[Nicola Gelormino]
Is an employee stock ownership plan right for your business? Today we're sitting down with an expert to cover everything from how they work to benefits for your business Like tax advantages and employee retention. You don't want to miss this episode so join us on this edition of The Inside BS Show Hey now, I'm Nikki G this is the Inside BS Show and we are talking all about ESOPs today We're going to answer all of those questions that you have I know you've heard about them and you want to know more.

Most of us don't really have a good understanding So we're going to cover all of that with our guest Before we do that. We're going to bring on my co-host Dave Lorenzo. Dave.

How are you?

[Dave Lorenzo]
Hey now Nikki G. I am absolutely fantastic I get asked at least once a week about an ESOP and most people who ask me about it Candidly they don't even know how to spell it. So there are so many misconceptions out there Nobody knows what ESOP stands for People don't know the benefits to their business.

They don't know how much it costs to do one They don't know why they should do it But every entrepreneur that I know that has a business that's doing more than 10 million dollars a year in revenue Is curious about an ESOP? So we scoured the earth and we found the best possible person for us to talk to today I am super excited to have this conversation Nicola when was the first time that ESOPs first came to the forefront of your mind? When did you did you like wake up in the morning and go?

Oh my gosh, I need to know what an ESOP is Like how did you first figure out that we needed to learn about ESOPs?

[Nicola Gelormino]
You know, I think like most people sitting in our audience right now you hear the term thrown around So at some point I did, you know If you're in the business world, you've heard that term and you likely don't know what it means and that's okay So either you're curious and you start looking into it or you just kind of wait for it to hit you like right now This episode so that's when I first heard it I am sure and started really digging into it when you and I were working through, you know Highlighting specific exit strategies that we thought our audience needed to know about.

[Dave Lorenzo]
Yeah So for me I was I did a talk at a vistage group and Whenever you speak to an audience of vistage business owners You you really are the veterinarian because in that room is every breed of dog cat sheep pig that you can possibly imagine And it's not just different industries. It's all different levels of business ownership There are people in there who have businesses that are doing like 2 million in annual revenue And then there could be normally it tops out at like 50 or maybe 60 so in this particular room There was a gentleman it was in it was in toledo, ohio And there was a gentleman who owned a construction company that was doing like 175 million dollars a year in revenue And I start the talk the way I start all talks and I said, hey, how is this going to end for you? Why don't each why don't we go around the room and each of you tell me?

What your plan is for when you're ready to exit your business? And the construction company owner went last and he said well dave, you know, I I'm, not really sure but I need to do something sooner rather than later And my financial advisor has mentioned in aesop to me several times. I'm thinking it might be a good strategy Dave, what do you think?

and i'm standing there and I Basically looked at him and i'm like aesop like like the fables like the guy who like the tortoise and the hare or whatever And and he's like no no, no, it's a specific plan So that was when immediately I like during the break i'm on my phone like googling trying to figure out This is before you and I were in esl together before we started this i'm trying to figure out what an aesop is And I said to him i'm honestly not an expert so I can't give you advice on that But anytime you start to think of a way to exit your business It's it's a good thing regardless of whether you're in your business from day one and you're thinking about an exit Or you're starting to think about it today So that was my way of kind of bridging the gap and I immediately Thought to myself I need to go try and figure out what this is and that's how we kind of Drove ourselves to meeting our guest today once we started exit success lab, we knew we needed to read up on esops and we Got into them and we knew for sure that we were never going to be the people to give advice to business owners who were thinking about Using this strategy as an exit for their business But the more I read about it the more I realized that this not only Would be a good strategy for someone long term. It also serves as an excellent Contingency option as well. So if you're joining us today and the question What is an esop has popped into your mind or your financial advisor or your accountant has mentioned an esop to you This is the show for you because our guest today is andrew nicolai and he is an expert in this area This is what he does all day every day.

He lives and breathes the thing that we are so baffled by So good morning, andrew. Welcome to the show today Thank you so much for agreeing to be here and to pull back the curtain on esops for us Of course, i'm excited to be here today and talk about esops. Thanks for having me Oh, no, thank you.

And I you know, the first thing I want to ask you out of the gate is Do you do people are people as baffled as I am by this? Like when you when you go to a cocktail party and you say listen I help people plan for their financial future and I have specific knowledge of esops. Do they do they look at you and go?

What what is an esop? Is it just me or is this a common thing?

[Andrew Nikolai]
No, it's it's everyone so don't feel ashamed Uh, even just what the acronym stands for we hear employee stock option plan, you know There's there's a lot of different words that get thrown out there So just to be clear, we're talking about employee stock ownership plans Uh, but yeah, it's very common, you know, like you guys both mentioned esop get thrown gets thrown around there Uh a lot and people really don't understand what it is how it works and there's certainly a lot of misconceptions about it

[Nicola Gelormino]
Let's start from the beginning andrew tell our audience what an esop is just give us a broad overview And then we're going to dig into a few different areas

[Andrew Nikolai]
Yeah, so an esop is An erisa qualified, uh type of retirement plan. So it's governed by similar rules like a 401k We think about an esop as a tax advantage leverage buyout of someone's company So esops are unique in that it can borrow money to purchase equity from a business owner so an esop, you know essentially functions like a tax advantage exit strategy where you're At the end of the day transferring ownership of the company to your employees through an employee stock ownership trust So a trust is formed that trust ultimately becomes the buyer of the equity in this transaction and that trust, you know has a trustee that Has a fiduciary obligation to the employees who are ultimately the beneficiaries of this trust

[Dave Lorenzo]
So let's start start from the beginning when when you say that ownership is transferred to the employees Do you when do you set up the esop? So if I i'm a business owner and i'm maybe 10 years away from exiting let's say Do I come to you at the when i'm 10 years away or 15 years away and I say hey listen I want to make sure that my employees are involved in this business and that they're engaged for the long term I want to I want to think about what i'm going to do to give them some piece of ownership How far in advance can you set it up? How far in advance should you set it up and then I don't lose any control as a business owner, right?

[Andrew Nikolai]
That's right. Yeah, so it's always better to start sooner You know, I think a lot of times if a business owner waits too long Then it can actually eliminate an esop as a potential exit strategy Because at the end of the day an esop is not a strategy where you can really walk away tomorrow And cash out, you know 100 of the value of your company It's really typically a longer term strategy where you're exiting over a 5 10 Can be a 15 year period so certainly starting sooner is better but Uh, yeah, it's it's a it's a strategy that you know has a lot of advantages Certainly, we're going to talk a lot about taxes today because there are specific tax incentives built into the tax code to incentivize more employee ownership And more esop transactions, so we'll certainly get into all of those as well

[Nicola Gelormino]
So andrew you you have mentioned I mean look at the timeline for the exit itself can be a period of 5 10 15 years How long does this process take to put the esop in?

[Andrew Nikolai]
Yeah, so i'll i'll cut the process into two different stages stage one Is typically called a feasibility analysis And it's meant to determine is an esop a feasible strategy for the business owner that stage takes about four weeks to complete uh, it's typically based on you know, an initial set of financial information and the goal is to Model out all of the different transaction structures that are available determine The valuation of the company the financing options and really lay out a comprehensive view Of what's possible with an esop and if it is feasible We'll sit down Go through that with the business owner for a few hours talk through all the options and if at that point It's something they want to move forward with we're going to move on to stage two Which is really a full esop transaction bringing in all the other parties that need to be involved And that stage two Process is typically more like a six month end-to-end process.

So all in you're looking at You know, I would say five to seven months.

[Nicola Gelormino]
Uh From stage one to stage two and and closing a transaction Okay, and since you started with feasibility i'd like to ask this What type of company is best suited for an esop because I know it's not for every company out there So what are you really looking at when you are doing the feasibility analysis?

[Andrew Nikolai]
yeah, so we're looking at does the company have you know a management team and a Significant number of employees in place that are going to be able to sort of operate the business you know one thing to point out with an esop transaction is The internal team that's running the company today Continues to run the company tomorrow It is not a transaction where a new buyer comes in and is going to operate the business So it's certainly important to make sure that there are operators in the business today that can run the business tomorrow post transaction Especially if the business owner is planning to step back and be less involved post transaction. So we're going to focus on that We're going to look at the financials Make sure that from a financial perspective they can support the cost of a transaction they can support You know if the owner wants to raise You know debt financing that the business can support that and really making sure that you know The company overall is ready to move forward with this transaction that can be you know, somewhat complicated. So We want to make sure the business has enough scale and size to support a transaction Typically we define that as being a minimum of 20 full-time employees and you know EBITDA or earnings of about two or three million dollars at the low end Uh, that was a that was the next question that I was going to ask is what size business?

[Dave Lorenzo]
Is needed in order to support this so two or three million dollars at the low end of EBITDA and I would also imagine and you can speak to this and this is my question to you is Do you need to be in a business or an industry that is relatively stable? So do you need to be in a business or an industry where there aren't a lot of peaks and valleys where you have significant recurring revenue where you have the ability to forecast a floor in Earnings year over year a floor in your EBITDA Year over year and the reason that I ask that is because I know There are specific I think anyway, I shouldn't say I know I think there are specific funding requirements for the trust so Andrew speak to the need for a significant amount of predictable Earnings and the reason why it's so important and the requirements that you need to keep up with every year When you enter into an ESOP

[Andrew Nikolai]
Yeah, that's certainly something that we're going to look at and is an important part of making a transaction successful and feasible Particularly when you know the ESOP trust that's coming in and buying the shares isn't bringing cash to the table It's not a private equity firm that has money raised So we're going out and raising debt financing most of the time to support a transaction And that's really what provides the business owner cash at close And so because of that the banks are going to make sure that the company has a sustainable level of cash flow They're going to be able to repay this debt going forward and especially if the business owner wants to take more cash out up front It becomes more important to look at the recurring nature of the revenue the sustainability and how predictable it is going forward So that's certainly something that we kind of analyze and look into as part of that initial feasibility analysis

[Nicola Gelormino]
And Andrew, I believe your background is in capital markets. And so for you that financing piece I mean, you've really been doing that before you moved into working with ESOP So I really want to ask you about when you were putting the financing in place You know, what what are you looking at in terms of like how you determine the amount of debt to finance? There's a there's a valuation associated with this, right?

[Andrew Nikolai]
Yeah, that's right. So there's two different pieces There's one what's the value of the company, right? And that's based on a discounted cash flow analysis.

It's based on Uh looking at publicly traded companies in this industry Uh, you know all of your traditional valuation methodologies and that sets the value of the company Then when we're going to go through an ESOP transaction It's split up into how much of that value am I going to get in cash? And how much am I going to get in the form of what's typically called a seller note? And so we need to look into both sides of the equation first setting the value And then if you want to move forward with an ESOP sale How much of that consideration and value is going to come in the form of cash versus deferred consideration that?

Ultimately is dependent on the future cash flows of the business to get that value out so we work with Uh, you know many lenders that are familiar with ESOPs. We have pretty deep relationships across the country So it allows us to you know run, uh, our clients and prospective clients um by By lenders who are going to finance these transactions and get a read from them on What they would be willing to do to support an ESOP transaction And then we'll model it out look into the the covenant levels look into you know The credit capacity of the company the collateral that's available and make sure that we're not putting the company in a tough position By you know putting too much debt on the business

[Dave Lorenzo]
I was going to ask that what's the what's the loan secured by what secures the loan? Is it A specific asset in the company So for example if the company owns a building or maybe the owner owns a building Is that what secures the loan or is it just the receivables that are coming into the business? How is the loan secured?

[Andrew Nikolai]
Yeah, generally the lender for an ESOP transaction is going to have a first lien on all the company's assets So that's going to include accounts receivable inventory There's any hard assets like equipment or real estate Uh, but you know a lot of times it can just be secured by the cash flows of the business And so that goes back to what we're saying About the sustainability and recurring nature of it You know with the construction company example that you mentioned earlier the backlog and and what's you know sort of built up Uh going into a transaction that helps support it. So it depends on each industry But generally they're going to have a first lien position On all the company's assets and then also look into the cash flow the contract structure of the business And and really get comfortable with you know, what is the company going to produce going forward to repay this loan?

[Dave Lorenzo]
and when The business enters into the ESOP and the and the ESOP is set up What is the communication like to the employees they don't technically have ownership on day one do they and what Percentage how do you decide what percentage the employees are going to get?

[Andrew Nikolai]
Yeah, i'll quickly cover two misconceptions because we hear a lot one You know people are concerned that employees are going to have access to sensitive financial information Which is generally not the case if the business decides to share that they can But it's not a requirement of an ESOP transaction Employees, you know technically are beneficial Owners through the ESOP trust structure. So the second misconception is i'm concerned You know if I sell to an ESOP and to the employees Everyone's going to be rich tomorrow and they're all going to quit and leave the company That again is not the case. Uh this the structure of the shares that are purchased by the ESOP Go into what's called a suspense account They sit there and generally get released over a long period of time call it 25 to 30 can be as high as 50 years and That structure is set up because this is meant to be a retirement benefit for the employees It's something that's given out over a long period of time And you also want to reserve shares for all of the future employees as the business grows and hires more people When there's turnover you need to keep some, you know dry powder i'll call it for those future employees. So Initially all the shares sit in the suspense account There's going to be an annual allocation where shares get released to all the employees and then each employee participates in that allocation Generally based on their compensation as a percentage of total company payroll and then Andrew

[Nicola Gelormino]
So we talked about the shares being essentially they're they sit until they're released over time and What happens if an employee does leave the company? Can they can they get the can they sell the shares and what are the the requirements there to be able to do it?

[Andrew Nikolai]
Yeah, so they're not allowed to take the shares with them They have the right to put those shares back to the company and the company makes them Before they leave the company uh They're building up value every year. They're going to have shares that go into their esop account There's an updated share price. And so they're building up paper value When you retire if you're terminated when you decide to leave the company That's when you convert that value into cash and there's certain restrictions The company can set up front when they're designing the esop plan In how that cash is paid whether it's over a five or you know, six year period if it's immediate So they do have the right to cash those in once they leave the company

[Nicola Gelormino]
Something you also touched on andrew was like who continues to run the company So the management stays in place because I think there's another misnomer that I want to ask about which is that people think the employees Now have a say in how the company is run because they have an ownership interest.

So talk to us about that a little bit Yeah, that's right.

[Andrew Nikolai]
So Generally post esop the board of directors is the one that's going to be running the company and making all the operational decisions There is really no change in the employee's ability to influence You know hiring and firing decisions other than what it was pre-transaction It continues post-transaction But it's not like all of a sudden, you know If you sell to an esop your employees can come the next day and say we're firing you That's not how it works A lot of our clients actually choose to go the path of an esop because of that retained control aspect Because you know, we have clients that are worried about their legacy Maybe their name is on the door or on the name of the company And they want to make sure that they're protecting that legacy going forward.

So an esop is transaction is a way to Monetize your equity get some chips off the table and diversify your wealth But still maintain control of the company that you've built over time And really make sure you're protecting the management team and the employees.

[Dave Lorenzo]
All right, so let's Look at a couple of scenarios and then we can talk about taxes. We can talk about What like we can talk about when you get all the money from the esop? And does the owner have to exit or can he or she continue to run the company?

But first let's talk about Something that this is like the first question that I get asked all the time about an esop So i'm in an industry dave where private equity is buying up everybody If I do an esop and private equity comes along am I going to be less attractive and that's my That's my client asking dave a question voice just so you know So andrew, what is the answer to that? If you're in an industry where private equity is gobbling everybody up and you have an esop in place what happens?

[Andrew Nikolai]
Yeah, I mean we we help our clients that you know have previously sold to an esop do some sort of third-party sale Every year it's certainly still possible I think one of the misconceptions that makes people think it's going to be harder to be sold in the future post esop Is you know the ownership structure what we talked about where? The private equity firm isn't going to come in and have to convince every employee to sell their shares to them, right? You're dealing with The top level entity which is the trustee who has the fiduciary obligation To make decisions that are beneficial for all of the employees So if a private equity firm comes and says We want to acquire the business for twice the price that you paid when you bought the shares from the business owner that's a good deal and the trustee has an obligation to consider it and most of the time if they have the option to Convert the value of privately held equity in this business to cash and put that cash in all of the employees pockets That's something that they're going to consider and a lot of times decide That's a good deal for us and we should take it on behalf of the employees

[Dave Lorenzo]
so Does the esop own the business the minute it's set up because the way you're the way you're talking It seems like ownership has already transferred

[Andrew Nikolai]
Technically the trust is the legal owner Of all the shares that the esop acquires Uh, but the the shares are sitting in that suspense account and and start to get released out to all the employees slowly over time but but all the shares are Legally owned by the trust Uh, but it also depends on the structure of the transaction, right?

Maybe you only sold 30% to the esop This is not an all or nothing type of deal. You can sell 30 49 75 there's lots of different options. So it depends on what the initial structure was

[Dave Lorenzo]
And you get paid When you make that transaction So if i'm setting up the esop 15 years before my ultimate exit and I say the esop's going to own 30% of the company You guys i'm sure do a valuation and you can tell us what the process is for that you do a valuation you determine the company's worth x and then You go out and borrow the money to pay me the 30%.

So I get that 30% right now. Yes Is that how that works?

[Andrew Nikolai]
That's right.

[Dave Lorenzo]
Yep, exactly How is the valuation done explain to the folks who are watching and listening how the valuation is done?

[Andrew Nikolai]
Yeah, so you hit on one of the misconceptions earlier that you know If I want to sell to an esop I have to be willing to sell at a discount or take a discount to what? I would otherwise get on the market and generally that's not what we see There are even some industries that maybe you can get a little bit more but especially when you consider some of the tax advantages that we'll get into and look at things on an after-tax basis, so We're going to be running a valuation just like a prospective private equity acquirer would be You're running a discounted cash flow analysis.

You're looking at precedent transactions in the industry Publicly traded companies and using sort of a blended approach of those different methodologies To come up with what's called a fair market value for the company So all of those approaches lead to this valuation. It is a negotiation that we have to do with the trustee Who also is hiring their own valuation advisor and expert who does the valuation on their side? And then we sort of trade back and forth and end up somewhere in the middle I would say You know relative to a strategic buyer who is willing to pay a higher price for the synergies that they're going to recognize Then yes, we will admit that an esop is going to be a discount to that But relative to you know a private equity or other financial buyer, I think you're going to see valuations You know pretty similar between those different transactions

[Nicola Gelormino]
So you mentioned that esops can really vary in terms of the Percentage that you're going to have as the ownership in the trust anywhere from it could be 30 to even 100 It could be a full amount.

So I think it's a great place to start with tax benefits So tell us and I think that that's probably the top advantage that we think about when we are considering esop So tell us about some of the tax advantages.

[Andrew Nikolai]
Yeah, so i'll start with The the first tax advantage that's really to the selling business owner and it's called section 1042 if any of the listeners are familiar with section 1031 in real estate Which allows you to sell a building and roll over the gain into you know a like-kind property 1042 is not too far away in the tax code and it operates very similarly, but it's specifically designed for esop transactions So when you sell your business to an esop subject to certain requirements and reinvestment requirements You can defer and potentially eliminate the capital gains taxes on that sale to the esop So that becomes an extremely powerful benefit, especially for business owners that live in new york city california other high tax jurisdictions Where you're going to lose, you know 30 40 percent In any other transaction with an esop that can be brought down to zero So some of the requirements to be eligible for 1042 Are one you have to you have to have held the stock for at least three years The company has to be a c corporation at the time of the transaction And the esop has to own at least 30 percent So that's generally why we use 30 as the low end when you're considering an esop transaction There's no requirement to take advantage of the 1042 benefit, but it does provide a significant Benefit when you look at it on an after-tax basis relative to other transactions

[Nicola Gelormino]
And so that's I mean, that's really a personal benefit to the owner So and there's corporate benefits on the tax side as well, right?

[Andrew Nikolai]
Yeah, that's right. So most of our clients eventually want to get to A hundred percent esop owned s corporation Because under that structure you can actually operate a hundred percent tax-free from federal and most state income taxes Which is a really powerful benefit into perpetuity You can be making 1 million dollars a year or 10 million dollars a year. It doesn't matter You don't pay taxes on it.

So That is a really powerful benefit that ultimately helps to like we're talking about before Repaying debt from a transaction all of the tax savings You know right now if you're structured as an llc or an s-corp and you're personally taxable for all the income of the company That immediately goes to zero all of those tax savings and cash flow is freed up to then Repay the debt from the transaction and pay out the business owner from the transaction So that that becomes a really powerful corporate benefit And that's under the s-corp structure if the company is a c-corp and is taxable at the corporate level There's also a sort of a bucket of tax deductions that are created From the esop and that can be used to shield your taxable income going forward. So under a c-corp structure You're probably going to be looking at a 10 or 15 percent effective tax rate After you factor in all the deductions with the esop transaction Okay.

[Nicola Gelormino]
Wow, that's significant. So at the s-corp level we can have up to 100 Tax-free operations state and federal level and then the c-corp we have significant tax benefits as well I just wanted to highlight that because that is very very significant.

[Dave Lorenzo]
How does the control of the business work if the esop? Is the 100 owner of the business does the trustee then crawl the shots? How does that work andrew?

[Andrew Nikolai]
Yeah, that's a good question. The trustee really comes in as a passive investor They don't want to make operational decisions because that's not what's good for the employees They know that the founder the management team the people that are running the business today Are the ones that are best suited to run the business tomorrow And if they do something to impact that or change that it can actually negatively impact the employees and the beneficiaries of this transaction so The trustee will sometimes require certain corporate governance Measures that be agreed on or negotiated as part of a transaction That can look like setting up a board of directors with one or two independent board members It can look like a compensation or an audit committee being set up to handle certain Measures like that, but generally the esop trustee is not sitting on the board of directors. They don't want to sit on it Any operational decisions like hiring firing bonuses all of that sort of stuff? is handled by the board of directors like it is today and the trustee will get involved for more major decisions like You want to sell a division of the company?

You want to make an acquisition? Larger scale decisions like that are then going to require, you know bringing in the trustee Having them review it and sign off on it But other than that the trustee really comes in as passive investor They want to look out for their fiduciary obligation to the employees and and to make sure that uh things go well for them

[Dave Lorenzo]
Now I have a i've heard I have a question about Uh something that triggers an automatic purchase by by the esop is there is there something where if uh, if an offer is made and the esop is In a better position that they automatic that that sale is automatically triggered. I don't know where I heard it I don't even know if it's a thing but do you have any idea what i'm talking about?

[Andrew Nikolai]
There can be something called event protection, which is really an automatic Acceleration of shares that get released and allocated to employees There's never going to be an automatic you know acceptance of a purchase or a sale because the trustee wants the right to Review the terms of the transaction at that time and it's hard to say now if the price in the future You know is the right price or is considered fair?

So there there there is something though where shares may be accelerated and given out to employees faster Uh, it's sort of like an accelerated vesting schedule Where you know the employees would receive more in a transaction if the company gets sold Uh in the future and to other specific trustees for just esops because I know in certain spaces There are like they're that's all they do. So tell us a little bit about the trustees who serve in this capacity Yeah, that's right most of the trust companies that we work with Uh have specifically been set up for esop transactions So there's a group of you know Call it five to seven trustees across the u.s that we work with a lot of times. They're former attorneys Uh, or maybe former cfo's individuals that have some sort of prior esop experience Uh that have gone out and kind of set set up a trust company or set up a shop on their own and they're exclusively set up to Negotiate esop transactions and serve in that trust capacity So their role is to negotiate the terms of the transaction On behalf of the employees and so they hire their own counsel for every transaction They hire their own valuation expert for each transaction and rely on those advisors expertise to help them determine what is fair market value and what are you know a set of legal documents in terms that Will be a good deal for the employees

[Nicola Gelormino]
And that makes sense because there's also a high level of regulation and compliance associated with esos And you you mentioned when we started that, you know, these are it's an employee benefit plan So talk to us a little bit about that.

[Andrew Nikolai]
I mean about the the structure associated with that because there is that compliance component so all esop transactions are governed by Uh the department of labor by the irs. Uh, there there are certainly Um landmines to avoid and a lot of sort of guardrails in place to protect the employees the department of labor is primarily concerned about The trustee and these transactions paying too much because it'll disadvantage the employees post transaction so there are certain restrictions and rules in place and it's very important to make sure that You're working with advisors and you know council individuals that are aware of these there is flexibility within those guardrails as well But there are things to avoid We also work with third-party administrators who can help run compliance testing And help with the bookkeeping to make sure that we don't run into any issues there

[Nicola Gelormino]
And especially post transaction kind of who's really who's really driving that ship making sure that we are remaining in compliance with the laws that apply

[Andrew Nikolai]
Yeah, so I think it's important that things are set up initially in terms of designing the esop plan So for example, you know vesting schedules for employees in terms of how they invest in their shares There are things that are allowed and things that aren't so it's first about designing things up front That don't immediately, you know cause any issues But then also, you know The trustees are certainly involved in looking out to make sure that nothing changes post transaction that would cause issues And then you have that extra layer of the third-party administrator who has very detailed software testing They're going to look at the allocation schedules by employees and really make sure that there are no Compliance issues and if something does come up, you know work with the company and their counsel to You know restructure things a little bit to avoid that issue

[Dave Lorenzo]
So andrew does everyone get the same amount of shares or can I decide can I say? okay, my management team gets these this amount of shares and You know the truck drivers get this amount of shares and the people who work in the warehouse get this amount of shares Can you portion out who gets what shares and is all the are all the shares weighted the same? Is there any preferred stock versus common stock?

How does that work?

[Andrew Nikolai]
Yeah, so there's two primary options to set up initially at a high level that ESOP has to be Uh done on a non-discretionary basis Meaning you can't pick and choose certain individuals that are going to get more than the other You set up a set of rules and all the shares get allocated out to employees based on those rules So the most common and first approach we'll talk about is based on compensation So everyone's payroll as a percentage of total company payroll is the percentage of shares that they'll get through the ESOP So the person making a hundred thousand dollars gets twice as many shares as the person making fifty thousand dollars so automatically you have more shares going to Generally, the people that are more important are the ones making more money in the company So you automatically have that disparity between employees? The other main option is to set up some sort of point system where you can give credit for years of service And other certain attributes where you sort of set up a formula and so now instead of compensation You're taking other, you know, maybe qualitative factors into account and allocating shares that way again but there are rules in place to make sure that The lower level employees that are making less aren't disadvantaged through these plans So a lot of times what we do as part of an ESOP transaction is set up an additional management incentive plan That allows you to pick and choose If there are other employees who you want to get more you already have some disparity in the ESOP But you can set up something like a stock appreciation right plan Where then you can pick and choose these three people or these five people are most important to me and so we're going to give them a little bit extra to make sure that they're incentivized to You know run the business and make sure it performs

[Dave Lorenzo]
so if I already have people in my company and i've said These three people are key employees and when I was doing Five million in revenue and two million in EBITDA I decided I was going to take five percent of the company and break it up among These three people or six percent break it up among these three people give them two percent each Now i'm gonna set up the ESOP They they're just treated like just like I am as other owners and they can Can they participate in the ESOP as well as have that percentage of ownership and can I as the owner? Also participate in the ESOP.

[Andrew Nikolai]
Yeah, so the main restriction on participating in the ESOP is Going back to that section 1042 capital gains deferral benefit that we talked about If you take advantage of that benefit Then you and your family are excluded from participating in the ESOP So you're going to get that capital gains benefit and instead you're not able to participate if you don't take advantage of it Then you are eligible and can participate in the ESOP.

So that's typically how it works But if you have equity outside of the ESOP, you can also get more shares through the ESOP That's not a problem

[Nicola Gelormino]
And I just want to put a fine point on this because I want to make sure it's clear for our audience So all the employees have to share in it once it is established And from there we can have some variation or disparity in additional participation whether that's from management or key employees or others

[Andrew Nikolai]
That's very common for our clients to want to have you know Everyone in the ESOP get something But then give the people that are sitting at the top and are really going to be running the business going forward To have a little extra to make sure that they're incentivized

[Nicola Gelormino]
That's great. And then a lot of what you highlighted really is suggesting that these are highly customized plans So talk to us a little bit about that because I don't think this is a cookie cutter situation with any ESOP plan that you're handling

[Andrew Nikolai]
It's something that makes it interesting and exciting every client we work with is a different situation So it certainly doesn't get boring or mundane, but it's also very complicated Just like we talked about up front you could sell 30 percent 100 percent or anywhere in between There are structures to include warrants these management incentive plans that we talked about So it's certainly very important to look at what all the options are Try and work with the business owner up front to figure out what they're trying to achieve and what their objectives are And then designing the structure around what they're trying to achieve Because an ESOP is so flexible. It provides, you know, virtually infinite amount of options.

And so it's really you know about that upfront work to Narrow down what options make the most sense and align with what the business owner is trying to achieve

[Dave Lorenzo]
So Andrew, what does it cost to set this up initially because that's the thing we hear I would love to do it But it's there's a cost associated with setting it up and then there are costs every year And the trust has to be funded I mean I get all kinds of nervous Nellies complaining about this stuff and most of the time they don't know what they're talking about so You do know what you're talking about because this is your deal What does it cost to set up? What does it cost every year? Tell me about funding the trust and I know that everything is customized blah blah blah But give me the minimum like the minimum for each level.

[Andrew Nikolai]
Yeah, I would say generally we tell Anyone who's interested in understanding what an ESOP would look like and what the costs are To at least move forward with that stage one analysis because it's so dependent on the structure and how complicated things are the size of the business all of those details We will typically outline all of the costs involved with the potential ESOP transaction as part of that stage one feasibility analysis Typically that upfront feasibility analysis is going to cost, you know, five ten, maybe fifteen thousand dollars So the idea is, you know, the cost is kept relatively low up front To unlock, you know, what does an ESOP look like? What are the costs involved if you decide you want to move forward with an ESOP transaction?

Generally all in the costs are going to, you know range, but I would say start around You know a few hundred thousand dollars at a minimum and scale up from there depending on the complexity Depending on the structure depending on the capital raise portion and what that looks like So there is certainly an upfront cost, but I think it's also important to Really see the full feasibility analysis to understand What are the benefits because if you're going to save, you know, five million dollars in capital gains taxes Have a business that operates 100% tax-free going forward and saves, you know, 100 million dollars in corporate taxes Well, maybe the 500,000 or million dollar investment up front to do the deal is a pretty good return when you consider it You know with all of those other benefits.

[Dave Lorenzo]
What about maintenance on an annual basis? Is there a percentage of the ownership or a percentage like how does the maintenance every year work?

[Andrew Nikolai]
Yeah, so there's three parties that will be involved and will continue to get paid on an annual basis. First You have the third party administrator who's responsible for doing all of the back-end bookkeeping Administration and compliance testing with an ESOP transaction. I would roughly say they're going to you know charge about ten thousand dollars a year Next you have the ESOP trustee and their valuation advisor.

They stay involved on an annual basis going forward Because they have to update the valuation and the share price so that when employees get their statement that says you own this many shares They need to also know what the price per share is. So the trustee and their valuation advisor I would roughly think about them on an annual basis costing Probably forty thousand maybe fifty thousand dollars a year So all in you know, I would say forty or fifty thousand on an annual basis is is really the ongoing maintenance costs

[Dave Lorenzo]
Okay, you said there were there were three So the trustee and the valuation advisor are two and three and the administrator is number one Okay, great.

So you're talking about I mean, you know fifty sixty thousand dollars in annual costs and you're talking about half a million to a million bucks to set up But you're going to save a ton of money in taxes and that's the way To look at it. And if you're and if you're saving them that money in taxes year after year after year That's how that's how it ends up paying off for you in the long run does size of the business have an impact on The fees to set it up and the administrative fees going forward or are those administrative fees pretty boilerplate? They just have to do what they have to do every year whether you're a 10 million dollar business or 100 million dollar business

[Andrew Nikolai]
Yeah, I would say maybe they scale up a little bit the administrative fees So, you know 50 to 75 for a higher business, but you know, they're generally pretty steady The cost up front may be a little bit more It also depends on if there's any sort of corporate reorganization that needs to take place so there's some clients that come to us and they have 10 different, you know entities that all need to be rolled up in a tax efficient manner So that they can all be sold to the ESOP So things like that if there needs to be some sort of conversion to a C corp or an S corp All that is taken into account when we think about the fees And then also the capital raise and the financing portion of it how complicated that will be How aggressive does the business owner want to get all of those sort of details are factored in?

[Dave Lorenzo]
When we think about the upfront cost and what happens if the owner dies the ESOP is set up And the owner still let's say we do a 49 51 ESOP And the 51 is the owner the ESOP owns 49 And the owner gets hit by a truck and he dies before anything, you know before he's ready to exit How is that handled with an ESOP in place?

[Andrew Nikolai]
Yeah, the nice thing about having done the ESOP prior is you already have set up a buyer that Can essentially acquire more equity at any point in the future. So, you know You've already set a valuation on the business. It's going to be updated on an annual basis So, you know pretty much what you're going to get for that 51.

It's subject to negotiation, of course But you've already kind of put in place a plan For future exit opportunities and for future sales in the future and it can be done in a relatively streamlined and efficient manner Because all of that due diligence information and all that work was done up front. So the second sale is typically streamlined and more efficient the other thing I would briefly point out is There are a lot of estate planning opportunities as well When you think about doing a minority sale of 30 or 49 percent initially A lot of our clients will take advantage immediately post transaction Of the lower valuation of the company because of the transaction debt that was placed on the balance sheet And use that temporary reduction in value to move, you know in this example the 51 Into a trust or into some sort of other vehicle that is now outside of their estate So if you do pass away before you monetize that value A lot of times you've already avoided the estate taxes that would come with it.

[Dave Lorenzo]
Yeah, that's a great idea.

[Nicola Gelormino]
I love that Andrew, I wanted to ask just briefly about the maintenance fees Are those governed by statute or is it just like standard in the industry?

[Andrew Nikolai]
Yeah, it's based on you know a fair market what trustees and valuation advisors are looking to Charge and be paid for the work that they're doing on an ongoing basis So generally in order to update that valuation and that price per share every year They need to look into how did the company perform last year? What are the expectations for the future? And essentially do the same valuation work that they did for the upfront transaction.

So there will be conversations with management a brief or a due diligence process But there is some work that they'll need to do in order to refresh the numbers and the valuation and so It's sort of just defined by what they're they're looking to be paid for that work

[Dave Lorenzo]
When people decide they don't want to do this, what are they telling you their reasons are if they you know besides money Let's take that off the table, you know cheapskates aren't going to do this But if they're eligible they meet all the criteria What is the reasoning? Why do they say no?

[Andrew Nikolai]
I think a lot of times Uh, it's because people are looking to exit sooner. They want to walk away tomorrow or the next day You know, they're burnt out they're looking for someone to come in and take over the operations And the ESOP is really not that we've talked about how the management team and the board it's going to keep running the business and so that's most common I would say is when You're ready to retire tomorrow and ESOP generally isn't going to be the best fit unless you have a really strong management team That's already running the day-to-day and it'll allow you to step back.

[Nicola Gelormino]
I mean on that point Andrew, what's what's generally the owner's involvement? Once it's in place

[Andrew Nikolai]
yeah, it's it's generally decided by them if they want to Step back and just be chairman of the board and have you know quarterly or monthly board meetings and and be updated Somewhat regularly and they trust the team that's in place and running the business That is certainly an option if they want to be the ceo continue to take a salary and continue to You know really run most of the operational decisions. That's also an option I would say we do have a number of clients that are young, you know, I think 40 years old They're proactively thinking about an exit strategy So maybe they start with a 30 percent sale, but they still want to work for the next 10 15 20 years and that's certainly possible But they're setting up a plan in place to sort of exit over that time period and over that horizon

[Dave Lorenzo]
Andrew tell us a little bit about your firm Tell us what what you guys do all day And then let's talk about how people can get in touch with you if they want help with something along these lines

[Andrew Nikolai]
So csg partners is a boutique investment bank that's based in new york city We've been around for 25 years now and have done over 350 esops over that time So we're one of the most active financial advisors in the country.

We have a nationwide practice Uh, we work in all different industries But esops are really all that we do if we work with the business owner And they decide they want to go through a traditional private equity sale or third-party sale most of the time we're going to step aside and say You can probably find someone better to help you with that transaction We go very deep and really specialize in esops the tax benefits How to structure them how to raise the financing for them and really how to you know, optimize the outcome for the business owner

[Nicola Gelormino]
Tell us when should business owners contact you?

[Andrew Nikolai]
Yeah, I mean, I think it's always worth at least getting that stage one analysis done We've had some clients that will do that come back, you know, five ten years later and say okay I'm ready to do it now, but at least they got that information and could make you know informed decisions about it going forward We're not going to sit here and say every single business owner should do an esop or it's always going to be the right fit But at least as you're considering your options and what strategies may be the right fit You should look into and at least do that initial analysis to see The full outcome of an esop transaction and then you can compare it to your other options and make an informed decision

[Dave Lorenzo]
So I want to recap for everyone who's listening and watching what people should be thinking about When they are getting ready to call you so the ibida threshold you said we probably should look at like three million and op in ibida because There's there's going to need to be kind of a tax justification For setting this up three million in ibida is the dollar threshold you mentioned I think you also mentioned a number of employees threshold.

What was that again? Andrew? Yeah, I would say 20 full-time employees 20 full-time employees That's when it makes sense there and then the upfront analysis that you and your team will do You gave us a range.

Let's call it fifteen thousand dollars That's what you plan on spending at least fifteen thousand dollars to get that upfront analysis done And what that is for you is that's going to be your guide as to whether or not it makes sense And even if you don't decide to do the esop now You've got the peace of mind you paid fifteen thousand dollars for an education to understand The potential tax benefits of doing the esop Then you can plan on spending a minimum of around three hundred thousand dollars to set up the esop Bigger more complicated esop planning ventures are going to scale up So anywhere from three hundred thousand to a million is the setup and then you're talking about Sixty seventy thousand dollars a year every year in administrative fees But you don't lose any control you immediately will get some type of a windfall Once the company is sold because they're going to get a loan that's going to pay you some money And every year you're going to participate in tax savings that will way more than offset these expenses so the question is Do you have the wherewithal up front to get this set up and make all of this happen?

That's why there's an ebita threshold of three million or more 20 20 employees or more i'm sure that has to do with government regulations and all of that sort of thing So andrew as we look at this whole thing and we look at the entire esop spectrum When owners are making this decision And they don't have a sale to somebody else on the horizon this is a really good contingency plan like you said if the owner gets hit by a boss or Somebody in their family gets sick and they decide they need to take care of them Immediately. There's a trigger to go ahead and sell I'm assuming that the valuation because you mentioned that there's a fee every year valuation is done every year So we know what the stock price is every year So if I wake up on a tuesday morning and I decide i'm out I can be out at any time

[Andrew Nikolai]
Yeah, it'll you know, it'll take a little bit of time to document it But certainly you at least have an annual You know sense of of what you know The rest of your equity would be worth and you know, we have some clients that say all right I'm going to do a 30% sale today Diversify my wealth put this option in place in the future and maybe in 5 10 some years down the line I plan to sell the business to a third party And that will allow the employees to at least participate in that sale and get 30% of the proceeds at that time And that'll be really my ultimate exit and where I cash out the rest of it So there's always a range of options, but it doesn't preclude any future transactions If you decide you want to do a minority sale today

[Dave Lorenzo]
So how long is your setup period in a moderately complicated? So not the easiest but not the worst how long is your setup period in the in the upfront?

[Andrew Nikolai]
Yeah, I think I would roughly say plan for six months to complete an esop transaction and a lot of that is defined on You know How has the business been prepared? Are they ready to go through a transaction? Do they need to get some sort of quality of earnings or reviewed financials or something done up front?

That's going to add time to the front end of a transaction before you can really start moving forward with it So if the business is ready and has prepared some of that already, you know, think about a six month process start to end All right, andrew tell us how people can contact you if they'd like to have a conversation about an esop Whether it's right now it's imminent or it's down the road. Yeah So our you know, our website is csg partners. We are here to be esop experts We want to be and we are talking about esops every day.

So Whether you have questions about it, you know, just want educational resources Want more detail on anything we've discussed today? You can find you know my information. It's a nicolai at csgpartners.com is my email address But our entire team is listed on our website You can reach out to any of us and we're here to help people Understand esops and and figure out is it the right fit for you?

[Dave Lorenzo]
All righty. Thank you. Andrew.

Nicolai from csg partners That is fantastic information. It has been Wonderful Speaking with you about this you covered every question that we had and we really appreciate it If you want to reach out to andrew his contact information is down in the show notes If for some reason you want to ask us a question We will probably pull andrew in and get him on a conference call so you can call him directly reach out to him With the information down below And esop is an option for you if you have a business with 20 employees or more are doing more than three million dollars in ibida and you Want to take some chips off the table in the short term and continue to run your business Continue to live your life the way you're living it with just a little bit more money and esop might be a good fit for you We are incredibly grateful to andrew nicolai for spending the last hour with us it has been an honor to have him here This is the inside bs show.

We're here every day with a show at 6 a.m Every week with a brand new interview for you. I am dave lorenzo the godfather of growth and she is Nikki g until next time here's hoping you make a great living and live a great life