The Exit Engine Podcast Episode 18: ESOPs aka Employee Stock Ownership Plans! (with Kelly Finnell)

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Welcome to the Exit Engine Podcast, episode 19. Good morning, John.

Joe, good morning to you.

How you doing, man?

I'm doing great.

Excellent. We've got a very special guest today.

Yes, we do.

I'm so excited about today because we have been— heretofore we have talked about, uh, you know, the 5 Ds, right? We've talked about all the kind of adverse ways that people exit their businesses. We talked about destiny being the 6th D, right? Which is like the, you know, the way people want to exit, right? Which is in control of themselves and on their own terms and all that stuff. But I think what people don't know is that there are several different kinds of exit strategies that are actually kind of out-of-the-box exit strategies that are important to kind of know about because some of them might be right for you, right, John?

Exactly. And I'm really excited today because I'll let you in on a little secret. I don't know barely anything about the topic we're going to talk to, so I'm psyched to talk to Kelly Shortly.

Excellent. Well, again, we're all going to get an education, there's no question. So let's just talk a little bit about ESOPs, okay? Also known as, right, as employee stock ownership plans. And this sounds like, uh, you know, oh my God, some financial guy's gonna come at me and try to sell me some, some plan, something, right? No, it's not that at all. What is an ESOP? An ESOP is a way of being able to actually Essentially is— well, Kelly's going to tell us specifically, but it's basically a trust, right? And essentially what you're doing is putting your business into a trust and allowing it to be run by partial owners, by other employees, by anybody who kind of is a member of that trust. And you get to keep your business kind of in that trust without— and pass that business along. And there's some tax benefits, and there's all kinds of things that I think Kelly's going to talk to us about. So I want to introduce to you guys Mr. Kelly Finnell. Is it Finnell, Kelly?

Yep, that's perfect.

Finnell, excellent. He is the CEO and President of Executive Financial Services. So Kelly is an attorney. He is an expert in ESOPs. He's an accomplished author. He's written a book on ESOPs and how they can be good for you. For those of, you know, Memphis, University of Memphis grad, right? And essentially is a, you know, probably the premier expert on ESOPs in the world. So he's going to talk to us about it. Kelly, it's nice to meet you.

Well, thanks. It's great to be with you. I appreciate the opportunity to talk about my favorite subject.

Excellent. Well, that's great. Well, we're excited too, because again, it is something that is, you know, lesser known. It's not something that we've dealt with even as exit planners all that much. And so we're really, really excited to get an education today. So thanks so much for being here. So first, Kelly, tell me, give us a little bit of background on the ESOP, kind of where it started, what's the basic premise, and how do people kind of take advantage of it?

Well, ESOPs came into the law for the first time with ERISA in 1974. And an ESOP is another form of qualified retirement plan. So it's a first cousin to a 401 plan.

Right.

And about 80% of the rules that apply to a 401 plan are the same rules that apply to an ESOP. But there are 3 big differences between a 401 plan and an ESOP. The first difference is that an ESOP can borrow money.

Correct.

Any other type of retirement plan, that's a prohibited transaction. But for an ESOP, it's allowed. The second is that an ESOP can engage in certain transactions with parties in interest. And then the third difference is that an ESOP is required to invest primarily in the stock of the sponsoring employer. So what happens if you have a qualified plan that can do those 3 things? An ESOP will purchase stock from a business owner. So as an alternative to selling to private equity or to a competitor, a business owner can sell their company to their employees through an ESOP. And we'll talk about why you would want to do that and the tax benefits. And so the ESOP needs capital. In order to purchase the company.

Right.

And so the sources of capital are a bank loan and seller notes. So I said that an ESOP is the only form of qualified plan that can borrow money, and those are the 2 sources of money that it borrows. And then I said that an ESOP can engage in certain transactions with parties in interest. So it takes those 2 forms of capital The bank loan and, uh, and the ESOP uses that capital to purchase the stock of the selling shareholder. And it can be 30% or 1%. It's usually 100% of the stock of the selling shareholder. And now that the ESOP owns the stock over a period of years, and that might be 20 to 40 years, The shares are going to be divided up or allocated among the ESOP participants. So I said that an ESOP is required to invest primarily in the stock of the sponsoring employer, and so that's how that happens.

Got it. Okay, so the reality is, is that— so what you're essentially— what you're doing is, is essentially is years in advance of your exit. Okay, really, you're actually putting in together, putting, putting, giving your, your employees the, the chance to participate in in a program that will eventually have them basically be owners, you know, members, owner members of the company in, in a, in a, at a future state where they're, and that ownership is actually growing and stuff over time as the company grows. And so the value of those individual shares grows over time. Is that right?

Yes, the value of the shares is going to grow over time. But I would take exception with, with one of the things that you've said. In many cases, an ESOP is established well in advance of the time the owner plans to exit. But there are lots of cases where the ESOP is established today and the owner leaves tomorrow.

Okay.

That's totally up to the owner.

That's it. That's huge. That's huge to know for, for people too. Yeah, it's— yeah, good.

And Kelly's not going to get paid out the day after he leaves because he's going to get some capital from that bank loan, But he's also gonna have the seller note and he's gonna get paid out over a period of time with the seller note. And you can bet that the owner wants to be the chairman of the board of the company and stay involved in the company during that period of time he or she's being paid out.

And is that something you recommend to owners is to stay involved that way?

Yes. And so ESOPs work best in companies where there is already a strong successor management team. And so oftentimes we'll see the selling shareholder move from the CEO of the company to chairman of the board and the successor management team move up. The owner still might be involved in a strategic role, but at the point of the sale turns over often the day-to-day operations of the business to that successor management team.

Management team, gotcha. Which is actually, as we talk about all the time, is one of the requirements for selling the company.

I mean, exactly, whether you're selling it to an ESOP or to private equity or to a partner, you've got to have those people that can run the business when you're gone.

That's exactly right. So what, what are some of the things that you look for? What, what's a situation— what are the situations in which an ESOP is kind of right for, for, uh, the right exit strategy for an owner?

If I'm in a meeting with business owners and they tell me that the key to company success is the company's culture, then I know that they're a good candidate. One thing that you can be sure of is that if you sell to a third party, culture is going to change, right? If you're not the owner of the business, that business is going to have the culture of the firm that bought you.

Correct.

And so the purchaser's always going to say, look, after the acquisitions, nothing going— nothing's going to change. But that seldom pans out to be true.

I mean, that's, that's, that's rare, right, Kelly? I mean, really, it's, it's not only seldom but very rare, right?

Very rare. And so ESOPs work best where company culture is the key. In situations where we see company culture being so important are businesses like professional services companies. Our biggest industry segment Is engineering firms.

Wow.

Okay, engineering firms, architectural firms, advertising and public relations.

Interesting.

Distribution companies are a big market. And now over the last 2 years, construction companies have become a huge user of ESOPs. We're going to do 11 ESOP transactions this year, and 5 of them are for construction/general contractor Wow.

Now, Kelly, do you know, or do you have any idea or reasoning about why that's sort of— because it seems like it's increased over time, or it's a larger percentage of the transactions you're working on. Is there a reason for that?

Are you speaking specifically, John, of the construction?

Yeah, sorry, the construction companies. Yeah.

Yeah, I think that there are several reasons. I think the biggest reason is something that you guys alluded to earlier. And that is when people ask me what the biggest problem is with ESOPs and why there aren't more ESOPs, it's lack of knowledge.

Oh, that's right.

And so imagine you guys are involved in this niche specialty of exit planning and, you know, are just getting completely up to speed on ESOPs now. If you were a tax attorney, or a business attorney in general practice, you would know even less about ESOPs. And if a client came to you and said, you know, I think I'm interested in exploring this idea of an ESOP, many professional advisors just as kind of a knee-jerk reaction would say, no, it's not a good idea because that advisor is not going to be able to help them with that strategy because they're not aware of it.

Right.

And so they probably know how to do a sale to private equity, and so they're going to steer them in that direction. So I think that the construction industry has become very aware, and we see that within different market segments, whether it's geographic or within an industry.

Mm-hmm.

You know, that we've got a city not far from us, Huntsville, Alabama, and I was visiting, uh, ESOPs are so prevalent. In Huntsville. And I was visiting with a business owner earlier this year. We've now implemented their transaction, but he said, I can't hire good engineers to work for my company unless I have an ESOP, because so many of the other companies in town—

From a competitive advantage standpoint, it's like it's a competitive advantage to work for a firm that's got it. Interesting. Very interesting. I, I'm fascinated by this about the construction industry because having been in it And, you know, terrible business. But what is it that— how is it that those firms are actually able to take advantage of this when so many of their— I mean, that requires full-time employees. Some of these construction companies, you know, obviously have a lot of 1099 employees and things like that. So, the structure of that. And then, my other question is, how is the company evaluated? And is it different? Is the valuation methodology and all that stuff different Or the same, or, you know, how does that work in terms of the, you know, in terms of an ESOP setup?

Yeah, well, Joe, to the first point, not every construction or general contractor is a good candidate. And so if you don't have a core group of at least 30 employees and perhaps some 1099 people in addition to that, then you're probably not going to be a good candidate. And so our typical construction company client might have an office staff of 20 or 30, and then field managers and, and people that are full-time W-2 on the company payroll, that's another 30. And then you might have 100 1099 laborers.

Gotcha.

The plan can only cover Those W-2 employees.

Right, right, right.

As a general rule, the employer doesn't want to cover the 1099 people anyway. Even if he wanted to, the law doesn't allow it.

Got it. Right.

And, and, and Kelly, question, what about the size? Because in that just example you just gave, what's the typical size of the construction companies that the, the, the construction company that you're working with this year? Like the average?

They tend to be some of our, our bigger clients. So I would say between $5 million and $10 million of adjusted EBITDA.

Got it.

Okay.

Yeah, yeah. Now you don't have to be that big to do an ESOP, and there certainly are many companies that are much bigger that are doing ESOPs. Kind of the minimum size that you need to be is at least $1 million of EBITDA and at least 30 employees. And then on the big side, I don't know if you guys heard about this, but last year BDO The large accounting and consulting firm sold a very significant— it was a minority interest, but a very significant interest in that practice for over $1.5 billion to an ESOP.

To their employees, right?

Wow.

And when you say to them, is that ESOP— that's— and forgive me for my ignorance— when you say to an ESOP, that's the ESOP affiliate, the BDO employees that own that ESOP, right? Or no?

The, um, yes, BDO is the sponsor of their ESOP, just like, you know, all of our clients are the sponsors of their ESOP. And then, as you said at the very beginning, Joe, there's a trust. And so where there's a trust, there's a trustee.

Trustee.

And the trustee is the owner of the stock for the benefit of the employees. So it's a huge misnomer that Um, people, for example, will say, well, I couldn't do an ESOP if I have more than 100 employees and if I'm an S corp, right? Because an S corp is limited to 100 owners, right? But what happens is the trustee's the only owner.

So on paper, the trustee's the only owner, not the rest of the number of employees. Got it.

So the idea of a trust goes back to English law, and it was devised because there were people, children, minors, that were inheriting property from their parents, and legally they couldn't own that property. So what would you do? They can't have legal title to that property, but the parents wanted them to benefit from it, and so the English came up with this new legal person that they called a trustee. And so the trustee holds legal title, but it's for the beneficial interest of the participant. And so every trust operates that way, whether it's the 401 trust. People ask me all the time, why didn't I get a 1099 on the money I made in my 401 plan last year? And the answer is because you don't own that money.

You don't own it.

That money is owned, that account is owned by the 401 trustee for your benefit. And the 401 trustee didn't pay tax on that money because they're tax-exempt under the law.

Right.

And the same is true with an E-Trustee. Excellent.

So, and then, so back to my question about valuation then, is it, is the, you know, everything is done the same way from a valuation standpoint in terms of this is what the company's worth and how we break up shares and all that?

Yeah, so valuation is typically a function of 2 different valuation methodologies. The comparable transaction methodology, and so you would search the available databases for companies in this industry of this size that have similar financial performance metrics like margins and those kinds of things, and There would be a specific multiple that companies had traded for, and there would be a range.

Yep.

And, you know, that would be how value is determined. Then the other approach is the discounted cash flow method of valuation. And so we would advise our clients to expect X amount from the trustee in terms of purchase price. evaluating the company using both of those approaches to valuation. And then that's the same methodology that the trustee would employ to determine how much they were going to pay for the stock. So there's going to be an arm's-length negotiation between the seller with us representing them and the trustee to end up with the final purchase price.

Gotcha. So In those situations, then, who is representing the employee, the trustee, or the trustee side of the negotiation? Is another attorney? Let me build on that.

Like, in those examples, in that example, Kelly, who is an example of a trustee? Like, what type of institution or entity or person is a trustee?

Yeah, I'll give you an example of a trustee that we work with that's located Uh, in the Midwest. This person was a CPA with a Big 4 accounting firm and then became the CFO of a business, a medical business, and that business implemented an ESOP. And so he worked with the company through that process, and he was on the seller side of that transaction.

Okay.

Then he became the CEO of that company. So he ran an ESOP-owned business. Then he went into the business of serving as a trustee. So that is an example of the kind of person— financial expert, accounting background, ESOP expert, having lived through it, and very valuably having been on the other side. He's now on the buyer's side. He had been on the seller's side Right. For a number of years.

It's interesting.

Yeah.

Interesting. So, so the, the, but the sponsor of the entire program is the company.

Correct.

So the company is saying, you guys need to have a trustee. Here's a person we recommend, or you have to, you know, how does that all come about in terms of the, you know, how do we go find the right person and all that?

We're going to send an RFP. I mean, we know every ESOP trustee in the country. And we're going to send an RFP to maybe half a dozen. And we're going to prepare a summary of the proposals that we receive. We're going to review that with the company, and that's usually the company's— the selling shareholder and the company CFO. So we're going to review those proposals with them. Then we're going to ask them to select 2 or 3 finalists. And then do interviews because it's not just a matter of the numbers. This is going to be a relationship that the CFO and the seller are going to have with this trustee for years to come. So we want to make sure that all of the objective factors and the subjective factors match up between the trustee and the company. Right.

That makes a lot of sense. The, um, as far as the structure is concerned, you just mentioned the BDO, you know, situation where it was a minority interest they were selling. So obviously ESOPs don't have to be you're selling the entire company.

Correct. It can be anywhere from 1% to 100%.

No kidding. So if you just want— and again, one of, one of the benefits from an owner's standpoint would be to be able to get capital.

Correct. Yeah, so it's a liquidity strategy. For an owner. It's an alternative to selling to private equity or to a finance or to a competitor.

Gotcha. But you're at— essentially you're asking the ESOP— the ESOP is coming up with the— with whatever capital is required based on the valuation to be able to buy whatever portion of the company that they're buying, 1%, 100%, or whatever.

And that—

that inform— that— that money might be—

been—

then be paid out over time to the, you know, to the, uh, to the company or to the owner of the company. And that, that, that time— how long is that time period normally, you know, from an earnout standpoint?

Yeah, so let me go back and make sure we're clear. There's going to be bank debt, and so the owner is going to receive that in cash at close, and then the company, with our assistance, is going to go to a number of different banks and receive proposals. One of the most important factors to know is that Banks loan money to companies to do ESOPs with no personal guarantee by the selling shareholder. And so I talk to business owners all the time and they say, look, I've been in business 40 years, buddy, and I have— my company has never gotten a loan without a personal guarantee.

Yeah, right.

And say, well, then we're not going to use your bank because we've got a stable of banks that know how to do ESOP lending.

Right.

And they know that they can't have a personal guarantee. An ESOP is an exit strategy, right? And a personal guarantee ties you closer to the company, which is completely contrary, right?

Exit, right?

Yeah. And so now we've got the bank loan, which is gonna be— have a term of 5 years. It's usually paid off quicker than that.

Okay.

And then the seller note might be a term with another 5 years after the bank loan. And so during that period of time, the company is going to pay interest only on the seller note. Let's say it takes 3 years to get the bank debt paid off because it's usually faster.

That's how the bank says— the bank says we'll take our interest, our cut first.

Exactly, exactly. And then the Uh, company, after the bank debt's paid off, goes back to the bank and says, look, this works so well, we want to refinance a portion or all of the remaining seller debt.

Sure.

And so they get a second tranche of debt. And so the owner might be out of this deal in somewhere between 3 and 7 or 8 years.

Okay.

Would be pretty typical.

Got it.

Excellent. And then, and then from a— what about like during the time of the ESOP? And I don't want to get ahead of ourselves, but, or when it's being set up, are— how are employees— are employees directly participating in the, in the process of creating this ESOP? Or could you talk a little bit about that at all?

No, the employees are not generally involved in the process. Okay. The process usually starts with the owner and with the CFO. And as a general rule, the employees don't know about the plan until the transaction is closed and we come in and do an employee communication meeting. So I'm going to be in Atlanta tomorrow working with a company that's in the construction industry that we did an ESOP for. We're going to do the employee communication rollout meeting So this deal closed a couple of months ago, and the employees don't know. They won't know until tomorrow that they now own the company. Congratulations.

So, okay, we gotta go. We gotta— I gotta dig into this a little bit. I don't want— obviously not to know the name of the company, but what are— I mean, I can imagine that that's a bit of a shock to people, right, when that happens. So, so, so what are the— what are the, the techniques or What are you trying to communicate in that brief period of time or with the materials you provide to them during that meeting?

We usually begin by saying, the owner has sold the company. And you're right, John, everybody has this shocked look.

Yeah, like, whoa!

I guess he sold it to—

And then we say, and he sold it to you. And so they go from shock to relief. And then we talk about—

Yeah.

The fact that while they have bought the company, it didn't cost them anything. They didn't have to put in any of their own money. There were no concessions. The company financed the entire acquisition. So now they're feeling really good. And but they're thinking, You know, that sounds too good to be right.

What's the— I'm thinking, I have my hand raised, what's the catch?

So then the next thing that we say is, look, this is not some gimmick or new idea. And we talk about the national companies that they know, and we have a slide on the PowerPoint with logos of companies that they all know that are ESOP-owned companies. And then we make that more specific. So I'll be in Atlanta, so we'll have a map of Georgia, and that map will show a scattergram of where the Georgia ESOP companies are. Then we can mine data and tell them how many Georgia ESOP participants there are. And believe it or not, we can tell them the number the dollar amount of the benefits that were paid from Georgia ESOPs last year. And so that, that number was over $1 billion.

Wow.

From Georgia last year. And so now they're thinking, well, you know, maybe this is a real deal. Maybe it's not too good to be true. And so then we, we show them projections. We help them understand that An ESOP puts everybody in the same boat rowing in the same direction. And that the ESOP is more than a retirement plan, even though under ERISA, that's what it is. An ESOP's really a wealth creation opportunity.

Right.

When we show them what the value of their stock would be, assuming zero company growth, 5% growth, and maybe 7.5% growth. So they get a very clear picture that their future wealth is tied to the performance of their company.

Okay.

And so what I found is, you know, 40 years ago when I started doing this, I thought we would do this meeting and all the employees would come up and give the boss a big hug and say, thanks, this is the greatest thing that's ever happened to me. But I've learned people are suspicious, and it really takes us repeating that meeting and providing other educational materials.

Sure.

Over about a 3-year period.

Okay.

In order for them to really begin to appreciate it. The higher the educational level, the quicker that appreciation is. So in an engineering firm, they get it much faster than a manufacturing company's employees. always would, but it takes time.

And, and, and breaking up the, the— or not breaking up, but allocating the amount of money that the ESOP purchases of the company. So, so let's say it's 30% of the company, or let's say it's 50% of the company. Um, and, and so the ESOP purchases 50% of the stock, and then allocating that stock out to the employees. Can you talk a little bit about sort of how that happens and what's the— what are the methods that you use to, to allocate that stock out? Yep.

So picture the, the ESOP trust as a box, and this box has 2 compartments. The top compartment is called the ESOP suspense account. So when the stock is initially purchased by the trustee, all of the stock goes into the top of the box and it's held in the suspense account.

Okay.

This would just be a simple example. Let's assume that there is a 20-year share release schedule. That's part of this design. So that means that 5% of the shares are going to be released from the suspense account each year. Then those shares are going to be divided up among the participants on what's called a salary ratio formula, which means that if you have an employee who makes $250,000 a year and another employee who makes $50,000 a year, that $250,000 a year employee is going to get 5 times as many shares in their account as compared to the $50,000 a year employee.

Got it. Okay, that's— and so then, so all the shares— sorry, not all the shares. On a yearly basis, a percentage of the shares— the percentage of the shares that's decided is released. So in 2025, as an example, 5% 2026 until all the shares are out of that top box. Is that right?

You got it. That's exactly right. Okay.

Interesting.

And then is there any other kind of like, you know, vestiture or, you know, in terms of the employee side or anything like that? Is it just a time thing or is there other—

often when they leave—

sorry, when they leave, what happens when they leave?

Yeah.

So let's go back to my initial premise, which is that an ESOP is a form of qualified retirement plan with those 3 differences. And I said 80% of the other rules are the same.

Got it.

So eligibility, vesting, years of service, all of those, all of that minutia that people who are familiar with retirement plans understand, all of that stuff is the same with ESOP. So there's almost always a vesting schedule that might be a 6-year graded vesting schedule.

Okay.

And then there are within ESOP the same 4 distribution events that you have with any retirement plan, including a 401. And those events are death, disability, retirement, or termination of service. So the timing of the distributions with an ESOP works very differently. This is another place where ESOPs are different from 401 plans. So with a 401 plan, you leave, 60 days later you roll your money into an individual retirement account. Right. With an ESOP, that's not the way it works. You leave on, you know, call it July 1st, 2024, then you're not going to receive the first distribution from your account until 2025. So you've left because of death, disability, or retirement. Which means that your distribution is going to begin the year after the year in which you left.

Okay.

So you left in '24, you're gonna get your first distribution in '25, and that's not going to be for 100% of the value of your account. It's gonna be for 20% of the value of your account. So '25 through '30, you're gonna get paid out essentially the same amount each year until your full account has been distributed to you.

Gotcha.

If you left because of that 4th reason, termination of service, which means you fired— you got fired or you quit, then in that case you have to wait 5 years and still get paid at the rate of 20% a year for the next 5 years.

And why is that?

The reason for that is Otherwise, you could have a run on the bank.

All of a sudden people start quitting.

Yeah.

Everybody quits to get their money. Right.

Right. And all you've got in the ESOP is company stock.

Right.

In a 401 plan, you have a mutual fund perhaps that can be converted into cash the next day.

Right.

With an ESOP, you've got the stock of a closely held company. And so you don't want to have a run on the bank because that destroys the value of the accounts of those employees who stayed.

Right.

And so you have this staged distribution which protects the company's financial integrity.

And Kelly, building on that or asking another question about that is part of the strategy I can imagine for managing that ESOP account by the trustee is generating some sort of cash so that, so that to your point about selling company shares, or talk a little bit about how that, that, that trustee is managing that account so that when people do quit, when people do leave and need that money, how does the trustee managing for those, you know, events that they know they're going to occur?

Yeah, managing, managing for that is really the responsibility of the company's CFO. Okay. And so the law requires that the company convert participant stock into cash.

Sure.

Now that can be done by the trustee, but the ultimate obligation's on the company.

Company has to— is the one flipping the bill. So, right.

That's right. And so let's assume that there's no cash. This would be very unusual, but assume that there's no cash in the ESOP. Person leaves. Hopefully the CFO of the company, after the time the ESOP debt was repaid, started accumulating cash, right? They were paying $2 million a year in debt service. Take that $2 million, put at least a portion of it in a sinking fund to protect against this emerging liability, which is the ESOPs.

Right.

repurchase obligation.

Right.

And so you're going to have within the company— generally it could be within the ESOP trust, but generally it's going to be within the company— a pool of cash that's going to be available for paying that. One of the reasons it's within the company is because we can accumulate money within a 100% ESOP-owned S corporation and not have to worry about the tax consequences of the earnings on that money. Because if you have a 100% ESOP-owned S corporation, your business is taxed like a church or a synagogue.

Wow.

No tax on the company's income. And the reason for that is we all know that in the S corporation, the company doesn't pay tax. It's a flow-through entity. So Let's get that out of the way.

Yeah.

That's simple. No tax at the company level. So why isn't there tax at the owner level like there is in an individually owned company? The answer is the owner is the ESOP trustee. That trustee is tax exempt under Section 401 of the Internal Revenue Code, just like the 401 trustee is tax exempt. So No tax at the company level, no tax at the owner level.

Okay.

Now, when the money comes out to participants, unless they roll it over into an IRA or a 401 plan, they're going to be taxed.

Right. They're taxed on the income that they get out of it and the whole thing, but the owner is never taxed. And in fact, the corporation isn't taxed either under this plan as well. And so basically, it's a— I mean, the whole thing is a Relatively big tax shelter really for everybody, right?

It's a hugely tax-advantaged, uh, planning strategy, right?

And, and so when participants, you know, receive that rollover money— I'm probably not using the right term— but if they're taking that money and let's say that they roll it in, they could, they could in theory roll it into a Roth, um, or another sort of separate account that, that would be again tax-advantaged. And they wouldn't necessarily pay taxes on that if they rolled it into a similar type of plan, right?

Yep, that's right. Okay, so at the very least, an ESOP offers an incredible tax deferral vehicle, but it's also a tax shifting vehicle. We've shifted taxes from the company to the employees who are the ones who are benefiting from this, so that only seems fair.

Right. Yeah. Um, and then, and then they— but they could, to your point earlier, they can further defer the taxes if they put it into a qualifying plan. Okay. That, that— I mean, what other tax advantages that you haven't spoken about already, Kelly, that should we talk about for our, for our listeners?

There is a tax advantage for the, uh, owner who sells under Section 1042 of the Internal Revenue Code. So 1042 Is a like-kind exchange provision. So most business owners that I talk to know how a like-kind exchange of real estate works. Many of them have done those.

Yep, like a 1038, 1030 exchange or something like that.

1031.

Yep, 1031.

Right, exactly right. So there are those 3 very similar like-kind exchange provisions in the code. 1042 applies to the stock of a closely held company That sold to an ESOP. And of course there's 10 pages of rules just like there are with any like-kind exchange, but the big picture— I own stock in my company, I sell it to an ESOP. So I sold stock, and so the like-kind exchange is I reinvest those sales proceeds in the stocks or bonds of a U.S. domestic operating company. That's the like-kind property. And I don't pay tax on the gain from this, my sale to the ESOP, but I've got a transferred tax basis in the stocks that I reinvested in.

So if I ever sell those stocks, that's at that rate, that's going to trigger the gain.

Okay. And then what about, what about drawbacks, right? We've talked about some of the tax advantages, the benefits for employees. What are some of the— not drawbacks, what are some of the challenges in In setting up an ESOP and, and going through the whole process?

The first one's complexity.

Okay.

When I start talking to a business owner about ESOPs, what they notice immediately is that there are lots of moving parts. Each one of those moving parts individually is pretty easy to understand. And so complexity means that While each of the individual pieces is easy to understand, the challenge is keeping your arms around all of the pieces at one time as they're moving. And they move in one direction and it impacts another piece of the concept. So complexity is the first challenge. And that gets back to— I said our biggest business niche are engineering firms.

Right.

Guess why? They love complexity.

Like, complexity is what they're all about, right?

Yeah.

Their life, an engineer's life, is solving complex problems.

Interesting. Yeah, you're right.

Yeah. Thrive on the complexity of ESOPs because that's what they do. They actually enjoy that. Right. If you have a hard-charging salesman slash entrepreneur who's a big picture person, And doesn't like to get bogged down. He hires people to take care of the details. It's more challenging.

Sure.

Is it— is it— is it— is an ESOP and a kind of everyday kind of stock employee stock program, they're not the same, right? I mean, to be clear, there are other kinds of stock and ownership programs as well that aren't this.

Exactly right. So there are many, many kinds. There are incentive stock options, there are regular stock options, there's restricted stock, there are stock appreciation rights, there's phantom stock. So there are probably a dozen different types of equity-based incentive plans.

Right.

ESOP is the only one that can be used not only as an incentive plan but also as an exit strategy for the business owner. And it's the only one that has this incredible tax benefit of creating a company that operates on a tax-free basis.

And, and, and just so, just so I'm clear, because I think I asked this question before, but I just want to make sure that I'm thinking about this, is once it's set up, right, like after that initial meeting that you're having later in, in tomorrow in Atlanta, the, the trustee, it's all set up, it's for the benefit of the employees, and there's some sort of process to allocate the shares. After that, you know, until one of those qualifying events happen, it's kind of, I'm doing my job, I'm, I'm doing my engineering work, and I, I sort of forget about it in the same way that I forget about my 401, although you have a little bit more control over that. Is that, is that right, Kelly?

I'm not going to let you forget about it.

Okay, fair point. Yep.

Because the key to employees appreciating the ESOP and what it can do for them is all about them understanding it. Okay, so we're going to send the employees quarterly newsletters. We're going to encourage the business owner to put on their signature block, you know, XYZ Company, 100% employee-owned.

Right.

We're going to encourage them in every employee communication, in every employee meeting To keep the fact that this company is employee-owned in front of the employees. And so it's really creating that ownership culture by keeping that in front of them constantly is really key, one of the keys to a successful ESOP.

That's interesting. The, uh, and of course from an HR standpoint, from a marketing, from a, you know, a recruitment standpoint, right? I mean, obviously this is all You know, great fodder for recruiting new employees and all that, you know, as well, right? So the reality is to be a company like this and to have this thing in place is a huge added benefit for employees.

Absolutely.

Yeah, absolutely. Amazing. Kelly, this is really, really fascinating. Is there anything else that people have to know about this stuff? I mean, we talked to— I think we talked about, you know, all this stuff inside out. I mean, it's really amazing. The, um, what, first of all, what, what, is there anything else that you, you, you know that we didn't hit on that we need to talk about right now?

Well, it's a big subject, and so I'll give, uh, people 4 resources that they can go to if they want more information.

Great.

So our website is basically an ESOP educational website, so you can go to execfin.com. And find lots of information. We also have 2 industry associations. One is called the National Center for Employee Ownership, so you can go to nceo.org. It's a not-for-profit educational organization. There's also an organization called TEA, the ESOP Association of America. You can go there to their website. And get more information. You can go to Amazon and buy a copy of my book, The ESOP Coach, and get more information. That one of the things I did with the book is include about 6 case studies. I think that's a way for business owners to, to really learn, is to find one of the case studies that looks like them.

Identify with, right, right.

And that successful company did and how they did it.

Yeah.

And so we've got probably half the book is all the boring legalese. That's the back half. Not many people read all 200+ pages. Most people read the first few chapters and several of the case studies.

Give me the gist, right? Give me the CliffsNotes.

Exactly. The bottom line. That's what we're all about.

Well, look, the bottom line here is no question that, that, that the, you know, an ESOP is a great opportunity from as an exit strategy, right, for an owner being able to actually essentially sell their company back to their employees. Obviously, there's some rules and regulations, but it's a great benefit for the business. Makes the business essentially tax-free, right? Makes the ownership, obviously, give the ownership great tax advantages. And then, of course, from an employee standpoint, I mean, especially if the company is doing well, Could be an even greater benefit, even shorter and shorter term than a 401 plan, right? Yep.

Absolutely.

Amazing. Well, Kelly Fennell, thank you so much for joining us here on the Exit Engine Podcast today. Really appreciate your insight on this. How can people get in touch with you, Kelly, if they want to talk to you?

My email address is on the website, obviously, but it's It's kfin@execfin.com. kfin@execfin.com.

Excellent. Great. And Kelly, thank you so much for being here. I really appreciate your time today. It was incredible education for both of us, and I'm sure our listeners appreciate it too. So, thank you so much. Really appreciate it.

Thank you.

All right. Hey, John. So, the ESOP thing has been something you and I have been talking about for months. The fact that Kelly walked in here today, Completely unannounced. No, just kidding. Um, was, uh, a great, incredibly fortuitous— um, this is an incredible thing that people need to know exists.

Yeah, and, and, and all the benefits, the, the tax benefits, the, you know, the, the cultural benefits, the recruiting benefits. I mean, what Kelly laid out here is, is a compelling reason to explore this option for business owners when they're selling. It was just a wealth of knowledge.

It's crazy. And still, the construction company thing still gets me. It's amazing. But I guess I understand, like, there are certain kinds of people who kind of understand this thing in a natural way, like engineering firms and construction companies and things like that, right? That kind of make it a natural fit where maybe it wouldn't fit with the, you know, with some other kind of business.

Yeah, yeah. It's funny that engineering companies are the ones that have taken advantage of this. I mean, obviously other companies too, but it's just interesting that engineering companies like that complexity to a degree.

Exactly right. Well, it's really great. Excellent. So you've been listening to the Exit Engine Podcast. I'm Joe, that's John. Thanks for listening to us today, really appreciate it. You can check back with us every Friday, we release another one of these things, and hopefully we'll have a compelling episode for you next week too. But special thanks to our guest, Kelly Finnell, for joining us today. ESOPs, employee stock ownership plans. Get into it, take a look at it, find out if it's right for you. You can contact us at myexitengine.com. You can, you can email us at info@myexitengine.com. You can find us all over LinkedIn. Jon, thanks a lot for today. Really appreciate it, buddy.

Thanks, Joe.

All right, we'll talk to you later.