On today’s show, Ed connects with finance experts Andy and Mark to dig into all things ESOP. Many business owners want to offer stock options to their employees but don't really understand the implications or process. Andy Manchir and Mark Flinchum...
On today’s show, Ed connects with finance experts Andy and Mark to dig into all things ESOP. Many business owners want to offer stock options to their employees but don't really understand the implications or process. Andy Manchir and Mark Flinchum of Indianapolis based CPA firm Katz, Sapper and Miller chat with Ed and answer some of the most common questions regarding the what and why of ESOPS and unveil when ESOP formation is a good option—and when it's not. Episode Page
Ed Mysogland 1:17
I'm your host Ed Micic. Land I teach business owners how to identify and remove risks in their business so they can sell at maximum value when they want, how they want and most importantly, to whom they want. On today's show. I'm excited to welcome Andy manager and Mark Fincham of cat separ and Miller. So to begin with, let's talk a little bit about Andy. Andy is a director at Katz sapper and Miller's valuation and Aesop's services group. And he provides valuation and ESOP advisory services for various purposes with particular emphasis on employee stock ownership plan services, and he graduated from Indiana University and he is a Certified Management Accountant, a certified Exit Planning advisor and is a member of the National Center for employee ownership as accredited member of the American Society of appraisers. Mark is a partner at Katz apre and Miller. He started with the firm in 1987. Upon graduating from Indiana University, he is a trusted business and tax adviser to his clients. His expertise includes strategic tax planning, business analysis and structuring advocacy and IRS matters and consulting and financial statement issues. Mark has been involved in assisting clients with growth opportunities, financing structure and succession planning issues. He has significant experience in planning, structuring and negotiating m&a transactions. Mark represents several ESOP owned businesses and has structured a number of business sales to existing and newly formed Aesop's. As I mentioned, Mark is a CPA and is also a member of the American Trucking associations and the Ohio Trucking Association. Mark serves as vice president of the board of the Indiana chapter of ESOP Association and as a board member and treasurer for the Miller backers. Welcome to the show, Mark and Andy.
Andy Manchir 3:07
Well, thanks. Thanks for having me. Andy and I on your program, a little bit about cat snapper and Miller. We're a large regional firm located in Indianapolis 350 employees or so with offices, of course here in Indianapolis, New York, Fort Wayne, new office in Louisville, Kentucky and a specialty office in our transportation space and Oklahoma City, specific to our ESOP practice, Andy and I formed our ESOP services group in 2011. Mainly, Andy is working on the valuation side, and I've been working on the accounting and tax side. And we're doing a long before that. But we realized that if we combined our efforts, we'd have an opportunity to go to market where we can service our clients in multiple disciplines, multiple services we can bring to the ESOP community. That's how we got started with our ESOP services group. And Andy has been working with Aesop's a lot longer than I have, he can tell you a little bit about what he's doing. Sure, I
joined cat Saffer Miller in 2007, after starting my business valuation career with an independent investment banking and valuation firm, and I was excited to come to KSM because cap sapper Miller is an ESOP company itself. And so we're a employee owned public accounting and consulting firm that way. So when we work with a business owner about Aesop's, we'll talk about it from the perspective of other client experiences that we've seen. Plus, we get to explain it from the context of our own ESOP because we've been employee owned that KSM for almost 20 years.
ESOP services dovetails real well into our practice group as a, as an accounting firm, we work with closely held, family owned businesses, that's the meat and potatoes of our practice. And those are the people that Looking for succession plans to the next generation selling to third parties or selling to their employees. And that's where Andy and I come in?
Ed Mysogland 5:07
Well, let's just start at the very beginning, then explain what exactly is an ESOP and how it works, what are the mechanics and why business owners should consider even using it?
Andy Manchir 5:20
Sure, ESOP was explained the acronym first, it's an employee stock ownership plan. So this ESOP own stock in the sponsoring company, what happens is, let's say you're an employer, you've, you know, been looking at your various options, you can create this retirement plan as an employee benefit of your company, and then that employee benefit plan can buy your stock. Now this employee benefit plan called ESOP, it can buy 100% of the stock. That's the circumstance with us at cat sapper and Miller, we're 100% owned by our ESOP, but we have plenty of clients who have the ESOP by a portion, it can own a minority or control percentage of the company stock. And once the ESOP owns your company stock, there are a number of tax benefits of that mark will explain later. But I kind of view it like it's a form of doing a management buyout, but in a more tax favored way. And it's a good alternative for business owners who want to look to get liquidity for their stock and get a good value for it, but not necessarily sell to a third party. For any number of reasons. We've had a number of clients that have looked at selling to third parties and owners have built their life building these businesses. And in a lot of times, they're in communities where they're very large employer in the community, very important to the community community. And the selling shareholder owner knows if he sells a third party, there may be a strong likelihood or even it's in the plans that if they sell, that that buyer is going to close that facility and consolidate in other locations and
the owners understand how important these businesses are to the communities and want those, their legacy to live on what those businesses to stay in those communities. And an ESOP is a perfect structure for those businesses to stay there with the employee ownership and maintaining those jobs in that community.
Ed Mysogland 7:20
Everybody immediately says, Well, I can just do an ESOP. And I know it's not that simple. So can you tell me the likely candidate for an ESOP look like so for once and for all we can say that, alright, I know that they're not absolutes, but here are here are the three things that you have to have to have an optimal ESOP situation? Well, I
Andy Manchir 7:41
used to use I think, to start with, you have to have an owner that that wants to transition ownership to them to the employees and as is bought into the ESOP structure that's going to that's going to be important. The other thing is, you know, nothing's free, there needs to be some way to finance the transaction, debt capacity, be it either by borrowing from third parties, or a seller who's interested in taking back seller notes to help finance the transaction. And there's a lot of ways that that can be structured, but there has to be debt capacity. It's very difficult if the company is very heavily leveraged to make an ESOP work from that standpoint. A lot of times, I think one of the most important factors is after you get past the debt capacity is, do you have a management team that is capable of running the business and going forward within that employee group, they're going to be the future leaders of that company and make that ESOP successful. And it's very important to have an ESOP Structure Plan, that ESOP will be successful going forward, not only financially, but from a management standpoint, and those are probably very closely tied to begin with. Yeah, I
was going to add it. This is Andy, I was going to simply add that, you know, headcount matters, this doesn't work for a super small business may be the, you know, main street level business may be too small, you probably need a good employee base of 20 or 30. Well, paying employees or maybe up to a payroll of 50 is a good threshold. If you've got a lot of hourly wage workers in your employee base. The reason being this is an employee benefit. So the larger your payroll, the larger the tax savings that can accrue to you as an ESOP company.
I'm sorry, I was gonna add in and it probably goes without saying, but maybe you should add here, Aesop's to work with profitable companies. If it's coming. It's had a history of losses and and you're have a seller looking for an exit strategy to sell the ESOP because no longer wants to fight the battles of cashflow shortfalls, that's not going to any stops not going to work to solve that problem. Yeah, no,
Ed Mysogland 9:42
it doesn't solve anybody's problem. What is there a particular type of business that an ESOP works well, for I know for obviously, professional service firms like cats, Mr. Miller, it has.
Andy Manchir 9:55
We've seen a lot of industries, Ed, I think you're right the professional services and A logical fit for employee ownership, because those are the employees who probably are skilled professionals that can go to any number of companies. And if you can offer them stock and the place they work, it's a way to differentiate yourself from others. So we've seen that be, you know, a nice feature of being employee owned, you know, it's a retention, and employee attraction tool. So industries where you're trying to keep good workers be a construction, be it, you know, especially trade to be at transportation and trucking, you know, where, where, you know, it's hard to find the employees they need right now. We see Aesop's being very successful. Conversely, maybe the only industry I don't see it for is really like, you know, medical practices where the doctors tend to own the businesses that does not fit this. And probably tech startups where maybe you've got losses, you don't have current year profits, but you've got maybe a great technology that someone will buy, that fits more of a third party sale model than an ESOP model.
Another industry would probably be real estate, obviously, where you own capital, and it's heavily leveraged. Although we have seen Aesop's with a real estate management companies like operations that manage hotels, manual property, yeah, kind of more of a professional type of a business. Now, we've
Ed Mysogland 11:22
seen some construction companies, and when we when we bring up the idea of, Hey, have you? Have you explored the idea of an ESA, a lot of the pushback that comes to us? You know, as far as you know, no, let's go third party route. It's look, there's no one in my organization that could possibly run this company, and other than me, and so, you know, how do you how do you get around that? As far as the skill set? I don't mean business acumen. I mean, how does an employee embrace owning part of their company that they work for? You know, what I mean? I mean, can you talk a little bit about how you bridge that gap? Other than just saying, Look, this is like any other retirement asset, you just happen to own part of your company?
Andy Manchir 12:12
Well, and I would actually kind of agree with those business owners now, that those the one part that's ironic is sometimes I've seen business owners, they have a lower opinion of the the ability of their folks around the place than outside advisors to that business owner do. You know, I've experienced that where they say, Oh, we don't have anybody can run this place, and their lawyer or their CPA or others would would beg to differ or people in the industry might beg to differ. So I would, I would ask those business owners to kind of think about their self awareness or, or ask for a third party to help them assess the quality of their leadership team. And then if they really liked the ESOP, but they're just not convinced they've got the people, the right people on the bus to use that phrase, then you'll hire them. We had one ESOP client, who did form their deal. Early on, we identified that they needed a clo, they had a president, they had other functional leaders in the business, but they didn't have a good number two, who could really take over for that President when the President retired. So as part of the ESOP transaction, we spent time interviewing both internal and external candidates for that position.
Ed Mysogland 13:21
Oh, so you go there, you go that far into it, where not only are you structuring and help develop it, you're you're you go so far as to work with perhaps that next future leader?
Andy Manchir 13:33
Absolutely, absolutely. I mean, we're not, you know, management, training consultants, per se, we might bring in those kinds of experts if that's what the company needs. But we've seen enough ESOP formations to know if there's a gap there, let's bring in the right expertise to fill that gap, either recruit or take someone and help give them the training, they need to grow into that, that role.
And that gaps, not hard to identify for a number of ways. Some of the Aesop's who have farmed have been longtime KSM clients. And so we've had first hand knowledge and maybe have been working on this even before they thought about ESOP. Just as a continuation of the business and strengthening the business just is not an ESOP just isn't a going concern. And you know, there's a there's a number of professionals at the table when you're forming an ESOP. And if there's an apparent or an obvious lack in management or skills that they need that not only be identified by us as we're working through a transaction, but I guarantee if the bankers coming up and lend millions of dollars on a transaction, they're going to do their due diligence to and we work as a team with the professionals that are brought in on an ESOP structure on many matters, but including, who is the management team, what does it look like? Are
we gonna be successful going
Ed Mysogland 14:50
guess my next question I wanted to talk about the value so many business owners think that the sale to a third that third Using their employees as to get a premium value over and above what they could get as a third party value. All right, so can you can you talk a little bit about the differences in in business value
Andy Manchir 15:14
by Andy's evaluation guy, but I'll start off when we were talking about what the candidates make, that are good ESOP candidates. And, and one of those ought to be is that the owner is not looking to drive the highest value because a lot of times a third party, a strategic buyer, can offer a higher price than what the ESOP kind of can pay, because ESOP can only afford to pay what the cash flows are going to be able to, to pay for the company. And so we have an owner that's trying to get the largest price they can get for their company. He's probably not a good ESOP candidate. But I will qualify that to say that don't be don't be learned by the by the large price, we did have a transaction that Andy and I worked on, where we didn't have a third party, the company was looking at both a transaction with third party and possibly an ESOP. And we had a third party come in with a purchase price that was 20 25%, higher than what the ESOP could justifiably pay. And when you run through the all the tax attributes, that an ESOP has the net, after tax proceeds of an ESOP sale generated about 10%, more than the third party sale would have generated. So you can't be you can't just look at the purchase price really have to dig into the detail and see what does that what does that mean, in real cash to the seller,
I think, you know, as podcast is focused on helping the owners look at maximum value, and so I'll have, I would encourage the owners think about maximum value in two ways. Number one, always think your maximum value an after tax basis, because, as Mark explained, he's our CPA, who does that analysis for the client, just the highest price doesn't always get you the maximum value, you may have to sell assets instead of selling stock, you may have other tax attributes that can help you net more at close through an ESOP. A case in point is a section of tax code known as Section 1042. This is the section of the code that allows a C Corp shareholder to sell stock to this ESOP plan, and defer the capital gains on the sale. And we've even seen circumstances where the business owner it sells their stock invest the money per this tax section to section temporary two, if they never spend or break into those assets that have a low basis. And if those assets transferred to their heirs, when they die, the basis will step up. They will never pay capital gains tax. And so it's a really powerful planning tool doesn't fit everybody. But when it does, they can maximize their value. Yeah.
Ed Mysogland 17:46
And you know what, you bring up an excellent point, and I've been dodging it, but let's dig into it. So the tax benefit. I know there's there's a slew of benefit to an ESOP. Can you give me the the elementary version of all the tax benefit of this vehicle of transfer?
Andy Manchir 18:05
Well, I would say an Andy hit a little bit on this, that if I'm a selling shareholder ESOP, can only buy stock. So buying stock is going to be taxed as capital gain to the extent that your your sales price is higher than your tax base as you're gonna pay capital gain. Whereas most third party sales, we see the buyer is looking to buy assets and sale of assets have an ordinary recapture ordinary tax to them. And the reason the buyer or third party buyer would want to buy assets is they want to get the step up to the fair market value of those assets, which means future depreciation on those assets and offset future taxable income. And under the Tax Reform Act, many cases, those fixed assets could be 100% deducted in the air of acquisition. So there's a real push by third party sellers to buy assets, instead of stock, whereas these off again can only buy stocks. So that's, that's a benefit to the seller because you're gonna pay less tax as an ESOP, particularly as an S corp. Besides that, if you're 100% ESOP, we'll say in this case, your income is tax exempt from federal taxes. 100% flow through S corp visa pays no federal taxes now, they still may incur state taxes, not state income taxes, but states have gotten clever states are hungry for revenues. And an ESOP will still be subject to excise taxes, franchise taxes, doing business taxes, commercial activity type taxes, but still that federal tax savings of being an ESOP flow through us Corp visa is pretty powerful and helping to finance the transaction. Those are the biggies that we talk about when we talk about tax advantages of an ESOP. We do have some Aesop's very few that may be C corporations, and they incur tax, just as any other C corporation would and there can be reasons for why and he stopped by ABC Corporation, at least for a short period of time.
Ed Mysogland 20:02
So I'm a business owner. And and I think I want to to go the ESOP route. I've checked all the boxes, do you have to have buy in from the employees? Tell me about how, how is this a sell from the business owner to the employees? Or is this? Is this something that you do? How is this communicated to the employees that this is a real good thing for you?
Andy Manchir 20:32
That's a good question. And it's one that maybe people don't always understand. This ESOP plan is a retirement plan. And retirement plans are held inside a trust. So the formation of the ESOP isn't dependent upon any one employee, like getting into their own pocket and rolling over their money, okay? You don't even have to have your employee base, aware that you're doing it until after your format, and all honesty, instead, what you would do is you would form an employee stock ownership plan and trust, you will hire an outside trustee. Now this trustee looks out for the benefit of the employees who will benefit from the plan. And that person carries a fiduciary duty. And that's an important term that people keep hearing more about in the financial marketplace. But the reason you can do this without really involving the employees directly, is because we've got an ESOP plan and trust that we bring in a trustee to make sure that, that trustee reviews evaluation, they hire someone who's independent of the company to appraise the stock. They review the transaction documents and make sure what they're seeing that, you know, like what would be a good market level kind of feel, for the ESOP plan to buy the stock?
So Andy's actually done a number of rollout meetings for ESOP companies we've helped create over the years. And, and I've been at a number of those, and there's always a there's always a question and answer type of parts of these rollouts. And I remember one we did a, an employee stood up and says, What if I don't want to be in the SOP? And the answer that is, why wouldn't you want to be you're not paying anything for it. company is making all the contributions on your behalf. And all you got to do is do your job. Well, think think like you're a company owner, you're now an employee owner, and help drive that business, that value of that stock up that gets valued every year, and you're going to benefit when you retire, and then place it Oh, okay, I get it. So I want to belong.
Exactly. You want to belong because, in essence, this plan is buying the stock, not individual employees. I don't hold any stock certificate that says ksn stock, but I'm an employee owner of KSM. Through my ESOP plan, I get an annual benefit statement, just like other folks might have seen from their IRA or their 401k. And my ESOP statement says I've got this many shares of ownership. And when I retire or become disabled or pass away, the ESOP plan will buy back my shares at the annual appraised value. And so those employees get an annual evaluation done on their behalf to make sure any buyouts happen at a current market price.
Ed Mysogland 23:26
Well, speaking of buyout when the business owner wants to exit, so they want to be out of the business 100%. And they want to take equity out of the business. So so there's a loan or something to make that happen. Are the employees now personally guaranteed to repay that loan? Or how does indebtedness work with an ESOP?
Andy Manchir 23:48
Yeah, how does it doesn't indebtedness work for an ESOP, in essence, and we don't have the employees provide any of their own personal guarantee that way, they're not on the hook for anything. By the same token that might limit how much a business can borrow. Because at its heart, this is a leveraged buyout, a leveraged transaction to live share, it's why we often see, you know, this work for a company that doesn't have other debt on its balance sheet. Because we want the credit worthiness as a company to allow the loan to come from a third party bank. And what's nice is, you know, the credit markets being what they are in 2019. There's a healthy market for lending activity on ESOP formation. And again, that's that can vary over time. But the credit worthiness of the company is what matters. There is not any one employee borrowing money on their own. This is a good alternative to not force them to do that.
Ed Mysogland 24:42
So if a business owner is saying, You know what I want out 100% I'm, I'm done with it. This is probably not the ideal situation for him.
Andy Manchir 24:51
Yeah, no. I agree that ESOP doesn't work if they want 100% buyout, like year one. It's best for maybe the business owner that's like well, you I'm looking to work another five years. And I'm trying to work out on what you know which of these options makes sense for me, we love the ESOP, in those circumstances that because they can get maybe a portion of the value now in cash based on the borrowing capacity of the business, and then maybe a portion of that purchase price is paid over time, in the form of a sour note to them, or they sell some stock. Now, on some stock later, you know, let's sell. I've got one ESOP formation currently, where we're selling 1/3 of the stock now 33%, because we can borrow that comfortably and safely. And then we think in three to five years time, we'll go back to the well and do a second stage transaction. That way the companies it continues to grow in value, the owners will get the current valuation for the stock. So what a nice way to kind of align the sale of the company with their exit plan in terms of when they want to stop working.
If an owner is looking to do 100% ESOP transaction, our experience has been that they need prepared to take some sort of seller financing anywhere from 10 to 50% of the transaction value, I think we see most of that end up in the 20 25% range. So your question about Get out 100%, it's gonna be real difficult to get 100% out of company and get 100% of your money with an ESOP transaction.
Ed Mysogland 26:22
Are you seeing Aesop's that are that you've done a decade ago that are now moving into a different stage where they're actually being sold?
Andy Manchir 26:31
Yeah, in fact, I've been involved with two in the last two and a half, three years. One a more mature ESOP, and one it was a fairly new Isa. And so there, there is a I mean, they sell just like any other company, would a privately held company would sell, you know, you do have to, typically, the way that works is that an offer is presented to the board of directors, who then approve that and pass it on to the trustee, and there's governance in there about how that might be approved. I mean, remember, Andy, you talked about how the trustee is looking out for the benefit of the participants. So he's going to be very attuned to what that offer is, and how that compares to the value of the company. And in the cases I've been involved with the offer is, is usually significantly higher than what the last valuation of ESOP stock was. Which, again, part of that is if a trustee is looking at for the benefit of employees, he's not going to undersell the company, and he's probably not even going to sell it for what it's valued at. But a premium offer is going to be something they're going to seriously consider
Ed Mysogland 27:34
after an Aesop's formed who runs it. I mean, it has the management structure changed at all, or is it in the Aesop's are all behind the scenes? Or does management chain well as
Andy Manchir 27:46
think of the ESOP transaction as taking care of the ownership succession? Right, who holds the shares. But the ESOP does not necessarily solve or fix that management succession. So what we often see is day one after the Aesop's formed, little change in terms of how the day to day management function works, but the ESOP should be formed in conjunction with your eventual plan there. You know, perhaps the current company, founder or CEO, wants to work a certain number of years, that will be negotiated as part of the deal, they might have a employment agreement that they sign at the Aesop's formation, that they will work for a certain period of time afterwards. And so in time, Ed, the question of who manages who runs the ESOP company, it kind of starts to look like a well run corporate governance model from a publicly traded company. You know, you want to have a board of directors. And oftentimes, the board of directors for this ESOP company might have one or more independent directors, like you see, for larger businesses, those people are there to help the officers of the business, and make sure they're thinking outside the box, make sure they're filling the functional needs that the company has. And so in that respect, it becomes more professionally managed, if that makes sense. And not just managed for return, you know, by one or more individuals that have historically owned the company. I honestly think that that's one reason ESOP companies perform. So we've got academic research we've seen by by business, schools that are found, employee owned companies often grow faster than non employee owned companies. They've had better returns that are safety records, lower employee turnover, any other kind of like quantifiable measure, they find they generally show that employee on companies outperform? I think part of that's because they've got this culture of being run for efficiency being run for best performance.
Ed Mysogland 29:50
I've seen the same studies. I know what you're talking about, and, and again, I think it's a wonderful solution. It's just one of those things of being able to say What does my business need to look like in order for me to take advantage of this transfer method? And I think you guys have shared that. How do banks look at Aesop's? I mean, I don't get can you get SBA financing or that's probably a little little lower on the on the lending scale, or is it all conventional in private placement money? How does capital work in a sock? Sure, I
Andy Manchir 30:24
think that SBA lending can be done on Aesop's. In fact, I do that maintain that Mainstreet Employment Act was passed by Congress with bipartisan support, not something we always see in our Congress these days, though, we had we had bipartisan support, you know, both parties behind the bill that was meant to expand the FBAs ability to finance ESOP deals. But that being said, historically, it's a conventional financing loan, you know, a commercial business loan. And in that sense, like I said, Before, the company's got to be credit worthy. An ESOP commercial loan, has to work, like a non ESOP commercial loan does, is there cashflow? And is there collateral, the difference being these days and 2019 banks understand these tax advantages. And the well run banks, the smart ones are folding in those tax advantages that Mark discussed, about saving on the income taxes if they're an escort, and the like. And the smart banks know, that will help your ESOP company pay the loan back
Ed Mysogland 31:30
better. And this is just something I was I was curious to know, Do you know how many Aesop's are formed each year? I mean, is it 500? Or is it 5000?
Andy Manchir 31:39
Closer to the 500. And the 5000. You know, I think the last day that we have from a trade group said that there's less than 10,000, Aesop's all around the country, you know. So it's definitely a niche, a small niche that way. So you want to work with people that have got experience in that niche. Because, you know, third party sales have been so frequent and are oftentimes what the business owner has thought of as their eventual succession plan or exit. But you know, since I like, the term maximum value that we talked about earlier, maybe maximum value for some of your owners, involves the dollars and cents they get, but also the legacy they leave at the company, right? And its ability to kind of keep growing and keep going without them. They've got the management team there to do it. Maybe the maybe the family business, and there's no more family members to be the next generation leader. This could be a way to keep the family name on the door. But have it be employer. Yeah, I,
Ed Mysogland 32:39
you know, is this a matter of of lack of information, or the reason that there's not as many Aesop's is for some other reason? I think it's the former, I think it's people don't understand that this is a viable option, you just need to understand what makes it optimal for for transferred. And I think that's what you guys have shared?
Andy Manchir 33:01
Yeah, I think I would agree with that. And I would, I would say that a lot of people know what Aesop's are. Maybe they've heard about them, but don't really know the details of how they work. And maybe they discounted right away and say, There's no way that will ever work for me. I mean, Andy, and I do a lot of education to potentially stop companies that are looking at it. We may give 10 of those presentations, and maybe two of them go forward with a feasibility study. And I always like to say, you know, if I'm a carpenter, and I've got a hammer in my toolbox, not everything looks like a nail. And sometimes an ESOP is just not the right solution. And Andy, oh, and I will be very forthcoming on that, you know, we love Aesop's, but hey, this, this isn't going to work because of XY and Z, and the way we feel about it, but it can be a very good tool in using the right hands for the right purposes to accomplish what a what a owner is looking to do.
Ed Mysogland 33:59
Explain the process. I'm a business owner, I think I want to explore an ESOP. I pick up the phone, I call the two of you. Tell me tell me what's going to happen next?
Andy Manchir 34:11
Sure, I think that logical place to start would be that feasibility study. You know, KSM kind of defines that for them as a valuation plus, right, because valuations a big hurdle, you know, will the company stock be valued at an ESOP deal at a price that the business owners willing to sell it for? So that's a bit of a threshold matter. But it's not only about valuation, it's about feasibility, in terms of if that's the price that can be paid? Will the company cashflow that price? It has to be able to leverage, you know, to buy that stock from the owner and pay back that loan with interest over time? And will that leave the company in a good position? So our feasibility study looks at that and looks at what the after transaction cash flow might be like, and how that would be repaid. And we want to look at that from a couple different stakeholders perspective, from the stakeholder of the owner, what's in it for them, from the stakeholder of the company, you know, can it survive and thrive, repaying this debt? And then finally, from the stakeholder perspective of the employee, if this thing does, what it's supposed to do, how much doc why be allocated? And how much will that look like as a percentage of my salary each year? What kind of employee benefit is being created for me? So I think truly, you got to look at it from all those three points of view of those stakeholders, the shareholder of the company, and the employees to make it good to go or no go decision.
Ed Mysogland 35:44
But it's all 100% confidential, right? You're not going in climbing over my over my business talking to the employees talking to customers? Because I think from an exit planning standpoint, that'll that'll really botch up someone's business in a hurry.
Andy Manchir 36:02
Isn't that true? Is that true? Yes. Everything we're doing is going to be confidential. In fact, it's oftentimes the case where we're working on this with the owner, and maybe one maybe their financial person in their business. And that's all they want to have. That's the exclusive group of people that know about this ESOP idea at first. So we can work in a very confidential way, at first, to help the business owner assess their thoughts before they would proceed on any path.
Ed Mysogland 36:29
Okay, so So the process is we do a feasibility study. We give the Go ahead. We move forward with it. The ESOP gets deployed. Now, what happens? Well, I know there's some oversight with the fiduciary or with the trustee, that has a fiduciary responsibility to the ESOP. Now, there's also ongoing, ongoing maintenance of the ESOP to to reevaluate annually. Is there any anything else besides the business valuation each year?
Andy Manchir 37:00
Well, well, there is, and maybe we should back up just a minute talk a little bit about the ESOP team, because once you've, once you've created this feasibility study, you know, you're doing a transaction much like much like any other transaction, so there's going to be a team of professionals, they're gonna need to be employees to take us from feasibility to an ESA, you're gonna need to hire ESOP counsel. To help establish the ESOP legally and set it up. You're going to need we've talked about this trustee, you're in need to hire a trustee, which company will do that, you're going to need to hire a valuation firm to value the stock for the transaction. What Andy does with this feasibility study is to approximate where the value is going to come in from the valuation firm, to give the business owner an idea what an ESOP trustee is going to accept as an offer to sell the company and the trustee except he's going to rely on that valuation person, you're likely to have your corporate counsel involved in the transaction also. And you'll also need a third party administrator to to get in line to do some of the studies that pulmonaria will need to be done as you're forming the ESOP not only be the record keeper, for the employees, benefit accounts going forward, but also to do some testing heading in to make sure that the ESOP is going to be properly diversified. Along those lines, of course, you're going to have to find a banker that is familiar and comfortable with ESOP transactions and doing those so working with those professionals and getting an ESOP transaction done is probably first and foremost. So once you form that he saw, things that might be different from what you what the business owner has been used to in the past and operating his company, he will be getting that annual valuation determine the valuation share, and working with that third party administrator. A lot of times because there's been debt taken on to form the ESOP, if the company was doing no assurance work on their financial statements, they'll step up to either probably a review or even an audited financial statements. So that will be something new and different as an ESOP company that you may or may not have had before. You're going to be engaging with your ESOP counsel from time to time as things come up. If you have over 100 participants in your ESOP plan, you're going to have to have that plan audited, that you may not have had a plan or an ERISA plan or benefit plan that was audited before and so that that will be new in the process also, is there
Ed Mysogland 39:33
is there a benchmark like 5% of revenue is is a good number that that you should back out of your your ongoing cash flow as I'm just trying to figure out if a business owner is sitting there saying, Alright, I've got a million dollars in EBIT up and it's gonna cost me two grand 200 grand each year to to administer the ESOP. Does that make sense? Yeah, no,
Andy Manchir 40:00
I, that number will be awfully high. No, I don't think the administration costs the carrying costs gonna be, there'll be a fraction of that because you do have to pay a valuation firm as Mark said, you have to pay that trustee if you want to have an outside trustee, and we recommend that there's that plan administrator, and occasionally the lawyer. But we often ballpark the some of those for, let's say, if you're a million dollar you but our company, oh, gosh, 40 to $50,000 will be those carrying costs. So much less lower, but there are carrying costs, you know, because you're administering an employee benefit plan. By the same token, if you're an S corporation, and your ESOP buys 100% of the stock, you know, a million dollars to EBIT, da, you might pay, oh, gosh, let's say 300,000 of tax or 250,000 of tax? Well, if I'm gonna spend 50 of administrative costs, let's say on the high end, and not pay hundreds of $1,000 of tax, that's pretty good deal.
Ed Mysogland 41:01
Totally, totally agree with you. Well, my last question, I want to be sensitive due to your time. But my last question is, if you had one piece of advice to give to our listeners that would have the most immediate impact on the value of their business, what would it be?
Andy Manchir 41:16
That's a good question. I think, pay attention to like who's on the bus, I think let's bring that issue back around. That's true, whether it's an employee owned solution you go with with an ESOP, or a third party sale, you know, invest in your own team, even if that means paying someone more paying them for training, don't be afraid to lock up those employees, you know, with a good golden handcuffs plan, or promise them a portion of the proceeds when you sell someday, you know, there's a number of ways you can work with your advisors to incentivize and retain your key people. But in a workforce that's increasingly hard to for, it's hard to find good employees. I don't know how many now hiring signs, I saw that over the past weekend, just driving around, you know, you're going to be you're going to be, you know, shorthand, if you can't find and retain good employees,
increasing your value for potential sale via to an ESOP or a third party, I mean, those those things you should look at are going to be the same in either case, and and he brought up good points, but also looking at your processes and procedures. And as kind of a vanilla term. See if there's any fat in your organization that you can, you can trim out. We all talk about modifications, diva doc expenses, that you wouldn't have, that a third party or an ESOP wouldn't have going forward, that should be added back. But inefficiencies in your business are usually not identifiable as easily. And correcting those before you enter a sales process is going to be pretty important maximizing not only a sale to a third party, but what your valuation would be in an ESOP transaction. Yeah,
Ed Mysogland 43:02
I agree. So what's the best way we can connect with you guys?
Andy Manchir 43:06
Well encourage everyone to look at our website, www dot ksm cpa.com/esop. There are some white papers that our group has published to kind of help everyone read a little more about the topic. First, we've got a white paper that serves as the beginner's guide to Aesop's explaining how the transaction works. There's one that helps you take stock of the option and see where you fit. There's also a white paper that covers the feasibility study comp topic I mentioned in greater detail. So I think that there's some great reading, I would encourage everyone to check out right away, and happy to work with, with that, and with any business owners that want to consider the option because as I said, it won't fit everybody. Mark said just because we have a hammer, not everything's a nail. But by the same token, I will be happy if all business owners at least think about it, and then assess that. And if that happens, we will have more employee ownership and in America than we've ever had. And that's gonna be good for the economy. It's gonna be good for the owners, and it's gonna be good for our workers.
Ed Mysogland 44:12
Well, you guys, I can't thank you enough for your time and I apologize for for going over a little bit. But it's it certainly was well worth the time on on my end and I and I can't thank you enough for for taking the time to share with with our folks and being defenders of business value.
Andy Manchir 44:30
We appreciate you taking the time to talk with Andy and I. We've enjoyed it.
We've enjoyed it and getting me to talk less about Aesop's is a challenge that you have faced or getting me to not talk about it is a difficult thing. So I'm glad we we kept it under an hour.
Ed Mysogland 44:44
Well you know what, let's do it again. Sometime we will have part two. Alright guys.
On today’s show, Ed connects with finance experts Andy and Mark to dig into all things ESOP. Many business owners want to offer stock options to their employees but don't really understand the implications or process. Andy Manchir and Mark Flinchum of Indianapolis based CPA firm Katz, Sapper and Miller chat with Ed and answer some of the most common questions regarding the what and why of ESOPS and unveil when ESOP formation is a good option—and when it's not.