Tax Advantages of an ESOP Exit Strategy

Tax Advantages of an ESOP Exit Strategy

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Today’s guest is Dan Zugell. Dan is the ESOP guy. Dan works for Business Transition Advisors and has been doing ESOPs for 19 years. The reason I wanted to have Dan on the show is because there are a lot of different messages about ESOPs out there. I wanted to get the full ESOP 101. Dan explains law changes, previous failures, how to value the business, payouts, finance structure and more. He totally demystifies the process including what life is like before and after ESOPs.

In This Episode You’ll Learn:

  • Dan shares how he got involved working with ESOPs by accident. He was helping a business owner exit and discovered that ESOPs were a great way to exit. He ended up starting and running the ESOP department at MetLife.
  • Employee Stock Ownership Plan is a qualified retirement plan. The primary investment is the stock of the company. There are a lot of tax benefits for everyone involved. Employees get shares with no out of pocket costs.
  • Good candidates for ESOPs need a company worth 5 million or more with 20 or more employees and about a million in payroll.
  • They are also an excellent vehicle for passing a business from one generation to another.
  • Dan shares concerns that may rise when looking into ESOPs, and how they are an internal sale with no outside buyer or influence.
  • Tax advantages include deferred capital gains tax, the company gets to write off the sale over a period of years, the company becomes an S Corporation and the profits aren’t taxed by federal or state bodies, and estate planning advantages.
  • The ESOP borrows money from a bank and buys the company stock. The company uses the tax savings to make ESOP contributions that pay off the loan.
  • Dan’s company takes the ESOPs to the banks. Financing is a combination of a bank loan and the seller taking back a portion of the note at market rate interest.
  • What life is like before and after an ESOP. The company owner can still sit on the board and run the company after establishing the ESOP. They even get board fees, salaries, and perks, but they can’t take money out of the company for personal use.  
  • How to pick a trustee and how they ask for the financials.  
  • The importance of preparing for liability and paying employees when they retire by making sure the company knows their numbers and plans properly.
  • Share allocation. The shares are given out over time. An example would be 5 shares a year over 30 years.


  1. The amount of control you have over the process of an ESOP with the structure and financing enables you to reverse engineer your goals into the actual structure.  
  2. You still have control over running the business after a properly structured ESOP sale.
  3. The tax advantages and the four tax strategies that Dan laid out are an opportunity to maximize tax situations.


Links and Resources:

Business Transition Advisors

Daniel Zugell on LinkedIn


About Dan Zugell:

Dan is Senior Vice President of the national consulting firm, Business Transition Advisors, Inc. (BTA) and oversees the Central U.S division. BTA is a nationally recognized firm dedicated to assisting owners of closely held businesses with their business succession and liquidity planning with nationally recognized expertise in the education, design and implementation of Employee Stock Ownership Plans (ESOPs).

Dan joined BTA with experiences spanning many financial service disciplines including investments, insurance, fee-based financial planning, executive benefits and ESOP implementation and repurchase liability financing as Regional Director-Central U.S. for MetLife Group’s Institutional Specialized Benefit Resources and Guardian Insurance Company. Previously, Dan held several positions with General American/MetLife where as Executive Director of Sales, managed the largest financial producer group relationships and oversaw the implementation of complex cases and strategic marketing concepts and sales initiatives.

Dan had risen to a nationally recognized thought leader in numerous aspects of ESOP related topics with special expertise in forecasting and managing the corporate repurchase liability inherent to privately held ESOP companies while Executive Director of GenAmerica’s and MetLife’s ESOP Departments. While the head of MetLife’s ESOP Department, he designed, implemented and successfully marketed innovative financing methods to address the legal and fiduciary obligation to “buy back” stock from exiting plan participants.

Dan continues to be a sought after speaker and author throughout the country including numerous local and national financial, legal and accounting industry meetings and symposiums (SFSP, FPA, EPC, NAIFA, CLE, CPE). Dan and BTA are also frequent speakers and consultants to the some of the nation’s largest insurance companies, broker dealers, banks and insurance producer groups. Dan has authored pieces in numerous publications including the prestigious Journal of Financial Service Professionals with his article titled “Executive Benefits for ESOP-Owned S Corporations” and Wealth Counsel Magazine as well as being quoted in TD Ameritrade’s Institutional Advisor Solutions and Employee Benefit Advisor magazines and others.

Dan holds a B.A. from Grove City College and has earned advanced financial designations from The American College including Chartered Financial Consultant, Chartered Life Underwriter and Life Underwriter Training Council Fellow. Dan and BTA are also proud Industry Partners of Forum 400. Dan is Past President of the Society of Financial Service Professionals-Pittsburgh Chapter, Past-Chair of the Pittsburgh Business Ethics Awards, Member: National Association of Estate Planners, The ESOP Association, The National Center for Employee Ownership, Ambassador/Strategic Planner for the Pennsylvania Center for Employee Ownership and Northway Christian Community Church.

Full Transcription:

Ryan:               Welcome to Life After Business podcast, where I bring you all the information you need to exit your company and explore what life can be like on the other side. This is Ryan Tansom, your host, and I hope you enjoy this episode.

Welcome back to the Life After Business podcast. Today’s guest name is Dan Zugell. Dan is the ESOP guy. We had the SPA guy on, and now we’ve got the ESOP guy. Dan works for Business Transition Advisors and has been doing ESOPs for 19 years.

The reason I wanted to have Dan on is because we have talked about ESOPs in some previous episodes. We’ve had Nina Hale on, who described her ESOP journey. But I wanted to start back and actually get the full one-on-one of ESOPs because I think there’s a lot of different messages out there about ESOPs and when it’s right. You hear a lot of bad horror stories about ESOPs that have failed, and Dan does a really good job at explaining what has changed and some laws that might have impacted some of the previous failures.

But we wanted to totally demystify ESOPs, understanding how you value the business, how the payment structures are paid out with a combination of bank financing and seller financing. We talked about what life was like before an ESOP and then also what it’s like afterwards, and whether your perks change – your control changes or not – and then what kind of employee structure – divesting structure looks like with the shares. Really just top down of what it looks like in order to accomplish an ESOP.

He talks about the four tax strategies and tax benefits that an ESOP just knocks out of the park. I can tell you what – it is amazing really having him clarify because of the tax advantages of this. The stories and the complications that come with an ESOP. The potential return on investment is like something I’ve never seen before.

Dan’s got a ton of credibility because he started at MetLife, built up their ESOP Division, and then worked on switching over to Business Transition Advisors and has been doing that for 8 years with them. If you’ve ever had any thought about whether an ESOP was right for you, or you want to know a bunch more, we get a little technical and we went a little long, but I really hope that this gets you the information that you need to start to visualize if whether this is something that makes sense for you or not. Without further ado, I hope you enjoy the episode with Dan.

This episode of Life After Business is sponsored by the Value Advantage. The Value Advantage is a platform delivered via peer groups and/or one-on-one to help you build a valuable company that can thrive without you, while putting an exit plan in place so you have the option to sell when you want to who you want for how much you want. You’re able to manage the business by the numbers, work in the business as much or as little as you want, and you fully understand how the business impacts your personal financials. If you wanna know more, check out the show notes or the website.

Good afternoon, Dan. How are you doing?

Dan:                 I’m fine. Thank you.

Ryan:               Looking forward to having you on the show. We have had a couple other episodes in the past about ESOPs, a story that Nina gave about her exit to an ESOP, and a couple other brief ones that I think the topic is one that we should really dive into, and that’s why I was excited when I met you at the BEI Exit Planning Summit because of your experience and how many transactions you’ve done. You challenged my thought process in a couple of things, so now that you’re here, can you just maybe start at the beginning with – how did you get into the ESOP world and started working for Business Transition Advisors?

Dan:                 Certainly. Thanks for having me. I do appreciate it. I started doing ESOPs about 19 years ago – kind of by accident. I worked for an insurance company, and we had business owners, who were looking to exit and looking for different methods of doing so. Somebody came to us and said, “Have you heard of this thing called an ESOP?” We said, “What is that?” Then we did some research on it and said, “Well, heck. This is a really, really great way for a business owner to potentially exit their business. Very tax advantaged, and it helps with family transitions. Just a lot of positive aspects to it, and we should explore it more.”

We ended up making a whole department, and that insurance company was MetLife. I ran the ESOP Department for MetLife for many years for the purpose of helping our clients with an exit strategy that perhaps they have not heard about that might be – net the most after-tax dollars in their pocket. An ESOP can provide the most after-tax dollars of any other method, and so at MetLife, we took that and ran with that because not a lot of folks were talking about it. Therefore we created quite a niche, and I’ve been doing it ever since, for a total of 19 years.

Ryan:               Is Business Transition Advisors part of MetLife then?

Dan:                 No. The Business Transition Advisors is the firm that MetLife outsourced the actual heavy lifting to.

Ryan:               How long have you been at Business Transition Advisors then?

Dan:                 About 8 years. The owners of Business Transition Advisors said, “Hey! You’ve been working inside of MetLife for many years with the high-end advisors there, but there’s a lot of folks out there that could use your advice on where an ESOP makes sense, what are the tax advantages, and how does it work with families. Why don’t you come work for us? You can spread the gospel many different ways as opposed to just through one particular company.”

I jumped at the chance, and I loved it ever since.

Ryan:               You’ve got so much experience. Even on your website – all the deals that you guys have done. I want to tap into that experience today, just having this, let’s cover all the different pieces of it as much as we can, without getting too far down one technical rabbit hole or another. But why don’t we just – let’s start at the beginning. What is an ESOP? Can you give us a brief overview?

Dan:                 I definitely will do that. I think any overview should not be technical to the point, where you’re talking about every tax change since ERISA was formed in 1974, which is a lot of ESOP presentations that I hear. I like to keep it more practical. Where does it fit? What type companies does it fit? What are the tax advantages? What’s the practical aspects of it that you don’t read in a textbook? That’s what I thought we could cover today, if that’s okay with you.

Ryan:               Yeah. I think it’s a good – the reason I wanted to have that because you hear there’s so many good things about it, but then I think there’s so much bad gossip around it from failed ESOPs that business owners have a lot of fear around it. There’s a lot of ambiguity, so I think, yeah, to your point, let’s go over the practical fits and everything. Yeah, I’ll just let you kick it off, going what is the main structure of ESOP and the general concept.

Dan:                 Right. Let’s do that. I like to start with – I believe Vince Lombardi said, “Gentlemen, this is a football.” I like to say, “Ladies and gentlemen, this is an ESOP.” The reason I do it that way is people confuse ESOPs with stock options. ESOP stands for Employee Stock Ownership Plan, not stock options that the Chairman of GE gets $10 million of stock options next year. An ESOP (employee stock ownership plan) actually means something to the Department of Labor, the IRS, and the financial professionals around the country.

An ESOP is a qualified retirement plan, Ryan. It’s like a 401K, like a profit-sharing plan. It’s literally covered under the same code section as 401Ks, profit sharing plans, and pensions plans. The big difference is an ESOP has one primary investment, and that’s the stock of the sponsoring company; whereas a 401K, another type of qualified retirement plans – they get money, they get deferrals, they get matches, and they go out and reinvest and help other company raise capital – IBM, Ford, whatever the mutual fund companies purchased – you’re helping them with their capital needs. An ESOP was designed to help the selling shareholder with their capital needs, namely an exit strategy and a purchaser of stock.

But being a retirement plan, there’s some pros and cons there. A retirement plan has rules and regulations. As we know, the Department of Labor oversees retirement plans because it’s for the benefit of the employees. We have to follow discrimination rules, testing rules, contribution limits, things of that sort. That’s where somebody like myself comes in. We make sure we cross those t’s and dot those i’s, but the flipside is because it’s qualified retirement plan, there is a lot of tax benefits to the selling shareholder, the company, and the employees that come along with doing an ESOP through this qualified plan.

The reason the government encourages this – they do. In fact, people say, “Boy. Dan, you talk about all these tax advantages (that I’m gonna go through in a minute). Why does the government allow this? When are they gonna close these loopholes?”

My answer is, “They don’t consider these loopholes at all. They encourage ESOPs.” As I mentioned, a qualified plan is a plan that’s designed for the benefit of the employees. If the ESOP, the qualified plan, buys stock of the company, and the shares are allocated to the rank and file and the workers and the employees of that company, the shares of the company are ending up in the hands of the folks that are helping to build this company. You can see where perhaps one political party might like the term “redistribution of wealth” – employees are getting shares through no out-of-pocket cost of their own in the company in which they work. That serves a social purpose.

The government says, “Hey. The more people that have independent wealth at the company in which they work,” in theory, that’s less they’re gonna have people on the government safety net later on. So one party really liked that. The other party really like the idea of, “Heck. I agree with the social policy there – more people with independent wealth and taking care of themselves, so we’re willing to give incredible tax breaks in order to accomplish this goal.”

Both parties have come together in a real kumbaya moment, Ryan, to promote ESOPs. In fact, there’s pending legislation to even promote and give even more tax advantages to ESOP companies to encourage them to do ESOPs. They’re not looking to close any loopholes; they’re actually looking to increase the availability and the participation in employee on plans.

Ryan:               I love it. I wanna hear more about those potential benefits that are coming down the road, but before – because I think the taxes is something that everybody wants to dive right into, but before we’re gonna get into that, let’s tee it up to – who are ideal candidates? Are there employee thresholds, valuation thresholds? Who is a good candidate? Because I think there’s probably two different ways to answer this – the financial avenue, but also there’s cultural things too – that I wanna maybe tackle both of those.

Dan:                 No, that’s a good point. It’s a good time to bring this up, before we delve into some of the other issues. Well, from just a fact pattern standpoint, the size and shape of a company. Typically, we need a company worth about $5 million of value or more, which equates to maybe a $1 million of net earnings, or for those financially sophisticated, a million of EBIDA. About a million of net earnings equals about 5 million dollar-company on an average. About 20 or more employees and about a million of payroll.

The reason I say that is when we talk about the pros and cons of ESOPs, people say, “Well, I hear ESOPs are expensive and complicated.”

I say, “Yeah. They are.” That’s why we need a threshold of about $5 million of value and payroll numbers and cashflow to be able to make the ESOP work, but when you get to those thresholds, generally the benefits far outweigh the costs of doing it in the first place. That’s kind of the threshold. That’s uniform. That’s not just me and my firm. That’s across the ESOP industry. It’s about the level there.

But when you say, “What does an ESOP company look like? Who looks at an ESOP?” Well, I have a generic example I’ve used for many years. I call it Joe’s and Mary’s Cement Company. Joe and Mary have had the cement company that they started 35-40 years ago with a wheelbarrow and a bag of Quikrete. They paid off the wheelbarrow, bought a truck, bought their building, paid off their building, bought a competitor or two, bought some additional buildings, bought additional competitors, put their kids through college, put a few bucks in their retirement plan.

Lo and behold, 30 or 40 years later, Joe and Mary have a nice business worth $10, $20, $30 million. The vast majority of their net worth is tied up in this business. Their kid maybe just graduated college, or maybe is thinking about getting into the business. Or forget the kid. Maybe it’s key managers they have working there, that have been beside them for a long time, and now a rub comes, the key managers or the children says, “I want the business.”

Mom and Pop say, “I can’t afford to give it to you. You can buy it.” But the kid’s and key manager say, “I’d like the business, but I don’t have any money. I can’t afford to buy it. The bank’s not gonna loan me what I need to buy this,” so we’re kind of stuck. Where do we go?

Well, that’s where an ESOP may really come into play. An ESOP’s an excellent vehicle to facilitate the transfer of power and management from one generation to another, yet providing the senior generation with the cash and the cashflow they need for a successful retirement. That’s where we see a lot of our initial inquiries come from – are situations like that, but that is by far, not the only scenario. But that’s a very common scenario that we see, Ryan.

Ryan:               That was us in our previous business. I think most internet marketer entrepreneurs – just whether it’s Joe and Mary – I mean, I think that transfers into almost any scenarios that I run through. I like this story. Let’s take Joe and Mary. How do you – let’s walk through the process and then figure out the benefits that they would actually have, having structured this. What are the questions that they start asking? How does the process begin?

Dan:                 Right. The first couple of questions – we’re gonna get questions of “What’s my value? How much do I get for an ESOP? If I let the ESOP buy my shares, am I getting more or less than somebody else from the outside? What happens to my favorite employees and my kid that works in the business? Are they out of work? What happens to my employees? Are they gonna take my patent and shut down my plant and fire my workers that have been here for 30 years? Is my picture on the front entryway – is that gonna be taken down and Acme company logo put there instead?”

These are the kind of questions I hear every day, when we’re talking about ESOP or other methods of selling a business. Where an ESOP comes into play, obviously, I’m painting a picture here. An ESOP is an internal sale, and so owners generally like it and say, “Look, I can still stick around, even if I sell more than 51% of my company. I can still be Chair, CEO, President of the company for as long as I want – still take salary and benefits. I just happened to sell some of the equity – or even all of my equity, but I don’t have an outside buyer. I don’t have outside influences that says, ‘We’re gonna wear ties on Fridays now.’”

Maybe the receptionist who’s been there for 30 years – getting a 4% raise every year, even in down years – generally that person, with an outside sale, they’re gonna be replaced with somebody that work for half the amount. I don’t think Junior’s car lease is gonna be renewed either, quite frankly, because people buy businesses – they like to trim costs, especially ones they can replace with maybe something more market driven and disregard the culture and the fabric in that community that this company has developed.

Moreover, many times, the business owner doesn’t want to sell their business to some outside buyer. By the way, the ESOP’s not necessarily a low bidder. Generally ESOP’s one of the highest prices you’re gonna get for the business, except for some strategic sales. But that owner doesn’t want to show up to church in this small town, where he and she were the largest employer – show up on Sunday in the brand-new Cadillac, and they’re looking at the faces of all those employees that just got laid off because the new employer just laid off the whole manufacturing division and shipped the manufacturing to some other town or another state altogether. Kind of that concern about the family feeling and the fabric of that communication and donating to the Qantas Club and having their company name on the t-shirts of the little league team. That stuff really matters, and ESOPs can really solve those kind of issues.

Ryan:               I love it. I think the biggest concern a lot of people have is the legacy. It’s the legacy of – like you just said – paying your receptionist above market rate because they’re a family friend. That’s why a lot of these entrepreneurs and – it’s so intertwined to your life. How do you accomplish all of that while getting the highest bid? Let’s dive into the valuation. How can your company afford to put that, and how does that work for the financial structure in order to be able to get the highest bid but yet accomplish all that stuff that they’ve built for years?

Dan:                 Well, this might be a good time to backtrack a little bit. Let me go through the four tax advantages.

Ryan:               Yeah.

Dan:                 Then we can layer on a typical transaction. Does that work?

Ryan:               Yeah, I love it.

Dan:                 Okay. The four major tax advantages. I’m not gonna get into the specific details of what type of entity – C Corp, S Corp, whatnot. We can delve into that later if we want to, but for purposes of right now, there are four major tax advantages.

One is – this is the oldest ESOP tax benefit. It says if a business owner sells their business to their own company’s ESOP – remember, it’s a retirement plan – so they sell their business to their own retirement plan. The seller can indefinitely defer and even eliminate the capital gains taxes that are normally due on a sale of a business. They potentially cannot pay capital gains tax on the sale. It’s one of the few scenarios in the tax code that allow this.

One is – people may be familiar with the 1031 real estate exchange. You have an old family piece of property by the river. You sell it. You buy a new piece of property. You don’t have to recognize and pay a tax on that gain. You take your basis of the old property by the river, which is practically zero, and you transfer it to this new property we just bought for $2 million. Now this $2 million property still has a zero basis, but you didn’t have to recognize a gain on it. 1035’s a provision on life insurance. We had an old policy. A better one came along. You sell it and buy a new one. You don’t have to recognize a gain on maybe any cash value increase that may have been generated. Well, that’s 1031, 1035.

1042 is the tax code which is basically the same thing, but only for ESOPs, that says, if you sell your stock to an ESOP, you can defer the capital gains. There’s ways you can eliminate the capital gains taxes altogether. That’s the first big tax advantage and the oldest tax advantage of an ESOP.

Ryan:               Before we go into the other three, Dan, it’s because you’re doing a stock sale, right? Because we’ve talked a lot about asset and stock sales on the show, but it’s because when you’re selling to an ESOP, it is a stock sale, which is why there is – capital gains is the biggest concern, correct?

Dan:                 Right. Even if you pay the capital gains tax in an ESOP sale, you are getting capital gains tax treatment because it is a stock sale. An asset sale, as you probably discussed, could be a combination of – recapture it – it might be some combination of ordinary income and stock sale. Then we have the issues of liability and why you want a stock sale versus an asset sale. But even beyond that – even though an ESOP would be taxed as capital gains, which is a preferable way of being taxed, ESOPs take it a step further. It says you may not even have to pay that on the sale. Maybe never.

Ryan:               It’s a big deal.

Dan:                 Joe and Mary may have started this business, like I said, with a wheelbarrow and bag of Quikrete. Their basis is $25 in this business. They sell it for $20 million. Normally you have to pay capital gains on the difference between $20 million and $25. In an ESOP, potentially, all that gain – basically $25 million could go to Joe and Mary capital gains tax-free, if structured properly. I don’t know of any other way of selling a business that gets you that tax saving.

Ryan:               I don’t either. Let’s go into the – what’s the second one then?

Dan:                 Second tax advantage is if Joe and Mary sell $25 million of stock to the ESOP, they potentially don’t pay capital gains on the sale, but also the company would get at least a $25 million income tax deduction for that sale. Joe and Mary get $25 million. The company gets to write off $25 million to lower their taxable income, and thus lower their taxes by the tax they would have paid on $25 million. Big deduction.

Ryan:               Yes. How long can you deduct that? Is there a certain schedule that they go for?

Dan:                 There is. We’re getting into some technicalities, but it’s over a period of years. The company will ultimately deduct the entire sales price. Maybe over a 20-year period. Annual – they get a big old deduction, and over time, it will equal and generally exceed the sale price. That’s a nice big deduction you get.

But with that being said, the third tax advantage is kind of the big one these days. This has changed about 18 years ago – about a little after I started in the ESOP business, where when S corporations were allowed to get involved in ESOPs. The third tax advantage is this: to the extent you’re an ESOP-owned company – and the trend is going 100% ESOP-owned company – you become an S corporation. And therefore because it’s a flow-through entity, to the extent you’re an ESOP-owned company (say, 100%), the profits of the company are now no longer subject to federal or state income tax on any level.

I said, the profits of the company – I’m gonna repeat that, because people don’t believe me sometimes. If you’re a 100% ESOP-owned S corporation, the profits of the company aren’t taxed ever again by a federal or state body, to any individual – the ESOP nor the company. Nobody’s paying tax on the profits. We’re literally driving 35%, 45%, 50%, depending on the state, additional cash flow to the bottom line of the company that they’re not –

Ryan:               You throw those no taxes and the deduction on top of each other. The amount of room in your cash flow goes through the roof.

Dan:                 Yeah. The interesting thing is there – I was just gonna say – you kind of alluded to it. If that third tax advantage of not paying an income tax is true, it makes that second tax advantage of the deduction irrelevant.

Ryan:               Oh yeah.

Dan:                 Even though you might have a $25 million deduction, it doesn’t matter because you’re not paying tax anyway. As great as that advantage is, it’s irrelevant if number three is true, and you’re…

Ryan:               That’s only for the 100%. Do you have to have 100% sale to the ESOP in order to get that?

Dan:                 To be 100% tax free. If you’re less than 100% – you’re at 50% ESOP, then that number two deduction, the second tax advantage, is still very valuable.

Ryan:               Yeah.

Dan:                 Even though only half the business is taxable, we’re gonna drive down that taxable income because we get that huge deduction. If you’re less 100%, that deduction still is very, very important. But if you’re 100%, which is the trend – we talk about trends here. This is the current ESOP presentation. About 75% of all new ESOPs are going 100% so they could be 100% tax-free. It’s just – cashflow’s a lot better.

Ryan:               Because what’s happening is the government is just taxing the employees as they retire and take the distribution, so it’s just like a normal retirement plan.

Dan:                 That’s right. When the employees leave, die, retire, become disabled, they have a stock balance. They say, “Look, I have 73 shares of Joe’s cement company. I have a balance of $72,000.” The company has a legal liability and legal responsibility to buy back those shares, when the employees leave, so the employees get the value of those shares. The company has to buy back those shares. The employees get that value. Then they generally roll that into an individual IRA because it’s qualified plan money, just like a 401K.

They roll it in IRA, and then when they use that money when they retire and they tap into that IRA, then it is taxable to them just like an IRA money would be. But they’re paying tax on something they were given, so yes, they are paying tax. They’re the only people who are paying tax here, but it’s on a huge gift that they were given. Most people believe it’s a fair tradeoff, and typically for the employees, Ryan – the employee’s retirement benefit, when an ESOP is in place, is generally two-and-a-half to three times the retirement benefit per employee than a 401K plan alone.

Ryan:               Wow. That’s a huge number.

Dan:                 Right. I didn’t say that very clearly. When you add an ESOP to a 401K plan – you have both in place – the average employee gets two-and-a-half to three times greater retirement benefit than a 401K alone.

Ryan:               Yeah. We can go over – I wanna go into the employees and the liquidation in a little bit, but let’s wrap the four. What’s the fourth tax advantage?

Dan:                 I’m gonna defer the fourth until we get to it later, but some very significant estate tax planning opportunities. It’s a great time to do personal estate planning for the selling shareholder when they do an ESOP, and it won’t make sense now, but when we get into that part later, I will remind us of number four (will still be an open topic) and we’ll touch on it then.

Ryan:               Okay. Perfect. Then let’s go into – how is this structured then? If the business owner is selling to the ESOP, how is it actually structured? What kind of notes are – who’s paying the seller the actual money?

Dan:                 Here’s how it works. We’ll just run through Joe and Mary here. Joe and Mary have this business. They create an ESOP. They have an additional retirement plan. They keep the 401K. They add another retirement plan called an ESOP. The ESOP goes out and usually borrows some money from a bank. It borrows as much as they can from the bank, and the bank lends the ESOP money. The ESOP takes the money they borrowed and buys the stock from Joe and Mary.

I didn’t say that very clearly. Let me repeat that. The ESOP borrows money from a bank. The ESOP now has money. It uses that money to buy Joe and Mary’s stock. The company now uses the tax savings that we were talking about before, which is we’re not paying tax anymore. We use all the tax savings we generated, and the company makes contributions to its ESOP, its retirement plan every year. The retirement plan says, “Thanks. What do I do with this? Oh, I know, I’m gonna pay off the bank loan that I took out to buy Joe and Mary’s stock.”

Every year, the company uses some of the tax savings that it’s generating that year, contributes it to its retirement plan. That’s why you get a deduction, because it’s a corporate contribution to a retirement plan. The retirement plan gets the money and says, “I gotta pay off the loan.” It takes the contribution it got and pays off the loan it incurred to buy out Joe and Mary in the first place. That just continues until the loan’s paid.

Ryan:               I love it because there’s so many tax advantages there. The ESOP, being an entity – how does it go find a bank? What kind of banks specialize in lending to ESOPs? Is there a certain – because I’ve gone through bank bidding processes and stuff like that. How do you find the bank in order to do this?

Dan:                 My company’s role – our role in the whole process is just to assist with the education, do the cashflow feasibility analysis – things of that sort, but then when we decide to do an ESOP, we help and assist with the financing. We write a financing memorandum and take it to banks.

Now we will take it to banks and get letters of interest. Some of the known national banks that we have relationships in – believe it or not, behind the scenes, there’s a lot of ESOP departments in all the major banks. We’ll go to those folks. I’ll tell you. A lot of the local banks and regional banks – they don’t wanna lose a customer, so they’re more than willing often to take a look at it and offer some lending on a local or regional level. They are out there. There’s no lack of ESOP lenders out there. In fact, it’s a good loan to them.

Speaking of the financing, can I take that another step? Unless you have another question, Ryan?

Ryan:               Let’s dive in.

Dan:                 Because in my example, you might have heard me hesitating a little bit because I didn’t know how I wanted to address it. But if we’re buying 100% of Joe and Mary’s business, many people listening to this might say, “Yeah, but there’s not a bank in the world that’s gonna lend 100% of the value of Joe and Mary’s business.” They’re not gonna lend all of it. They’re gonna lend maybe 30%, 40%, or 50% of the value of the business – maybe a couple multiples of their earnings basically, so that leaves a gap.

Now, because we’re not paying income tax anymore, we have virtually all the cash flow we need to finance 100% sale. The problem is the bank’s not lending us all we need, so what do we do? It’s short ball. What do we do?

Well, typically what we do is we say to the seller, “Hey look, Seller. The bank lent 40% or 50%. Why don’t you take an installment note for anything above – for the remaining 50%? We’re gonna pay you so much a year for the next 10 years.” We have a combination of a big upfront payment from whatever the bank lends at 4% or 4.5%, and then the seller takes back a note for maybe 10 years – subordinate note behind the bank and gets periodic payments until they’re paid off 100% of the sale price.

Yeah, people are saying, “Heck! I’m on the hook then.” Well, in a way, because you still have a seller note. That’s true. If the company has some financial problems, and they owe you money, there might be a delay or may not even get it in a certain year. That rarely happens in the plans we do.

Ryan:               Yeah, but it’s the same thing with any kind of internal management transition, or even if you’re to sell to your kids anyways, you’re still carrying a lot of risk.

Dan:                 That’s exactly right. That’s exactly right, but there is some good news. If we did this podcast, Ryan, six years ago, I would have said to the listeners, “Hey look. The bank’s charging 4.5%. You’re taking a seller note. You’re entitled to market rate of interest. The bank’s charging 4%, while your market rate’s 4%.” We’d go happily on our way. We do 100% sale, be tax-free. The bank would get 4%, and the seller would get 4%.

But in the last four or five or six years, people started saying, “Wait a minute. Is that really market rate?” If the seller is sitting behind the bank and people are scratching their heads, “Well, what would another lender – what would a mezzanine lender or private equity – if they were coming in here and they were subordinate to a bank, maybe interest only, until the bank’s repaid. They don’t get paid until the bank gets paid off. Would they charge 4%?” Heck no!

Ryan:               No way.

Dan:                 [inaudible 0:31:23] charge 8%, 10%, 12%. To take that risk, they deserve that rate of return. Why the heck shouldn’t Joe and Mary get that same market rate of interest? Finally, 4, 5, 6 years ago, all the courts and the Department of Labor and IRS said, “Yeah. They’re taking the same risk as that secondary lender would. They deserve the same market rate of return.” Therefore Joe and Mary can get a total rate of return 8%, 10%, 12% in some scenarios, should they want to.

Now, there are some problems with that. The problem is the bank hates it. The bank doesn’t like anybody making more interest than they do. Sorry, bankers listening to this. They don’t. Second of all, the seller – that interest portion – remember the principal portion – may be taxable as capital gains or may not be taxable at all, depending if we structure it upfront. That was the first tax advantage – was potentially you’re not paying any capital gains at all on the principal.

However, if you’re taking 8% interest or even 4% interest, the interest portion is gonna be taxable no matter what, at ordinary income rates, because it’s not the principal you’re selling – you’re getting money. That’s the interest you’re getting. That’s taxable ordinary income. If you’re getting 12% interest on half the company, that’s a lot of taxable income. It’s gonna bump you up in your personal rates.

You’re probably gonna lose almost half of that to ordinary income tax, so the modern method, which my firm specializes in, as well as other top planners out there – this is right down Main Street – will say to the seller, “Look. You could take 8%, 10%, 12%, but how about this? Let’s do something different. Why don’t you take 4% like the bank? We’re gonna lower your current taxation. The bank’s happier, and we’re helping the cashflow of the company because they’re not paying 8%, 10%, 12% out the door. They’re only paying 4%.” But the seller should be rewarded for taking 4% instead of 8% or 10% or 12%.

What we do is we say, “Look Sir. Take 4%. Lower your tax rate. But because you did that, we’re gonna reward you with a payment in kind. We’re gonna give you something else.” Often it’s in the form of – we call them – warrants, which is basically only a future equity stake in the company, as a reward. We can generally, in a financing package, because that seller took 4% instead of 12%, we can give them 20 or 20% of the future equity value of the company, even though they already sold 100%. They get another second bite at the apple up to 20-25% of the future equity value of the company. When the bank loan and that seller note at 4% is paid off, they get another check or note for up to 25% of the future value of the company, and that’s taxed as capital gains, not taxed as ordinary income, as that interest would have been.

Ryan:               In that time horizon, if we’re back into that, that’s roughly 10 years down the road, when that actually happens?

Dan:                 Eight to twelve years generally.

Ryan:               Okay.

Dan:                 Sometimes a lot sooner because the company’s not paying tax. They can pay off the bank note a lot faster than 5 years, and they can pay off the seller note a lot faster than 5 years. It could happen fairly quickly, however, we have a lot of owners who say, “That second bite of the apple – the 20-25% is payable when the other notes are paid off? I love the fact that my value (25% of the future value) is growing every year. I don’t want to pay off those notes. I’m sticking around. I’m still President, CEO. I might be in the ESOP. I’m getting salary, perks, benefits, healthcare, cars. I’m happy working here, even though I don’t own it anymore. I’m an employee making more money than anybody. I love sitting here. I’m happy to have these notes not paid off because I want my future 20% to be worth as much as it possibly can, so I might delay that 20 years, if I want.”

It’s all back to the circumstances of what the owners – what they’re looking to do. They want out and go fishing? Or do they want to stay busy, as a lot of business owners do? They want an office to go to. They don’t want to be kicked out the day they sell to somebody. That’s another [0:35:16] with ESOPs.

Ryan:               I like that topic because what is life like before and after an ESOP? Obviously before – maybe I can tee this up, so I think we’ve referred to it on the show before, The Great Game of Business by Jack Stack, where he refers to his ESOP strategy. There’s this open-book management, so there’s a lot of stuff that has to happen in your culture and the way you manage it before. Just like us and every other entrepreneur, there’s a lot of perks that come with owning a business, so what is the relationship – what do you gotta do to clean it up? How does the relationship with your business and the perks change afterwards? The perks and the control – what is the before and after look like?

Dan:                 That’s very important. I’m glad you brought it up. In general, control really doesn’t have to change. The ESOP buys the stock, but however, it’s important to note the employees never actually own a share of stock. They have a beneficial interest in the trust that owns stock on their behalf. They don’t have minority shareholder rights. I’m getting a little nerdy. They don’t have minority shareholder rights that are granted by the states. That means they don’t have a right to see confidential financial information.

Ryan, if you own one share of my company, you’d have a right to certain financial information. State law would say, “You have a right to see what’s going on in this company so you’re not being taken advantage of.” In an ESOP, the employees don’t have those same rights because they don’t have actual shares. However, the trustee, who owns the stock on their behalf, will get to see some financial information. But that trustee has no interest in running the company, nor do they control the board.

So in an ESOP company, Mom and Pop can still control the board, be President, CEO, and have majority control on the board, and the trustee doesn’t even sit on the board. Mom and Pop still control the board, and they direct the trustee how to vote the shares many times. They say, “Trustee, show up at the next board meeting and vote for me and my wife and my kid for the next term of the board.” Trustees – directed trustee – they don’t have discretion, unless the owners are telling them to break the law or take advantage of the employees. That trustee will show up at the next board meeting and vote for the Mom and Pop and the kid to be on the board for the next term. Because Mom and Pop are on the board, they may get some board fees.

In our example, if Pop is still the President and CEO and still driving sales, Pop is still getting commissions, President and CEO salaries, gets the perks, the cars, the phones, whatever’s ordinary and customary for somebody in that position of a company that size. We may have to clean up the cousin who’s on the payroll that’s not actually working there anymore. We’re all laughing, but we know about that. That boat down in the port that’s for customer use, we have to clean some of that stuff up.

You actually have to have board meetings now because right now, board meetings are at the breakfast table. We’re gonna actually have to have some board meetings and have maybe an attorney. We know some good attorneys that could do that. They’ll sit down and have a board meeting once or twice a year, just documented, because if the Department of Labor comes in, because it’s a retirement plan, they wanna see that this company is being run properly.

One other thing that might change post-transaction – I say this tongue in cheek. I’m kind of smiling when I say it. But the seller loses their thieving rights. Because right now, if there’s an extra million bucks sitting in there – right now, the owner could say, “Well, it’s my company, I could just go grab that if I want to. I want to buy a vacation. I want to take that million bucks.” But once you sell it to the ESOP, you lose that right.

You’re an employee. You’re getting fair market value for your stock. You’re getting a future equity stake potentially. You’re getting the market rate of salary, board fees. You don’t have a right to still go in and grab that million bucks that’s sitting there because you don’t technically own the company. You’d be taking that from the employees’ pockets, and that’s where the trustee has to say, “Hey, look. It’s not your money anymore. It’s the ESOP’s value – it’s part of the company value.”

Now, we can use that money to go buy a competitor to drive value. We can do it to launch a new product. That’s different. You just can’t take it to go buy that house wherever you want to buy it.

Ryan:               With the trustee, how do you pick the trustee? Then when do they actually ask for the financials? Is it an actual cordial relationship, or is it kind of just like for show? Or is there actually more strict limitations to it? What’s the relationship look like?

Dan:                 It’s a very friendly relationship. But the trustee – for the transaction itself, when the ESOP’s buying the stock – I kind of glossed over that, but that’s a true-blue sale of stock with due diligence. There will even be an independent trustee that doesn’t know the company that’s gonna negotiate the sale with the seller.

With that being said, it’s probably the most friendly negotiation you’ve ever seen. The trustee wants to buy the stock. The seller wants to sell the stock, so it’s a very friendly negotiation, however, it’s got to be a negotiation. They can’t be too out of whack. The trustee gets their own valuation. My firm generally serves as the valuation firm for the seller. I don’t see their valuation. They don’t see ours. We negotiate for a fair sales price. That’s for the transaction itself.

Ryan:               Let’s take a pause there. I’m curious on how are you guys valuing the business. Is it a discounted cash flow? Is it a multiple of EBITA? Do you do market rates? How do you guys actually come to that conclusion?

Dan:                 All of that. It’s whatever’s ordinary and customary for that type of business. It’s usually a blended value of all those different methods.

Ryan:               Got it.

Dan:                 Then we weigh things differently: 25% for the discounted cash flow method, maybe 50%, whatever. Then we blend those together, fair market based on what other companies that are in that similar market and similar size, how they’re valued.

Ryan:               How do you take in unique circumstances… We’re familiar with the value builder system, John Warrillow’s key drivers or any kind of value building approach where there might be something outside of just the EBITA or the cash flow that’s important. How do you take some of those intrinsic values and factor that into your valuation?

Dan:                 Just like any valuation, you look at anything extraordinary. You look at one-time expenses, you look at adding back some of those things we talked about. Patents, excess cash on the books, signed contracts that maybe aren’t realized yet, the revenues. We have iron clad contracts with these six companies. Here’s the revenue that we project coming in.

The ESOP’s look a lot more forward at projections than generally any other type of sale. Yes we look at trailing 12 months but the ESOP really looks a lot more forward to what’s coming down the pipe. As long as it’s realistic and could be justified like with signed contracts and things of that sort.

Those type of things really enhance the value of ESOP which is why I say the ESOP value other than outright strategic sale that says I have to have you and I’m paying a 30% premium for you. All things being equal, in a financial sale, ESOP will be either at the same price or maybe even a little above.

Ryan:               Those are kind of like a tipping point where you want to get full value. Yes you’ve got a combination of seller notes and bank financing. But is there a certain ratio of where you don’t want to load too much to suffocate in the actual business even though you are getting those types of advantages?

Dan:                 Yeah, definitely. You read my mind. Yes. I say cash flow is to an ESOP is to location is to real estate. It’s all about the cash flow. The good news is we just found a lot of cash flow without paying tax. We found a lot of cash flow. But even with that being said, we have to make sure we’re not chewing up too much cash flow that the business can’t operate their business.

The good side of the seller financing is that’s extremely flexible. The bank is not extremely flexible. They want their payments. Seller could say, “Hey, look. I’m having some trouble this year. Don’t pay me this year, just pay me interest. I’ll pick up a principal payment on the back end.” Or it might be more positive than that. It might be, “Hey. There’s a competitor down the road. I’d rather use the million you owe me and go buy that competitor for $1 million.” A lot more flexibility on the seller financing side of things than there is on the bank financing. In fact some people say, “I don’t want the bank at all. I’ll do it all on seller financing.”

Ryan:               Got it.

Dan:                 In addition to that, just something we didn’t talk about but you said you might want to bring up. At the end of the day, the company has the legal requirement to buy that share of stock. I think it’s absolutely vital that the company use some of their tax savings to squirrel away into some kind of a corporate sinking fund, corporate assets to grow money so when the company has to buy back these shares down the line, they have some assets to do that and some savings to do it. The CFO 20 years from now will be very appreciative. Upfront, the more highly leveraged the stocks are not worth much if they’re highly leveraged because of the vesting schedule. The stock takes 20, 30 years to be allocated to employee accounts. Upfront, the first 5, 7 years, it’s hardly any liability to buy the stock back. Later on if it comes bigger, I think it’s absolutely vital that the company puts some money away now. It’s like saving for college. You start when your kid’s born, I won’t say you might pay for it all but you might make a dent in that college tuition. Same thing here when your liability is low, you have all the tax savings. Now’s the time to squirrel some money away to prepare for that future liability.

I’ve written some articles on this because I think I take this very seriously. Any ESOP or if anybody’s considering ESOP should bake this into their calculations because you need to be prepared. Otherwise there might be some nasty surprises down the line and some consequences you don’t really want.

Ryan:               Do you run those in your financial models where you’re saying okay, out of 100 employees, you’ve got 30 that are 50 and they’re going to retire at this. You just kind of figure out how much you’re going to have to pay them, or are there liquidation events?

Dan:                 Yes. With every ESOP we do, we give our clients. It’s baked into our everything fee, our normal fee, a 20-year projection of what that liability and that out-of-pocket cost is going to be. Then we’ll work with their financial advisor or with the company themselves and help them develop some strategies that are prudent to finance that future liability and even make suggestions of how much and what type of vehicles.

Ryan:               I’m sure you’ve heard the horror stories, Dan. There’s a company around here, I won’t name it, but they’re very large. They grew extremely fast from a couple of hundred like a thousand. I believe that the key management personnel there – the company was going to owe like $60 million because all of these people were leaving and they didn’t have enough. They ended up selling to a financial buyer because that was the only way to get the money out.

Dan:                 When you hear stories like that, when I hear ESOP companies that are in trouble, like you mentioned earlier, the horror stories of ESOPs – I would bet 95% of them revolve around two issues. One of them has been solved because of a certain institution got their hand slapped really hard. It changed the ESOP industry completely. We’re already there. I’m happy to say we have no issues whatsoever.

But one of the issues revolves around valuation. I said that the trustee gets the valuation, we do a valuation. We don’t see each other’s valuation. We negotiate. It used to be you got one valuation, you threw it on the table then you negotiate it from that. What Zoe would do, Joe and Mary would get their brother-in-law to do the valuation.

Ryan:               It’s kind of like the financial crisis when you say, “Hey. I need a new mortgage on my house. Why don’t we just figure out what this is worth and then go get a loan?”

Dan:                 That’s exactly right. That’s what was happening. A large majority of the ESOP lawsuits and the ESOPs get in trouble revolved around valuation. It wasn’t an arm’s length transaction. Remember I said the ESOPs look at projections. This company, the cement company could be a 2% per year growth. All of a sudden they’re going to do an ESOP and the projections are a hockey stick. People used to get away with this. A lot of the lawsuits were around that. That problem has pretty much been solved. That’s good for the industry. I’m glad that came about. I was very supportive of that.

The second thing is the repurchase liability, the obligation of the company to buy back the shares when employees eventually die, become disabled or retire. When I was at MetLife, they did a very important study. They spent millions of millions of dollars. They figured out that everybody dies. Point is one way or the other, the employees are going to cash out. You’re going to owe them some money somehow. You just put your head in the sand and say, “We’re going to do that by cash flow because the timing is always going to be good.” That’s very silly. That’s when the seller of the company gets sued. In fact the company’s board of directors could get potentially sued.

There was a lawsuit that said to the board, “You knew about this liability. It’s an off the balance sheet liability.” But they knew about it nonetheless, it’s in the footnotes. You did not prepare for it. The company tanked and the ESOP value tanked because the company could have the cash flow. Therefore we’re potentially suing you personally for not managing that liability. Not to be scared of you buddy but those cases are very, very rare. But it shows the importance of preparing for that eventual liability. We think whoever’s in ESOP should be very conscious of that and prepare for that. Even though it may be down the road and that certain advisor may no longer be in the business or even around but the consequences of that to the company could be drastic.

Ryan:               This is where it comes down to knowing your numbers. Do you find that it’s easier? Or there’s that certain smoothness with the financial maturity of certain companies if they’ve got clean books and they kind of know their numbers where they’re able to surface these kind of situations a lot easier?

Dan:                 Of course. Yes, of course. Proper planning is everything. I made a big deal of this repurchase but the companies I’ve been working with for 19 years now, nobody’s had a problem. Because we’ve set them up, they’ve put a systematic plan in place. In fact there’s even – I’m not going to push insurance anyway because I don’t sell insurance or investments. But there are actually insurance projects that are used to finance these long-term liabilities. Once again, MetLife did a study, everybody dies. You could buy some policies on key executives and those death benefits could flow into the company tax-free later to help pay for these future liabilities. Or the company could just put money in some mutual funds or some CDs or they could put money in a tin can in their backyard. It doesn’t matter. I just think they really need to save for it one way or the other.

Ryan:               Let’s go back to the structure. How do you prioritize? If it’s 100%, then how much the bank finances versus the seller? I’m assuming they’re kind of leveraged at all or pull and push in various directions. Do you see what I’m saying? As much as you possibly can, the bank will do a certain, let’s say 50%, then you’ve got the seller wiggle room. Does that also balance in with how much you actually sell to the ESOP?

Dan:                 Generally not. Generally we’re backing into. Generally when you talk with the financing, it’s kind of the tail of the dog.

Ryan:               Got it.

Dan:                 We know when we’re getting some bank financing, we know we’re going to have to sell our finance somehow, what the exact number’s going to be. We can give you a pretty good guess. But at the end of the day, the bank’s going to lend two times your EBITA, that’s two and a half times your EBITA, your earnings. Maybe a little bit more in certain scenarios. Anything else is going to be seller finance. If they’re a six times multiple company, the bank lends, two times, we know the seller’s going to finance four times their earnings, which is what it is. We have a pretty good idea what that’s going to be.

Ryan:               Got it. As we’re kind of just wrapping up the financing, the notes and stuff, you have to have very big considerations on the industry. I mean obviously the company needs to be sustainable for the next foreseeable future. But also thinking about the industry, do you guys really dive into that? The reason I asked the question is I’ve talked to some people that were heavy in the online space and did an ESOP. It’s interesting because you’re placing a very large bet on an ever-changing industry. Where does the industry fit into you guys’s analysis?

Dan:                 That means that it matters a lot. I should say, because people always ask me. You didn’t ask the question but I’m going to answer it anyway. People say, “What are the industries that do the most of ESOPs?” Then I’ll go into what you’re saying.

Ryan:               Okay.

Dan:                 Manufacturing is number one. Construction is number two. Then, third is something a lot different, the technical industries – the engineering, architectural and financial industries. That rounds up the top three. Then every other industry falls behind that somewhere but it is across the board all over the place. But industry doesn’t matter as far as obviously valuation goes, as what the bank wants to finance. In fact sometimes the really high multiple industries are really tough to do.

Ryan:               Yeah.

Dan:                 We have an 11 times multiple on some fancy tech company and just because they’re worth that it doesn’t mean they can cash flow it. Remember, the cash flow might be what a normal 5-time multiple company would be. If you’re doubling the value, you’re doubling the cash flow requirement. Even though we might not be paying tax anymore, we still might be tuning up more cash than we have. Yes, it does matter when we’re doing our planning. That case it might be a partial ESOP instead of a full ESOP because we just tanked cash flows in our own bank.

Ryan:               Okay. As you just mentioned, growth. You and I had a conversation with a friend of mine who has been thinking ESOP. He’s got a very long runway. When in the growth cycle of the business is a good time? I had this misperception that you should do an ESOP because you can have tax-free growth where if someone’s in heavy acquisition mode, which I’ve seen in the past, where they’re essentially buying their competitors tax-free because of the structured ESOP, but you had said that depending on the structure, you should use that growth for yourself. Then as it plateaus… why don’t you answer that, fill in the gaps there?

Dan:                 Yeah, certainly. As we discussed, it just depends on what the person’s trying to do. I have found that more often than not, the business owners start their business, they’re running their business, they’re on hyper growth mode pursuing the American dream. I’m trying to grow this business so I could cash out for me and my family. That’s not selfish. That’s just business owners. That’s why people start businesses. They’re growing at taking risks and they want to sell it at a higher value than which they bought it.

If you sell to an ESOP today, yes it may be tax-free. You’ll be using tax-free dollars to buy other people. But you don’t own the stock anymore. The employees are getting all that benefit. Because when they cash out, they’re getting the advantage of all this growth you have and they’re getting the wealth out of that. The seller might only have that future equity stake they got from the financing piece. If they’re buying this business, they’re growing this business so they can grow individual wealth so they can roll that over into another business or to donate to charity or whatever their objectives are – more often than not when they’re younger, they don’t want to give away that future growth because that’s why they started the business in the first place. With that being said, these entities, there are a lot of industries for example the brewing industry, the beer industry. It’s more of a hey, we’re a big hog.

Ryan:               That’s awesome.

Dan:                 Let’s have a beer, a beard and a hug. We want to share this thing. We want the employees to share in all of the wealth that we’re growing here. Let’s do it now. We want to do all of it right now. We’re all on the same boat. We’re all doing this together. The hybrid of that is I do love my employees, I do want to keep them all but I do want my future equity. Maybe we do a 30% ESOP, maybe we do a partial ESOP.

They have an employment stake unit, they have an ownership stake unit. They act as owners, they grow value as owners. They appreciate it, they stick around. Retention goes up, worker’s comp goes down. You have all these positive things, you have a lot of tax breaks. But you have the seller still retains the majority of the future equity. Then later on, they can sell the balance to the ESOP and they are ready to step out.

But I do say that the whole financing process and the payout – I would say allow 5 to 10 years lead time before you want to walk away completely. Because if there’s banknotes out there that the seller might be putting personal guarantees on them and if they’re seller financing, they want to stick at that company at least as chair of the board until those notes are off. They don’t want to sell to ESOP, they want to just hope that the management you left behind can meet all the financial requirements. You want to stick around at least as chair to make sure that it’s all taken care of. I’d give a 5 to10 year glide path to that.

Ryan:               That just shows the model and the scenario, and how important it is. You can’t just punch out today so you got to have a little bit of runway but you don’t to be putting a rocket field to it while you’re doing that runway at the same time unless you calculated the risk of the equity that you’re giving up.

Dan:                 Exactly.

Ryan:               Just one more thought on this. Let’s say you’re to do 100% ESOP, how does the distribution of the shares go with all the employees and the management? Maybe this kind of ties back into the fourth and we’ll wrap it all together. How does the share distribution happen? How do you get the management and family members? What does the whole structure look like after the fact?

Dan:                 Yeah. You read my mind. One item left on my list that I didn’t cross off is share allocation. As I mentioned earlier, the ESOP may buy – even 100%, I’m not forcing people into that. It just tends to be the popular thing right now. You don’t have to do 100%. But in any scenario, when the ESOP buys shares, the shares are not allocated and put into employee accounts the day the ESOP buys them. Because what happens if you hire somebody tomorrow? The shares are out, “Sorry, you weren’t here yesterday.”

The ESOP buys shares day one but the company has to decide how long do we want to allocate these, how long do we want to be handing these out. This is our employee benefit. We want to figure out what’s too much, what’s too little, what percent of pay we want to be giving out every year because we’re buying substantial assets here. Generally, the company says, “We’re buying 100 shares. We’re giving you out 5 shares a year for 20 years.” Or multiply it by how many shares there are. Generally it’s a 20 or 30 year period that the company says, “Look. We bought them all day one. ESOP bought them all day one. But we’re going to hand them out over the next 30 years.”

We can recruit to that. We could say, “Look. Hire your friend, call your friends and your hardworking family and buddies. Work here, stay, become more vested. Every year you’re here you get more shares. Every year you’re here you get more vested. That’s a good reason to have it over a longer period of time, keeps people involved. If they leave any time before 30 years, they’re leaving chips on the table. They’re leaving future allocations and future value on the table.

Let’s say it does take 20 years to allocate the shares. That means every year for 20 years, 5% of the shares are being allocated every year. 5 years for 20 years, 100%. Year 1, the first 5% is going to be allocated. That’s subdivided to the employees based on that any individual workers, their compensation relative to total payroll. If Suzy makes 3% of payroll, Suzy’s going to get 3% of that 5% that’s being handed out that year. Hopefully that made sense.

Ryan:               Yeah.

Dan:                 Next year Suzy gets a raise, Suzy makes 4% of the payroll. Suzy gets 4% year 2 of the 5% that’s being allocated.

Ryan:               Which is why you’re doing all the compliance waiting and discriminatory modeling. Do you figure out payroll and salaries and all that stuff in accordance to making sure everything’s fair?

Dan:                 I don’t know if I got the question exactly.

Ryan:               Okay. If you got $1 million of payroll, you got the whole top heavy that risk is always looking at. How do you figure out who’s getting paid in accordance to making sure that you got your executive bench all nailed down and topnotch getting paid when they should be? Does that make sense? How do you structure all that?

Dan:                 Yeah. I’m going to cop that out. We recommend a topnotch third party administrator. Post ESOP – the administrator, the third party, just if you might have a 401(k) administrator. But in ESOPs I would say it’s even more important. They keep track of compensation, who’s eligible, who gets a payout in any given year, who’s vested, they fill up the forms, the 5500 reporting forms. They would help keep track of all of that stuff. The burden on the company is I wouldn’t say light but not heavy. They just have to give some reports to the third party administrator. They kind of track all that stuff. They’ll tell you if somebody leaves, they know how many shares they get at any given year, they quick die or become disabled and how much they’re owed and tell the company you owe this person this amount of money. That’s the ESOP shares.

In addition to that, generally for team managers in the top, top inner circle, we generally want to do a little something extra for them too. Some kind of phantom stock or synthetic equity, generally something tied to the stock value. Even if the stock is all in the ESOP, we may say to the management, “We really like you guys. I want you to stick around. You’re the future manager of this company when I’m paid off. We’re also going to assume you have 200 shares outside the ESOP. You don’t really but we’re going to have a legal binding contract that says you are owed the value of 200 shares. You get that in 15 years. If you stick around, you get the value of 200 shares. If you don’t stick around, you lose it.”

Ryan:               I didn’t know you could layer a phantom stock right on top of the ESOPs. It’s just the typical however you structure – whether it’s some key retention or whatever performance, whatever it is.

Dan:                 Exactly right. I don’t want to gloss over. There’s some testing – take away the value of the company and leave nothing left with the rank and file. But when you’re done in conjunction you can certainly do it. Now we could look at the overall picture. We have the rank and file that has a future equity stake at the company. They stay for 20, 30 years. They’re getting shares every year for the next 30 years. You have a management that have the ESOP shares. They also have other compensation that’s driven off of the equity value and these phantom shares or something else like stock appreciation rights or something.

Then you have the seller who sold the stock but still has a future equity stake because of the financing package. Remember the future 20% or 25% that they may be getting off the company. They’re trying to drive stock value growth. They’re smiling like a butcher’s dog because every single person in the company is driving stock value. It’s very successful. ESOP companies drastically outperform their peers. This is a large part of it due to the current structuring when we do some of these structuring techniques that we just talked about.

Ryan:               Because everybody’s driving in the same direction. Just to finalize some thoughts on that. Can you put a deferred compensation structure in place? Or is it just phantom because it has to be very clean?

Dan:                 It certainly could be either. One of the drawbacks of doing it through a deferred comp…

Ryan:               Have insurance and all that stuff because you want to be careful.

Dan:                 Yeah, that’s true. I was also going to say many owners would have liked to have done phantom stock or stock appreciation rights but they wouldn’t have the value to stock all the time. We’re already getting the valuation done every year.

Ryan:               Yup.

Dan:                 The ESOP requires that. We already have evaluation being performed every year. The addition of phantom stock and stock appreciation rights, we’re not acquiring an additional cost because it’s already being valued every year. You can give them a statement telling what it’s worth every year because you’re already doing it anyway.

Ryan:               Yup.

Dan:                 I think it makes sense to have their compensation tied to corporate performance or the stock market. You could, if you want to – I have no problem. I’m a big fan of deferred compensation plans and the supplemental objective of retirement plan, I’m a big fan. In conjunction with the ESOP when you’re trying to drive value for everybody, I personally feel that maybe the stock appreciation rights and phantom stocks might be a little more appropriate.

Ryan:               Then you’ve got the whole foundation laid like you said.

Dan:                 Right.

Ryan:               How does that tie into family and gifting estate planning? As you’re kind of restructuring the whole family estate with this, the ripple effect touches everybody that the estate touches. How does that get integrated in everything?

Dan:                 Let’s talk about the fourth tax advantage that I deferred. You nailed it on the head. Here’s what it is. As soon as the seller does the ESOP, that’s the time to do personal estate planning. Let’s talk about a couple of things.

First of all, remember that future equity stake we’ve talked about – the warrants, the future equity stake. The day you get that future equity stake of the company, it’s of a company that it was just 100% leveraged potentially. What’s the value of the stock that they get? $0, right?

Ryan:               Yup.

Dan:                 If the company’s worth $20 million and we just borrowed $20 million, the equity value’s practically $0. You have a 25% equity stake 15 years from now that’s worth $0 today. That’s hardly worth anything. That future equity stake is hardly worth anything. That’s the time to gift that away into family, partnerships and future generations because it’s hardly worth anything. Knowing darn well when the debt is repaid, the company is going to go back to $20 million, maybe $30 million because you’re a tax-free company. You may be giving away 25% of a $30 million company later for a gift tax consequence today of practically $0. It’s a great way to transfer vast amounts of wealth from the seller’s generation to future generations with zero or little gift and estate tax consequence today. It’s a fantastic time to do that.

Secondly, you can do that with – I’m not an expert in all this stuff but I know grantor-retained trusts. You can retain an income stream in the seller and when they die the remaining balance goes to family or you could donate to a charity called a charitable trust. You can say, “I’m donating this when I die. In the meantime I’m taking it as an income. When I die, you get the remaining asset.” The seller gets some incredible tax advantages when you combine it with charity. There’s all kinds of stuff there.

As well as the seller note. Remember, the seller note is subordinate to the bank. Remember the reason you got the warrants, the future equity stake, is because you’re getting less than the market rate of interest. It might be interest only until the bank’s paid off. That can be discounted 40%, 50%, 60% in some scenarios. If the seller doesn’t need that portion, the seller note, they can live off the principal and other assets or the down payment that the bank gave them on other assets. They don’t need the seller notes. They can gift that away to family members as well at a very low estate tax planning consequence.

There’s all kinds of charitable grantor trust. We can get income streams, the straight-up gifts to charity, moving gift and estate taxes, the future generations. Plus we found the assets to do ILITs for estate planning, for estate tax purposes. We’ve found all the assets we need from the sale proceeds to fund any – it might be insurance policies and all these other gift and estate tax planning. It’s the great time to do all of that. That’s the fourth tax advantage left on the table earlier when we’re talking.

Ryan:               It’s one big rubric’s cube. You’re going to see the return on your investment with the work you put into place on this.

Dan:                 Right. When people say it’s complicated and expensive back to what I said earlier, yes it is. But look at what we’ve done. Yes you may not be paying capital gains tax on the sale, the company may not pay federal or state income tax ever again on the profits, it’s not going to equate on a $20 million company. That might be a $30 million of tax savings over the next 10 years plus not paying capital gains tax plus gifting away to future generations with virtually $0 gift tax consequence, that might cost you a couple $100,000 to put the ESOP in place. Is that really expensive?

Ryan:               Yeah, right. It has a pretty good return.

Dan:                 Yeah. Exactly.

Ryan:               What’s the time frame from thought process to execution? What are the major key steps?

Dan:                 We do five steps. It’s like this. Everybody else has a variation, they may combine steps. I like to do a lot of education. Almost everybody I know in the ESOP community like to preach the gospel. We love to tell the story. How many seminars have we been to with different events by universities or by CPA groups or insurance companies? They talk about business obsession. ESOP’s not even a bullet point. It drives us crazy. I don’t know why. It’s complicated and they’re scared. We like to preach the gospel and talk a lot about it. Education is the key. We do all the education the client would like to hear at no cost.

We like to sign a non-disclosure and do a complementary multi-point review. Just to see if the nuts and the bolts, the cash flows were, where the value’s in a range where the owner expects, the value’s in a range that makes an ESOP effective. Do they have enough employees, do they have enough payroll, are they getting the benefit out of it? No cost to that. Just to see – we don’t know their start time or their time, either written or verbal report. Just to see if it makes sense.

Then generally after that step – that’s the multi-point review. Generally our first pay step is we call it preliminary evaluation / preliminary analysis. It’s where a couple thousand dollars, we’ll provide a calculation of value, you can hang your hat on for ESOP purposes. Based on that value, we’ll run a model of couple scenarios. Maybe 50% sale or 100% sale. Maybe a C-Corp sale or an S-Corp sale because there’s different tax consequences. We run different models, look at total benefit, tax savings, net proceeds and what affect on cash flow it has, just to see if the company can cash flow based on the value. Like I said, that’s a couple thousand dollars just to see if we’re making sense. Because if you don’t do that, why are you going to spend another $20,000 to figure out how to change your board structure when you can’t get the value in the cash flow right, you might as well stop there. We carve out that little baby step so you can hop off the train if the train’s not going to the direction you want it to go.

Then you move into a feasibility study where a lot of people start. If you want the full boat and you want the blueprint from implementation right from the get-go, you can start here. We’re happy to do it. We suggest you take the baby step. But you’re going to a full blueprint from implementation where sharpening all those things we already did plus talking about the financing package, designing the future equity stake, getting letters from the bank to see what they’re willing to do, we’re recommending board additions, recommending stock splits, we’re talking about what are we going to do about the match [01:10:52]. We’re figuring out all the details.

At that stage, you’ll know what it’s going to cost to implement the rest of the plan. What are the attorneys going to cost, what are the administrators going to cost, what are the trustees going to cost, what are the valuations going to cost. Kind of figure all that out and give the client and say, “Here’s the blueprint. We talked to all the people that need to be involved. We brought in whatever we need in suiting your scenario, the best attorney for you, the best valuation person in the industry. We’ll bring all these people together and say it’s going to cost x to do what we laid out in this feasibility study.” If they want to go forward, they sign all the contracts including my firm’s. Pull a trigger and we hire everybody and we get the deal done. It’s generally three to six months from beginning to end. A lot of that’s due diligence gathering and waiting on people to do what they’re supposed to do.

Ryan:               Yeah. Just the gospel and educating people’s so important. There are so many things where you just jump the gun and you realize you went through all this work and then it’s not worth it. I think that’s the biggest fear that a lot of people have. Honestly, I think Dan ran through everything we did. It was fantastic. Now we understand what kind of project we’re willing to tackle. Because you have to have your head in the game if you want to go down this road. You’re going to be able to reap the rewards.

As we wrap it up here, what’s the best way for our listeners to get in touch with you?

Dan:                 Happy to just check out our website. You can get my information at My telephone number is 724-766-3998. We have a lot of white papers we’ve written and articles and the information about our firm and other type of information you might be interested with. We’re happy to send anybody a complementary book put up by the National Center For Employee Ownership that kind of talks about the nuts and the bolts of how ESOPs work. It’s complementary. We’ll send that to you if you like that and answer any other questions.

Ryan:               Thanks Dan for coming on the show. I appreciate it very much.

Dan:                 Thank you for having me.

Ryan:               I hope you enjoyed that episode. That was probably a lot for a lot of people because we got really technical on some of the different areas. But I wanted to do that because I think there’s just too much ambiguity around ESOPs that it painted a bad light when you can see the crazy amounts of benefits that it brings.

My three main takeaways from the episode with Dan:

One is the structure in the financing. When you’re sitting down and doing a sale to an ESOP, if you can see the amount of control that you have over the process, it’s pretty crazy. If you’re going to go sit down and sell to a strategic buyer or a strategic competitor or even a PE firm, you’re going to be at odds with them because you’re both dealing with the effect that you want the most amount of money and they want the least amount of money to hit their returns. You got the asset stock sale complications. All of the stuff that puts your attention at odds with the buyer and the seller right off the bath if you’re not doing this.

Or in this situation, the time it takes to plan to structure the right deal between how much the seller finances, where you get your banking and the relationship of the interest rates tied to the seller financing, and the terms and the conditions that you have and the flexibility you have with the seller financing after the deal that I was actually unaware of. Just realizing that you can almost reverse engineer into your goals because you’re working with yourself and the team of advisors with you. Yes you have to get to that true valuation but then everything comes about optimizing what you currently have. I think the amount of control that we all want as entrepreneurs, ESOP brings a crazy level of control to a sale. You continue to be in that business as much or as little as you want depending on the work you’ve done ahead of time with management and with operations and stability. I just think it’s a very huge opportunity to maintain control over the process.

The second takeaway, I was really resonating with the amount of control that you have before and after the deal. I was surprised to hear that you’re still pretty much running the business as is. I know I’ve talked to a lot of other people that say, “You no longer own the company.” Technically yes that is true but how you structure the board of directors and the trustee allows you to have the control over the things that really do matter. On paper you might not own the business because the ESOP now does. But you’re still able to have a lot of control over the fabric, as Dan employed it, of the business and the culture and the people that you hire, why you hire them and the things that you do which I think is mostly the reason we all get in the business anyways. Because we want to help people change their lives. You still have that ability to control that should you set yourself up for that.

The third takeaway I just have to say is taxes obviously because those four tax strategies that Dan lays out, he clearly identified all of them. I think he did it in a way that you’re able to articulate and envision what that kind of tax savings does. The biggest thing I think all of us are constantly concerned with is what kind of annual taxes I’m paying today and then what kind of taxes I’m going to pay when I sell my business and give my wealth to my kids. ESOP is a crazy vehicle to be able to maximize and optimize all of those different situations if done correctly. I think that’s even worth looking into if there’s even an option. You’ve heard from my story that the amount of taxes we paid and most people are paying to sell their business is not enjoyable. It’s worth doing to do those and to look into this if it’s a viable option.

If you’re still listening, I appreciate you sticking around. Hopefully it was beneficial. Until next week.

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