Kelly Finnell - Premier ESOP Consultant, Author, & Speaker

Welcome to another Founder Wisdom podcast. We have, uh, Kelly Finnell with us today. Uh, Kelly is a founder and CEO at, uh, EFS ESOP Consultants. We're going to talk about what that means today. Uh, it's basically employee stock ownership plans, right, which is something that's ultimately interesting for me. He's been at that company for 45 years. That is crazy long. I've I don't think I've ever had anyone on this podcast stay 45 years at one company. So Kelly, uh, welcome to the pod. Tell us a bit more about yourself and what you've been up to.

Well, thanks. It's good to be with you. Um, as you said, I've been in the ESOP business my entire career. Um, we are a boutique firm that has a singular focus. ESOPs are all that we do. Our business is is from coast to coast, and we do about 8 ESOP transactions a year. An ESOP at its core is really two things in one, Charles. It is first a way for a business owner to cash in on their life's work. So an ESOP is an alternative to a sale to private equity or to a strategic buyer. Most business owners are not aware that this opportunity exists. They think that their only options are private equity or a strategic buyer, but an ESOP gives a bonus, gives a business owner a way to sell their company to their employees with this huge tax subsidy. And so for a business owner an ESOP is a liquidity strategy. For the company's employees, an ESOP is a retirement plan. So once the ESOP has purchased stock from the business owner, that stock goes into the ESOP retirement plan. And an ESOP is essentially a first cousin to a 401 plan. And over the years, the company makes additional share allocations to the employees' accounts, and their accounts grow as a result of those additional annual allocations and as a result of the company's performance and its growth. And so it really gives a very elegant option, alternative to a sale to private equity or a sale to a strategic buyer.

And how would it help me, uh, generate the liquidity strategy as a business owner?

Yeah, an ESOP is funded with usually 3 sources of capital. The first would be excess company cash. Some companies have money in the bank that they don't need for current operations, and that can be used to help buy out the business owner. The second source of capital is a bank loan. So banks will loan money to companies for them to buy out the owner via an ESOP, and that might be 35 to 40% of the value of the company. So if we had a little bit of excess company cash and a bank loan of 35 to 40%, maybe we have 50% of the value of the company that can be paid to the owner at close from those two sources. And then the difference, the other 50%, is paid to the owner in the form of a seller note, which is simply an IOU issued by the company to the selling shareholder that says we're going to pay you interest only while we're paying off principal and interest to the bank. And then after the bank is fully repaid, we'll either do one of two things. We'll either amortize principal and interest on the seller note, or more likely, the company will go back to that bank and say, look, this first ESOP loan works so well, let's do it again. And the proceeds of that second loan will be used to pay off all or a portion of the remaining balance on on the seller note.

Do most of banks loan for that? Why is it such a safe value and, and low-risk investment for them? Or is it like a couple few banks like, uh, JP Morgan?

Well, there are specialty banks that do ESOPs. So there are banks— I met with one yesterday that has a specialized ESOP lending unit. So there might be a dozen banks out there that have an internal division that specializes in doing ESOP loans, but any bank theoretically could do an ESOP loan. One of the reasons that an ESOP loan is attractive to a bank is that the selling shareholder is going to be subordinated via that seller note to the bank. And so the bank has a very high level of comfort that the owner is going to stay engaged in the business and make sure that the bank gets repaid, because the owner is not going to get paid his 50% on the seller note until after the bank is fully repaid. So that gives the bank a high level of comfort, uh, that they're going to be repaid.

Okay, so just to make it simple for the audience, right, like the bank loans the money to the employee and the company to buy the stock.

No, loans the money to the company. Okay. And then the company relends that money to the ESOP, and the ESOP uses that money on behalf of the employees to buy shares that over time get allocated or divided up among those employees' retirement accounts.

Got it. And then the bank gets repaid once the employee liquidates their stock. Is that how it happens?

The bank gets repaid quarterly over the first 5 years that the ESOP is in place.

Interesting. From the cash flow of the business, or—

yes, exactly right.

That's exactly how much do they lend usually. Is it a million dollars? Is it $100K?

Uh, it is usually 2 times the company's adjusted EBITDA. So let's assume that we have a company that has $2 million of adjusted EBITDA and they're going to do a $12 million transaction. Then maybe the company has $2 million of excess cash. It's going to borrow $4 million from the bank, 2 times its adjusted EBITDA. So now we have $6 million of capital, and then the other $6 million that's needed is going to be in the form of those seller notes. So the owner would get $6 million at close, and then the other $6 million paid out over time after the bank loan has been fully repaid.

That's pretty big loans, right? It's like, uh, I don't know, an average $15 to $30 million in your client's case.

Yeah, I mean, it's all over the ballpark just depending upon the size of the company. And, and your instinct is right. I mean, there are some very large ESOP transactions that are done, and, you know, you can't have a small community bank, that's willing to loan $100 million, uh, to do a transaction. So sometimes you have to go to one of the money center banks to borrow that much, or sometimes there will be a partnership of banks, uh, that will come together, maybe just as an example, each of them loaning $50 million into that $100 million total facility.

Interesting. So banks may partner up with one another and collaborate to, to make it happen. Um, are there outside sources of capital that fund this as well, like not just banks but investors?

Um, there are, there are, um, non-traditional lenders that sometimes get involved. in ESOP loans. Um, and so that is a possibility. Those sources of capital are almost always more expensive. And so the first option is always, uh, senior bank debt, right?

And just to give us an idea, the size of your clients in average, is it 500 employees plus? Is there a specific type of company? Is it in your geography or is it throughout the US? Give me like, uh, the exact description of your ideal customer persona.

Yeah, the minimum size company that we would think is appropriate for an ESOP would be a company that has at least $2 million of adjusted EBITDA and at least 35 employees. Last year, our smallest client fit that description. Our largest client had, um, uh, $33 million of adjusted EBITDA and 800 employees. So that's two, you know, extreme ends of the spectrum. If you look at our average client last year, that company had 95 employees and, uh, $4 million of adjusted EBITDA. And that is pretty much the, uh, heart of the ESOP market— transactions for companies of that size and description. And it's really a variety of industries. Traditionally, our primary industry sector was engineering firms, but over the last 3 years, our primary sector has been construction and specialty contracting firms. And again, that is not just our practice, but that is what we're seeing consistently throughout the ESOP marketplace. And yes, our business is coast to coast, from the Northeast to the Southeast.

Is it the first time that they would touch ESOPs when they come at you, or do they already have ESOPs, most of them, when they go and contract your services?

Yeah, most of our business comes as a result of referrals from professional advisors, and so it's very rare for a business owner to come directly, uh, to us. So those referral sources would be lawyers, CPAs, investment bankers, commercial bankers, and financial advisors. So most of our clients come to us as a result of talking to one of their professional advisors and telling them, look, I need to have a liquidity event. I'm a baby boomer business owner and maybe I'm 70 years old and it's time for me to cash in on my life's work. I've talked to private equity, don't like the way that feels. There aren't really any strategic buyers that would be appropriate for us. And my heart tells me I'd love to sell to my employees, but they don't have the cash or credit to be able to buy the company. And my financial advisor told me about this thing called an ESOP. Could we talk? And so we help them understand what an ESOP is, how it works, how it benefits them and their employees. And then we would lead them through a process that would begin with us doing a feasibility analysis so that we could take concepts and apply them precisely to their business and run a lot of financial models.. And if they decide based on that, that an ESOP is the right strategy, then we will lead them all the way through the implementation process.

And isn't the first reflex, I want to keep my top talent and I want to potentially, yeah, liquidate off that later on? Is it like their first need, the need to keep the top talent? Is that why they would open a Isaac first.

Yeah, um, if during a first meeting, uh, a business owner says to us, culture is the key to our success, uh, we provide, uh, a family atmosphere for our employees, and as a result of that, uh, we've done a pretty good job of retaining people, and I want an exit strategy strategy that is not only good for me and my family, but a strategy that at the same time protects and rewards the people who have helped me get to the point where I can cash in on my life's work. So yeah, our clients are focused on maximizing the value that they get from their business. That's just natural. But Their goals usually go beyond that. In addition to maximizing the value that they receive, their value set tells them that they want to take care of their employees at the same time.

Yeah, which only makes sense, especially if they've been instrumental to your success. I think it's a bit, uh, egotistic not to give them something. Um, your partners, do they get a percentage of the transactions when they bring you deals? Uh, how does that work?

It depends. Um, many times the attorneys and CPAs have a conflict where they cannot accept referral fees, but investment bankers and investment advisors often can. And so if that's something that is not opposed to their legal ethics, then we're happy to provide that.

Got it. And your network of CPAs, lawyers, investment bankers, it must have be— it must be gigantic at this stage. 45 years in the space. How do you get them? Uh, how do you grow your network? Right? Because I do a lot of partnership in my own business this year, and I'm just curious of how you, you grow that network of yours.

Well, part of it's through, uh, podcasts like this. Part of it is through public speaking, and so I am frequently a speaker at professional events. For example, this morning I've been working on a packet. I've been invited to speak at the Great Plains Federal Tax Institute in Omaha, Nebraska in December of this year, and that is a gathering of 400 professional advisors, mainly lawyers, CPAs, and financial advisors. And so as a result of speaking events like that podcast, I've also written the leading book on ESOPs called The ESOP Coach. I've had 3 articles published in tax journals. And so, um, part of my mission is to create awareness of what ESOPs are and their many benefits, while at the same time making people aware of who we are at EFS ESOP Consultants and opening markets via those, those strategies.

Interesting. And let's say, give me an average of, from your, your smallest client and your highest client, what the fees can be if I decide to open my own ESOP on your side.

Yeah, the total all-in fees, and so this would include all of the advisors that would be involved, and let me give you some sense of the advisor team. There are really two teams involved in every ESOP transaction, one that represents the purchasers in the transaction, so that's the buyer team, and the buyer, as I mentioned, is the ESOP trustee. Well, that trustee has a valuation advisor that it hires, and it also has legal counsel that it hires. On the other side of the transaction is the seller, so that's the business owner, and the business owner team is going to be led by us but also consists of their CPA and their lawyer. And so we've got, uh, those two sets of advisors, and then the bank is going to have legal counsel that represents it in negotiating the, the terms of the bank loan agreements. And so among all of those parties, the minimum fee to set up an ESOP is going to be around $600,000, and it can go up from there depending upon the size and the complexity of the transaction. And so that's why, as a general rule, I say it doesn't make sense to do an ESOP if you don't have at least $2 million of adjusted EBITDA because the cost-benefit ratio is going to be difficult to justify, uh, for a very small company.

And that $600K, does the bank loan to pay it? Um, because there's also like me like selling some shares and all that, so I, I finance it, right? If I want to open that, it's fully financed or what?

Uh, they money that the bank loan— loans can be used to pay all of those professional fees. Otherwise, it's paid out of company cash.

Wow, that's a big chunk. So let's say I make $2 mil a year, that would be, uh, I don't know, like 35% of my revenue. That, that's pretty high, but I can understand the why. Um, it's such a fascinating industry, like, uh, and complex, right? Like, is that why you could stay 45 years in that game.

Yeah, that's very perceptive. Um, it is endlessly interesting and challenging, both from the technical side and from the people side. I mean, I talk to very interesting, very successful, very smart business owners and their advisors every day. Uh, after 45 years, I don't get many new questions, but I get some. I was dealing with one this morning. I was talking to with, uh, one of the attorneys that we work with frequently, uh, about a technical question that I hadn't dealt with before. And so I love the business. I love being able to help business owners consummate the most important business transaction of their lives, cashing in on their life's work. I find that to be very rewarding. I find the fact that they're doing that while benefiting their employees to be very rewarding. And I do find it to be very interesting, because there are constant new people challenges and technical challenges.

And my ICP is Silicon Valley tech companies, right? Very high growth. I don't know, OpenAI, Anthropic, like these types of people. Do they also create their own ESOPs? And is that the type of clients you could help as well?

No, uh, that is one of the industries where you almost never see an ESOP, uh, is in technology. Uh, almost every other industry, uh, you see ESOPs, but tech is one of the few industries where you don't. There's no particular reason for that. There's certainly no legal or technical reason that you don't, but oftentimes they are focused from the very inception of their business building something, uh, that they're going to sell to private equity. And often private equity is an investor early in the process. And so private equity is going to drive the growth, provide the capital for the growth, and then drive the sale to the next private equity firm or to an IPO.

But these guys do give stocks to their employees.

Yeah, they do that through a different methodology though. They usually do that through options, uh, and so you could see options or stock grants or, uh, restricted stock, stock appreciation rights. Um, so those are ways to sell or to share ownership with a company's employees but they're very different from an ESOP. Because remember at the beginning I said an ESOP is two things in one. It's not only a way to share ownership with your employees, it's also a way for an owner to cash in on their business. And so ESOP offers both of those opportunities where the other options that I mentioned only benefit the employees.

We're almost going to an end here. I want to ask you, what changed in your space in that 45 years? Has something changed in business owners' mentalities or in the business structures of things? What have you seen in these 45 years of business activity?

Yeah, great question. We've seen— and the attorney that I was just talking to about this new unique technical issue, and I shared this comment— that we're just seeing a huge boom in ESOP activity, um, and that boom is driven by the aging of the baby boom generation. So that's, that's generation of people that was born between '46 and '64, and those people are just at the age now where it's time, based on, uh, their age, to cash in on their life's work. And so that has combined— that demographic wave has combined with an increased awareness of ESOPs. And so as a result of those two factors we're seeing a huge boom in ESOP activity.

Yeah, and possibly reshoring, I would say, right? The reshoring brings a lot of local talent back in the business, and that local talent is more precarious. They want something, they want a stake, right? As the economy is not going any better for the middle and lower class, I would say. So that could be an interesting phenomenon. Uh, Kelly, thanks for showing up to the podcast. Where can people find out more about you?

Uh, our website is www.execfin.com. So that's E-X-E-C-F-I-N.com.

That was Kelly and Charles