Second Stage ESOP Transactions: What Changes When the ESOP Goes to 100%

Ben Spadt (00:00)
good morning, everybody. welcome to a special edition of ESOP Radio. today we’re talking about second stage ESOP transactions and planning the next chapter for.

the company. let’s get started. I’m Ben Spadt

And I’m here with Trevor Gilmore. we’re with the Menke group. And yeah, what we want to accomplish today is by the end of this, to have a better understanding about second stage ESOP transactions, what they are, and how they differ from the initial sale of shares to the ESOP, the steps that are required to execute a successful second stage transaction, who’s involved.

You know, similar there are similar parties to the initial transaction and there are some that are potentially different or not required. and some key issues and best practices that we as advisors have run into as we’ve taken these on. so Trevor, what is a second stage transaction?

Trevor Gilmore (01:01)
Yeah, thanks, Ben. And hi everyone. Good morning. so big picture, what is a second stage transaction? And in the context of today’s discussion, it is taking the ESOP from its existing ownership.

Which in the today’s conversation is going to be less than 100% up to a higher amount. Usually it means taking the ESOP from a minority ownership position, meaning less than 50%, up to 100%. But we see all things here at MENKE. So sometimes it means taking the company from 30% ESOP to 49% ESOP, taking it from 40, maybe up to 70, 75. Usually though, when we see it go above 50,

It’s two a hundred for a lot of reasons that we’re gonna cover today.

Ben Spadt (01:44)
And so you know, this like I said before, this is not the initial formation of the ESOP and the first purchase of stock. So it’s a little bit different there. And it’s often a follow-on transaction. Like Trevor said, you know, we’re moving from some material amount of shares to usually a hundred percent, but we do see some instances where there’s less than a hundred percent being purchased by the ESOP. so before we get into what’s next.

Trevor, what do you find that triggers, you know, whether it’s a company metric or attitude or something like that, what triggers the need for a second stage transaction?

Trevor Gilmore (02:28)
Yeah, absolutely. So most companies who hire us to execute quarterback and see the second stage transaction from beginning through end and beyond have a lot of intention going 100% ESOP. That’s usually their long-term vision here. So maybe we did the first tranche, maybe we set up the ESOP and it has a small stake, 10, 20, 30 percent, maybe 49%. And then the pathway of the company is to go 100% at some point. So

Overall intention, that’s one of the the biggest indicators, but then you think of some qualitative and quantitative aspects too. so you talk about the company, is there a strong management team in place?

Is the company operating well in the financial aspects, operational aspects? Are revenue steady growing. Same thing with profit. I’m going to share the story of a second stage transaction that we did recently for one of our clients based here in California. And they did the first tranche back in 2016, sold 40%. The company is a

I guess these days you’d call them a high-end gourmet grocery store. They’re based up in the wine country, so north of San Francisco, I think Sonoma County, Napa County, up in that region. Company started in the 70s and basically grew to five plus locations and the ownership were made in the hands of the founder. And over time, of course, looking at the various options, big box stores, et cetera, wanted to buy them out.

They said, hey, we are better off independent. Let’s go ESOP. We have a strong team in place. We have a very strong brand and a very loyal customer base. So the ESOP made tons of sense. So in 2016, they did a 40% ESOP deal where the ESOP came in and became the 40% shareholder. That went well. The debt related to that was paid off over five years, and the company

continued to grow and its revenues reached about 250 million and they started talking to us about going a hundred percent because they they were ready. The owner, the controlling owner wa is in his seventies and it was time to oversee that transition to the ESOP. They tested it out with 40% ownership. It achieved all the goals and objectives they had laid out and it was the natural fit. So our role in the very beginning was to

Assess the value trajectory, see where the company is, where it’s headed, and then also take a look and see company management. Are they ready for a hundred percent scenario here? Because the owner was phasing out. board aspects as well. So governance. I know we’ll talk a lot about that today. What is the board looking like? And a lot of minority e-sock transactions and minority ESOP companies, the board often

remains small ’cause you don’t have a lot of governance changes needed in that situation. In a control situation, boards do often change slightly.

Let’s take a step back and talk about the grocery store. So one thing they discovered going 40% back in 2016 was that the ESOP greatly enhanced the ownership mindset that was already baked into the company culture. So on all accounts, that first tranche was very successful, which led us and everyone involved to be very excited about going to 100% because we knew hey, the company already has.

A solid base. They’ve already tried this out. It works. So it’s a natural next step. The company enjoys a very high employee retention rate, which for you all that employ anyone with customer facing jobs, think grocery stores, et cetera, typically turnover is very high. And the ESOP, because of its rich benefit and ability for employees to participate and build retirement wealth, employees stick around there. So much different compared to

the competition. And also the ESOP is very popular with their customers. So customers love coming in and seeing that the company is employee owned on the walls and so on. And they vote with their pocketbook. The company enjoys a cult like following. You know, think like Whole Foods back in the beginning years ago when Whole Foods came out. Same thing. And also their customers love that the money’s staying in the community. So all those aspects came together making this hundred percent

ESOP transaction, you know, really I would say easier and like a natural next step for the company, but there’s still obviously a lot of work that had to be done, and so on, namely reviewing valuation, setting up governance, figuring out the debt stack as well. How do you finance this whole transition? What does it mean for the seller and their cash flows? What does it mean for the company and their cash flows? And then lastly, what does it mean?

And this is most importantly, what does it mean for all the employees as well, you know, in their future retirement wealth? So a well-thought out and well-designed second stage transaction contemplates all that. And you’re going to get to a positive solution there. but Ben, I know we have a lot of more questions. so this second stage deal is about a year work here. So we got engaged and started planning and doing the financial advisory, looking at the

financing options, advising the company on the board governance, and so on. And it took about a year from beginning to end. And you’ll see that with second stage. You know, usually it’s anywhere from, you know, six, nine months to a year. And we’ll talk a lot about planning as well and why it’s so important to plan these early versus call up and say, hey, let’s do it in two months. You know, and we’ve seen those, we’ve done those at Minke of course. but of course we

longer you have time to plan and weigh the pros and cons of structure, bringing a bank on or not, doing seller financing or not, warrants or not, management stock appreciation rights plan or another management incidental plan or not, and so on. Those are all key decisions that you know should be well thought out.

Ben Spadt (08:45)
And Trevor, you’re right, we do have a couple things questions popping in, but I think we can answer them in this next section. and so utilizing the framework of that grocery store, let’s kind of walk walk through that transaction. we’ll talk about the business and strategic timing that you alluded to before, but what triggers suggest a company is ready? And this one, you know, you had stated that they had the initial transaction paid off the debt really quickly.

In and thought, okay, well, this was a good thing. Can we make it a better thing? And so they decided, well, let’s talk to Mankie, let’s go 100%. but then when it came time to decide on value, on price, you know, what are these shares going to be? What are they going to sell for? How was that different than the initial transaction? And how did that valuation shift from

You know, forty percent being non-controlling interest to one hundred percent controlling interest. Trevor, how did that differ?

Trevor Gilmore (09:50)
Yeah, so assuming most people listening today have an ESOP in place and we we looked at the the all of our customers signing up yeah most of you clients out there do have a minority or control. So that means you already have a trustee in place and you also have an annual evaluation that that happens. In this case it was a minority valuation. So generally speaking, minority annual valuations, and that’s used for the ESOP statements and so on.

generally have a discount for the minority position. Usually it’s ten to twenty percent. We see it in that range. So when we start thinking about what is this value of the company, what’s the value range? Value is always a range, you know, it’s not one number. You have to think of it in terms of control. So you eliminate the minority discount. And on top of that you have to roll the valuation forward and take a look, are there new market comps out there that are similar? Are there new data points out there?

For valuation. What are the year-to-date financials? Also the the TTMs and finance the trending 12-month financials. What trajectory are we on? So the in this case, we the deal closed in October. So relying on that 1231 valuation, of course, you can’t do that. And that’s the trajectory, you know, guideposts in terms of value and history, but in terms of where the company was at, well, they acquired a few stores and revenue was much higher. So we’re talking about

valuation that was materially higher on a controlled basis compared to the minority. So a lot of what we do is positioning and understanding what that current valuation is today with its trajectory.

Ben Spadt (11:26)
That trajectory that trajectory is important, Trevor. And the TTMs are very important too, because if you talk, think about that October transaction and you just did a year-to-date financial statement analysis, you know, you’re lobbing off the holidays there, which for the you know, high end grocery store is gonna be a big amount of business over a short period of time. So capturing an entire business cycle is very important in that and and

seeing how the value has changed over time, cash flows have changed, all very important. But then, you know, how do we pay for this? How do we structure this differently for this purchase of these tranche of shares than we did in the past? you know, before it might have been a seller note, might have been part bank financing. are those same things available to us now?

Trevor Gilmore (12:20)
Absolutely. So what we’re finding with our second stage deals is a lot of banks are interested in financing a good part of it, maybe even all, depending on the block of stock we’re talking about, the value of that block and then also what the balance sheet of the company looks like. So the financing options are very strong. A lot of transactions we’re working on these days involve bank, but a lot of them also involve seller financing. So the right answer to what is

the overall debt structure or deal structure, basically how is are we paying for this block of stock? That’s very flexible for companies that have strong balance sheets, good clean reviewed, audited statements and so on, good profit, good trajectory, good management team in place. You have a lot of options out there. And actually senior debt these days is you can get decent r you know, we’re talking about silver plus two or something like that. So you can find

relatively speaking good interest rates these days on bank financing. So one of the questions we always ask when we start this conversation is what are the goals and objectives you have as a seller and also with the company? If it’s 1042, which is that reinvestment that you sell the stock to the ESOP and then buy qualified stocks and bonds and defer the capital gains as part of your long-term trust and estate plan.

Then you’re probably looking at bank financing because you’re going to need upfront cash at close to assemble that QRP portfolio. But some of our clients have so much cash on the balance sheet as well that you could actually fund some of this by company cash flows and not even bringing in a bank. So it’s very nuanced and no right or wrong answer there. Often, though, it’s going to be a combination of bank, seller, and existing company cash on the balance sheet. And it all comes down to what

the seller cash flows needs are and how that corresponds with the company’s cash flows and we’re gonna talk about the coverage ratios and and so on, but it all is related, you know, so you have to find a solution there that meets all objectives and one that’s sustainable at the end of the day as well.

Ben Spadt (14:36)
That’s a very good point. And you know, those that stated objective, or perhaps it’s not stated, and that’s why we asked the question. you know, what are your goals here? second, you know, the the trust is already in place. It’s not like we have to, you know, write a new plan or anything like that. So most of that work is done, most of the legal work there has been done unless we need to make an amendment or modify the plan to for regulatory issues. But

We have that in place so really the the flexibility that exists and and the partners that we use. And Trevor’s right. I think the last three or four transactions that we’ve worked on have involved bank financing. So lenders are out there wanting to get a little bit more you know involved in ESOP transactions, whether it’s an initial transaction or a second stage. so they are out there.

and you alluded to something that’s very important that everybody wants to avoid, and that’s tax. And when we set up a lot of initial transactions, one of the questions is can I defer or eliminate capital gains tax? And and we, depending on the corporate structure or how we we do these transactions, we can elect a 1042 or the the selling shareholder can elect 1042.

to so delay the payment of that capital gains tax. So can we do that again on a second stage? And if so, are there any limitations?

Trevor Gilmore (16:10)
Ben, absolutely. So if you’re a C Corp and you want to sell additional shares to the ESOP, as long as the ESOP has 30% ownership right after that transaction, you can do 1042. So 1042, you see that a lot on second stage transactions. but again, in terms of what makes sense, we also have to take a look at the balance sheet, take a look at the basis. If it’s an S-corp that has a sizable basis, which we see. We’ve seen some S-corps with insane.

basis. So then 1042 is less valuable in that situation. but let’s talk about a C Corp with very low basis. Then you’re probably going to see 1042 and on second stage that often is going to be part of the structure there. Also we’re seeing more qualified small business stocks at QSBS companies where you formed a C corp and capitalized it in that framework, you know, and basically grew the company. So we’re seeing some of that as well, which the beauty of QSBS is

There’s no rollover needed. You just report it on your tax return and you don’t pay capital gains on that piece.

Ben Spadt (17:14)
That’s you know, that’s a very good point. We there are lots of avenues that we can explore. And you know, we we have a number of those conversations along the way, and we like to include the seller’s CPA, fine, you know, wealth management partner if it exists, to get that total picture of you know, what are your estate objectives, what are your legacy objectives, and you alluded to this a little, Trevor, but

That’s probably the most important because here we’ve got, you know, we’ve poured our life and soul into this business and sold 30% or some minority stake and it’s been successful and now we want to sell the rest to the ESOP. So how do we still remain in line with what those goals and objectives either were or how they’ve changed today? And that’s very important. And one thing that I find really exciting, I guess, about eSOPs.

Is that ownership attitude with the rank and file employees? And Trevor, you stated, you know, that in the grocery store example, that the people, the employees, the culture, all of that was sort of in concert with the the that early sale of of the minority share. And you know, the customers bought in, the employees bought in. But how do we communicate a move like this from

You know, we had a small stake to a much larger stake that is now ESOP owned. And how do we reinforce that with that ownership culture to say that, you know, now you are an owner of the entirety of this organization or the vast majority? how do we communicate stuff like that and and what’s our involvement as as advisors?

Trevor Gilmore (18:59)
Yeah, so how companies communicate going a hundred percent to their employees, generally I always say it’s a natural move, you know. So it shouldn’t come as a complete surprise to employees, but it also shouldn’t shock, you know, it shouldn’t be surprising, shocking. but it also doesn’t lead to, hey, you know, we’re we’ve won the lotto, right? It’s hey, this is the natural progression of the company and this makes tons of sense.

And being transparent about what it means, a big aspect of these second stage deals can be an impact on valuation. Because I think most people attending now have experience with these valuations, it’s you know really similar to most of fair market value, but equity, you know, so any debt on the balance sheet reduces your value. So when you go 100%, depending on how it’s financed, you’re probably gonna see a value reduction.

for the next couple of years, as it because now the company has to basically be levered up, whether it’s seller financing bank or you’re using excess company cash or whatever, there’s gonna be a balance sheet impact. So communicating that and explaining clearly what it means. And then on top of that, the benefits, a lot of second stage deals involve companies going to S or they already are at S, and then you have the S Corp tax shields, and now you no longer have tax distributions they

So that really conserves cash flow and helps pay for the second stage transaction. But with overall employee communications, we found you know, sharing the right amount of information, which is different for each company. It all comes down to the culture, management style, management philosophy. Some clients do open book where they share everything. I mean, at Mankie, we’re ESOP, we share quarterly financials, and then you see them, you know, and so on. you know, talk about the trajectory of the business.

So describing the ESOP in that too is is crucial. and our team goes in and can do second stage communications as well. There’s always fun to do. And I know you’ve done several of those with clients, you know, post close and talking about what it means at a high level and also what the ESOP is and so on. But we found communication it’s constant, it’s ongoing. so it’s not just one simple message, hey, we went a hundred percent.

and and so on. It’s gonna be ongoing communication. And the good thing is most of these companies who are minority soft now considering second stage already have some sort of communication already in place. You know, whatever is in place, if it’s working, just continue that with a new message about going 100%. as an employee though, you should be very excited because that means more shares are going to be released. And

If you have 10, 15, 20 years left until retirement, guess what? Your ESOP account, all things equal, is gonna go up by whatever it is, 10% a year plus whatever that stock price growth is. Think of value of compounding. so you’re in a good place to build a sizable ESOP account as well. And work hard, work, work smart, of course, you know, to help continue to build the value of the company.

Ben Spadt (22:18)
Well, there’s a you know, perhaps a little bit of nuance here in that, you know, you might have individuals that have an ESOP balance already. I’ve worked for the company for X number of years. In the grocery store example, you know, let’s say it’s three, four, five, six years, and then that second stage transaction happens. I already kind of know what the eSOP’s all about, but somebody that enters might not. And so we have two different how do we communicate to somebody that has been enjoying

An ESAT benefit for a number of years and somebody that’s brand new. you have that at any percentage, but here where we’re, you know, creating this new tranche of shares, and not creating, but purchasing this new tranche of shares, how do we explain that to both parties, both groups? And what is it, what is the impact to them? Because not only will you see that compounding effect that you talked about, Trevor, but also you know, somebody that’s starting from zero.

would still get a pretty very dramatic effect and and kind of communicating that with those individuals and and making sure that they understand the power of of this. And you know, we do find and and studies have shown that this is a great wealth building opportunity for our our rank and file employees and and it’s yeah it’s a great tool. And I do love going and talking to companies and talking to staff. I do a lot of

all hands meetings and things and you know a common question is when do I become a millionaire? And which is, you know, I understand the question, but you know, that labor that you have, the that hard work, that blood, sweat and tears turns into value and you know, in in a way other than just your paycheck. And I think that that’s very powerful and very important to convey to these these individuals. So it’s great.

Great stuff. So we’ve got a couple questions popping in. So the first one, and this kind of backs up a little bit, but Trevor, you mentioned 1042 requires the ESOP to have 30%. Was that a limit or a maximum? And it’s a minimum, you know. you have to sell at least 30% to an ESOP to elect to be able to elect 1042.

And that’s 30% in aggregate. It’s not just, you know, I own 60%, Trevor owns 40% of the company. I sell 15%, Trevor sells 15%. We can both elect 1042 if we want. Trevor, do you want to shed a little more light there?

Trevor Gilmore (25:01)
Yeah, thanks, Ben. And one more comment there. Once you hit the 30% aggregate and the ESOP still owns 30, any future sales, you can do 1042. So let’s say you’re doing a piecemeal approach, and we have some clients who do this, they pay for the ESOP as you go, basically. So they they don’t want to have debt on the books and so on. So they do 10% a year sell. So let’s say you’re at 30% today, you sell another 10% on that second 10% tranche, you can do 1042.

‘Cause you’ve already met the thirty percent threshold.

Ben Spadt (25:34)
That’s an important point. And you know, 10% is a good example because a lot of times we’ll see we buy out the founder, the ESOP buys out the founder, and let’s say that is, you know, 30%, 49%, something like that. We have a lot of other shareholders that have smaller amounts. Well, one of those might hit retirement age or a couple of them. And so, okay, well, that amasses to 10% new sh of shit new shares for the ESOP.

In that instance, then yeah, those selling shareholders can elect 1042 because you know 30% had already been sold. So it is an aggregate. And once you hit that that you know that hurdle, I guess, then yeah, you can continue on.

Trevor Gilmore (26:20)
Looks like we got a new question here. So do ESOP participants actually own shares or do they just own a quote unquote beneficial interest in the overall ESOP? And the answer there is the actual owner of the company is the ESOT, the Employee Stock Ownership Trust. So ESOP participants aren’t direct shareholders. So for US Corps out there, the best evidence of this is the fact that the ESOP gets the K1 for its ownership piece. The individuals do not.

so yes, it it’s true that the ESOP participants own a beneficial interest just like anyone in a trust. so there is a key distinction there in terms of are they actual direct shareholders? The ESOP is the shareholder, the ESOT, the ESOP slash ESOT is the the shareholder there, and the trustee is the fiduciary acting in the best interest of the ESOP participants.

Ben Spadt (27:18)
And you know that comes into play in an important way in voting on those shares. you know, not there are very limited things that pass through to the bed the participant in the ESAP. and you can expand that if you’d like, but the trustee basically votes on that block of shares that the trust owns. and you know we can talk quite a bit about that if we want, but it

It is a beneficial ownership and part of that their retirement.

Trevor Gilmore (27:52)
That’s right. Hey Ben, why don’t we change gears and talk about governance? Because that second

Ben Spadt (27:56)
Yeah, I would I was just gonna Yeah yeah.

Trevor Gilmore (27:59)
stage deals and it’s often a big one that takes a a lot of you know thought and and planning around.

Ben Spadt (28:05)
Yeah, so that’s a good point. You know, let’s let’s go back to that grocery store example. What what was their board makeup in that when during the initial sale?

Trevor Gilmore (28:14)
Okay, so the initial sale so the board was basically all insiders. so eSlop came in, bought a minority stake. So you know, with that, there’s no requirement for independent board members and so on. So the board, controlling shareholder, a few insiders, that’s it. you you see that in a lot of companies. I’m on the board of a few c companies as well that have very well thought out independent members and so on.

But you do see most closely held companies have smaller boards. so once you go control, then there’s gonna be a negotiation with the trustee to increase the independent board member count on the board. And also formalize the board if it’s not formalized already. And we’re not talking about going from you know zero to you know some sort of very formalized, complex board structure. No one wants that because

At the end of the day, the company needs to operate, the focus needs to be on operations and so on. But we’re talking about professionalizing the board a bit. And the trustee will often say, Hey, you need to have an independent or two on there. And generally speaking, they look to the existing board to nominate who those independents should be. A definition of the independent is basically someone who doesn’t work for the company, doesn’t receive professional fees, and so on. So that true independent.

And the best independents out there are generally people who are going to bring value to the board, not just sit there and nod their head, but you know, bring true value and maybe fill a skill gap. If the board has insiders on there, maybe you need someone who understands some sort of s strategic initiative out there that that’s lacking. in these days it could be technology, understanding AI adoption could be finance, you know, if it’s a group of

People who are very strong in architecture engineering, you know, maybe having that strong finance person on the board and so on. So every company is different, every company’s unique, and what sort of board is going to be high performing and drive value is different for each company. But that is always part of the second stage is taking a look at the existing board, us going in before we actually start negotiations with the trustee, understanding.

what makes the most sense for you and your team and getting to a solution there that works for everyone. And then you do see some committees formed on the board, often a compensation committee and a nominating committee and so on. I want to go back to or I should rather take a step back and mention what the purpose of boards are. And the purpose of the board is to oversee management and management of all companies.

run the businesses, run the day-to-day operations. So boards, you do see some operating boards and so on who are very hands-on and day-to-day, but that’s not usually the objective of most boards. so their big role is really to empower the CEO and the leadership team to perform their best for the company. And that’s obviously very important in the ESOP context, because going 100% company has debt to pay down.

and so on and you basically have this new chapter as a hundred percent ESOP company. And any way to make sure the company continues to thrive, of course, is is what some of these governance type negotiations, the spirit of them are. And do you have anything to add there on the the board? And I know I kinda threw a lot out there.

Ben Spadt (31:56)
I was just gonna say the importance there to note is as we move to a con owning a the ESOP owning a controlling stake in the company, things just get more formal. Perhaps it’s a board of three insiders, like Trevor said, expanding to five with having some independence. basically formalizing things, making sure that you know there’s adequate checks and balances there. We’re not runaway train.

that has nobody that’s got familiarity with you know finance like trevor alluded to or perhaps a retired CEO that was a CEO of an ESOP company that understands what a mature ESOP what those issues that they face might be. So that formalization is important. And then these committees, compensation committee, an ESOP committee benefits committee, those types of things are often included in some of the

the transaction language and sometimes not. It’s just more an informal kind of understanding that, okay, we need these things. But there are elements that are included in the transaction documents that state, okay, we expect you to have within 12 months, you know, one or two independent board members or these types of committees, things like

Trevor Gilmore (33:14)
That’s right. And the in these control negotiations, the board doesn’t have to change tomorrow. Usually there’s time that we negotiate. So you have usually twelve months. I’ll give an example. one recent deal we did 100%. So we’re talking about control. the board pre transaction was the two counters, right? And that’s very common. The trustee came in and said during negotiations, well, hey, them two can stay on because they’re still operating the company and so on. And

Had a plan to retire over the next couple of years. But we need to talk about increasing the size of the board. And for them, the correct number actually came to five. Three insiders, two independents. So sometimes you’ll see a smaller board, you know, three people. So then maybe it’s two insiders and one independent, you know, and so on. we generally caution people to go too crazy on the board side.

If they don’t already have a formalized board, because it is a lot of work to have quarterly board meetings, create the agendas, make them effective, and make sure the management team gives the the info to the board chair so that you know those meetings are effective, right? And so on. So going from a very small board to like, you know, nine or ten or eleven person board, you know, that could be very overwhelming, especially when you factor in the focus that these second stage deals take.

I mean at Mentkey we handle a lot, you know, recorder backing and so on, but it’s a lot of focus on the company side too, all those data requests, you know, the the negotiation, looking at the term sheets and so on. so a lot of focus obviously to go through these. And then if you then have to spend the next several months focusing on board formation, you know, then it’s well, hey, the business needs attention too. So we always say, Hey, on the board side.

‘Cause you can always increase the board in the future. So three, four years in, if it makes sense to increase it, but we always say to start off smaller, and and what’s achievable really and and what’s gonna be effective versus versus starting larger.

Ben Spadt (35:21)
You know, jumping right from three to seven or nine really just makes for an expensive lunch every quarter. and you know, yeah, taking those baby steps is important. I’ve got a few questions here now that are s related and it’s it’s a bit of a tangent because it’s post-going 100%, but I think it’s important here. the first question is: we had an an original ESOP formation at 100%, provided benefits for 15 years.

And created a very satisfying retirement for many, which is good news. The outstanding loan only has about four and a half years left, and we see a very strong future. What’s the next step for us? Piggybacked on this are a couple individuals that ha are in a 100% ESOB that is fully allocated and wanting to know what the options are. once you become fully allocated. so first to answer that first question where we

we have a a short period of time left on our our ESOP loan and then we become fully allocated. we’re in mature ESOP territory and we deal with mature ESOP problems. And a lot of what we do and we have current and upcoming ESOP radio podcasts about this and it’s we’re dealing in then in in terms of repurchase who owns what shares.

And what are we obligated to pay and win? And and a lot of times you’ll see the trustee want to want to have a repurchase obligation study done. we do that, it’s it’s you know, our Minke success score is our version of it, and we look at the current population of shareholders within the ESOP, their ages, you know, are they approaching retirement? How big of a block of shares?

are approaching retirement because a lot of times you’ll see once you are fully allocated that regardless of the performance of the company, let’s say we have a great year, but nobody leaves, then no new shares are recycled and spread among our new hires or our individuals that have only been there a short period of time. Or we have a a year that’s flat, but we have a couple big balances leave the company. And so there’s this wave of

Shares that are being recycled and people get this huge benefit. And they’re like, well, I thought you said the company was flat this year. We didn’t have good performance. So it can be kind of incongruent with what the company is actually doing because all of these shares are held with certain people’s accounts. One of the questions asks about creating, issuing new shares. And is that possible without diluting the current participants?

And the answer to that short answer is no, but the long answer is probably how much does it dilute them? And will the performance of the company be whatever that dilution is? And we can manage that to to get to that benefit level that makes sense for you and for the intent of the company. the other piece there is instituting releverage. so if we do have retirees that

You know, somebody’s got a big balance. Let’s say we do have a seven-figure balance, which is happening in the in the ESOP space now and they leave. Well, I don’t necessarily want to, you know, allocate a million dollars worth of shares right away, this huge windfall of shares, so I can create a new loan between the company and the ESOP. So these shares are on a shelf again and are allocated slowly over time.

there’s several different strategies. And again, that’s something that we can engage in to work with our clients to make sure that we’re following what the intent of the ESOB is, what our current goals are, and also avoid any you know, regulatory violations, any contribution limits, things like that. so I guess bottom line is contact us and we can walk you through some of the

the options that we have and other things that we can do because the final question here is what avenues are available to incentivize future employees? And you know, we can walk there’s a a a list of of options and it’s plans dependent, plan specific, because you know, if we do have fully allocated shares and they’re with individuals 55 plus, and I only use that as an example because I see that a lot.

How does somebody that’s coming in that’s 20, 21 years old, just starting out, how do they, how do we tell them, you’re going to enjoy this really great benefit, but it’s currently tied up in all these other individuals’ accounts? So we can walk through that. Again, that comes down to repurchase and the Mankie success score, but that is sort of the ultimate with a second stage transaction, the ultimate end if you set it and forget it.

all the shares become allocated. They’re all in participant accounts. So what then? so we could have a whole another webinar based on repurchase. And I actually am speaking on repurchase in September at the Midwest conference. So if anybody is going there, we could talk some more. so yeah, I guess Trevor, do you want to say anything additional?

Trevor Gilmore (41:07)
So two two quick thoughts here and then one, congrats Jesse on the original ESOP formation a hundred percent, and providing excellent benefits for fifteen years. That’s amazing. You have four and a half years left on the outstanding loan. So I’m guessing that means you have four and a half years left of the internal loan, meaning the stock allocations. So as as Ben mentioned, releverage that can make a lot of sense. You know, basically redeem some shares out of the ESOP and high years of repurchase obligation, we can help you.

understand the mechanics there and resell those back to the ESOP over a long period of time to basically get new shares out there. So that could be one strategy. Two is if the company is performing, you can also think about some acquisitions too. You know, if you’re 100% owned ESOP with no debt and so on, you know, we’ve seen that avenue, that can make a lot of sense as well. So you have a lot of options out there. You just have to think at the board level what is

the next one, three, five years look like for our company. And we’re always we always enjoy having those conversations. And the next step is and Ben I know you touched on this as well. The hundred percent ESOP with fully allocated shares. Again, you’re probably looking at releverage. That’s probably gonna be the easiest way to get more shares in there. Otherwise just as people come and go from the company, they get bought out then that’s your share pool for new people. So that’s not consistent.

You know, and so on. So if you’re using the ESOP a recruiting tool, a big part of that is probably saying, guess what? Our ESOP pays whatever it is, seven, eight, nine, ten percent a year. And on top of that, our stock prices averaged some of our clients is 13% a year, but whatever that number is, and that’s usually a a good selling point to recruit because it’s not a common benefit for you know the competitor down the street, you know, and so on.

so releverage probably makes sense. And then also, and and we do this with a lot of our second stage deals, and then also 100% ESOP transactions, is a separate management incentive plans. So you have ESOP for everyone, makes a lot of sense. On top of that, the board can adopt a management incentive plan. So think like stock appreciation rights plan, medium term incentive, and it gives them basically an incentive that’s tied to the future.

value the company since it’s non-qualified plan you can design these a lot of different ways usually it’s five to seven years so if if I’m in a plan that I get stock appreciation rights today granted to me and then they vest in five years then I’m gonna do everything I can do to make sure that value becomes something. So that’s something we see a lot in second stage. Again we do those, we have the plans in-house and so on. So

Definitely talk to us.

Ben Spadt (43:59)
Absolutely. Yeah, I was just gonna make a plug for us as well. If you have, you know, continue to have questions, please shoot me an email, give me a call, let’s talk about it. because it’s unique to every plan and we wanna make sure that the advice we give is specific to your situation. So please reach out and we’ll we’ll help knock that out.

Trevor Gilmore (44:23)
And I saw one more

question that just came in as well in another chat window here. Are there any issues with an original owner gifting shares to specific key employees?

so where I would go with this is what’s the amount you plan to gift? is there a dilution to the ESOP? And just understanding the economics of it and also the intent, what you’re trying to do here. Are there any issues on the face of it? No. You know, we have companies that have management stock bonus plans, very common structure. so in the context of a hundred percent ESOP, if you’re already there, then we’d probably look to the separate management plans I talked about, like the stock appreciation rights.

to achieve that same objective because if you’re 100% owned ESOP and let’s say you’re an S-Corp, you’ll you don’t want to have any new direct shareholders because then you just have to start making tax distributions and so on and you you blow what’s called the S Corp tax shield. So nuanced situation for sure, nuanced discussion, but there’s a lot of options out there for you. So if you’re a partial owned ESOP, then it’s just a matter of, you know, what total

Share count, are you thinking of you know, gifting and is this part of like a management stock bonus plan? What is it? And then also are there any fiduciary considerations depending on the e stop ownership and so on, involving the trustee and just giving them a heads up on what you plan to do. so

Ben Spadt (45:49)
I want to think about the tax ramifications for the gift, gift or for the person gifting the shares. make sure that that’s still in line with what your your goals are there. and speaking of tax, Trevor, you know, when you’re 100% ESOP owned now, we did the we completed the transaction for the second stage, and we’re 100% ESOP owned. Let’s say we’re an S-corp.

What benefits exist for us as a company being one hundred percent S Corp owned?

Trevor Gilmore (46:20)
Yeah, so if you’re an S-Corp, congrats and 100% owned by the ESOP. You don’t pay tax, as we said earlier. And the industry you attend the ESOP conferences and all this, they call it the S Corp Tax Shield. And basically ESOP is a pass-through. So if you’re a taxable shareholder, you get your K1 and you file your taxes. I’m in California, so I’d file my California return and federal to the IRS, showing my earnings, and then I’m my earnings allocated to that S-corp.

ESOP, if it’s the 100% owner of the company, it gets its K1, but it’s a tax-exempt trust. So it doesn’t have to pay tax. So the beauty there is no tax distributions are needed if you’re 100% owned S-Corp ESOP. partial S-Corp ESOP, meaning you have let’s say 70% taxable owners, 30% ESOP is

probably people on this call fit that profile, then ESOP still gets its 30% share of the distributions. But since it doesn’t pay tax, what does it do? It accumulates that cash. It can be used to pay down debt, fund buyouts, and so on. But the beauty of the 100%, which is where a lot of companies ultimately want to go, is the tax shield. Because if you’re a California or in a high-tax state, the the top marginal rate is basically 50%. So those distributions stop.

And guess what? like let’s say a company’s making five million a year and you’re paying two point five out just to cover taxes. Well, guess what? That two point five can be reinvested in the business, can pay down the ESOP debt, fund the buyouts for employees who have left the company, retired, and so on. So it’s very powerful. And over time, you see a lot of S Corp hundred percent ESOPs start acquiring other companies and and so on. And

Basically using that tax savings really to you know, fund corporate growth.

Ben Spadt (48:21)
The tax savings can be huge and you can start to generate some real cash. and you know, it’s it’s an effective tool for sure. So we’ve got what eight minutes left here. we want to go over some key takeaways today. So I’d say, you know, first, if you’re a controlling owner of an ESOP owned company, make sure you know the current value of your stake.

what the cash flows of the company are and the tax strategies before going in with the second stage deal.

Trevor Gilmore (48:57)
Yeah,

so I would say if you’re the controlling owner and contemplating a second stage, obviously you need to really understand what your cash flows are. Cash flows are different than the amount you get at close and so on, especially if you have a seller note, you’re getting paid over time, maybe there’s warrants involved, et cetera. So understanding that and also understanding your tax strategy, because that’s really gonna drive a lot of the the mechanics of the structure. You know, if ten forty two is important and you’re an S Corp, we’re gonna have to get you from S to C.

Do the deal and then you generally have to wait a period of time before you can go back to us. another key takeaway as well for the controlling owner is making sure you have a high performing management team in place as you consider this, because on the value side, your company’s gonna be worth so much more if you have a solid CFO, COO, so finance and ops team in place, the company is is gonna be much more valuable.

and the trustee and their appraiser are going to notice that and say, hey, this company is set up for long-term success and it’s gonna be reflected in the negotiation for sure. And on top of that, these second stage deals, they are a focus. You know, so you also wanna make sure you have a solid team in place that has the bandwidth. the grocery store example I talked about earlier, we specifically, even though we started it as a year process, we didn’t actually do negotiations.

With the trustee and their lawyer and their appraiser until the summer, because that was more of a slower period for management. because the holidays and so on are very busy, they would have no bandwidth. And so you also have to think about when the right time of the year is to do it, to actually negotiate. But then there’s so much legwork that goes in before that. So intention is another one as well, is is planning ahead. But I would say making sure the business.

is set up for long-term success before contemplating this. That’s absolutely key. And next up, if you’re the CFO of the company, which I think there’s a lot of CFOs listening today, you know, make sure you deeply understand the financing options and cash flows required for a second stage deal. And again, that’s our role is to conduct a competitive bank shop and do the value positioning and so on. But the really strong CFOs that we work with, you know, they’re an awesome partner.

throughout entire process. And that just makes for a a solid deal to be had. And then of course long term sustainability afterwards, because there’s so much excitement doing these deals, but the excitement needs to continue. And also the company needs to be sustainable as well. So that’s a big focus.

Ben Spadt (51:38)
And that ESOP is buying the future cash flows. So working with the CFO to determine can these cash flows support what we’re trying to attempt here, whether it be the bank financing, seller financing, or even just you know, providing this benefit to the employees. And a strong CFO is great because we can sort of speak the same language, if you will. Trevor and I are both CPAs and

Recovering public accountants, I guess if you want to put it that way. So it’s it’s nice to be able to you know, look at some financial statements, have a conversation about it, have a conversation about the style statement of cash flows to talk about are we you know, does this make sense right now? Will it make sense going forward? Can we make this a sustainable long-term benefit? Because that’s the ultimate goal of the ESOP to begin with, whether it’s 30% or anything greater. And then finally.

no matter who you are in the company, make sure you have a game plan with your advisor team and plan early and often. You know, we’re here, not just as advisors, we, Trevor, and myself, but you know, we have a team of attorneys as well that can help amend plan documents, make sure that they’re restated so that we can meet Secure Act 2.0 at the very least, or anything that you want to change. I was just talking with somebody today about.

Increasing their lump sum threshold because they’re they want to, you know, once somebody leaves, they want to clean out all these balances of terminated employees. So instead of that seven thousand dollar limit, can we increase it? What does that look like? so we talk about things like that on a day-to-day basis. You know, your normal interaction maybe with one of our benefits consultants, but we do have a number of other advisors here, and it’s important to

to utilize our services as well. It’s we’re not just like some of the other guys that do a transaction and then just leave you. Or if you were to use a business broker or traditional MA firm to sell your company to a third party and they just leave after after the ink dries on the on the transaction documents. We’re here with you the whole way and to help guide you through these decisions. and I know that’s sort of what makes it fun.

here for me. so yeah, we’re part of your planning process regardless of what it is. You know, we spoke earlier about those one hundred percent ESOPs right now that are getting to the mature stages of life. Give us a call and we will we’ll help talk you through what your options are. Trevor, you want to add anything there?

Trevor Gilmore (54:22)
Thanks, Ben, and and a good plug, by the way. Yeah. So I want to close this out with the fact that esops and second stage transactions, think of it like a team sport, because it is. it you have a whole team that including the company, its advisors, the trustee, and their team, it’s a total team sport here to get either a partial ESOP or 100%. And endurance is a key aspect of this as well, just like business itself. So

Same thing goes with the ESOPs. We have a lot of successful 100% ESOP clients who went ESOP years ago and they just thrive. And it’s so awesome to see that. And that is often what drives these long-term successful ESOP companies is the culture and the team aspect here. So we hope everyone enjoyed it today. Thank you for joining us. Reach out. Trevor Gilmer on LinkedIn, T Gilmer at Menke. You know, you can track me down for sure. And we’ll send a follow-up email.

with our contact info and also the contact info of your Menke team as well. Cause I know we have people joining us from all over the country and we have a team of fifty plus here at Menke.

Ben Spadt (55:33)
Yeah. I’m Benjamin Spadt at on LinkedIn. please check out ESOP Radio. We’ve got an ESOP boot camp that kind of talks through some of these elements that we touched on today. We have other interviews with companies that have gone 100% ESOP. We have other you know, we kind of take a look at what is happening in the legislature, things like that, what we see as some of the trends in the industry. So

It’s a little bit more topical and I don’t know, I think it’s kind of cool. so check out ESOP Radio, check out all of what you see on the screen here and yeah, reach out to one of us if you have some questions. we’re here for you and we’re here to help. But thanks for joining us today and I’ll see you next time, I guess.

Trevor Gilmore (56:25)
Have an awesome day, everyone. Take care.

Ben Spadt (56:27)
Bye now