Inside the ESOP Decision with Matt Middendorp - Ep- 582

Every business owner really needs to consider 4 different buckets as they're trying to decide what's next for their business. They need to think about price, right? You built it, you took the risk, you deserve to get paid. You should not have to sacrifice when you transition your business, right? So the trick with price though is there's 2 different prices. There's top-line price and there's your actual return, what you actually take home, right? Those are 2 completely different things. So you need to understand really how all the different exit options play into price.

Empowering employees, securing your future. We're going to take a look inside the ESOP process. So stop settling for traditional exit strategies that destroy company culture and discover how to align your exit with your values using the ESOP blueprint. Welcome to Streams to Impact, brought to you by State Talker Capital. I'm your host, Allen Lomax.

Dr. Allen.

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Sorry, I didn't mean to break the flow.

That's okay. Well, today, as the director of ESOP consulting at VisionPoint Capital, he's here to share how business owners nationwide are leveraging employee ownership to secure their legacy and maximum value. So, Matt, we're glad that you are with us here today. I think that our audience is going to be very interested in this. Many of them are W-2 employees.

Okay.

And if their companies are facing a sale, might inspire them to step forward and take control of that sales process. So we're glad you are with us here today.

Well, thank you so much for having me on, Allen. And I love, I love having entrepreneurial grit this early in the morning.

So that's always a good thing. Well, for starters here, what is it? Well, first of all, just give us a little bit of background about who you are, Matt, and how, how you came to to do what you do?

Yeah, absolutely. So I'll make a very long story short. Former banker, former bank executive. Hopefully that doesn't make anybody jump off and stop listening, right? But trust me, the story gets better after that, right? So left banking in 2013, July 28th or June 28th, 2013, roughly 4:15 PM or so. I stepped out of banking and I started my own business. So here's what's awesome about what I do now, right, is as a banker, working with business owners, I got to see a couple of my clients actually transition into ESOP-owned businesses, employee stock ownership plans. Uh, I had a couple of clients that were ESOPs already. So, as a banker, I got to see the financial side. I got to see the truth behind the data actually in real life.

Mm-hmm.

Leading into then my own, my experience as a business owner, having, having been a 10-year business owner who eventually sold my business in the spring of 2023. I got to experience what we as gritty entrepreneurs go through every day. And let me tell you what, there is nothing that consumes you more than owning a business. And there is nothing that causes greater angst than selling one. It is the single hardest decision I ever made. So I've seen the reality of ESOP from a financial point of view. I've lived as a business owner who sold a business and made that decision to transition up or out of my business. So when I sold it and I had an opportunity shortly after to come into the ESOP space, I knew them, I liked them, I saw the promise in them, and I jumped at it, right? So for the last, gosh, what's it been, 4 years now, my job has been combining that financial expertise with my experience as an entrepreneur, as a business owner, and helping educate people about this fantastic option to exit or to transition your business. It's been a lot of fun. I really do love what I do, and it's, uh, it's not every day you can help everybody win through that process. And we'll talk more about what that means, I'm sure.

Yeah, well, thank you for sharing that. Your passion certainly shows through on that.

And—

Oh, I've been holding back. I can let it out if you really want to see it.

Yeah, well, And that always makes, that always makes a difference. And it also makes it much more personalized as well. So, and, and what is it that, that business owners most misunderstand about the SOP process before they actually even seriously start exploring one?

Sure. So, I think the biggest misunderstanding that every business owner gets as they're thinking about what's next is That ESOP is a sacrifice. So, here's what I mean by that. Every business owner really needs to consider 4 different buckets as they're trying to decide what's next for their business. They need to think about price, right? You built it, you took the risk, you deserve to get paid. You should not have to sacrifice when you transition your business, right? So, the trick with price though is there's 2 different prices. There's top-line price And there's your actual return, what you actually take home, right? Those are 2 completely different things. So you need to understand really how all the different exit options play into price. You need to understand control, meaning who runs your business after you're done. You need to understand your identity as a business owner and are you ready and how are you going to transition that out? Because your name's on the door, right? This is the thing you built. This is another child. If you have children, trust me, I've been there. Like I said, I lost sleep. So, so how do you understand that? And then the last piece is legacy. So price control, identity, and legacy as a business owner. Do you want to look your people in the eye when you leave or doesn't it matter? And when you consider your exit plans, your strategy under those 4 buckets, then what's important to you? And that helps you decide where you should go, right? If all you're worried about is price, top line price specifically, then by all means, sell to private equity or a third party.

Right.

You don't have to worry about control after that. You'll just be an employee in the business that you owned. You don't have any real control over legacy. You may get a better top-line price, but you aren't necessarily going to see a return. Right. After taxes, it's a very different story. So, so as you go through those different evaluations and trust me, most business owners don't— exits just happen to them, right? They wake up, they get a call or an email from private equity. And I want to stress, by the way, I'm going to talk about PE a lot. There's nothing wrong with PE if it meets your goals. Then do it. It's got to meet your goals though, right? And for most business owners, it doesn't meet their goals. I'm working with a client right now. They sold to PE in 2017, bought the company back after PE killed it in 2019, and now they're selling to an ESOP, right? So when you ask to bring it back to your question, what is the biggest thing that people don't understand? It's that when you're making a deliberate choice based on those 4 buckets, You know how, you know, the ESOP isn't a sacrifice. You aren't having to give up your return through that process. You stay in control of the company. The people that ran it the day before the transaction run it the day after. You don't have to give up your identity as a business owner. You don't have to let that go. And you can look your employees in the eye, right? You can high-five them on the way out the day that transaction closes.

Mm-hmm.

So, it's a fantastic tool. It's a business transition tool that allows you to really maximize all 4 of those buckets.

Well, there is, I'm sure there's so much to consider in conjunction with selling a successful business. And certainly we hear a lot about private equity purchasing businesses really for the purpose of of really stripping them of their assets. And although not all of them work that way, but many of them do. And then even if that's not their purpose, they oftentimes don't know how to run the business like it has been run.

Yeah.

So how do you help? And then the other thing you mentioned, of course, were taxes, and that makes such a huge difference in the actual return. And I don't think people think of that until They actually get their tax bill and it's too late at that point in time. So how, how do you help owners determine whether an ESOP is actually the right exit or is it the wrong exit?

I always tell people that 80% of my job is education. That's really what I do for a living. And again, we're going to start with understanding what your goals are. In the, in the, in the, in the path of price control, identity, and legacy, are you looking to exit your business? Are you looking to pull some liquidity out of your business? Right. Are you looking to diversify? Are most of your assets tied up in your business and you're trying to, to pull some money out so you can do some different things?

Right.

So there are a lot of different reasons that people look for this business transition. It's not always about exiting out. Sometimes it's about transitioning the business into a more powerful business model. I have a client, it's a pool construction company that has a retail component. 4 sellers, they're all in their 40s. They're not going anywhere. They're going to stay in this company for 10 to 15 years, but they did it because they wanted to hire and retain better talent. They wanted to see the productivity gains in this and the growth gains that happened to ESOP companies compared to non-ESOP companies. But personally, they did it because they wanted to pull money out of the business and go invest it in other places. So absolutely, there are— that's a very powerful reason to do that. And when you talk about taxes, you know, we can dig into this more in a minute, but there are some very powerful tax reasons for ESOP as well, both for the individual and the company.

Well, let's go ahead and talk about those tax aspects of it because I know it is— it's much more significant part of a sales transaction than what most people think.

No, absolutely. So it's a key part of it, right? We talk about the difference between top-line price versus your return. And here's what happens in a typical private equity transaction. And again, if this is meeting your goals, there is nothing wrong with it. So I want to be really, really clear with that. I don't want to villainize anything because for the right path, it makes sense. Just like ESOP for the right path makes sense as well. It's not for everybody. So from a tax perspective, right, what happens in a PE transaction? Uh, the transaction closes, you're gonna pay 30% off the top. Um, it's just, you're in the end, your return isn't what you expect it to be because there's always earnouts involved, right? Meaning that you just don't get a big check. They give you a very small percentage of it. They pay you the rest later. Um, and to get the price that they promised you, you gotta meet certain metrics that they determine.

Mm-hmm.

And you're not in control of meeting anyway because you're just an employee. Right. And that's not including the fact that a lot of private equity now is requiring you to put money back into the private equity fund, too. So you don't even get to just take it and go do what you want with it. You got to put a piece of it back into what they're doing for you. So the return just isn't there.

Right.

But because ESOP transactions are stock sales, right, you're complete— you're setting up an ESOP trust. That ESOP trust is purchasing the shares of the company from the sellers.

Right.

Okay. So which is why, again, the control of the company stays with the people that run it the day before the transaction closes. But from a tax standpoint, in an ESOP transaction, there are strategies where you actually do not even have to pay capital gains. You can defer it. And if it's money that you don't need, you can defer it until you die and your estate doesn't pay taxes on it either. Your beneficiaries, right? But even if you don't go that route, You still get preferential tax treatment. You're actually going to pay a lower tax rate on ESOP transactions because they're stock transactions versus asset sales, right? So, so you pay a lower tax rate. And we actually find that for a lot of our clients, when we go head to head with those other options, actually win in the ESOP space versus some of the other things that they're looking at. So that's from an individual standpoint. Do you mind if I jump into the company tax benefits of ESOP?

Sure.

Yeah, go ahead.

Okay. We should probably warn your listeners to pull over if they're driving. If you're eating, set the spoon down. If you're listening to this over breakfast, just take a minute, make sure you have a clear airway because I don't want you to choke when you hear this. This is amazing. This is one of the biggest parts of ESOP that people gravitate to from a strategic transactional standpoint. If your company is an S corp, And you are 100% employee-owned, that company no longer pays federal taxes. And in 46 out of 50 states, doesn't pay state taxes anymore either.

Really?

Pause to let that sink in.

Wow. Right.

The K-1s that normally go to the shareholders go to the ESOP, that trust. And that trust doesn't have to pay because it's a qualified retirement plan.

Hmm.

So what does that mean? It means the company has resources suddenly, in some cases millions of dollars that they can use to grow, they can use to pay the sellers, they can use to buy other companies, right? They can reinvest and they can do things with that. There's a reason ESOP companies grow faster than non-ESOP companies. Again, we've already talked about hiring and retaining better talent. But one of the other reasons is because they aren't burdened by tax So they can do things that other companies can't do. The goal of an ESOP transaction is to make sure that the sellers win, that they get the return they deserve, that the company wins, that it's better off from a cash flow standpoint than before, and that the employees win too.

Yeah. Wow. Well, that is amazing. That's certainly—

I should add, by the way, just to be clear to everybody, it is proportional. So if you don't sell, if you only sell 30% of the company to the trust and keep 70%, you would get 30% of that benefit. So it is proportional up to 100%.

And I'm sure there's different reasons for doing it different ways. But when you look at the final outcome of the transaction, everything's finalized, what separates companies that thrive as ESOPs from those that struggle after that transaction closes?

Yeah, absolutely. That's a great, great question, Alan. Thank you. What separates successful ESOP companies from ESOP companies that don't necessarily see that benefit is education. And by education, I mean specifically to the employees, right? ESOP company employees tend to stay 4 times longer at the company than a non-ESOP employee, right? They— ESOP companies grow 2.4% to 2.6% faster than non-ESOP companies. Actually, in the first year after becoming an ESOP, a lot of ESOP companies see a 4 to 6% gain in productivity over the previous year. Right. So what changes there is education from the minute you roll it out and introduce it to everybody to the continuous discussions that happen after it becomes a part of your culture that you have this employee ownership and successful employee-owned companies make sure that it's always top of mind for the people that work there. Heck, when I entered the ESOP space, I worked for a company that was an ESOP. And we made them for a living. We administered them for a living. And we still talked about our ESOP and educated us people who were already experts on the basics to remind us to keep it top of mind all the time.

Mm-hmm.

Almost every meeting we brought up an aspect of ESOP that we all already knew, but we wanted to make sure that we stayed cognizant or aware of this amazing thing that was— that we had available to us and that we drove the results of the company as an outcome.

Well, what is it that employees going into an ESOP, from just being employees to actually being owners, what is— I mean, I can see the motivation there. They're going to be much more motivated than—

Yeah.

Because their earnings are coming to them rather than just a salary. But what is the big lesson that they need to learn to transition from a W-2 to ownership?

Sure. Well, so let's be clear about one thing. They're still W-2 employees. So being an ESOP owner means that you are a beneficial owner. You're a beneficiary of the trust. So you don't actually have direct ownership of the company. And that's an important thing for people to know, right? Is they suddenly don't have voting rights or decision-making. Again, the people that run the company the day before close is the same people that run the company the day after close. So those employees don't have direct rights to those shares. And that's a really important thing to know, nor do all the shares go out at once. It's the same typically subtransaction. The shares will go out over 30 years.

Hmm.

So 1/30th of the shares are distributed or allocated to the employees in a given year so that those balances build up over time. versus just a flood of shares and suddenly they're millionaires. Right. And that is one of the amazing things about ESOP is you hear about Publix, for example, the grocery store chain in the Southeastern United States. They're employee-owned. And you hear stories all the time about people who are just cashiers who have worked there for 20 years who are multimillionaires because they work for an ESOP company. And because Publix and other successful ESOP companies do a great job with that education piece, Specifically educating the employees on how they impact the bottom line. Because when you're an ESOP company, the financial goals of the company are aligned with the financial goals of the employees. And for most of us, that's for the first time in our entire careers that we have that alignment. So if I'm an employee of that company and I know how I prevent loss, right, prevent shrink stealing, How I can, again, if I'm a teller, scan faster, scan more accurately. If I'm in sales, how do I sell more? How do I not waste if I'm in production? Right? All these different things that have a direct impact on the bottom line. If I know how I do that, if I know how to be better and the company measures it and tells me how I'm doing or tells us how we're doing, man, we're all pulling in the same direction, right? Row the boat in the same direction and we all see the benefits of it. I'm going to stay engaged. I'm going to want to be a part of that.

Well, I can certainly see how the educational process is going to be really important because in that transition, I mean, most employees aren't going to see any really significant changes initially. And so they're going to go, well, what's the big deal? And so that educational process could be really critical to the success. But looking at this from the ownership once again, at what point in the company's life cycle does it make sense to start thinking about an ESOP?

So—

And, you know, I mean, a company is going to have to evolve to a certain point to even start thinking about sales or selling it or Or disposing of it. So what do they need to be looking for in terms of, hey, ESOP might be a possibility here?

So can I put on my banker hat for a minute?

Sure.

My business owner hat? Here's what I'll tell people. It's the same thing I told them back in my banking days. The day you start thinking about your transition is the day you start your business, right? Creating something that you know in the long term will be sellable.

Mm-hmm.

It just makes sense because guess what? When you're an ESOP company, you have to be sellable. ESOP is not an escape hatch. I've had people call me and say, well, nobody else wanted to buy it, so I'm just going to sell it to my employees. Yeah, it doesn't work that way. You got to be profitable. You got to be in the US. You have to have at least 15 to 20 employees. So something for people to think about, right? So as you're going through this, I always tell people again, from back in the banking days, is always be thinking about, am I creating something that's too Matt-centric? or too owner-centric, right? Do I have people that understand the processes, people that can take over? When should people start specifically talking about a transition or an ESOP transaction? I would say, you know what, you can close a transaction and walk away in an ESOP, but most sellers, 3 to 5 years before they're actually ready to be done, right? Start pulling money out of the business, start diversifying, Start that transition. So when you're ready to be done, you can step onto the board and into a governance role and out of the day-to-day.

So how would somebody starting out— I mean, I totally agree with you, the time to think about disposition is when you're starting out. What are some tips you could give to the person just starting their scratch firm business?

Sure.

I mean, from the get-go.

Right. I guess, you know, part of what I'm going to say is it depends on the business. But the biggest thing I'll tell you is don't create a business that can't function without you. I'm talking to a couple right now, a husband and wife team that own a business in Wisconsin, and they are fried. They're absolutely burned out. And again, if you've ever owned a business, it's something I didn't understand and appreciate when I was a banker, just how much being a business owner does consume you, right? You never stop thinking about it. It's part of your identity. It's part of who you are. So as you're going through that process, they're in a spot right now where they're working 70, 80 hours a week. They're exhausted and they've been doing it for decades. When I came in and I said, well, okay, you don't have anybody ready to take over, so you're— we can do this, but we need to be thinking about a transition in 3 to 5 years. The first thing I said is, what's something you want to take off your plate? And they immediately said the financial side. I'm like, okay, hire a bookkeeper, hire a controller, hire a CFO, hire somebody to take that off your plate, somebody who's going to do the bookkeeping and the invoicing and the balancing. And get the statements ready to send the accountant? How much would that take off your week? And they're like, oh gosh, that would take 15, 20 hours off my week. And I'm like, okay, hire that person. You can find that person, right? So, so what I would tell business owners starting out who are thinking about creating a successful business is make one that doesn't rely on you.

Yeah, that truly is thinking into the future for most of us, for sure.

Yeah. And I realize that that's a transition. In the beginning, it has to rely on you because it's expensive to hire people. But always be thinking about— a lot of business owners I talk to, the first person they hire is a salesperson usually, but that's usually the first point of frustration, right? So thinking about some of the other stuff you can take off your plate and do the parts of your job you enjoy is a great way to be successful.

Well, if an owner is curious but not committed, what's the smartest first step they can take To evaluate the fit without going completely down a rabbit hole that goes nowhere.

I always say the first step in an ESOP conversation is the— I call it the I think I want to phase, right? Meaning do the research. The NCEO is a great organization, the National Center for Employee Ownership. They have a ton of resources that are available to people. Our website, esopready.com, E-S-O-P-ready.com, has got a ton of great information as well. When you're on there, you can actually take an assessment. That kind of shows you— it takes 5 minutes. It shows you where your company's at and how it aligns with ESOP, specifically your goals and how they work. Because again, ESOP is not for everybody. It's got to accomplish what you're setting out to accomplish. So as you go through that, I think I want to phase, the thing you need to know is you don't need to say yes to ESOP. What you need to say yes to at the end of that phase is something called a feasibility study. It's where you get a valuation of your company. It's where we actually show you the impact on the sellers, meaning what's their return going to look like? We show you the impact on the company from a cash flow and tax perspective, and we show you the impact on your employees. What are their balances going to look like? For a lot of people I talk to, that's where they want us to start. Show me how much my employees are going to have in 10 years. It's a great place to be. So you don't have to say yes to ESOP. The first place where you're going to put any resources in other than time and energy Is that feasibility study at the end of the I think I want to phase?

For— well, my last question here, I think anyway. Is it feasible for someone just starting a new business to establish it as an ESOP?

Yes, but with caveats. And it really does depend on the specific business, Allen. So I apologize if I don't go too long on this. Other than to say, yes, it happens. It happens all the time. I get calls every week from people who sold their business to private equity or a third party, didn't like what they did to their business, pulled their best people out, and they're starting the same business over, starting the same business again. And this time they're setting it up as an ESOP.

As an ESOP. Yeah. Well, Phenomenal look into this world of employee ownership and the power of ESOPs to secure a legacy while unlocking immense value for both owners and their teams. So Matt has shown us that the best exit strategies aren't just about the final numbers, but they're about building a sustainable culture that lasts long after the transaction closes. So if you are a business owner, Curious about whether an ESOP is the right move for you, Matt has provided a fantastic resource, and you can—he's mentioned the site already—but that site is at www.esopready.com. So that's esopready.com. So you can learn a whole lot more there. Take the readiness assessment he mentioned, and you can schedule a time to dig into. What this amazing non-traditional business transition tool is all about. So we hope you've enjoyed this conversation and that it has given you value and insights into protecting your capital and creating a lasting legacy. So don't forget to claim your free gift, Beyond the Paycheck, by going to www.gobeyondthepaycheck.com. steedtucker.com/beyond-paycheck. So thanks for spending time with us on Streams to Impact, brought to you by Steedtucker Capital. If you enjoyed this episode, we'd really be honored if you just take a moment to like, share, and subscribe. This really does help us to build our audience. It also helps others to find their path to financial impact. So, until next time, keep building your legacy.

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