Here is the Text Version of the Interview
Today I am here with Richard Harmon, currently managing director at CSG Partners. He’s led a diverse career as a CPA, CFO, an entrepreneur and now as an investment banker for the nation's leading leveraged ESOP practise. He joined CSG in 2011 and has led transactions for a range of privately owned middle-market businesses. Today, we are going to demystify ESOPs and get a real understanding of how they can harvest equity, enhance liquidity and create tax advantages.
Can we just kick off with just a brief explanation of what ESOP is?
Absolutely. ESOP stands for employee stock ownership plan and it is one of the retirement plans that was created along with IRS and 401K. It has really unique features. In this case, the owner sells shares to a retirement trust for the employees who are allocated shares over time, and then in the future, they get to sell the shares back, put the money into their own 401K plan or use it for retirement.
So who buys these ESOP’s?
Any business owner can create a retirement trust. There is a Trustee, ideally an institutional Trustee, who is empowered by Congress to pay no more than fair market value for the shares. An owner can sell shares ESOP, get some liquidity on a tax-enhanced basis and employees have a chance to own equity in the enterprise.
Who sets the price of ESOP’s?
The price is set on kind of annual basis. Initially, the Trustee hires its own independent valuation firm and they use all normal methodologies, a discounted cash flow, they can find public comps or private comps and they come up with a value range for the company. Part of our job is to make an offer to sell shares to the retirement trust, the Trustee counters, and then we go back and forth until we hit the fair price.
How does this get funded?
When you’re selling company, fair market value is usually in a range of four to ten times, if you have a financial buyer versus strategic buyer. Banks, senior lenders, and major money center banks are generally willing to lend three, three and a half times your EBITDA to help fund any soft transaction, so the outside debt gets paid down largely with or entirely with pre-tax dollars.
Who gets the shares?
The shares get allocated to the employees each year. There is an internal loan and how it gets paid down is each year, the company makes a contribution to the ESOP, the ESOP hands it back in payment of the seller notes and the employees each year get allocated that pool of shares based on their W-2 salaries.
How do employees redeem their shares?
The employees get their statements annually, they have the economic benefits and rights to those benefits, but they actually never own the shares. The upshot is, when they turn 55 they get to sell 25 percent of their shares back at fair market value, at 60 they get that other 25 percent opportunity and at 65 they get to sell the rest of their shares over a five year period. There is the annual fair market value that's determined by an independent valuation each year.
How long has the concept been around and when did ESOPs, as they exist today, come into being?
Back in 1957, Lewis Kelso came up with a capitalist manifesto. As everywhere in the world, one percent of the population owns everything, so he dived into questions such as:
- How do we create more capitalists?
- How do we inspire an owner to share equity with the employees?
He was able to put the first ESOP in the country. Together with Huey Long, chairman of the Senate Finance Committee he included ESOP in 74 IRESSA legislation. His goal was to make it more lucrative for the owner to sell to the retirement plan versus a third party. So, the first thing they did was they made the whole transaction deductible. Later, they created a 10:42 rollover, which allowed the owner to differ all their capital gains and they got to have a year after the transaction to reinvest in other things. Later, in 1998, S corp ESOPs got allowed. After congressional hearings, Congress had stood up for 100% ESOPs and these are in place now for over twenty years.
What does the landscape look like today for ESOPs?
There are over 7000 ESOPs in the USA today. This covers about 10 million employees, well over a trillion dollars in assets. A company doesn’t always stay at ESOP, so five to ten years later, if they sell to somebody else, all the employees get the benefit much more quickly and nobody goes back to a different structure.
How did you first get acquainted with ESOPs?
I started out in public accounting in California in 1979 and I have been a CPA for a very long time, although I haven’t practiced public accounting since the 80’. Around 2007,2008 I picked up an assignment serving as a part-time CFO for a $50 million dollar revenue ESOP-owned manufacturing company. Later in 2011, I transitioned to my investment banking role.
Why do firms consider ESOPs? What are its key benefits?
ESOP is a retirement plan, but it is also a corporate finance transaction. It’s the tax benefits that Congress has put in place that inspire choosing ESOPs, which result in a two-turn benefit versus a normal outright sale situation. The owner ends up with more after-tax cash. One of the key benefits is also aligning your workforce. The actual statistics are that ESOP companies lay off less in a recession and they grow about three percent faster than their peers and this can be used to inspire the team.
Can you tell me what control looks like in ESOP?
Initially, when you are putting ESOP in place, you have an independent Trustee who is the buyer, and they are charged by Congress with paying no more than fair market value. Ninety-five out of a hundred owners, if they are going to share control in a meaningful way, they are not going to do the transaction, they will either continue managing the company or sell to a third party. Post-ESOP, the Trustee generally doesn’t have a seat on the board or they have an independent presence. The board that's in control at the time of transaction stays in control as long as they like.
Do you have valuation requirements? Do you have to do annual valuations?
Yes, that’s one of the issues with an ESOP. Every year you have three parties involved that you are not paying today. One is the independent Trustee, the institutional Trustee, the second is a valuation firm. Each year, there is an independent valuation and they take the results of their valuation and hand it to a third party administration firm, which creates statements for each employee.
At what size does it make sense to have an ESOP?
In our experience, if someone is making less than a million and a half, two million a year, chances are the weight of the expenses to maintain these up, make it a less interesting scenario, than someone who is making more than million and a half in taxes.
What does liquidity look like for the employee? Are they able to sell stocks whenever they want?
That’s very specific. If they have been in the plan for ten years and they turn 55, they can sell a portion of their shares. The company will make a market at that year’s fair value, and then the employee can take that money, put it in their own IRA or 401K account and keep growing it. When they finally pull the money out of the retirement fund they pay ordinary income on it.
Tell me, what does the typical client look like for you?
A typical client is someone who’s matured to the point that there is a CFO controller in place, they have gone through all early-stage mishegoss and they became a good tax-paying citizen. If someone is paying a million or more in taxes, that’s a good conversation to have.
How do people get started setting up an ESOP?
The first thing we do is have formal conversations with the owner, get a sense of the revenues, how profitable they are, the industry and the like. If it makes sense, I’ll ask them to allow us to do analysis to give them their optics into the future and we immediately set up a data room.
We collect five years of historical financial information, current tax return and projections. Then we go and do the analysis, which takes us about three weeks or so. Once that is done, we meet with the owner, discuss with them what their future looks like if they continue operating as they are, what does it mean for them on an after-tax basis versus a leveraged optimized ESOP. I the end we find, in almost every circumstance, that leveraged optimized ESOP leads to a lot more after-tax cash flow and abundance for the selling shareholder.
What are the steps of putting an ESOP into play?
We offer to do analysis, sign an engagement letter, an NDA, we’ll ask for five years’ financial statements, a current tax return, and some projections. Once the information is provided, we set up a secure data room. We do a certain amount of due diligence, complete our analysis and then talk to the owner about what their options are.
If they find our presentation inspiring, we engage in stage two, when we have additional due diligence meetings, we build financial memorandum, and then we go to the market and start raising capital. Usually, we are successful raising three, three and a half times EBDA, no personal guarantees.
Also, at that point, there is an independent process that goes on with the owner’s legal counsel, a non-owner employee group, a committee who will then interview all the Trustees and select a Trustee, after which we have a Trustee due diligence meeting. The valuation firm informs the Trustee about the valuation range and it is at that point when we start engaging in actual negotiations. The whole process takes from four to six months and then we have a closing.
So, earlier we talked about the tax benefits of the ESOP. Does the corporate structure have an impact on that?
The corporate structure is part of every ESOP. A Lot of times if we have an owner who is an S corporation, we’ll do an analysis and recommend they close as a C corporation. If they get to do that, they get to differ all their gains on the sale, but they have to live as a C corporation for the next five tax years, before they can become tax-free 100% S corp ESOP. With an LLC, however, they are actually not allowed to be ESOPs, except in very unique cases. So, you are allowed to do a tax-free exchange of your LLC into a C corporation, and then you can become an S corp very quickly thereafter.
Tell me more about upsides. How can the owner of a 100% ESOP retain upside in their company?
There are a couple of ways. Let’s say we had a company and we were gonna sell it, the enterprise value was $10 million dollars. We might suggest to the seller to sell 75% of their company for $7.5 million and that we’ll raise $5 million at closing for you. Then we suggest that they redeem the remaining 25% actual equity for warrants.
After that, we go further by suggesting they take a lower interest rate and get them more warrants for that, so they can end up with 40% warrants, redeeming that remaining 25% equity. At that point, the 75% sold to the ESOP becomes the only outstanding shares, so now the ESOP owns 100% of the outstanding shares and there is no more tax consequence and warrants are disregarded for tax purposes.
Are there broader benefits to having an employee-owned company?
The whole idea of aligning employees’ and owners’ interests is huge. It is one of the best ways to balance the concentration of wealth a little bit. You’ve got everybody who’s rowing in the same direction to create a valuable enterprise, there is that allocated equity in the enterprise that they are going to be able to monetize at a certain point in the future. Not to mention it inspires employees to work better.
Can you give me just some other examples of companies that you’ve worked with, just to get a sense of how the transactions have played out?
Sure. There is someone I worked with who wanted more liquidity and so we explored leveraged optimized ESOP versus a third party sale. The enterprise value was $20 million and we have suggested selling 80% for $16 million. We were able to raise $9 million at closing, he had $7 million dollar seller notes.
Post-transaction, he still had 20%, which we had him redeem for warrants. He was able to take the entire $16 million off the table, defer all his capital gains, which saved him over $3 million dollars in capital gains taxes. After a couple of years, he wanted to sell the whole company and we allocated and invested half the shares, which was 30%, and the other 30% went back to Treasury.
The selling shareholders still had 40% of the former warrants. The employees and the owner ended up with on average with five times their annual salary into their retirement plans. It was great!
What’s the craziest thing you’ve seen in M&A? An ESOP transaction?
Once in a while, I see these situations where the ratio of earnings to headcount for employees is really high. So in those circumstances I know it is going to create this magical benefit for the people down the road.