Exploring ESOP and Employee-Led Buyouts: Insights from a Private Equity Perspective

Welcome to ValuationPodcast.com, a podcast and video series about all things related to business and valuation. My name is Melissa Gragg, and I'm a mediator and business valuation expert in St. Louis, Missouri.

Today we are discussing ESOP and employee-led buyouts insights from a private equity perspective with Michael Koeppel. In his 30 years of experience, Mr. Koeppel has been exposed to a host of industries, but his primary focus is on technology, manufacturing and service organizations. In 2001, he founded eCapital Financing, which specializes in assisting startups and challenged entities to obtain financing. Today, the firm works with a host of companies in both the Los Angeles and Western New York regions, while eCapital Financing currently focuses on investing in startup companies and projects, Lakelet Advisory Group LLC was funded and founded in 2012 to focus on challenged organizations in turnaround situations.

1. What are the top exit planning strategies you're seeing right now?
2. When do business owners start planning on selling their company?
3. Before someone sells, they need to know the value of the company. What are some rules of thumb?
4. How do venture capitalists look at valuations differently than private buyers?
5. How do you know if an ESOP is better than employees buying the business? Is there a difference in an employee led buyout?

Melissa Gragg CVA, MAFF
Expert testimony for financial and valuation issues
Bridge Valuation Partners, LLC
Email Melissa
Call Melissa
Bridge Valuation
Mediator Podcast
Valuation Mediation

Michael Koeppel
https://www.lakeletag.com/
Cell: 716-984-5303
Email: MKoeppel@LakeletAG.com
https://www.linkedin.com/in/michaelkoeppel/

Transcript Below:

Melissa (00:00):

Welcome to valuation podcast.com, a podcast and video series about all things related to business and valuation. My name is Melissa Gragg, and I'm a mediator and business valuation expert in St. Louis, Missouri. Today we are discussing ESOP and employee-led buyouts insights from a private equity perspective with Michael Koeppel. In his 30 years of experience, Mr. Koeppel has been exposed to a host of industries, but his primary focus is on technology, manufacturing and service organizations. In 2001, he founded eCapital Financing, which specializes in assisting startups and challenged entities to obtain financing. Today, the firm works with a host of companies in both the Los Angeles and Western New York regions, while eCapital Financing currently focuses on investing in startup companies and projects, Lakelet Advisory Group LLC was funded and founded in 2012 to focus on challenged organizations in turnaround situations. Now, that's a ton of information, but welcome, Michael. We are so happy to have you here.

Michael (01:08):

Thank you Melissa, I appreciate you and your team offering me the opportunity to talk about this topic. I think the changes with regards to exit strategy have been significant over the last 10 years, and probably even more so as a result of the pandemic. Privately private equity firms were definitely the route to go. For the vast majority of companies we're talking about anything over 5 million to 50 million. That was a sweet spot for them. But we're seeing a lot of changes in there right now, and people are trying to, companies, owners are trying to take care of the next generation outside the family, and I think we'll see more and more outside the family. You know, the, the adage is very true. The next generation halls doesn't do as well as the first generation. Actually 70% of the time, they do significantly less.

Michael (02:02):

And the loyalty of the employees today that managers and owners want to take care of them. And it's easier to do a structured exit plan with those people in place because any organization, the true value of the organization are the people. So if you can do a deal in which the people not only stay on and have significant roles in management, but end up being the owners of that, that is a great motivating force to make sure the company can go to the next level, several generations from the point where they're at. Now, there are some challenges and you see other areas as the private equity has diminished significantly over the last five years. I think we're seeing some big advantage of strategic buyers, not necessarily private equity companies as well. Established companies are buying up the competition and the small players to get that growth.

Michael (02:54):

Instead of doing the growth organically, they're willing to go out there and buy these companies. They'll buy these companies at a premium. One advantage a strategic partner has is strategic partners can pay more. Their risk is less. They know the industry, they know the product, they know the players. They already have a market, and that's a, usually the company they're acquiring is a strategic fit. It's piece of the puzzle that they can utilize to go to the next level. But that presents a host of problems with regards to some of the ESOP players. A strategic buyer will definitely pay a premium where an ESOP does not pay such a premium. And actually an ESOP is very limited in the premium that can pay the, to go through an ESOP route, which one of it has to do is to have a business valuation. Of course, all these steps, no matter what the exit strategy is, a good succession planner will insist on getting a business valuation as a benchmark where they're at now.

Michael (03:52):

And then an ESOP would need another business valuation just before they convert over to an ESOP by a trustee. Ironically, it should not be the same valuing firm that does both. Actually. A trustee would be remiss if he let the same ESOP firm of the same consulting firm do the business valuation at the beginning of the succession plan at the end, they have totally different objectives, those business valuations, and that raises a very interesting point. The business valuations themselves are seen through different lenses. If you're gonna be a buyer versus seller, it's, it's a totally different objective. We all know that the fair market value of an asset or a company is what independent buyers and sellers take a look at. It's two sides of a coin. So often when we do business valuations, we're just looking at one side of the coin.

Michael (04:43):

The company, well, realistically, what's the other side of the coin? Are you planning on going to an esop? If you're gonna go to an esop, it's gonna be very more, much more conservative. Let me say that. If you're going to a private equity firm, is it a strategic buyer? What are you gonna do? How, and another thing out there is how long are you willing to let this sit on the market? That is one beauty of doing it with employees, whether it be an ESOP or non esop, and we can talk about the differences in a few limits, but you at least have a market and, you know, you have somebody out there, so many deals today, you have to shop around, go through the infamous PitchBook process, the business valuation process, hoping to find a buyer. Mm-Hmm. <affirmative>, and then you, that process, anyone who says it takes less than six months is a, bless them.

Michael (05:32):

They must have some secret sauce. But it takes about the six months on average to find the right business partner who wants to go through the deal and it can do some preliminary due diligence on the process. And that definitely impacts the evaluation of it. So when you do the business valuation, you don't wanna say, well, the value's gonna be contingent upon who's gonna buy it. But you have to take that into consideration, seriously into consideration. And it is not unusual to see several business valuations saying, look it, if we're gonna take the ESOP route, the company is worth approximately this. If you're not doing the ESOP route, you may be able to add the average premium. The average premium is about 12% more for non ESOP versus esop. That sounds a little bit misleading and deceiving, and that's what scares a lot of people who do not fully understand.

Michael (06:25):

Esops. The cost of an ESOP in United States today is significant. There is no doubt about that. You have to deal with the bureaucratics of the Internal Revenue Service, the Department of Labor. You have to have a trustee, you have to have multiple audits. You have to have multiple CPAs involved and two different valuation firms involved. You add that all up, you're talking hundreds of thousands of dollars to perform an esop. But the secret of an esop and the benefit, if someone takes a look at it, their tax savings over the next two years are significant. You're not only paying capital gains tax versus ordinary, you get to defer. The seller can defer if it's a a c corporation, he or she can defer all their capital gains, almost at Infinitem. If it's done right in the investment, the proceeds from the ESOP are properly invested.

Michael (07:23):

They will not be paying any taxes on that. If it's so structured, the seller or, and the, excuse me, the buyer gets a significant benefit in it. Many of the costs of the ESOP as well as the loan itself paying for the ESOP is tax deductible. And they do not get the, you have to pay taxes until the money is distributed to them, and a similar structure as a 401k. So when one considers doing an esop, they have to take a look at the big picture. Cuz if someone says, I just worry, I'm worried about the cost. Yeah, the outgoing cost is significant, there's no doubt about that. It's much more than a normal strategic transaction. But the other side of the coin is take a look at what your tax savings gonna be over the next two, three years. And it's significantly on averaging the United States. You can save 20% of, of the difference between ESOP and non ESOP just on the taxes over the first 24 months. So that can be significant.

Melissa (08:25):

Michael, the, that w we came in hot, like we are talking about so many different things. So I think that one, one place that we can kind of start is that a traditional auction style process that you talked about takes time, effort, and money. And a lot of times a company may be in a situation where they have employees that wanna buy the company and they think that that's an easier route, is to sell it to my employees as opposed to sell it out in the open market. Now, that's not always the case. I think there's, you know, it's really about finding what the right fit is for your company, your employees, your future. But it is one of the options, and I think that it can be formalized in an esop or what you you're gonna also talk about is kind of these employee led buyouts, which is just a structuring.

Melissa (09:24):

The other thing that I'm seeing in exit, you know, like I, I see an exit planning, nobody planning to exit, you know, I see that people are very successful in business and they wanna continue on, or they want that legacy to continue. And so they're not kind of hoping to end, but they get a knock at the door and somebody comes and says, Hey, I wanna buy you, I'm, I'm your competitor down the street. And this is a, you know, like, we could be great partners and this is amazing. And unfortunately, then they're in a situation of like, okay, well what's, what's the value? Did anybody, does anybody know? And that's where we see people coming in and starting that process. But quite frankly, do you see, you know, like w planning to sell your company when somebody's knocking at the door to buy the company may not be, you know, the best time although it works really well. But do you see business owners planning on selling their company? Or do you see kind of them looking more at the employees as an easier option to exit?

Michael (10:37):

I believe that the seller of the company, the current owners need to explore all their options. There's no longer one size fits all. An ESOP may not make sense if you have less than 20 employees. And ESOP may not make sense. If certain tax characteristics of the seller are in place, they, they don't get the tax benefits. There are certain things you have to look and you really have to get ESOP work is very specialized now, extremely specialized work. The other challenges that we have with regards to that is the succession planning is, should be a key part of a company. And it's not, it's like almost like a disaster recovery program with technology. Everybody says we will have it. We'll have, it's like an insurance policy, but you, but you really need to have it in place at a certain time. And as you go forward with regards to having a succession plan, put it in place, brush it off every year. Too often we get involved with regards to someone who wants to do a a sale. It's just because of a strategic event, a terrible event may happen. The li the company we're doing ESOP for now is, it was totally unplanned six months ago. He just had a heart attack and has to sell the company. Hmm. It's cause of this lack of succession planning though, it is significantly mitigating his options.

Melissa (11:59):

Yeah, yeah. And we're seeing a lot. I mean, you'll see health issues be a contributing factor if you're not planning ahead.

Michael (12:07):

It is. And that's why the planning, succession planning get a proper professional succession planner and, and do an occasional business valuation. So often when I meet with the companies, they say, well, I had the an audited financial statements done last year. So I know no, as we all know, the audited financial statements are based on historical numbers and have no reflection at all of what the current value that enterprises work. And it, it behooves companies to have it done on a periodic basis to see what it it is worth.

Melissa (12:37):

And to get, you know, in some cases we're, we kind of call this the reality check because, you know, we see business owners thinking that their companies are worth an amazing amount of money unless they're getting divorced <laugh>. And, and, but, but then when they go in to sell it, they're like, okay, well I'm gonna make 10 million, you know, my company's worth 10, 20, a hundred million. And we come in and we say, so I think it's worth 2 million. And they're like, what? How is this possible? And it's really that they go through this business process and this business life just with imaginary numbers in their head. And it does provide a sanity check because you can say, okay, am I okay with this amount or do I want more? And what you talked about at the beginning that I think that, that maybe people didn't quite understand, is that there are certain buyers that will pay more for your company. It doesn't mean that your company is necessarily worth more, it's worth more to them. It's worth more because you, they maybe your revenue or services fit right into their process. But it doesn't necessarily mean that me off the street at fair market value would buy that company for that premium. Right. That I wouldn't just arbitrarily. It's sort of like if you like, you know, a certain car or a certain house, you might pay more for that. It does not mean that everybody else is going to do that at all.

Michael (14:17):

No, the you're spot on there, Melissa. I think most entrepreneurs think they have their next Google on their hands. You know, they say, well, another year someone could do an I P O and we'll all be not millionaires, but billionaires. And, you know, the company's worth this amount of money. It put my kids through college, it did this, it, you know, helped my family for so long we'd be able to do this. But you have to take a step back and figure out what's it really worth in the market. And as you and I have been talking about, what is the market you're looking at? Are you looking at the market of selling to your employees? If you're gonna sell it to your employees, you, you better be willing to hold quite a bit of paper cuz they may have a hard time financing it without you holding some paper or you staying around at least as the chairman of the board earn some meaningful role.

Michael (15:01):

It's not like you've sold to a private equity. You wish everybody the best and the next day you're driving out the parking lot and that's it. That may not be the case. It definitely would not be the case for an esop. You'd have to stick around for X period of time to help with the transition. So the rules are totally different with regards to that. And people need to, when they do a succession plan, not only need to know what the value of the company is, but what is their plan? Who are they gonna sell it to? Even if you're going to sell it or quasi give it to family members, you need to have a proper business valuation and for both estate and gift taxing. And if you're gonna do that, you have to have a valuation to go through that process and know who the end customer is on the valuation.

Michael (15:43):

But you gotta be very cute. And when these family members are gonna do, whether it be ESOP or family members or whoever get a meaningful truthful business valuation, if you try to get cute on one side of that business valuation to keep the taxes down and keep it low, then that party's gonna have to go out with that same business valuation and try to raise money. So don't be, you gotta be very candid and put all your cards on the table for 60, excuse me, a succession plan. And people have to realize that succession planning and selling one's entity enterprise, almost like one's child, is probably the most monetarily significant thing they're gonna do in their lifetime. Get some pros to help you do that. A small company I know it's expensive, can pay up to 10%. Let's say a company with less than 5 million mid-size company, 5% of the total cost to do the whole go through the whole process except an ESOP is gonna be a little bit higher. But again, you get the tax benefit if it's done properly and you get the blessing of the department labor and the IRS before you pull the trigger. That's very important. The significant rules with the esop, you gotta get the blessing before you do it, not after, and let them know what you're gonna do. It's a long tedious process to get to both. You can imagine jumping through the hurdles of both the Internal Revenue Service and the Department of Labor.

Melissa (17:09):

Yeah, no, go ahead. No, I mean I, I'd never really even heard that because I think that ESOPs are very complex, but it's, they're complexity is to protect the owner and, you know, the buyers, which are the employees. You know, and we've participated in several, you we've seen them a lot in large construction companies or large manufacturing companies where you have like a really good second tier management that has maybe even been taking care of the company for years. You know, that it, but also in smaller companies you could see a team of two or three that would be maybe more for an employee led buyout as opposed to an esop. But even when people are considering this succession planning and estate planning, right, right. Before somebody sells their company, they need to know the value of the company. And a lot of times they're like, okay, well I think I know the value. Like I don't think I need to get somebody involved. And so they'll say, they'll say to us, they're like, well, can you just, you know, and I have attorneys that call all the time, like, can you just tell me the rule of thumb? Like, do you have any, you know, just like random things cuz I own a this type of company and it's this size. Do you get those questions and then like how do you respond?

Michael (18:33):

That's, that's a prominent question. I think all business evaluators get, it's a little bit of dangerous out there. You know, they'll get a book of, whether it's the Pepperdine University or a whole host of others and say, look at the multiple for this company is 8.4 over the last three years, therefore I'm gonna take my infamous ebitda, multiply eight times four, and that's what I'm putting the company up for sale at. That's very, very naive. First of all, that's average and no one company is average. You should have different characteristics. You may have different customers, you may have customer concentration, you may have some international opportunities. You may already have an f d a process under control. There's so many characteristics that make each and every enterprise unique and not to consider those one is really short telling their opportunities are made available to 'em. And anybody who would use or recommended just do the the quick multiple route. It's just, it's very, very dangerous and you would not be doing justice to your clients.

Melissa (19:36):

And I think one of the issues, and I I I talk about this concept a lot because I kind of love it, but you know, my concern when somebody calls and they want kind of a, a multiple or, or something like that, which we can a you know, the hard part is we can absolutely typically give you that. Like I, I can tell you what certain multiples are in certain industries or the companies that I've valued, right? The problem is once you anchor that number in their heads and you've said, okay, well rough estimate it's 3 million. And then you get into it a little bit and you're like, oh gosh, it's only 1 million or it's 10 million. I mean, if it's higher, it's usually fine, but if it's lower is the problem. And quite frankly, like cash is king. You know, like if you want to sell your company for 10 million and you're making a hundred grand, I'm gonna tell you I don't think I wanna sell your company because it's just gonna be, you know, so in some aspects you need to hire a team around you that's gonna tell you the real deal and that's gonna walk you down the path of selling your company, which is emotional.

Melissa (20:50):

It's like having a second job or a second whatever. During this process, it gets you very distracted. And you also are kind of starting to have a relationship with your new partner which is a stranger. And quite frankly, after they buy your company, you could be doing something completely different. These types of situations could be different if you had employees that you already kind of know and you feel the transition. But like you said, you might have to hold that debt. You might not be able to get all that cash immediately. And for some people that's okay. They've made a lot of money in the business and they want it to transfer in a certain way. So it's not always about money. Although we're talking about money, I think one of the other interesting pieces and, and as we talked about your background, you've been helping startups, you've been helping getting financing. You know, you look at this in a money and business in a lot of different ways maybe than other people do. So how do venture capitalists or private equity or you know, different buyers look at valuations differently than like your competitor or, you know, me who just wants to be an owner operator, you know, like, how do we know how to go get this money from these guys? Like what are they looking for?

Michael (22:22):

Well, as we talked about before, there's two sides to the coin. And on the other side of course we have the venture capitalists who start with the the smaller entrepreneurs or the businesses going to few. They look at it from a totally different unique lens. First of all, you might as well throw EBITDA out the window. You're lucky if there is such an ebitda. In most of the cases it's even pre-revenue. So they're willing to take a higher risk. Now, of course, for that risk, they want more and for them they want more equity or they want a higher premium or warrants associated justify that risk. And the venture capitalists are willing today to recognize that 40% of their investments in 15 months are not worth the paper they're written on. They're willing, they're willing to take that risk. That's the nature of their business.

Michael (23:13):

Ironically now private equity is not that far behind as of the latest ratios. 25% of they private equity transactions are not getting their ROI back. And it's because there's been so much competition chasing these companies it's just been crazy what premium the private equities have been paying for companies just to get companies. And I think a lot of it in the private equity world is they have the funds and gotta use it or lose it. And if realistically, if was my personal money is scratch your head and say, what? Why the heck they buying this? Well, you know, it's the end of the quarter and we got 24 million in our pot, otherwise we gotta give it back to the investors. So we're gonna take a swing at this one. Or they say, well, we'll buy this with the hope of getting another rollup that added on and that never materializes.

Michael (24:07):

Or they're paying a premium for that rollup so they, they have different lenses in total in the different risk and also a different way of dealing with the companies. I find that most venture capital group, they want, they are more interested in the management team in the product than anything else. They wanna see who the jock is, who's gonna drive 'em to the promised land. Have you ever done with startup before? Have you done private equity? You really know the product. What, what's your network? Right? How many people can you call to help us? Or private equity is although somewhat interested in that, you know, but they're willing to put their management in totally in place in day two. And in many times before the ink is dry on the contract, they got a new CEO and CFO sitting at the door.

Michael (24:54):

So, so from those perspective, it's totally different. And, and also private equity, they, they might say okay, we're gonna ride this out for five to 10 years venture capital. That would be unheard of. I mean, right? Yeah. You know, 36 months is a lifetime a career for most of those people. So that's a a a totally different realm that they look at it from. And as I said, you know, we started the conversation with these are important factors when you do the business valuation in the startup business valuation, you know, it's, everyone has the infamous hockey stick. You know, you gotta put in metrics to show that and be realistic with the venture capital people. They know that 40% are just gonna, only 40% gonna succeed. And they're willing to accept that. Just be realistic and put that forth. There's one topic that we haven't discussed, which is important, is as a component of a pitch book, the business valuation, at least a summary should be in there.

Michael (25:51):

But a good pitch book should be like a good resume. Don't put in all superfluous stuff in there. A nice simple thing to help you sell it, even if you know who the audience is, let's keep it simple. You're going to turn it over to family members, at least put together pitch book, map it out, put everything in writing the good, the pros and cons. And you can even use that at a minimum to go help and finance the deal. And it also helps the attorneys put together the deal, that effort to put together a good pitch book. I re, excuse me, I consider that as a roadmap. Put some time to put it together so everyone can see what it's like so there's no surprises in there and things change. Keep documenting the pitch book or roadmap accordingly. Don't circumvent that process cuz things change and you have to document it. And as I said, it can help you from everything from the lawyers to raising capital, to managing the expectations of all parties so you can know the slot who's gonna fit and where in the organization going down the road. So you're not having that debate after family members taped in over the company.

Melissa (26:59):

Well, and even if it, if it was a private buyer or a competitor, you're gonna have some of the same issues. And con like I think people, when they go to sell their company, it's, it's like somebody's gonna come in and magically make this just like a very easy process. And the reality is that, you know, you're, you're letting go of something that you've done for maybe 20, 30, 40, 50 years or has been in the family for you know, a tremendous amount of time. And there's going to it, you know, it is a process. And if you have an outside buyer, private equity, venture capital, anybody, another competitor, private buyer, they're gonna come in and it's gonna be uncomfortable because they have to come in and look under the hood. They have to come in and look in the closets, you know, they, they're gonna be critiquing all of the things that are, you know, they're gonna tell you your baby is ugly and, and cause your baby ugly. Yeah. Notice,

Michael (28:00):

Say you're spot on. And a private equity firm as well as venture capitals, they have pro firms, professional organizations that do the due diligence forms. So if you think you can get cute with the financials, you're not gonna be able, if you can get cute with your customers, your customer concentration, believe me, they'll catch that before they have their first cup of coffee. Be honest with them. Put the cards on the table with them, the good, the bad, and the ugly. No company's perfect, so don't try to be perfect.

Melissa (28:27):

Mm-Hmm. <affirmative>. But definitely don't try to hide. You know, like we always talk about, take out your skeletons and dress them up, put a pretty outfit on because they're gonna get found. You know, like people, these larger e even on, I would say even on deals that could just have be between five and 15 million, which you're gonna see a ton of people selling at that level or even 1 million. You're having large accounting companies coming in and doing a quality of earnings report. You're having them coming in and checking, you know, are your financials really your financials? Like some of the things that we tell people to start at the beginning, just go get somebody to look at your financials, you know, like start to clean. I don't know how many times you've gone into a business valuation kind of review with a, with a company and said, Hey, we're we have some questions about your five years of financials.

Melissa (29:26):

Yeah. And they are like dears in the headlight. They're like, whoa, we've never seen, wow. I was like, do you know what happened here? And they're like, no, that's our financials. You know, cause we look at the current year in the past and the past year, we look at the current year and maybe a proforma like, what's gonna happen in the future? But we don't get into this like what really happened. Even if it's good or bad, we kind of put our head in the sand and we're like, oh, that's in the past. We don't have to deal with it. As well as, as you're selling, you know, how important is your trailing 12 month situation? Like, like I don't think anybody really understands that in valuation. We're looking at the past five years or 10 years, what's happening when you go to sell your company? What's a trailing 12 months? What does that even mean, Michael <laugh>?

Michael (30:25):

Yeah. The, the challenge and I, in an ideal situation, if you can control your destiny succession planning is very important. I would like to have ideally at least a minimum of 15 months before you sign a succession planner and end the transaction. And then again, I use the word ideally, I like to have one full balance sheet between now and then because I would handle my processes and my accounting all within US gap differently. If I knew at year end I was gonna be selling and that was gonna be the basis of a sale. Mm-Hmm. I may not spend so much on r and d as I would normally would. I would have that go to ebitda. I may spend more on hr instead of getting a controller, I might wanna get a strong C F O knowing that I'm going through a strategic transaction and I will need his or her help and the people add value to the company.

Michael (31:21):

So if you could have that whole period to go through it, it really can help in every dollar that you add and save the money and the processes can grow geometrically when it's time to do the transaction of itself. Now in many cases, you don't have to get that time, but you definitely would be, it would be very alarming as using your analogy if you got that phone call say, I'm interested in buying a company. Well you may have just had a terrible quarter, or your business may be cy cyclical. You need to have all that into account. And that's why ideally I prefer if, if possible, 15 months. And that's when I work with succession planners and attorneys is say, can we get the 15 month runway and really dress up the company and the balance sheet, even if it's a finance company or something along those lines.

Michael (32:09):

You could put in some sock reporting, some things that can prove that you have your processes in place and the right people in place. And there's a lot you can do in 15 months if you're just focused on the transaction itself that add tangible value. Cuz I think the vast majority of us would run a company totally different if we knew we had an exit strategy within the 15 month horizon than going forward. We may take less risk, we may not launch certain products. There's a whole array of things that we would take a look at differently to do. But the other side of the coin is once you make that decision, the bullet's out of the gun. Because you can't go back and say, well, I'm not gonna do it. Well guess what? Your r and d may be behind times. You didn't do the product launch, you didn't do some international stuff.

Michael (32:54):

And the other side to go hand in hand with what we first talked about, Melissa, knowing who I was gonna sell to may be very important with regards to what I do in that 15 month period. If I knew it was gonna be a strategic buyer who wanted a product, I would talk to 'em, say, Hey, can we have a joint venture during the interim to we can launch it to, and we can do it together in hypothetically, if I sell it to you, you get to join venture. You know, there's a lot of things like that. If you can step back and do strategically, give yourself the time and don't rush into it. I know it's time is important and it costs money, but again, this is probably the most important financial transaction an individual has to do with the smaller mid-size company behoove and take the time, believe me. And if, if you don't do it right, the cost to be unbelievable.

Melissa (33:38):

And if, if any of our listeners zoned out for the last three minutes, I need you to rewind because that is probably the second large golden nugget of this podcast is that they're, you know, like, and I tell co I tell, and, and I'm really serious about this because I tell companies, you're gonna have to start paying taxes. And they're like, what does that mean? And I was like, that means you need to stop running all of your personal expenses through your business. You need to, or tell your accountant to put it in a certain line so I can take it out. You know, like stop doing all of those things, run it clean, have all the cash flow flow to the bottom line and get prepared to go through this process. And I think that what you've just said though, takes that exponentially to another level when you start to actually strategically plan to sell.

Melissa (34:34):

And, and you have to understand that if you've done this your whole life as a business owner, strategically planning to sell is going to maximize your exit in any capacity. You wanna go start new businesses, you wanna go, everybody does. Like nobody goes. And we were laughing about this the other day. No one goes and sips my ties on the beach. We all are crazy business people. We're gonna go do more things. But it might be that it's a next time, you know, like the right time to move isn't always the right time when you're ready. It might be strategically a different time. One of our last questions I think, which is, is a pretty good one, and we've talked about ESOPs and we've talked about these things not in as much detail because I think you just, if you need to know more, you need to reach out to a good team of, of this. Yes. But how do you, you know, is there even a way to know if an ESOP is gonna be better for me than an employee buying the business? And is there a difference, you know, like maybe tell them a little bit that an employee led buyout is different than an esop, but, but how, and and really most people you know, are doing either an employee led buyout or a, a str you know, selling out to a third party. So tell them maybe a little bit about how they would know,

Michael (35:54):

Let's, if you're gonna sell to the employees and you're determined, should it be an ESOP or shouldn't it be an esop? And we already talked about the cost of that and let's assume that they understand that mechanism and the tax savings. There are several things that right off the bat one needs to consider. One, you need to at least, at least 20 employees in place to the, the numbers really wouldn't make sense without that. Number two, appreciate when you do an ESOP that the trustee is really running the company. Mm-Hmm. Consider the trustee, the chairman of the board, and a very active chairman. I might add the C E O C F O who will be put in place, or our employees today have to work with the trustee and make sure that everything that the C E O C F O are doing is to the benefit of the o new owners and the new owners being fellow employees.

Michael (36:52):

Mm-Hmm. <affirmative> have the other key is, and this is yeah, something that you can't you don't learn in business school, but have the individual who is selling have the right temperament mm-hmm. <Affirmative>, in other words, what I'm trying to say is make sure that he or she is willing to walk away in an esop. They, they have most 30 months to be a consultant and help out with the company and help it strategically and get it back on on its feet or do whatever they have to do. But after that, he or she's gotta be willing to walk away. And so many times you see what these small companies or family members, the original owner still, well, I want a corner office or you know, what about my parking spots? Do I still get my Yankee tickets? Do I still get all this stuff?

Michael (37:37):

No, it's gotta be a, a clean break and be willing to walk away. And the other thing is with regards to the employees, the employees have to understand in an ESOP what exactly they're getting, the tax benefits, everything's deferred, similar to a 401k, what happens if they leave before that versus what happens if they don't? And the other challenge with the esop, that is getting somewhat mitigated, but it's still a significant challenge. Financing ESOPs, if you had a, let's take a manufacturing company, if you have a proper collateral and everything like that, and the own the seller is willing to take a 30, 25, 30% paper on that, it'll help with the transaction. And you're in the financial services and have virtually no e no assets at all. And the owners still have to hold 25 30% without trying to get that collaterals very hard considering you got a new management team in place.

Michael (38:35):

Because as we all know in the entrepreneur, that individual who is leading that company for decades is now going into the sunset. And not only temporarily, but he has to go into the sunset. Because previously in the ESOPs, people may have been cute saying, well, he's selling a company to employees, wink, wink, but he's still in the office every day for five years getting more money than he. No, those days are long gone now. And the Department of Labor and IRS really watch out for those unique circumstances. But those are the key things. The employees wanna do it because it's quite a bit of responsibility. I always refer to it as, you know, the first officer of a ship, does he really wanna be captain? Is he ready to be captain? And he or she has to move up. And sometimes it's very hard on selling to the ESOPs.

Michael (39:24):

The trustee will make sure that you got the right people in place. The trustee is like the chairman, he's independent. He has to get audited financial statements every year. He has to get an independent accredited business valuation every year. It's entire, a whole host of safeguards are in place to protect the employees. When you just sell to employees, it can be held or skelter the guy, you know, who is in charge of the shop floor is now quote c e o. And there's no safe rails in there. They may not have a CPA advisor, they no longer need a business valuation. They no longer need audited financial statements or any of the processes. So there's some significant inherent risk with that. And although people say financing in ESOP can be difficult, I think financing a company where employees are just buying it is even more difficult.

Melissa (40:15):

Yes, I agree. And I think that that's one of the, the bigger issues, even even in, I see smaller businesses trying to sell and use like an S B A loan for the buyer is going to get an S b A loan to buy like a very small company. And, and they were like, oh, this is great. We're going to, I was like, yeah, but if they can only get 80% of that deal, you're still gonna have to hold back 20%. And I was like, and you're not gonna get paid until after the SBA A gets paid and then that could be 10 years from now. So, and

Michael (40:48):

Any other challenge with the SBA loans, it's not only is it maxed at 5 million, but unfortunately the government had good intentions, but the bureaucracy to go through and get those loans, it's just mind boggling. Mm-Hmm. <Affirmative>, it, it's just cruel and inhumane punishment. Mm-Hmm. <Affirmative> for small business.

Melissa (41:03):

Yeah. And I mean, you really have to have an asset based business. I mean, you have to have like some tangibleness to your business or, you know, sometimes the lenders are not gonna wanna lend. Right. If you're just like a service, if you're just like air, you know, and people not always are they going, even regular banks are going to finance that type of thing. And I think that that's why people have tended towards going towards employee or esop when the reality is all of the processes in order to transfer your business are going to have steps of them that are gonna be uncomfortable. You know? That's right. It's, it's a process. But, so if it's a process, then it's really then more important to determine which is the best path to go down if it's all gonna be a, a path and even willing to stop that process if it becomes not the right situation.

Melissa (42:00):

Because what I don't think people understand is people come in and say, okay, I'm gonna buy your business for a million dollars. And now I got my accountants that came in and they don't really like what they see and you know, we, we thought this looked a little bit different and you know, we like you but I think it's gonna be like seven and, and now we're three weeks out from closing date. And they're like, you know, I think we're, I think we're actually willing to buy buy you for $750,000. And you're like, what? Well, Melissa,

Michael (42:32):

I think that's even more germane in the private equity world doing these deals for over 30 years. I never heard of a private equity saying, oh, the due diligence better than we thought we're gonna give you 10% premium. I I you'll never see that happen <laugh>.

Melissa (42:46):

No. They're always going to kind of, you know, cut you down a little bit. Yeah. And you have to be prepared for that. And I don't think, I don't think business owners are always prepared for that because they've been the top dog, they've been the one Right. You know, driving this ship and now somebody, you're gonna ask me questions about this. Yeah. Who do you think you are? So it really is that if you're a business owner, you need to be prepared. If you're an advisor, if you're a professional in this space, you need to prep your client. Like if you don't know the space well enough, then maybe get some education because it's a process. And most people that have gone through it, even if they make millions at the end, they're still like, that was awful. That was, that was not

Michael (43:30):

Fine. You're actually right. It's a process. And I think as much as we may be experts in the numbers of the business valuation, I say 50% of the transaction is holding people's hands and psychological ramifications. You know, oh, what does that mean to my son? Is he still gonna be able to work here? You know what, you gotta tell him the bad news. Probably not because he never shows up as it is. You know, <laugh> probably

Melissa (43:51):

And he was overpaid.

Michael (43:52):

Yeah, yeah. Probably not. You know, what about this, what about this issue? Yeah, it's, but again, just be candid with him and tell him the good in bed and ugly upfront. You don't want to tell 'em as they get close to the close and go through that emotional rollercoaster. Yeah. It's not good for you. It's not good for the client or or the other party.

Melissa (44:11):

Yeah. And that's why I think in some capacity, and I'm gonna start showing some information about you and how they can reach out to you in some capacity. We've been doing a lot of work for I mean we call it joint valuation, we call it one valuation expert, whatever you wanna call it. In coming into these situations, especially at the preliminary point, you know, like the family or everybody's getting together, we're like, what can we do? I was like, okay, let's just see what the value is. And then once we see what the value is and we see what tragedies we need to like figure out from the past to explain away, then I think that they can get a better sense of what's happening. And one of the things that I have to tell them is I was like, I'm gonna need you to go get a hobby.

Melissa (44:55):

And they're like, what? And I'm like, I'm gonna need you to double down on a hobby. I don't care what it is, but I need you to start doing that more. And, and they'll be like, okay, that's interesting. And I was like, you're not gonna have enough time to do it, but you're gonna do it more because when this is over you're gonna need that. Yeah. And other things to fill your life because this took up a lot of it and it's time to move on, you know? So I think that this has been super helpful. Do you have any other suggestions? I know we have a lot of people that are gonna enjoy your startup conversation and getting funding. Do you have any suggestions for people right now that are kind of trying to seek out their second round of funding or you know, they're past the friends and family? Like do you have any suggestions for anyone parting words?

Michael (45:50):

Even if it's not a formal plan that you would see in business school? Put your thoughts on a piece of paper. Go talk to someone who's done it. I'm not saying you have to worry about the billable hours or something upfront and see how reasonable your expectations are because you don't wanna go spend your time and money if what you're trying to achieve is just not unrealistic. And talk to an advisor who can point you in the right direction. There's a lot of money out there right now. There's crazy money in the economy today. You just have to know what look, and I think too often small businesses just know the local small bank and it's getting more and more difficult to deal with the banks today. Before it was absolutely generous pandemic error. They didn't do foreclosures to banks. Your interest rates were two 3%.

Michael (46:38):

If you pay 4%, it was almost considered. Usually now it's over double that. And they're really getting down to putting things in special assets that the company isn't doing well. So don't be afraid to talk to other financial sorts. There's family offices out there, there's a lot of people out there with the money who can do it. There's a lot of opportunities. And one thing you may want to consider is if you have a decent, profitable company and not enough small companies want to take a look at this, take a look at some joint ventures. It'd be interesting someday to talk about the, the joint ventures. There's other people in the same position you are in, maybe in a different part of the country or maybe in different part of the world. The same pro do a joint venture. You can expand your top line and bottom line geometrically. If you find the right partner to do that. Maybe that's a prerequisite before you get rid of the company or sell the company or exit it. I would say look at all your options and the joint venture being one of the many options, Melissa, that we've been talking about.

Melissa (47:33):

Well, and I think it's very interesting and I'll, I'll kind of finish with this saying something crazy, but I don't think the money is in the banks. I think the money is in the businesses, especially strategic buyers right now are sitting on cash that they need to buy things or partner. I think you are also onto something with this joint venture and partnerships. I think that more companies are going to come together, but with relationships not necessarily merging, but like, hey, how can we mutually kind of do this as a, as a preferred provider's preferred referral, you know, like partnering in that, but maintaining their autonomy. And I think that that is kind of how capitalism's moving.

Michael (48:18):

We've been very successful in doing that REC recently. We do a lot of staffing agencies and as you can imagine, the staffing companies in the healthcare, I mean, they're writing their own check right now. You just cannot get enough healthcare providers. And there was one company in California and one in Florida and we're both dealing with, and they had the same problems and doing this. So we said, let's do a joint venture with the two of you and they never knew each other before. And we'll have an M S O, we'll have one service organization that takes care of all the backdoor office and takes care of all the payroll, takes care of all the stuff, and you guys just can focus on the marketing and reduce your overhead and you get a bigger bang for the dollar. And I think that has turned out extremely profitable for everyone.

Melissa (49:03):

Ooh, that's brilliant. Ooh. People are gonna be lucky if they waited till the end of this. Cause it's tough.

Michael (49:08):

The answer's always outside the box. Yes, yes. So talk to people who've done it.

Melissa (49:15):

Go to people that when you have that, because I know that you probably give, you know, initial consultations and so do I. And so do a lot of professionals. And if you find somebody that you think that you want to work with, try to get an initial consultation. If in that call they can give you some of the stuff that we've just received in this hour call, then that's somebody that you wanna work with if they understand it. Because I will tell you, I've been doing this for 20 years and there was some amazing nuggets in here that even I didn't know. So I am very grateful. Thank you, Michael. This was, this is, this is really good. We might have to come back and talk about a little bit more about some of the private equity or even startups because I think startups are really struggling with knowing where to go and there's not a lot of people kind of directing them. I think some startups should use social media to get funding, but you know, maybe that's a Mr. Efinance, maybe, maybe that will be a conversation for another day.

Michael (50:17):

Melissa, thank you. We'll tag that as coming. Attractions.

Melissa (50:20):

All right. Yes. Coming soon. <Laugh>. Thank you Michael.

Michael (50:24):

Thank you Melissa and your team. I appreciate it.