s, we clearly represent the owner in this relationship.
So, if we were a real estate, we would be a realtor working for the seller, not for the buyer. Now it’s not that we’re anti employees. It’s just what we’re really, really good at is getting top dollar valuations for the owners on the business themselves on the business itself, and we have to be able to work with the trustee to negotiate those numbers. So it’s a different transaction. I mean, you’ve got a trustee in there because you’re setting up an ESOP trust. The trustee has experience and whatever business that we’re plugging them into. The owner picks the trustee from a list. If they don’t like the trustee, they can get another one, but the trustee’s main responsibility and their legal responsibility is make sure the company is running the best interest of the employees.
Now they’re not on the board. They have no voting rights, but they have a legal fiduciary responsibility to protect the best interests of the employees. So. We have to be able to negotiate with those trustees. The trustees have to come up with their own value of the company. And then we help to negotiate the number that the seller, the trustee, and everybody is in line with, uh, to put the final sale number into place.
And again, now that you’ve heard that looking at the grids, it might make a little bit more sense.
Patrick: And, and I’m going to, this is something you talked about that I, uh, remember from when I saw you speak, uh, I believe it’s maybe code section 5960 that, that allows us to look forward in, in our valuation and try to, you know, when I’m, when I’m thinking about how do we maximize value for the owner?
Cause some of the concern is, Hey, I’m on a good growth trajectory. I don’t want to sell right now. Can you talk a little bit about how that, that would play into, um, when, uh, an owner would decide to execute on an ESOP?
Brad: Well, you’re more than just a pretty face. You’re more than just a pretty face, Patrick, remembering 5960, the tax code. 5960, the tax code, something that’s very unique to ESOPs. Normally, if you’re, if you’re valuing a business, um, from a private equity standpoint or competitor standpoint, it’s a multiple of last year’s EBITDA. So what a company or an investment group is doing is they’re trying to figure out how much of that future growth is going to end up in their pockets and that’s okay.
That’s business. That’s how it’s supposed to work. With an ESOP, when you’re valuing an ESOP, code 5960 says we get to look at the five-year forecast. So if your company is growing, if you’ve got some huge projects in the future, all the better. But if your company is at least on a upward path, you know, um, we get to determine the value.
We will determine the value of the company based on that five-year number, not based on just last year. It really comes important. It’s very important to understand if a company is on a downward spiral, about the only reason the owner might want to consider an ESOP is strictly for the employees, because the ESOP is not going to look as good with a company that’s on the downward spiral.
It’s not going to look great at all because we have to factor that five-year spiral into that number too. So, if your company is going to be stable and have any kind of growth, you can capitalize on where you’re going to be at in five years to determine the value of the company. And at the end of the day, that puts a lot more money in the owner pocket over that 7-10 year period. And I’m again, extremely impressed that you remember tax code 59 60. So good for you.
Patrick: It’s just really good note taking.
Brad: So, uh, yeah, you’re a good note taker. All right. So let’s look a little bit on this grid. We’re going to go through this kind of quick Patrick, but obviously we have your company, the company that’s being sold adoption ESOP.
it has to set up an ESOP trust. So the first thing we’re going to do once it’s all been determined by the board of directors and everybody likes the numbers and everything’s put into place, is we’re going to have the, uh, the business itself take out a loan, and that loan is going to be from, it could be from your local bank, if they understand, sure can be from a list of lenders that we can provide who love ESOPs.
We’re going to borrow a couple on a $10 million company, going to borrow probably $2.5-$3 million. That’s going to be a down payment. That’s going to go directly to the owner. So that’s going to be some cash at closing. So, we establish a, the lender bar, we borrow the money from the bank.
That’s a senior lender goes into the company. The company loans it to the ESOP trust. The ESOP trust then buys $3 million or $2.5 million dollars of stock from the owner. So now you’ve got $3 million of your $10 million in your pocket. And then what we’re going to be doing is set up a seller note on the other $7,000,000 in this case that you’re owed, and you’re going to be able to charge interest on that seller note, meaning the owner.
So you got $3,000,000 up front, you still have your salary, you’re still earning your bonuses, now you’ve got, uh, 7%, roughly on a seller note, you’ve got 7% of $7,000,000 or $490,000 in interest. You continue to get that from day one until the bank loan is paid off because that’s a five-year note. Most of our clients get that bank loan paid off at about three and a half years.
Again, remember the company is no longer paying state or federal tax. So that’s where those dollars are coming from. And then once the bank loans paid off, cause the bank wants to be paid off first, then the, then the seller gets not only the interest on the note, but begins to get principal and interest payments until they’ve received all of the money that’s owed to them on the sale of the business.
Patrick: Yeah.
Brad: So what makes this work so exceptionally well is when you have a, when you have a, a typical financial arrangement that’s put into place, this one’s highly unique because obviously, without even pay state or federal tax, it gives us a lot of extra dollars to work from. And the reason the company doesn’t pay tax also, even in the beginning is that once the company is an ESOP, there’s no question, there is no state or federal to pay. But in the beginning we can eliminate even usually anywhere from six months to 12 months of the prior year’s tax is paid because the money that’s loaned to the company and loaned to the ESOP trust is deductible as an employee benefit to the company.
So that creates a really nice tax credit, uh, in that first year. So the quicker we get it into place, the quicker we can regain. Previously paid taxes. Now we talked a little bit about the employees, which is a big part of what makes an ESOP so fantastic. The employees have beneficial ownership. As we mentioned, they don’t have stock.
Their shares that they receive create some huge retirement accounts for them. It’s on average about seven times more than a 401k with a match. Now, if you’re doing a four, if the owner’s doing a 401k or a profit sharing plan, no problem, you continue to do it. We build it into the modeling. If you don’t want to do it at some point in the future, it can be taken out.
So, this is completely over and above and separate from their, their current retirement plans, five triggers that turn their shares into cash are right here. If they die, their shares that they’ve received to that point, then have to be cashed out. If they become disabled, if they go into retirement, if they get terminated, voluntary or involuntary, and diversification is the last trigger. And that’s just a, an employee that’s been with you over 10 years. Who’s over 55, who just wants to spread some of their, um, retirement risk into another qualified plan. What we do when we’re designing an ESOP is we do a 20 year actuarial study for the owners and say, look, here’s how much you should be setting aside and here’s where it’s going to come from to build that sinking fund, to cover those obligations.
Cause you know, in the first few years, no big deal is very few shares given out it. But as that snowball continues to get bigger, those potential obligations require more and more management. And that’s why you need to have somebody, you know, Patrick, like you and your team managing that, that sinking fund to make sure it’s performing.
Patrick: Yeah. And just a couple of quick questions on that. So would it make sense to have, I’ll say life insurance on key people versus the dollar figure sitting in an account, like, is there decent leverage there and would the same apply with like a disability insurance policy or?
Brad: Yeah, no, it really doesn’t listen.
And, you know, you’re asking me questions that I built most of my financial life on. So, uh, and we don’t, we just be crystal clear. BTA doesn’t sell any products. We don’t broker any products. So, uh, 40 plus years in financial services. It’s that’s a perfect solution. One of the things, a lot of the owners like to use is they’ll use a high cash value, corporate owned life insurance policy on a handful of the key employees, you know, cause unfortunately people do die.
But then if, because, because of the structure, if you know, if in a year or two years from now, you needed to pull back everything that they put set aside for premiums, it’s in the cash value. So, it’s a great holding vehicle. Annuities are decent and, you know, then just typical investment, you know, where, where you’re, where you would invest the dollars on your own.
However, you see to manage that. We make sure there’s enough money set aside in the transaction to be able to cover those long-term expenses. It’s just, you know, you need the discipline to make sure you actually manage it. Makes sense? Qualitative benefits, golden handcuffs. That’s such an old term. I like platinum tethers.
It just sounds better. This is, this is a great way. I mean, look, look how difficult it is today to recruit and retain. If you’ve got a really good employee and there’s such a starving need for really good employees, you’ve got people making ridiculous offers to take them. And take your talent elsewhere.
And unfortunately you get left with the ones that aren’t flight risk, you know, which are the lower, the lower grade employees that you could afford. So, platinum tethers to me is if I was looking to retain, if I was looking to hire in a track, new talent, everybody’s most, everybody has 401ks or safe harbor matches or whatever, they all make it look great for retirement.
But imagine if you had that and you’re saying, and we are employee owned, we are associate owned. This is a company you’re going to have equity in as we grow the company, you’re integral in growing and will be paid for that on top of your salary and bonus and benefits. It’s pretty appealing, right? It’s the same thing.
Somebody goes to recruit one of your people away. You know, the first ask is how much equity am I going to get to go work on that line?
Patrick: Right. Yeah.
Brad: You know, unless it’s another ESOP, it’s not going to happen. So, it does reduce turnover and attrition and recruitment advantages over competitors, greater productivity for the workforce.
Greater productivity for the workforce to me is something I think is just amazing. You know, if you’ve got five guys on a line, as an example, and you know, three of them are working hard and two of them aren’t, unless you have a manager on the floor. Nobody is really pushing those other 2 people to work harder, but when you have 5 owners on the floor, and 1 of them is slacking, you’ve got 4 people managing that person to increase their productivity.
We call it getting everybody to roll the boat, right? In the same direction.
Patrick: I also see like, there’s a, there’s a really good book out there. I believe it’s called The Great Game of Business where they have like an open book management style where everybody can see all the financials because it allows people to make wise decisions on the floor.
Like, oh, hey, I understand when I’m more productive, more efficient, that type of thing, it financially benefits me and the company and everybody else. I assume like open book management works really well with an ESOP type structure. Is that?
Brad: Yes and yes and no. Because, because like everything else, what they don’t understand, they misunderstand, I’m not being offensive in that statement, I hope.
There is no requirement for opening the books because we have owners the same way that the employee owners don’t have voting rights, so they get a statement each year and the statement shows the value of the shares that they’ve received and what the projections are for the near future, and as they see that grow, that becomes part of that management, what a lot of smart ESOP owners will do is they’ll pick two or three key employees, make them the head of the committee, and those people can go back and explain whatever everybody is comfortable explaining about the finances of the company. But there is no, there is no open, um, there’s not to say somebody couldn’t, but there is no requirements to keep your books open on an ESOP.
Patrick: Fantastic. And I don’t know if this is a good spot, but we’re always interested in the tax consequence to the owner. So, let’s say I sell my business for $10 million to the ESOP, where does that leave me from a tax perspective? We already talked about, you know, if I had a million dollars a basis, you know, after the tax, I would, I would end up with six and a half or something along those lines, uh, in a normal structure, where does the number shake out for the ESOP?
Brad: If I took this, this company, I’m going to show you right here. We’ll just use as an example. This is a company we closed in ESOP trust to last year. Obviously we took the name of the company out of it. There’s a few steps that we went through when we’ve gone through, you know, uh, three years of their financials and gone through their balance sheets and came up with a number, and then we went to the ESOP trustee and they came up with a number and then we negotiated.
We ended up with that $37,800,000 was the value of that company. And that’s what the fair market value rounded was. And that’s what we used. And that’s what the owner was going to receive over a period of time, not including the interest or the warrant bonuses at the very end. So, we’ve agreed that the company had the high in the market was the low in the market for that structure of company was $33.5, the high was $42.1 and we landed on a valuation of $37,800,000. What this owner received. Over the, over the period of time, we’re skipping ahead here. Uh, but we can go back to any parts you want, but you asked the question. If we went and sold this, this is what happened over the 10 year period. We picked up in this case, they had a cash down payment from the bank.
That was that senior note of $4 million. They had a seller’s principal note. So, the seller, the owner of the company was charging that interest until they received interest in principal payments in full. So we had a seller note for $33,800,000. The seller note was 4% interest because the bank was only at six a year ago.
You know, it’s up, everything’s up a little higher now. So the seller received $9,066,000 in interest on the notes, $33,800,000 off their seller note, $4,000,000 from the bank for a total of $61,209,000 over nine and a half, in this case, it was a little over 10 and a half years. So, this $37 million company put $61,209 in proceeds or a 10.5 to 1 multiple. Um, I take a 1 multiple any time of the day.
Patrick: And that, that also doesn’t include any of the wages, bonus, that type of thing that the That’s got nothing to do with it.
Brad: That’s 100% correct. It’s got nothing to do with the fact that the seller is still earning the salary and bonuses that they were earning before the transaction.
So, comparing it now, you know, out of fairness Average time value of money, but we’re still talking about $61,209 versus $37 million minus, uh, 30% or about $9 million in capital gains tax that that seller would add to sold. So they would end up with about $21 million versus $61,209 plus their salary component that they earned over the last nine years.
So, you know, under the right conditions and ESOP will put a lot more money in the owner’s pocket. And they still continue to control the company.
Patrick: Yeah. If I look at what rate of return I need to get on my $20 million to end up at $61. Yeah, it’s a pretty tremendous rate and it’s going to be hard to get without putting all of my equity at risk so.
Brad: Absolutely. Now you’d have something we’re going out of order, but I don’t I like this pace. I’m going back to 1 of the things that we need to do is, you know, the owner needs to create that 5 year forecast with their financial team. It’s important that that number has historical relevance. Um, you know, if you come in and say, we’re going to double every year for 5 years.
Yeah. The sub trustee is not going to buy it and you’re not getting any advantages because you have to demonstrate that those numbers are, are, are legitimate. So once that, uh, five-year forecast is put into place, this was one that was done on 2022 through 2032, right? So this one, we ran it all the way through.
And then our CSA evaluators all put together and got together with their CFO and the numbers came down here, but a couple of things I want to point out. So in this case, their EBITDA on that top line for $22 was $6,766,000 a year. And again, it’s, it’s all proportionate, right? So, if we’re at $10 million, we’re sixth of that.
Go down to that first line that says, uh, the second line that’s gold, that says cashflow after debt. And then debt is a percentage of cash flow. This is a really, really critical number. And one of the reasons I went to work with BTA versus anybody else, though BTA is aggressive in creating the highest value delivered to the selling owner.
It’s also very smart. And the reason we didn’t lose any, any ESOP customers during. COVID as an example, and we’ve lost one ESOP customer to financial situation. It was a home builder in 2009, whose revenue went from $555 million a year down to $68 million in 18 months. The owners got their money out of it.
The employees got a piece of it, but the company just couldn’t sustain those levels. And that’s the only one of 546 ESOPs we put into place that ever eventually had to get shut down. So here’s the reason behind that number that you see is debt as a percentage of cashflow, 62.5%. Then take a look at 2023, 46.4%, 39.9%. What those numbers represent is what. We designed to cover all of the operational expense of the company and servicing the debt. So everything it takes to run the business and pay down the debt, we used from 22% to 32%, 59.4%t of the projected revenue to service the debt and, and control the business and pay off the owner and pay off the bank.
That’s really, really critical because stuff does happen like COVID. And if you’re designing and I’ve seen designs that way, where they’re using 80 and 90 percentile of a projected five year number, I think it’s insanity. Yeah. So, we come back in and say, look, we need to make sure there’s a cushion. That’s excess cashflow on debt service.
If we use the client’s numbers for their 10 year projection. We left $34,020,000 on the table that was never used for servicing the debt or the operations of the company.
Patrick: That’s fantastic. Now, can you break down for me just the, in our listeners, like if we get too aggressive on that, can you explain why that’s a problem?
Because I think there’s probably a thought of like, Oh, if I get aggressive on this, it maximizes my value. I also feel like we, we, we talk a lot about like, let’s do the right thing. Let’s act in integrity. You know, like the numbers have to be real for these things to work or they, they tend to fall apart.
Can you explain a little bit about what happens if we, if we try to dial that number up to, you know, a figure that’s just unreasonable.
Brad: It happens, it happens in worlds outside of just ESOP. I mean, I know some private equity, I’ve worked with some private equity guys in the past and, and they had a philosophy.
They’d go to the owner and say, hey, what are you going to do over the next few years? And they’d kick out a number and they’d say, okay, so I think my company’s going to be with $20 million based on that. And the private equity people say, no problem. We’ll give you the full $20 million, but there’s going to be clawbacks.
So, if you don’t hit these bogeys. That money is going to go back to us. I knew a guy who sold his business for $24 million to private equity and ended up with $2 million after clawbacks. So, they knew his numbers were smoke and they didn’t care. They wanted the business, but they also knew they were going to build a contract in a way that they weren’t going to pay for something they weren’t getting.
With an ESOP for us. It’s, it’s a little bit more regulated. I mean, look, we’ll come back in and we’ll look at the numbers and say, if we need, we need to be sold on why the fact those numbers are legit, meaning BTA, we need to be sold on the fact that those numbers are sustainable because we’re the ones that have to negotiate with the trustee and the fiduciary responsibility to be able to buy into the forecast for the financials for the company.
And that’s their job. And these aren’t, these are people they may be doing 30 of these things individually. They’re not just working for one as a trustee, they’re doing 25, 30, or 40 of these, they have rules that they have to follow if the numbers are blown out. Yes. It looks really cool to the owner, but there’s going to be clawbacks.
Patrick: Yep.
Brad: We don’t design these unless it’s a real exception to the rule where it’s like, you know, you have a contract that’s going to blow the numbers out of the water. Yeah, we can get the trustees to agree to that number and we can negotiate. There’s probably going to be a clawback if it’s a ridiculous bump in the numbers.
So from our perspective, what we want to do is we want to get the legitimate five-year, six-year, 10-year numbers. And we want to plug in and make sure we’re leaving ourselves enough room in there. So, there’s something like COVID comes back in, or we have, uh, outrageously high interest rates, or there’s a down dip in the business, we’ve got enough cashflow to be able to cover operations and debt service and still have money on the table.
Now where that’s going to be advantageous to the owner, Patrick, is that we have what’s called a second bite of the apple. It’s called warrants. We design all of our ESOPs with warrants. And those warrants allow you to pick up between another 15-20% percent of what the company is valued 60 days after you’ve received your last payment.
So, if I’ve got a $10 million company today, and it’s just going through normal growth. Companies worth $30 million in 10 years. I’m going to pick up probably between $4-6 million, 60 days after I received my last payment warrants. And the only reason that we can issue warrants and the reason that they’re designed the way they are is the bank is going to tell us what that five-year notice.
So, give you an example. That first couple, 3 million, we borrowed bank rates today as we’re talking, you know, November 10th of 23, five-year notes are about a 8%. That’s about what they’re going for right now. The bank does not want the seller note to charge more interest than they’re charging because they don’t want that drag on the company.
So, they want you to subordinate to their rate. So, if they’re at 8%, they’d like to see you at 7%. Make sense? Yep, three and a half years, four years into it, we’ll have the bank note paid off. The owner continues to get their interest payments on their seller note, which is everything over what the company’s agreed to sell for over and above, over above that down payment that they received at closing.
All right. So in this case, it was $3 million at closing and $7 million seller note. The reason that we can do warrants legally is that, even though the bank’s mandating, you can only charge seven or you have to subordinate to their note. That’s second tier mezzanine financing. And today, as we speak, that’s about 15%, 14-15% is what I’d pay on the street to borrow second tier mezzanine financing, but I’m being told I can’t charge any more than seven.
So, what we do is we multiply what that loss is. We turn it into a share value that’s due at the end of the term. And after all the payments been paid out, that second bite of the apple is the conversion of the value of what you should have been able to charge, but weren’t allowed to because of the bank subordination.
Does that make sense?
Patrick: Yeah, that’s, that’s great. And I, I love that it seems to align incentives doing that, you know, it protects cashflow, the business continues to grow, the owner gets to participate in that, that additional growth. That’s fantastic.
Brad: Well, here, look at the warrant. The warrant value on that $37.8 company was another $12,991,000. And by the way, that’s due in full, not in stock. That’s due in full 60 days after the last payment is received by the owner. So, after they’ve received their debt and their interest payments, 60 days after that, the company has to come up with $12,991,000. Now, if the owner wants to, okay. The owner could say, look, I’m willing to take that over a couple of years.
If the owner doesn’t want to do that, they certainly don’t have to in the company now has no debt. So they certainly could be a borrow, they’re now a $30 million company. They could borrow the money to pay the note.
Patrick: Yeah. And so Brad, you said something earlier that I I’m also taking from previous conversations we’ve had around.
How this could work for, I’ll say a younger entrepreneur. I just look at the tax efficiency of the ESOP. And when I think about that from a competitive landscape, how that, that could allow a business to really accelerate their growth.
Brad: I’m so glad you brought that up. This is one of my favorite things in the world. I’m really glad you remembered to bring that up. When I used to listen to ESOP explanations, Patrick, it was always about exit strategies and succession planning and all that and retirement or the owners selling for the owners. I have more recently, especially over the last couple of years, have been doing more transactions around younger owners who want to substantially grow their business and have an advantage.
So, I’ll give you an example. I had one last year who was a paving company and the paving, the paving company, the guys 51 years old. He’s not going anywhere for the next 15 years. He loves what he’s doing, but he wanted to really grow that business for his own additional wealth as well as that of the employees.
So, because he became an ESOP, he no longer has to pay state or federal tax. So, the question is, is when he’s competing on a bid, can he bid less than his competitors who have to pay state and federal tax and still be profitable on the transaction?
Patrick: Absolutely.
Brad: So, his thought, his thought process was I’m going to dominate the free world and not only was he aggressively going to be outbidding his competition, he wanted to acquire his competition because the minute he rolled that smaller company into his, it goes underneath his tax exempt umbrella.
His plan was to have his warrant values. be worth more than his original selling price to the ESOP trust. So, if you substantially grow the business, you will be compensated for that. So, if you blow your numbers out that you had on your five or 10 year That 20% can be it could be considerably more than 20% because it’s based on the end value of the transaction Substantial, substantial amount of money for somebody who’s looking to grow it.
So I’m really glad you brought that up Yeah, it’s it’s a great acquisition Or a local market domination strategy.
Patrick: Wonderful. So I’m going to give you a quick summary of things we’ve talked about so far. So it sounds like in the right scenario, the ESOP will get significantly more dollars to the owner than if they sold it outright, paid the tax.
There’s also the benefit of, I have as an owner, I, my identity is tied up in this business and I can, uh. I can continue to be involved. I can continue to invest in my people. I can continue to have, we’ll just say purpose. And then there’s the last thing that we just talked about. Like, there’s an opportunity to accelerate growth because of the tax efficiency there in the right scenario.
Can you, can you talk about why this isn’t necessarily a fit for everybody, like what are the, I’ll say some of the downsides of ESOP and why wouldn’t somebody, you know, apply this from my perspective, everything we’ve talked about so far, it’s like, no, no, we, we all need to go get an EBITDA you know, we got, uh, even a three, four or $5 million and 20 employees.
Like I probably ESOP, but, uh, can you, can you walk through maybe why that wouldn’t be a great fit?
Brad: Yeah, I mean, smaller size, less than 20, less, 15, less than 15 employees. We’re going to call it, we call it 20, but smaller company could do it with 15 or 16 employees. There has to legally be enough folks to be able to share those share values out over time.
So, you know, they’ve got five, I had a very close financial client of mine for years and years and years and wanted to go ESOP and is 140 million company. Um, clothing manufacturing. I never knew he only had seven employees. I, there’s nothing I can, there’s nothing you do. What you could do is you’d go out and hire about 50 employees and still pay less than taxes, and if you sold it to your competitor, but that didn’t seem to make a lot of sense to him.
So yeah, you’ve got to have, you’ve got to have 20, you have to own the business for at least three years. Right. So you can’t use this as, uh, you can’t go buy a business tomorrow and make it an ESOP. So there needs to be a timeframe from the owner in there. If you’re less than, you know, if you’re less than let’s, let’s call it $8 or $9 million, just economy of scale, the expenses makes it tricky.
So here’s the example. If I’m doing $100 million company in valuation, we’re going to charge about three quarters of a point. That’s our fees. That’s how we get paid. Yep. Um, if we’re doing a 10 million company, it’s going to be probably closer to three and a half. We know what we need to net when we do a transaction, right?
And that’s, that’s our fees. So that pays by the way, that also pays for the legal fees for the trustee and the trustees, legal fees as well as ours. The only thing that doesn’t pay for, it doesn’t pay for your, the owners. Feed a review everything before you pull the trigger. So, it’s kind of an all inclusive in three and a half isn’t bad.
When you consider, if you go to business brokerage, you, you probably end up paying more than that to sell the business. And then you’re going to end up paying capital gains.
Patrick: Well, and you bring up an interesting point. Almost. We have, we have a lot of different strategies we execute on that have costs to set them up. But when we take a look at the cost to set it up, and if we just pretend it’s all the setup cost or the tax, we just consider it all tax, right? 3.5% is cheaper than 20%. Like my simple brain can go, that’s a lot cheaper than capital gains tax. And if we set it up properly, it sounds like we can, we can go a long way to avoiding a lot of that tax.
Brad: So, one of my favorite terms I’ve used in the last 30 years of educating financial advisors and wealth tax strategies. You don’t want your clients to be involuntary philanthropists. Exactly. You know, if you’re, if you’re just paying, if you’re just paying the number that shows up, it’s like, you know, if you’re just paying that number that shows up every year, you’re an involuntary philanthropist.
You can control those dollars. And if you think you can do better. Controlling that money than the U S government can, there’s ways to do that. So, in this case, the government loves ESOPs for all the reasons that we discussed. So, there’s some huge tax advantages that you don’t have in any other, like I said, there’s only two businesses and we’re certainly not accrediting it.
Patrick: Yeah, this is great. So, we talk about four different levels of tax strategy. Okay. And I’m going to outline those real quick and you can help me understand where ESOP fits. I think I’ve got a decent idea. But level one is the IRS gives us guidance, but it doesn’t take any investment. Okay. So, this is good administration and bookkeeping.
Good example would be, making the S selection. So I’m not paying so much payroll tax, right? QBI deduction, pay myself the appropriate wage, whatnot. Level two is the IRS gives us guidance, but it takes financial investment. Now this is going to be. 401k plan, that type of thing.
Level three is the IRS may not like it, right? Because they’ve been abused in the past, but they’re permitted. So, you have to do them properly. Okay. A good example of that is like captive insurance. Those have been abused. If you need a captive insurance company, find somebody that’s administered one and has a sterling track record and then what is it?
Brad: What’s the form? 8882. Is that the prophylactic form that the IRS requires? If you want them to know that, you know, you’re doing something they don’t like. Yeah, you don’t have any 8882. Right?
Patrick: Yeah, good. And then level four is tax fraud. And the reason we bring up tax fraud is there strategies out there that people are on Pitching is legitimate, like these different trust structures and people can just abuse.
We’ll call like, from my perspective, putting your kids on payroll and not having them do legitimate work is tax fraud. Like stop doing that, you know, there’s, there’s enough opportunities we can take advantage of, that are legal and legitimate. So out of those four different categories, where do you see ESOP fitting into?
Brad: We’re black letter IRS law. I mean, this, there is no opinion I don’t, you know, to me, anything that requires an opinion letter means there’s a strong possibility IRS hates it. It’s like anything else. You can take all the deductions in the world until you can’t. Right. So, in things can change 5 or 6 years down the road.
This is regulated by the IRS and the Department of Labor. I mean, this isn’t something that started 2 years ago that, hey, let’s figure out how to make this even better than it is. My biggest fear in explaining an ESOP transaction. I mean, it’s complicated, but my biggest fear is that, parts of it look too good to be true.
Well, it’s not, it’s not too good to be true. Part of what makes it work is that owner’s commitment to transitioning that business out over time and having that desire to provide that guarantee that their DNA stays in the business and their employees are taken care of over a longer period of time. So, when you’re asking about who this is not for, it’s not for the, for the, the business owner seller is I just want to get my money and get out tomorrow.
If that’s the case. Take a private equity, roll it up, get your best offer. You know, God be with you. That’s fine. And there’s nothing wrong with that. There’s nothing moral or unethical about that. You built the business, you can do what you want with it. But if you have a desire to receive the money on the most tax efficient basis, you want to provide some guidance and protection for the employees.
You want to control its legacy and protect the legacy and what you build over your life’s blood. It’s pretty good, pretty darn good way to do it. And I don’t know of a better way. And I spent most of my life looking for better ways. And you know, this one was already in front of us and the government loves them.
Patrick: So very good, Brad, is there anything else before we wrap up that we should talk about in relationship to ESOP that we haven’t discovered yet?
Brad: Yeah, that’s an excellent question. I mean, Part of the Patrick that, I mean, I’ve spent my life working with financial advisors, planners, CPAs, tax attorneys. I mean, that’s who my business was built on.
They paid us retainers to be able to provide education strategies. And 1 thing I’ve learned is that a strategy is as good as their ability to execute service and maintain, which is why it’s really important to have somebody like you and your team because look, we, we build the framework. We build the structure.
We bring the bodies together. We negotiate. But at the end of the day, we’re not there 24/7 after the transaction. You are. So, I am very selective and have my opportunity to work with just about anybody I want to in the industry because we have a really cool tool and very few people explain it as well as we do, and even fewer executed as well as we do.
So, we get to kind of pick and choose who we want to have in our sandbox. Who we know is going to do a good job for representing us as well as the clients. And, and I know your team and I speak highly of your team and, uh, we did our due diligence before you and I, you and I ever had our conversations.
And I think that’s, I think that’s really important. And you know, by the way, I also commend you because you’re bringing ideas and concepts instead of product solutions to your clients. Uh, and that’s the, that’s the marquee of a, of a strong provider of, of financial guidance. So, I congratulate you on that.
Patrick: Thank you very much, Brad. That’s very kind. And I think we think the same thing of your business, you know, uh, business transition advisors does a great job. We, like we talked about, we love advisors that. Have been there, done that the fact that you have over 450 transactions and we have to look back to a home builder in the middle of the housing crisis to find the last one that’s fallen apart is, is a beautiful thing it, uh, we, we hate putting things together and then having to help take them apart later, and, you guys have a wonderful track record. So, thank you for that.
Brad: Appreciate the good work. Hey, thanks for having me on board and I look forward to talking soon.
Patrick: Thank you for listening to the Vital Strategies Podcast for the links to the resources mentioned in today’s show. See the show notes of this episode at vital strategies.com/episode7 , follow the vital strategies podcast, wherever you listen to podcasts, and don’t forget to rate and review the show, letting us know how these tips are helping you pay less tax and build more wealth.
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