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The Berman Buzz

EP3 - The tale of two ESOPs

[0:11] Hey everyone good day to you this is the ESOP guy we are on season 3 and, 20:22 is here like it or not we're getting right back into all the things that go about in the ESOP world and excited to be with you again to do another episode of Journey to an ESOP, so this podcast are for those that are thinking they might want to consider an employee stock ownership plan and I can tell you 20 21 was an exciting, year as we went through a lot of different conversations with folks thinking about doing an ESOP I think 2022 is starting off the same way and we're really excited to come to you with this podcast which is really just a resource to help really understand better how the Employee Stock ownership plan and process works. And I really will start off with this episode and really just say this as we start thinking about. [1:05] The 20:22 period and just things that that are coming the inspiration of this episode really started with thinking about sitting in the car. And for Christmas vacation we got to go to California and we went to go up to Tahoe for some skiing from with me and my family and it was just a phenomenal time. But I had a lot of time in the car because it snowed so much that we were really just stuck in the snow we went in the car to get home. And they had closed out one of the main main roads in California and the Tahoe area so we had to go everybody had to drive down 50 to get out. [1:48] And it literally took us 14 hours of DriveTime to go about 100 miles and, so I had a lot of time to contemplate and one of the things I contemplated were really these last two ESOP deals I did at the end of the year, and so I wanted to kind of start off thinking about 20 22 with these in mind and just kind of talk through those a little bit. And I'm going to basically start off with this it was the best of times, it was the worst of times it was the age of wisdom it was the age of foolishness it was the epoch of belief it was the epoch of incredulity it was the season of light it was the season of Darkness it was the spring of hope it was the winter of Despair we had everything before us we had nothing before us we were all going direct to heaven we were all going direct the other way, in short the. Was so far like the present period, that some of its noisiest authorities insisted on its being received for good or for evil in the superlative degree of comparison only. [2:45] Dot dot dot Charles Dickens from the very famous Tale of Two Cities today's title of our podcast is going to be called The Tale of Two esops. And what we're going to do is we're going to explore these two specific deals. In just some of the highlights that we went through to to provide some takeaways that really I think might be helpful as you start thinking about. [3:10] Your own ESOP deal and I think we learned a lot as we go through one deal at a time and so this is just a good opportunity it gives me an opportunity to. Take all of that stuff I was thinking about in the car for 14 hours and throw it, and throw it out to you guys so it'll be just a fun time to rehash all of that so as we said this before but this podcast is really there about you know really trying to help you, understand the opportunities that you have within the Employee Stock ownership plan. Possibilities when it comes to taking the ESOP in your and really in acting and implementing a succession or Exit Plan. We have a lot of episodes so if you go to our website at journey to an you can find all of those and look at topics or things that you might have an interest in with other with other interviews. [4:02] So the title of this episode as I said is the tale of two ESOP deals and. One of the things I was kind of as I start about this and all the podcast episodes I've done so far I think that everybody probably thinks all I do is watch movies, here's the deal I do read books and I have read this book and so there you go I'm not just a movie guy I'm also a book guy and. [4:28] You know one of the reasons I chose this this quote is only because it just says so much and it honestly it makes me think about like when I think about the quote itself about. How it's kind of these two different things that are that are positive and negative juxtaposed with each other, that it just feels like an ESOP deal if you've walked through and done a nice job deal it looked literally does feel like the best of times and the worst of times there's all these different things that are are pulling and giving way and it's a you know it's a tremendous time. To work with clients that go through this process and. Like I said it you can kind of because I get the opportunity to start the very beginning when they're just thinking about the concept of an ESOP and they also get the opportunity to walk through the entire process with them all the way to the the clothes. You get to feel that kind of emotional pull push and pull type of thing with alongside the client course. When you're doing it for them it's not as deep but it does it does feel like that. [5:34] So when I start off with a reminder of the what I would call the ESOP process and it will help us to kind of work in the tale of these two. The very first beginning step in before we get into or after we get into the conversation about hey what's an ESOP. What are the conceptual pros and cons of an ESOP so like I had a client meeting today with with somebody that we've been talking over the last three or four months. About Aesop's in this can tend to happen where people get stuck in this position where they're thinking about doing an ESOP. And finally they just know the thing is he just let's just get started because we've spun our Wheels on the same idea and questions that we've had for so long. [6:14] And so this really process that we're going to go through really starts with after they've made a decision to really think about the numbers and starting to apply them and in the very first process part of the process what we do is we do a valuation model and some people call this a preliminary evaluation and the model itself is going to help us determine the potential transaction value of what our business is going to transact for so in this specific situation one on one side we had a possibility with this one company that, was in the in the same industry they're both companies that are in contractor types of Industries and in both cases we basically walk through the same type of valuation model where we evaluated the historical approach with the capitalization of earnings method with the five years of average cash flow we went through there add backs. [7:10] With that we put together a forecast or we help the client put a forecast together we work through that forecast to the discounted cash flow model and we were able to come up with. An estimate of Enterprise Value based on that based on based on the numbers that were coming in. In both cases we're looking at to support the forecast, what their backlogs were so very similar with that one case there was a significant amount of normalizing in trees add back in trees in the other case it was not as, significant but still there were add backs in both cases that that contributed to an increase in the overall value. [7:53] So the next step is going to be as we go through the processes we're going to then take that number, and we're going to work it into our feasibility model and to do that we're going to end up you utilizing the forecast Hazard as their primary. Cash flow model as we start to layer different items in that cash flow model and so what we're wanting to do in the feasibility. Is we want those companies to understand what the. Debt obligation is going to do and so in both of these cases in both of these we had banks that were interested in financing the transactions. [8:30] And we were able to work early in the process what those potential term sheets were going to be in the feasibility models that we created so what that included was. Taking those potential term sheets building a ation schedules around those term sheets and then blending that into. The debt service requirements for the cash flow that both includes the requirements for the seller node and the bank financing. In addition to that in those cash flow models after taking the forecast we're going to read then take the, the benefit of being an ESOP in both these cases we were able to project the benefit of being an S corporation ESOP which means we're going to get to add all the taxes back into, the model itself. And show what our ability of the company is going to have to service the debt for the period of time that we've built around both of these both of these individual models now. [9:32] In both cases we had we didn't have the. [9:37] What I would call hockey-stick forecasts we had very realistic forecast where the you're looking at, good good good growth rate but not an astronomical growth rate and a growth rate that, was very sustainable based on the historical cash the historical revenues and the financial models that we had before so that was all positive those really did help, to support the ongoing needs that the both all the banks had in terms of underwriting the notes. To determine what they can do now in the difference as we went through this is one both both of the. [10:15] Clients in this case went to their incumbent Banks to get it under written in one case in the smaller case, that bank wasn't really comfortable with, Maurice app type of lending and so in that case where the smart we talked about the smaller deal versus the larger deal it's just going to keep coming up the smaller deal ended up going with a larger National Bank for their financing and a larger deal the larger Enterprise Value company went with a. Community Bank. That participated out the loan so so that was immediately something that we saw kind of in the differences between the what happened with the two deals at the front end. [10:58] And at this point what we were doing is then in the feasibility is then we basically for both of the companies we're going to estimate the total cash flow, that's going to be available then to this to the selling shareholder, now both in both of the large deal and the small deal both were owned by one individual so that was easy one of the things that come up relative to ESOP deals is when you do have multiple owners. There is a bit of work to be done to make sure that all the owners if it's 100% ESOP, or it's a partially so that the owners understand the ESOP and everybody's on the same page and that can become more complex when you have owners of different ages and different exit plans so in this case super simple we didn't have to worry about that. [11:46] And. So we early on established how we were going to do the bank financing we did the cash flow relative to the individuals that all looked good after taxes they everybody felt like there they were in the right place, and then we also Then followed up with the 40 44 15 and the 409 P analysis because they were all going to essentially be S corporation Aesop's and those would all be part of the whole testing so. So we finished the first two steps of the ESOP process valuation model and the feasibility model and one of the things about the planning side of doing esops is its much. [12:26] Quieter in the very beginning stages because it's just you and the client you're working through it and so as time goes on as we go and build this process a little bit deeper. Things start to UNI start including more and more people in this case you know it's just me and the client and then the banks that we were talking to to get the financing started. [12:44] The Next Step I call ESOP strategy and what I'm doing in this is we're going to pull together. The all the the work that we've done so far the deliverable of the valuation model that we've created in the DCF the feasibility model, and we're going to analyze that and determine really how much of the of the company are we selling What percentages are we going to sell so we're going to re. Establish the the actual objective we're going to set some timing to the transaction when do we think we're going to want to close. [13:16] We're going to talk through the possibility of using warrants and SARS and we're going to sometimes model that out to see what the potential for those SARS and warrants are going to be now those, just like everything else that's going on so far the evaluation the seller node and the interest rate of the seller note how we are going to build and structure the ESOP with, um you know the sale price and all that is all going to be negotiated the warrants and the stars are all going to be negotiate with the trustee we're going to negotiate the deal with the bank so so there will really still in the planning stages. The ESOP strategy stage really is to kind of put together exactly what we want it to look like when all of this all these parts and pieces are together. One of the things we're going to identify in this in this step to it was really what are the strengths and weaknesses of these two different ESOP deals, and how do we play those out early on in the process and terms of disclosing what do we really need to disclose and set up for what I'm going to call the next stage which is the deal memo so that that we can really identify, the most likely scenario for the structure of all this and so some of this for the warrants in the czar's really get kind of built around the model of what's going to what's going to be in the best interest of the client. [14:39] So in the smaller case of the the smaller ESOP deal that we did the individual owner did not want warrants, and wanted but but also one is ours so we ended up do not doing warrants but we did end up establishing a Tsar plan for their key for her for the key Executives of that company and on the other larger deal that client wanted warrants, they already had a management incentive plan established and did not see the need to do an additional sir. [15:10] So all of that's being we're moving it forward and those are some of the differences we saw and now the the next step is going to be called in a what I call the deal memo so we're taking again, all of those pieces that we just put together the valuation model feasibility all the strategy and we're going to now put all that into a written document which I'm calling the ESOP deal memo. Now this deal Momo does the very first thing it does is for each of the individual clients and myself it kind of puts everything down on paper and says all right. What exactly are we trying to accomplish. [15:44] How are we going to go about it you're including warrants your including SARS how are those really going to be structured so it gives us that we straight we populate that Dilma with all the strengths and weaknesses of what we think the deal is. What are we going to disclose in the very big the next part of the process which is coming what's coming next is the trustee interview process. And so once the client and I have worked through that we've kind of finalized it that is also something that we will we will share with the bank so they can understand how we're looking at structuring, this deal and so we're going to send that off to the bank and review them as well. [16:23] So now we've done that and we're ready now to interview the trustees now I pretty much go with about. Three interviews for each client so in both cases the small deal and the large deal we interviewed three trustees we selected the trustees based on the clients. Based on the agenda of items that we had we wanted to go through the way the structure is and what kind of questions that we did how did they answer the questions that we had in that process, and so in both cases we kind of settle in on a scoring system for the 300 for the three trustees. And we said all right that's the one we want we selected the trustee that we wanted and then then we engage the rest of the team so. [17:06] So really this in both of these deals are very similar in terms of how we structured the trustee relationship and then hiring the the engagement team with the with our attorney and the valuation firm. And so from there we're kind of at this point I think we're you know in the process itself is very similar the deals have a lot of good momentum. I would say one of the main differences that I saw up to this point in both in the smaller deal versus the larger deal is that the smaller deal, although I didn't act and interact with some of the key managers I spent most of my time with the selling shareholder which is pretty common. On the larger deal I spent most of my time with a key employee who is not the owner so I thought that was an interesting difference between the two things and don't think it played out to be a negative or a positive, either way there was there were both very effective at supporting the the ESOP process they were both very committed to it. One thing I notice in the process itself is is momentum builds as you get through the first couple steps and then they start to see okay now we're really making a commitment to go on to the next step there's a there's a magic point that goes on, right after feasibility where we really start to get into pulling together the strategy side, where they actually start to understand and the clients that yeah we're we're ready to go and so we have a great amount of momentum moved into. [18:34] Get the the sell-side and the buy-side team engaged. And then from there on both deals we went right into due diligence now in both cases we were really successful at having already populated, primarily all of the information in the data room that needed to be pulled for the trustee and for the valuation firm. And so partly that's because at the very you know as we go through the process on an ESOP transaction. We're in the very early stages establishing a portal, that the client would be updating all the financial information to and then we're making sure that that's available for, ongoing information that we're collecting through the next several steps and so as we get more and more information that data room, isn't it's not like we're populating that data room like right after we hired the trustee we're pretty much almost ready to go. So that's really an important part of the staff than both of those cases the client one thing that can happen in this case in this did not happen with these two esops has the client might not be really ready. To do due diligence and I've seen this where accounting their accounting, has too much work or they're not they're not in a place where they can really facilitate, the information that needs to be put together so that's one of those items that need to be thought about early on in the process of of your ESOP. [20:03] So you're not going to get stuck spinning any money and engaging people before you really are ready to do that so that's something I really watch out for so that. [20:13] We don't get stuck there so. The next thing we're going to do is we in the midst of hiring the engagement team we're already starting to build this management presentation in the management presentation which could be a podcast by itself really is just an overview of the company it gives a. [20:32] A good sense of the leadership team and the resumes and the people that are that are really building value in this company whether the selling shareholder Key Management Future Leaders all of those tapes are types of things are going to be highlighted. We're going to go into the management presentation a lot deeper into some of the strengths, and really kind of build the case for ultimately as we build up into the forecast what is the reason why we think we are going to be able to hit the forecasted numbers and how is that going to work so in both of those situations I think the management presentations were for really really well done, and that's not because I did them it's because we worked collaboratively collaboratively together with both of the the clients in their teams to put together the right information and really debuted I think one of the things we debuted well for both these companies even though one was smaller one was larger is that, these companies were able to build very strong business processes that weren't overly dependent on individuals decisions. But we're more about how the company has been able to grow and be process driven so I think both in both those cases those were those were definitely highlighted. And I think they played out to be strengths in both cases. [21:50] One of the difference in the in the companies between the two companies the small and large one is the larger company really the owner really had, two really done a great job at transitioning a lot of their responsibilities to and was it in didn't even have an office in the location anymore the other smaller business was, definitely in process of doing it and it wasn't a problem for in the ESOP by the way it wasn't like oh, that person's nearly not completely turned it over yet it's just a matter of what is the plan and how is it going, and each company though had a very good transition I would call management transition plan but it was interesting how the larger company was able to move, had already gotten through that a lot of those types of hurdles you know earlier on in the process, so we've got our site visit scheduled so everybody shows up in both of the companies at this point we've got at the site visit we've got the trustee and evaluation firm, and of course myself and then the client and their engagement in there and their leadership team. And in both cases it was really about going through that presentation and really hitting all of the all the elements of what makes this company tick and why this really does work. The company's financial performance and their history and then how they're going to affect their forecasts and. [23:14] So I think at the end of that meeting I think we're all we all kind of like make sure we got the rest of information and then we went right in from there to negotiations. And in both cases I think the negotiations went really smoothly we really went through what we expected what we felt like we were going to get and then we really I think. Hit those numbers for both the large company and the small company. [23:37] So at this point we were kind of in that place where we brought the bank's back in to get all the clothes the commitment letters together so we could now start to really see we could see the light at the end of the tunnel. How are we going to get this to closing and so now both of these deals started to go towards like well we're going to have to want to close before the end of the year and. And that's where that the when we start looking at the Smart the smaller deal versus the large deal where I saw I started seeing some major differences. In primarily what I saw on the smaller deal which had a National Bank during the financing versus the larger deal having a local community bank doing is that the, the process of doing that now both Banks need to understand both banks have experienced legal counsel. That are absolutely necessary on an ESOP lending transaction so as we get closer and closer to the closing. What I'm seeing happening is you know of course we're work we're walking through some of these meetings and now we have, the ESOP attorney the trustee the valuation firm now the bank and then all the bank's Council, my client and then just these meetings basically are really important and one of the things I will I will say as a takeaway that I think it could have been done better in the process is we could have had, more of. [25:06] Formal kickoff meetings especially on the smaller deal where it just felt like the whole thing got really a lot more involved. But a kickoff meeting would look like hey we all every single person on the transaction is going to stop. And we're going to all talk about the closing date we're going to talk about the checklist of items that needs to be completed, who's doing who's doing what and so in this case there are multiple people that are going to be doing a lot of work and so on one side on the sell side you're going to have the ESOP attorney making sure. [25:43] That they're doing the the ESOP, we've done the ASAP plan design in both these cases so they're doing the ESOP documents the plan document the summary plan description in the trust document and. [25:55] They're going to have documents that they're putting together have to be reviewed by the trustee and then the bank's legal counsel is going to have to review that as well now the Banks Banks are also going to want to have access to the data room to make sure that they've reviewed everything is part of their underwriting, so what's happening is this everything is really starting to converge in there does need to be somebody that is leading the charge in. In these types of transactions and so in the smaller deal that really kind of became the bank's legal counsel. And in the larger deal that really kind of was our attorney doing the ESOP documents and so those are kind of some differences, I thought it was interesting in the transaction though because the larger deal was probably, five times the amount of money that was being lent to compared to the smaller deal and the bank got satisfied pretty quickly what they saw and so it felt like that deal got done a lot more smoothly, although both of them closed and activate both transactions were successful it felt like the other one the smaller deal had a lot more nuances to it and and. I think part part of that has to do with the bank's requirements in terms of how the banks looking at it but also it just comes down to, you know individuals and who's doing what in the circle of things so. [27:18] So as we as we went through the the process of getting to the closing I think it was both both were successful and I would say that. Two you know the real takeaways were they both of them work or contractor companies both had very successful businesses both had really great teams. We did in in terms of differences we did use a large Bank National Bank for the smaller deal versus the. Larger company used a Community Bank for the larger deal and. [27:54] And so I think looking at the closing I think it both of them were successful in that but they're the biggest challenge was just getting through a lot of details that I think the smaller Bank. Are the smaller deal with the larger bank had had done that. So anyway those are those are the tale of two ESOP deals that we close by at the end of last year hopefully there's just a reminder of the ESOP process as we go through that and how how it really works to get through all that. No deals perfect and there's in but the key is is to just keep keep it moving forward fine in the process the person who is going to move it forward. Should be usually the advisor that's that's doing putting the whole deal together as a quarterback but it is definitely a matter of personalities and also who who's doing what in terms of who you're working with in terms of banking partners. Legal Partners how the trustees reacting to all that and so you know part of this is to illustrate its you know there are a lot of parts and pieces to it and it's really important to just try to stay on track with it all. So hopefully that helps you as we start 2022 to think about your potentially sub transaction, and all the things that are going to go into planning it and hopefully you know making it a smooth process for you. [29:22] So I just want to say thanks again for listening if you like what you hear please subscribe to the podcast also check out our YouTube channel we've been doing a lot of our interviews just videoing them as well as doing the podcast so that's all available for you, so with all of that I want to say thank you so much for listening today everyone you know keep on keeping on and have a great day see you next time on this journey to a Nissan.

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