The Business Exit Strategy Few Owners Understand … ESOPs with Katy Whitehead

E#55: In this episode of Budget Your Business, Scott Geller sits down with Katy Whitehead to break down how ESOPs (Employee Stock Ownership Plans) work and why they are becoming an increasingly popular succession strategy for business owners. They discuss how ESOPs can help owners preserve company culture, reward employees, maintain independence, and create a long-term transition plan without selling to an outside buyer. Katy also explains the financial structure behind ESOPs, the role of cash flow and valuation, how employees benefit from ownership, and the key factors business owners should evaluate before considering an ESOP.

Book Recommendation: The Five Types of Wealth by Sahil Bloom

Find out more about Katy Whitehead: https://esoptrustcompany.com/ 

Find more episodes on Apple podcast, Spotify, Amazon Music and here: https://budgetyourbusinesspodcast.buzzsprout.com/

Transcript

Welcome And Guest Introduction

SPEAKER_00 0:00

Welcome to the Budget Your Business podcast, where small business owners go to learn how to financially plan for every aspect of their business. Let's get started with your host, Scott Geller.

Scott 0:13

Hello, I'm Scott Geller, your host of Budget Your Business, and today we are talking about eSOPs with Katie Whitehead. Hello, Katie. Thanks for joining us. Absolutely. So, Katie, let me ask you the big question, my first big question here is Is saying eSOP plans redundant, or can I say ESOPs? ESOP is great. Okay. All right. So for our listeners, and and I'm a proponent of making sure folks know what acronyms stand for. ESOP stands for Employee Stock Ownership Plan. And it's an ownership structure that quite, you know, I've talked to businesses about quite honestly. I don't know a whole lot about. So I'm really excited to have Katie on here today to help us understand what it can mean for them. So, Katie, why don't you tell us a little bit about yourself and what you do?

SPEAKER_02 1:12

Sure, I'd love to. Um, I'm a co-founder and shareholder of ESOP Trust Company. So I am an ESOP trustee. I am based in the Portland, Maine area, and my background is in tax and business valuation. Before co-founding the firm with two partners, I spent more than a decade working in the ESOP space, including time at one of the largest national institutional trust companies. Just to give a quick background on ESOP Trust Company, we're an independent institutional ESOP trustee firm. We're licensed and chartered in the state of Washington, and why Washington? Because one of my business partners is a Washington resident. And we serve ESOP clients nationwide, all the way from Maine to Hawaii.

Scott 2:01

Wow, that's that's interesting. So that just being licensed in Washington doesn't mean you only operate in Washington, right? I mean, you you're sounds like you're across the entire U.S. then.

SPEAKER_02 2:11

That's correct. We're chartered out of the state of Washington. So we're we're regulated and licensed by the state of Washington, but we are a trust company nationally. Gotcha.

Scott 2:21

Okay. Well, let's let's start with in the simplest terms of can you give us an idea of exactly what is an eSOP other than an employee stock ownership plan?

ESOP Basics In Plain English

SPEAKER_02 2:34

Sure. So just some really simple terms. Um, an eSOP is a retirement plan that allows employees to gradually become owners of a company they work for. And I often get the quote the question of, well, is it is it like a 401k? And it is like a 401k, which is a retirement plan, it is different. Uh with a 401k, employees are contributing part of their own paycheck and often are investing in a diversified portfolio of stocks and bonds. But an ESOP works differently. It's primarily invested in the company's own stock, and employees don't put it in any of their own money. And instead, the company sets up a trust that holds the company's shares, and those shares are gradually gradually allocated to employees over time as a retirement benefit.

Succession Legacy And Employee Ownership

Scott 3:29

Okay, so let's start with why would a company consider an ESOP?

SPEAKER_02 3:35

Sure. So in my experience, it usually comes down to three things: succession, legacy, and employees. Most owners want to transition out of their business in a way that protects the company they've built. It's their baby. They want to preserve the culture and take care of their people who have helped grow the company and who they also consider oftentimes as family. And an eSOP can make that possible. It can provide liquidity, help the business be stay independent, and create real ownership for the employees. And over time, it can often lead to stronger employee engagement and long-term wealth creation for the employees.

Scott 4:18

What does the owner get out of this? Like of the actual ESOP transaction?

SPEAKER_02 4:23

Sure. So besides eSOPs are appealing from a legacy and cultural standpoint, they also create a built-in buyer for the business, which allows an owner to transition gradually instead of selling to an outside party.

Scott 4:40

Yeah, tell us a little bit more of that. Because I think a lot of well, I know you see a lot of stories about the baby boomer population moving on and selling a lot of businesses selling these days and a lot of transactions. But why does this work? Or maybe compare this to going and truly just selling a business in maybe the more traditional route. Sure. Like to an outside buyer. Correct. Yeah, that's a better way of saying it. Yes, versus uh selling a business to an outside uh party.

SPEAKER_02 5:19

Sure. So again, while why while east why eesops are really appealing is because they allow the company to stay independent. And a lot of times we've seen with companies that sell to a third-party buyer, the um often the business can be closed down, the um taken away from the community. So the you know, a lot of these businesses um are part of the community and they employ a lot of the individuals that live in the community. So it kind of preserves the company, it preserves the community, and then the business doesn't get absorbed or disappear, and it continues with the same people and often a stronger sense of purpose. And another another um advantage of ESOPs are tax advantages. So some eSops may offer some tax advantages for both the company and the selling shareholder, depending on the how the transact uh transaction is structured. So, for example, a 100% ESOP town S-corp generally pays no federal income tax at the corporate level. And in some states, they may also be exempt from state income tax. So that can be really appealing to a to a seller as well.

Cash Up Front Notes And Taxes

Scott 6:35

Okay. And let me I'm I'm really curious about how does that so when you sell at an external party that say I sell my business for $20 million? I'm gonna get, unless there's some type of earnout, $20 million. You know, if I close on the 8th, on May 8th, then I'm gonna get $20 million in a in a in a wire within 24, 48 hours. Maybe there's some earnout, but let's just say it's all. How does that really work with an eSop? Like, am I still getting that money up front, or does that differ a little bit?

SPEAKER_02 7:12

Sure, that's a great question. And and it it varies um based on the transaction. But most eSop transactions are structured where the seller may receive a portion of cash up front. It depends it depends on again how the deal is structured. But let's just say typically they'll receive a small portion of cash up front at close, but then there's financing, and that could look like bank debt or uh seller financing. And more often than not, what I see with the smaller and middle size ESOP companies is that the seller does hold a note and they are paid, they are paid for their ownership over a period of time.

Scott 8:00

And where do those funds come from? I mean, where where does it coming from the performance of the business, coming from the employees?

SPEAKER_02 8:08

That's a great question. So the company does, in fact, make the payments through cash flow to either fund the bank debt or the seller note.

Scott 8:19

Okay, so it's very similar. Well, you said it yourself, it's very similar to a seller finance sale where the business is is funding this, which to me as a from the CFO side of the house means you really have to, I mean, the the it has to be a successful business, right? It needs to be a cash-flowing business that has profitability in it. Otherwise, there's nothing to pay the owner back.

SPEAKER_02 8:49

Absolutely. And that's typically, you know, when we look at companies who are best suited for an eSop, and those are typically the companies with strong predictable cash flow, strong leadership, and then a focus on long-term growth and stability. Those are very important because you have to make sure that you know cash flow can fund the um the debt structure with the ESOP. And that and that is part of the whole like transaction structure that happens in discussions before the ESOP close, obviously. We look at feasibility, we look at cash flow analysis, there's valuations done. So there's you know, a long-term um purview of what does the future cash flow look like and can it support the um structure of the ESOP?

Scott 9:38

And does the owner have to put that together ahead of time? Or is that where we're like your your maybe your uh company would have come in or or somebody else to help them figure that out?

SPEAKER_02 9:50

Sure. So I can just briefly walk through the steps you know a business owner would want to take to become an ASOP if that's helpful, because I think that will answer your question.

Scott 10:00

It it probably will, and it'll probably answer like the next two or three questions as I jump around. So yeah, let's let's take that round instead of me uh uh jumping around a bit.

SPEAKER_02 10:08

Sure, sure.

Feasibility Study And Advisory Team

SPEAKER_02 10:10

So, first of all, um what would be important is if if a business owner is interested in in investigating an Aesop, um you know, they really they really have to think about like, is it a good fit? And that usually starts with like a high-level look at the business. And again, talking about like, does the company have a steady cash flow? Is there a strong leadership team in place? Um, does the owner care about both value and legacy and not just the highest price? So really getting an idea of is the company a good fit? And if the business owner, I'm just gonna use singular, if the business owner feels like, yeah, this seems like a really great, a great um path to investigate, you know, I want to preserve the culture and the stay in the community and and treat and reward my employees, then the next uh step would be a feasibility study. And so that's where really the business owner digs into the numbers, like what's the company worth? How much could they realistically be sold to an ASOP, and whether that structure actually works financially? And then once you get that feasibility study done, um, which you would use a professional professional to help with that, and then the the business owner would start building a team, an advisory team. And that would look like um ASOP legal counsel, valuation advisor, maybe a financial advisor or a banker, tax professionals. It's really, really like a team sport. And then after that, that's where the independent trustee um would be hired to come in to uh oversee that everything um negotiated is uh in the best in a best interest of the employees.

Scott 11:52

So is it similar to to, I imagine it's gotta be somewhat similar to going through like a due diligence process?

SPEAKER_02 11:59

Yes, there's definitely a lot of due diligence built in throughout the process from from the during the feasibility study and um assembling the advisory team.

Trustee Oversight And Fair Market Value

SPEAKER_02 12:14

And of course, to the trustee would hire their own team, which would be ASOP uh counsel and evaluation advisor, to also um look at the terms of the deal and to make sure that the price they pay is not greater than fair market value.

Scott 12:30

Right, because you you can't otherwise it's it'd be kind of one-sided, right? That's right. So that provides that that counterparty where the employees aren't going to get together and put together their own counterparty for this situation, but it's but it has to be there for somewhere.

SPEAKER_02 12:52

Yes, and so the trustee really is is appointed to represent the best interest of the employees. So the employees don't have, you know, again, they don't put any in any of their own money. Um, they earn ownership over a period of time through um the allocation of shares to their own retirement plan. But the trustee makes sure that the ESOP pays no more than fair market value. And at its core, fair market value is what a well-informed buyer would reasonably pay for a company and what a well-informed seller would accept under normal conditions. So no one's under duress or pressure to sell the business. And I think of it like selling a house. The fair market value is the price you'd get after a normal sale with informed buyers and no pressure on either side. And so in an ESOP transaction, we're doing something very similar, but instead of a house, it's a company, and it's the trustees' job, my job, to make sure that the eSOP pays no more than the fair price based on an independent analysis. So even if the owner might get a higher price from a strategic buyer, the ESOP has to stay grounded in fair market value.

Scott 14:06

Understood. Speaking about this fair price, and and it's I get that you had the trustee and the seller. Have you seen any situations where maybe the seller's goal uh goals or or you know objectives kind of conflict with the ASOP structure?

SPEAKER_02 14:31

Yes, I have seen that, but uh very infrequently because typically the the ESOP deals that I am um the trustee for those the alignment of what is the seller's goals um are aligned with the with the ESOP structure because they have a good advisor, a sell side advisor. So if they're going through those steps I spoke about, like, is it a good fit and having a feasibility study and really understanding the ESOP structure through their advisory team more often or not? Like if they feel like they want to sell to a strategic buyer, they just they just walk away from from even moving forward with an ESOP. So yes, I've seen that, but more often than not, that's vetted very early in the process when they kind of go through those first steps to figure out if it's a good fit.

Scott 15:30

That makes sense. And and if an owner's going down this or considering this, you you want to vet that out probably early because it's not it's not free to go through this process, right?

unknown 15:41

It's not.

SPEAKER_02 15:42

It's a it can be costly, and um, so it's really you know, you want to be really clear about is this the right path for you?

Scott 15:50

Right. Okay. Let

How Employees Build Real Wealth

Scott 15:52

let me I we we've really been focusing on the owner side, and I want to kind of switch directions a little bit because I'm curious from the employees' perspective. And how how do employees typically take this or or like how do you see the employees react to this type of program?

SPEAKER_02 16:14

Sure. So I would say that employees, you know, it's all about the communication of the eSop to the employees. So what are the benefits of an ESOP? How can it benefit the employees? How can their actions help um increase the value of the company? And so I really think what's important is really to communicate that ownership culture to the employees, where they treat the butt the business like it's their own. And so in practice, um I often see over time, as the as the as the um employees become more knowledgeable about what an ESOP is, um, it may look like the employees spot problems and fix them without being asked. And they look for ways to improve efficiency or reduce costs. And they think beyond their job description to help the company succeed. Because ultimately, you know, the efforts they put into the company can reap the rewards and long-term growth, stability and profit and higher profitability.

Scott 17:26

Specifically, how do they like financially? How does that come back to the employees?

SPEAKER_02 17:32

Sure. So an ESOP is valued annually for an industry administrative purposes. So every year, typically that falls on December 31st, the company is valued. Uh, the trustee, the independent trustee oversees the valuation process. So they hire an independent, competent valuation firm who um performs diligence and and lots of calculations and provides a valuation report for the ESOP trustee to review and then approve. And so that uh share price is set um, like I said, typically 1231. Some ESOP companies it may be 630, it depends. Um but I more often than not, I see uh the administrative value set at 1231. And so presumably over time, um that value should increase uh based on the uh cash flow and the uh profitability of the company. And so how what that um comes down to is over time, the employees will have shares allocated to their umesop accounts. And so those shares, if the value, the annual value of the ESOP increases over time, therefore their ESOP balance should increase over time. Much like if you hold a stock, like let's say in Coca-Cola, you buy the stock at a dollar a share, and you hope that over time that dollar per share will increase to $50 per share.

Scott 19:17

Okay. And then at some point, I imagine, they can sell this uh share. Is that is that kind of the end point of word in uh ultimately?

SPEAKER_02 19:29

Sure. It's they don't sell it exactly, they redeem the shares. So for instance, let's say um an employee is departing from the company because of retirement. And that end and that employee, the ESOP's been in place for 20 years, the individual retires at 60, their shares would be redeemed, and then that employee would be paid out for their shares, typically over a set period of time. It depends how the plan document is written, but let's just use for basic conversation. They would res they would receive that value of the shares in their ESOP account over a five-year period.

Scott 20:10

I see. Okay. So does that well let me ask you this though. I I I get the side of if you retire and and I imagine if if you leave, maybe I'll throw out two two scenarios. If you leave um without retiring, you just kind of leave, it's one. But what if what if you're um let go, right? Like like what if this you you it's involuntary because the company lets you go. How how does that work?

SPEAKER_02 20:39

So if you if you're um fired? Correct.

Scott 20:42

Yes.

SPEAKER_02 20:43

So again, it depends on the how the plan document is written, but if an employee is fired um and they are vested and their account is vested, then they would still receive the value of their ASOP shares. But again, it depends if they're vested. Just like with a profit sharing plan, um, if you leave before you're vested, you you forfeit that profit sharing contribution, right? Um same same for the ESOP. So however you depart the company, if you're not vested, you will not receive the proceeds from the ESOP shares.

Scott 21:27

Understood. That makes sense. What about new employees coming in? How does how does that work?

SPEAKER_02 21:34

Sure. So for new employees coming in, again, it depends on how the plan document's written. So typically there's a certain amount of hours and time that the that the individual has to be at the company before they will they will start to receive allocation of ESOP shares. Very similar to a 401k, where a lot of companies require You're there for a certain period of time before you can start contributing or before you receive any um profit sharing contributions. Okay, that makes sense.

Scott 22:11

Now I I get it. I I'm a CFO by heart, so I've been heavy on the financial side of this. Sure.

Ownership Culture And Financial Transparency

Scott 22:19

Let me step out of my CFO uh seat and say, what have you seen this do to you you touched on this before, but what have you seen this do for like the culture of an organization?

SPEAKER_02 22:31

Yeah, so I would say that typically, and there's always nuances, but typically it creates an ownership culture. And again, it's it's the employees treating the business like their own. I mean, when you own something, you tend to treat it with more care. And your decisions that you make are more, I'm not saying always, but more thoughtful. Um and, you know, again, if you see a problem or you, or you can, you know, you think about how can I fix that going forward? Or sometimes even if you see some some other employees that are making choices that aren't in the best interest of the company, you might bring that to the attention of your supervisor or or the president because you see that it could harm the long-term profitability and growth of the company.

Scott 23:26

And do they also have a little more insight into the financial performance of the business? I imagine they would have to.

SPEAKER_02 23:36

Well, it depends. Um, it depends on the company. And if there's transparency um by leadership. Um, typically what I see is the communication of the financial aspects of the company. If they're not transparent before the ESOP, I don't typically see them becoming transparent after the ESOP. Now, of course, the employees will receive a share statement annually, um, just like most individuals receive their 401k statement quarterly. Um, so they are aware of the value of the company. However, there's no requirement that the financials become transparent to the employees. That's dependent on management.

Scott 24:33

Okay. So so you it's not like like a publicly traded business where you have to disclose your financials quarterly and uh Correct. So, okay. All right, that that helped. I I I'm sure it's probably how how you write it up as well, but that that that makes sense.

Company Fit Costs And Leverage

Scott 24:50

So let me ask you, um we what type of companies are best suited for an ESOP?

SPEAKER_02 24:59

So I would say the best type of companies, best suited or type of companies that are best suited for an ESOP are typically uh companies with strong predictable cash flow, again, strong leadership, and a focus on long-term growth and stability.

Scott 25:18

And do you see this in any specific industries?

SPEAKER_02 25:24

I would not say it's industry specific. Um we work with companies across all different industries. So it really just depends on the company and the leadership.

Scott 25:38

Okay. And you you did mention at one point, you you mentioned that you know kind of a small and or and it makes makes sense for small and medium-sized businesses. I've I found everybody has a different definition of what's small and medium size. Are there specific sizes that work better than others?

SPEAKER_02 25:59

Well, I think the most important thing to remember is that the company needs to be able to support the transaction. So again, with an eSOP, the company is highly leveraged in in the early years, right? Because they need to buy out the selling shareholder or shareholders. So again, it comes down to can the company uh can the company's cash flow support a leveraged company? And that would be part of the whole feasibility study process and the diligence process of the trustee as well as the um uh company's um advisory team. So, and there are costs that um are incurred, some are one-time, some are ongoing costs to become an ESOP. So you have, you know, again, your transaction costs, and then you also have your administrative costs post-transaction, which looks like an annual valuation, um, the annual trustee fee, the um uh you need an administrator to um handle your your um ESOP um um administrative items, such as like um so like a third-party administrator, like most companies have for their 401ks. So there are some costs um that are ongoing. So I guess it really depends on does the um struct will the long-term structure and profitability support the ESOP? So I'm and sorry, so I've seen ESOPs that are 8 million, you know, like of eight million um to 500 million. So I mean it again, it's does can cash flow support the ESOP structure.

Scott 27:53

Got it. Okay, yeah, uh I I I I see that I imagine maybe one one kind of wrapping this up is um why don't more companies go down this path?

Why ESOPs Are Still Underused

SPEAKER_02 28:08

Good question. Probably um lack of knowledge. I mean, it is it is really a great um path for owners who are looking for both liquidity and preserving legacy and not just the high highest price. So I I think it comes down to educating business owners of the benefits of an ESOP, like I spoke about earlier. There are some tax advantages based on how the deal is structured. Um again, there's a lot of benefits to the community and um creating again liquidity. Um it's a runway for for business owners who aren't ready to exit the business, but they create an it creates a nice runway for those business owners who want to over time um exit the company and they put a succession plan in place. So there's a lot, there's a lot of amazing benefits. Um, not to mention that I would say on the average, like ESOP companies are more successful, not always, but can be more successful just based on the fact that there's that ownership culture in play. So, and a lot of a lot of um, I would say cus like I've talked to some ESOP companies who whose customers love the fact that they're employee-owned. You know, they they want to work with them because they have the employees are are part, you know, owners of the company. So I think there's lots of benefits, and hopefully we'll continue to see um eSops grow as as um there's more education around them. There's a couple of great organizations too that are really um wonderful in providing um eSop education, whether you are considering an ESOP or you are an ESOP. And those two organizations are the ESOP Association and then NCEO, which is stands for the National Center for Employee Ownership.

Scott 30:18

Thanks. Thanks for that. I was I was about to ask if there's any resources because I don't know uh you you've definitely opened my eyes to this. I I I've I've had a cursory, I've not worked with an e-sopp, I'll put it that way first, and and two, I've had a cursory understanding. And I could continue uh diving in deeper around this, but I know we're I I want to respect your time and not take up too much of it.

Three Actions Owners Can Take

Scott 30:42

This this has been a a really interesting dive into eSops. And as we wrap up our shows, the the one thing we always ask is our guests is one of three immediate takeaways that our listeners could literally put into action as they turn off the podcast. And I'd like to hear what you might share with us. It might be and if it's something you've already mentioned, that's fine. You can even remind us.

SPEAKER_02 31:09

Great. Sure. So I guess my the first takeaway would be like if you're you know, if you're a business owner or you're like in the C-suite and you know, you're thinking about, whoa, okay, like how can we reward our employees? And or I want to find an exit strategy. And and um I guess it's ultimately if you're interested in becoming an Aesop, the first takeaway would be to talk to a professional. Um, I'd be happy if any of your listeners are interested in learning about more about esops or about umesop trust company. Um, they can find me at um on our website at esoptrustcompany.com. Um I'd be happy to to talk to any any of your listeners. And then the second tech takeaway would be again, as I mentioned, is figuring out if it's a if an eSop's a good good fit for your company. Um and again, that goes back to like cash flow, leadership team, what are your values? Do you want to preserve legacy and not just at the highest price? And then the third takeaway would be um really determining if if an ESOP is feasible for the company. So digging into the numbers and determining what the company is worth and could it realistically be sold to an ESOP and whether that structure uh would work financially.

Scott 32:32

I like those, and I appreciate you walking through those uh those three because I do feel like this is uh an area where an expert can be really valuable. We'll we'll include those in our in the show notes as well. Great. Uh the the the last question I have is we enjoy a good podcast or a good book recommendation. What do you have for us today?

SPEAKER_02 32:53

Sure. So I have this great book that I took out. I love the library, so I take out books from the library all the time. And I actually, and so I read books from the library, and then I decide do I want to invest and buy the book? And I did, in fact, buy this book. So it's called Um The Five Types of Wealth by Sahel Bloom. That's S-A-H-I-L, and then Bloom. And it's a transformative guide to design your dream life. Um, and he covers the five types of wealth, such as time, social, mental, physical, and financial wealth. So I highly recommend this book. I think you'll be using your highlighter if you still use a highlighter, which I do.

Scott 33:38

So I I use a highlighter as well. I'm looking at two sitting to my right that I have high, you know, notes sticking out of as well as highlighting in it. So I'm right there with you and appreciate you sharing that one. That that's a new one for us. It's that it's great. Well, Katie, thank you again. Well, where can I think you threw out there once, but just try to wrap it up. But where can people um find out more about you?

SPEAKER_02 34:05

Yes, so you um you can find out more about me on our website, which is uh Esop, that's ESOP trustcompany.com. And um my contact information is on the bottom of the website. So I welcome any of your listeners to reach out to me if they want to learn more about esops or about eesop trust company, and I'd be happy to talk with them.

Scott 34:32

Well, thank you. I I know I've learned a lot today. This is this has been a uh great deep dive for me, and I appreciate you joining me today.

SPEAKER_02 34:40

Thanks so much, Scott, for having me. I really appreciate it.

Closing And Share The Show

Scott 34:44

All right, folks, that's it for today. I appreciate you joining us and hope you join me for the next episode.

SPEAKER_00 34:55

If you like the show or found something useful, text someone right now and say, I have a podcast recommendation to check out, budget your business. You can also like the show or find more at your favorite podcast locations, Apple Podcasts, Spotify, and Amazon. Thank you for listening, and we hope you join us for our next guest on Budget Your Business.