You Bought The Biz, Now What! Business Systems and ESOPs roll in M&A

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E95: CEO Mark O'Donnell: Climbing Mount Whitney And Beyond With EOS Worldwide

Summary/Abstract

Mark O'Donnell is the CEO of EOS Worldwide and recently completed a summit of Mount Whitney, the highest peak in the lower 48 states. With the leadership team and portfolio members of the private equity firm Firefly, O'Donnell and his team trained for six months before embarking on the climb in September 2021. Despite warnings of altitude sickness, the team was determined to make the summit and completed the one-day climb. Along the way, O'Donnell's integrator, Kelly Knight, began to feel a migraine which they initially attributed to altitude or conditioning. Despite this, they were successful in making the summit. 

The speaker and their companions were on a mountain-climbing expedition when they realized one of them was suffering from altitude sickness. With darkness and cold temperatures approaching, they had to figure out how to get her down. The speaker put her on his backpack and they started to drag her down the mountain. Due to the altitude, it was difficult to land a helicopter in the area, so they used a GPS text messaging device to call for help. Emergency services were a bit hesitant because of a recent helicopter crash, but eventually, the speaker and his companions were able to get the woman down safely.

Mark O'Donnell and his brother, along with some business partners, had built a vertically integrated pharma and biotech services business with nine different companies, including a laboratory and an engineering company. Despite their success, they were struggling with confusion from running each company separately. One of his business partners suggested looking for a way to run the companies as if they were one company. This led O'Donnell to learn about EOS, the Entrepreneurial Operating System. After learning about it, he started to implement it and eventually became a CEO and visionary. He was able to use the system to help his business succeed and thrive.

Mark O'Donnell is the Visionary at EOS Worldwide, a system designed to help businesses have a sense of control and build value over time. O'Donnell implemented a system but found it too difficult to get everyone on board. He then signed up for an EOS boot camp and met an implementer, Jonathan Smith. Smith inspired O'Donnell to become an implementer himself and eventually the Visionary at EOS Worldwide. Through EOS Worldwide, O'Donnell helps businesses get more of what they want from their business. To hear this incredible story and how EOS is perfect for integrating imperfect companies, listen here:

Check out:  Acquisition Aficionado Magazine’s Latest Issue (Sponsor)

E96: Gamifying Your Business for The Win W/ Steve Baker: The Great Game of Business -VP

Summary/Abstract

Steve Baker is the Vice President of the Great Game of Business. He was not originally meant to be a part of the company but ended up there after studying art in college and taking jobs to survive. 

Steve Baker is a creative and intelligent problem solver with an entrepreneurial background, but he's constantly taking jobs in order to make money. He tried to help his bosses achieve their goals but never had access to any real information. He sold a variety of consumer goods, such as wooden wear and giftware, and was even the king of fragrant bath salts. In order to make more money, he drove to Bentonville, Arkansas, to try to sell his products to Sam Walton of Walmart. He ended up shipping a large number of fragrant bath salts to Sam's Club, thinking he had a big win. Years later, he went back to have dinner with the owner and found out they didn't make any money from it. 

Steve Baker joined the Great Game of Business 17 years after leaving his house to get materials for a bonus. He was interested in blending business acumen and creativity and pitched the idea to Rich Armstrong, who was running it at the time. The Great Game of Business is a concept of open books and financials and is focused on teaching people that it is hard to make money and generate cash, and connecting them with a direct line of sight to how they can help. It demystifies business and makes it more accessible to people. Jack Stack is the founder and author of the original book the Great Game Of Business.

Listen in to learn how the team has bought and/or spun off over 69 companies since 1983, many of them turn arounds using The Great Game of Business.  Listen Here:

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What’s cool:

Flippa.com Debuts The First AI Recommendation Engine for the M&A Industry 

Flippa, the largest online marketplace for buying and selling businesses, has launched the first-ever AI-powered recommendation engine for the M&A industry. The new feature will leverage data to deliver custom recommendations for buyers and sellers based on their search behavior and interests. The engine will also improve the user experience by offering an easy-to-use interface and seamless search capabilities. The AI engine is a game-changer for M&A professionals and is expected to increase the efficiency and accuracy of the search process. Read more (200 words)

Founding Member Shout-Out

Thanks to Sweetview Partners, an Acquisitions company looking to buy Texas-based B2B companies in the $1MM - $30MM revenue range. Click on the logo to check them out. 

This week’s “DEEPER” Dive: 

The power of ESOPs (Employee Stock Ownership Programs) - A fan favorite of EOS and The Great Game Of Business:

Have you been contemplating a liquidity event, a complete exit, or a business acquisition? Are you spending a fortune on taxes and looking for financing that won't break the bank? Look no further than an Employee Stock Ownership Plan (ESOP).

An ESOP is a non-discriminatory, tax-qualified employee benefit/retirement plan that allows business owners to sell their companies to their employees, rather than selling out to a strategic buyer or financial buyer. This plan provides tax incentives to business owners and gets equity ownership in the hands of the workers.

ESOPs provide a plethora of advantages for both owners and employees, including tax-deferred growth, increased employee morale, and a new level of wealth creation.

Larry Kaplan and ESOPs by Della Kirkman CP

I bought my boyfriend a multi-tool, hatchet thing-a-ma-bob for Christmas. It’s an ax, a hammer, a three-bit screwdriver, a pocketknife, a can opener, and a bunch of other things all in one compact tool. It can easily hang from his belt or maybe even fit inside his back pocket. But, it’s still in the box. I’m not sure he appreciates it. Maybe it’s because it’s new and he’s old, and he just likes doing things the way he’s always done them. Maybe he doesn’t get all the things it’s capable of, but when I saw it on the shelf, all I saw was power and efficiency. Just like the incredible financial tool known as an ESOP, because man, this thing can do it all!

Employee Stock Ownership Plans

Want to take some money off the table with a liquidity event? Look into an ESOP. 

Leaning more toward a complete exit? ESOP.Spending a fortune on taxes? Try an ESOP.

Want your employees to truly be part of the wealth generation process they’ve helped you build? ESOP.

Looking for financing that won’t break the bank? Take a peek at the ESOP.

Contemplating a business acquisition, either as a standalone or as part of a roll-up structure? I know, broken record, but an ESOP might be the right tool for this job, too.

So what is an ESOP anyway? For that beautiful but complex answer, we sat down with expert Larry Kaplan, founder and managing partner of CSG Partners out of New York City. He says, in a nutshell, an ESOP is a plan “where the government provides tax incentives to business owners to get them to sell their companies to their employees, rather than selling out to a strategic buyer or financial buyer… [in order to] get equity ownership in the hands of the workers.” He also describes it as a “tax-advantaged, leveraged buyout.”

In more formal terms, an ESOP is a non-discriminatory, tax-qualified employee benefit/retirement plan born out of the 1974 Employee Retirement Income Security Act, affectionately referred to as ERISA. It’s a trust fund that owns shares in the company for the benefit of the employees. The trust is set up and funded by the company. It can be paired with a 401K plan or stand-alone. It’s the most powerful way for employees to enjoy the fruits of their labors through company ownership, and it provides a plethora of advantages for the original company owners. It’s like a friggin’ miracle! As a CPA, I’ve known about ESOPs for a while, but this DEEPER dive blew my socks off with the multitude of ways it can be utilized and how it can allow both owners and employees to create a new level of wealth. 

It's a plan generally available to S Corps, C corps, and LLCs, though the rules and advantages vary amongst the different entity structures. Sorry partnerships, you’ll have to sit this one out. ESOPs can be utilized by businesses of varying sizes and by both private and public companies. Employees are represented by a trust and receive shares in relation to their salaries. The shares are held inside the retirement plan, allowing for growth on a tax-deferred basis. It usually involves a vesting schedule. The original owners get to defer and sometimes skip right over, yes, skip, paying taxes on their sale proceeds. Are you intrigued yet? 

Read on for details on the benefits, pitfalls, processes, and some super exciting ways to use an Employee Stock Ownership Plan in your business.

The Benefits

We’ll start with Corporate America’s underdogs, the employees.

The employee benefits begin with the fact that, unlike a 401K plan, ESOP contributions do not come from the employees’ pockets. The company typically funds the account. 

Like a 401K, and other standard retirement plans, ESOPs grow on a tax-deferred basis, keeping all the dollars working until distributions begin.

ESOP employee wealth generation is not a fantasy. According to a Rutgers study of low/moderate income workers participating in an ESOP, the median account value is $165,000. The typical American home in this income group has only $17,000 in retirement savings. Rutgers also found that low/moderate income participants ages 60 to 64 have ten times more wealth than the average American in that same age range. 

The ownership program also provides an increased level of employee morale and pride in their work. Punching a time clock feels so much better when you know you can impact the bottom line and your own net worth simultaneously.

As great as the benefits are for employees, the real magic happens for the company owners. The incentive for owners to transfer their company to their employees is huge. Kaplan explains it like this, “So if a business owner sells their stock to an employee, when they receive that cash, if they reinvest it under Section 1042 of the US code, which is investing into stocks and bonds of US operating companies, they pay zero tax…because you don't have to pay capital gains taxes when you sell to an ESOP. …You have to be a C Corporation to do that.”

Larry goes on to give us an example, “Say my company is worth $10 million, and I sold half of it to the employees for $5 million. The company receives $5 million of tax deductions that he could use to offset its income going forward. So assuming that company was a pass-through entity, paying 43, 44 cents of every dollar in taxes, now it's going to hopefully be paying zero in taxes for many years. So those are the two major tax deductions, no capital gains taxes to the shareholder, and then the company receives tax deductions to pay its debt down much faster.” Most ESOPs are funded with debt, but that’s the beauty of it. The employees don’t have to have money on hand to buy the stock. 

Now you’re probably thinking you need to switch to a C Corp, right? Don’t give up your S election yet! S Corp ESOPs are, are you ready for it, tax-exempt entities! (At least to the extent of ESOP ownership.) You’ll find some examples of this in action later in the interview.

Another benefit is that once the decision is made, the ESOP transaction can happen quickly, meaning liquidity happens fast as well. This allows the owner to take some chips off the table, while still playing an active role in the company. Or, that liquidity can be a financing source for capital improvements, refinancing debt, or even growth through acquisition.

The Pitfalls

Every job done is done “better” with the right tools, but those tools always come at a cost. The table saw is much better for a big construction project than a hand saw, but the table saw is more likely to cut your hand right off. Plus, it’s much more expensive to buy. The ESOP is no exception.

Both the initial implementation costs, which can be a staggering $300K for large companies, and ongoing compliance and regulatory fees, can certainly be prohibitive. Obviously, the tax savings must be weighed against these costs. If getting top dollar is your ultimate exit goal, then an ESOP may not be for you. An ESOP valuation will most likely result in a lower price tag than you could get from private equity or a strategic buyer.

The complexity and lack of flexibility for the original owner can also be a problem. It’s prompted some companies to forgo the tax advantages of an ESOP and create their own customized employee ownership program. As ownership is transferred to the plan, the original owner will be giving up more and more control over the thing that has probably been their 110% focus for the last few decades. If they sell more than 50%, but less than 100%, the owner may no longer be able to steer the ship or prevent the company from taking unnecessary risks.

And speaking of risks, the lack of a strong management team with the leadership skills to carry the company into its next round of success is probably the biggest risk of selling your company to your team.

The opposite can be true as well. If the original owner remains at the helm, and he or she has been running the business in a loose-goosey fashion, with sloppy books and poor valuations, lawsuits are sure to follow. As mentioned earlier, the ESOP is a trust. It must be run for the benefit of the employees. The fiduciary duty of the trustee is serious business and comes with regulatory responsibilities and risks, including the risk of an employee lawsuit.

Owners often implement a high degree of leverage to fund the plan and, therefore, their exit, leaving the company with large amounts of debt and the inherent risk that goes with it. It’s common practice to sell out to the ESOP over time, and as with any time-based payments, there will always be the risk of running out of the cash needed to make future payments.

Potential pitfalls exist for employees as well. They often don’t get to participate in the day-to-day management of the company as intended. Or the education to do so responsibly isn’t provided. Look up the United Airlines ESOP from 1995 for a high-profile ESOP horror story. Yikes! Studies have shown that true employee participation, including education, can increase the growth of ESOP companies by as much as three to four times over ESOP companies that leave employees out of managerial tasks. On top of this, ESOP employees often end up with an unbalanced retirement portfolio, much too heavily weighted in their own company stock with little to no diversification. If the company were to fail, both their job and their retirement savings will be down the drain. United proved this point all too well.

As great as they can be, ESOPs aren’t going to work in every situation. So who are the best candidates for Employee Stock Ownership Plans? The companies that have the most success will have a strong management team in place, a team that extends beyond the owner. They will have at least 40 employees and will have strong, consistent financials. Most importantly, the owner must be prepared to give up control of their baby. The steps to move forward with an ESOP are outlined below.

Process for Implementation

• Prepare a feasibility study. This will include an analysis of items such as:

  • Is there adequate payroll?

  • Is there adequate cashflow?

  • What will the repurchase obligations entail?

  • Complete a business valuation. The valuation expert should be hired by the trustee and should not have any conflict of interest. Valuations must be completed on an annual basis.

  • Obtain funding for the ESOP. Funding sources could include borrowing money from

    • Traditional banks

    • Private parties

    • Existing benefit plans

    • Bond market

Larry lays out the funding plan as follows, 

“Where's the money come from, right? The employees don't have any money. And if I'm a shareholder, yeah, I'd rather sell to my employees. But if they have no money, where are they going to get the money to buy my company? We leverage a company's balance sheet. And the most important thing is, if they're big enough companies, [we do it] on a completely non-personal recourse basis. Lenders are lending money to the company, collateralized only by the cash flow and the assets of that business. So we've got a network of banks and non-bank lenders all across the country that are actively seeking to invest into employee-owned companies. And that bank will lend the money to the company; the company lends that money to the ESOP. And the ESOP gives that shareholder the cash [in exchange for shares of company stock], so it's a debt-financed transaction. And because the company doesn't pay any taxes, we can pay down that debt very, very quickly and then build up the equity value for the employees.”

• Choose a trustee.

• Hire an ESOP attorney to create the plan and trust documents. Documents will be submitted to the IRS for a determination on whether it meets the tax qualification requirements.

• Select a third-party administrator, like CSG Partners, who will

  • Maintain all record-keeping for the plan.

  • Maintain all record-keeping for the employees.

  • Perform non-discrimination testing.

  • Purchase the stock.

  • Communicate the benefit to employees.

Now that the ESOP is your new favorite tool on the bench let’s look at some of the finer nuances and the masterpieces that can be created with it. 

Publix Super Markets is the poster child for this program. It’s the largest employee-owned company in the United States, with 80% of Publix stock held in its ESOP. Every employee at Publix receives company stock after 12 months of service, regardless of position or salary. Their profit margins are the highest of any company in the industry at 7-8%, higher than Walmart’s which is around 3%, and way higher than Kroger’s at a measly 2%. Publix has about 225,000 employees. Of that total number, the stock is held by approximately 205,000 Publix workers, 91%.  Barrons.com estimates that the average Publix employee has about $150K in company stock. Much of the company’s success is credited to the corporate culture built on the premise of employee ownership, translating into the highest level of customer service delivered to patrons at all 1300 Publix stores.

Though this next company cannot be named directly, Larry shared another success story. “We did an ESOP we implemented for one of our clients about five years ago. They were an insurance brokerage operation, primarily property, and casualty, a nice local, regional property and casualty agency. Then we sold 49% of that stock [to the ESOP], and the employees started building value. There were 40 employees, right? And within four years, five years of implementing that ESOP, they started receiving takeover offers that were so high that they had to take, I mean, they were just really crazy offers. And so, within five years, 40 employees split $70 million. Now, that is a 100% true story.” He goes on to say, “And by the way, they get that cash that goes into their IRAs because a lot of these employees were 35, 40 years old. They get to keep that money growing in a tax-deferred account until they hit mandatory retirement age. So it's life-changing for them.”

As mentioned earlier, the ESOP is a non-discriminatory plan, but that can be “enhanced,” we’ll say, with a little Kaplan Kreativity. (I made that up.) Larry calls it an ESOP-MBO, or ESOP Management Buy Out. He describes it like this, “So the ESOP itself is what they call non-discriminatory. That's why everybody participates equally, based on their compensation. …You've got an employee making $150,000. You have another one making $50,000. Each year, when shares get allocated, that $150,000 employee will get three times the amount [of company stock] as the $50,000…but a lot of times…we combine a management buyout with an ESOP. …We'll try to build into the deal where key managers can have up to 20 or 30% of the company. So they'll all be participants with the ESOP, but we want to build up a little something extra for the top people so that they're completely incentivized. So everyone's rowing in the same direction and they get a little bit extra.”

We’ve talked about the ESOP as a liquidity/exit strategy, but it is also great for an acquisition strategy. Larry shares this example, “Say the business owner is not ready to retire. They want to do a…growth by acquisition strategy. We could turn these companies into 100%, employee-owned S Corporations. …The owners can have approximately, let's say, 45% of the stock in what they call synthetic equity…which gives them [the owner] the right to buy back in at a later date, at a price that's scheduled at the time of the transaction. So now I've got a company that's entirely tax free. The owner participates in…this tax-free business. And now they can acquire all their competitors around the country. When they acquire them, the owner of that selling company, if he sells to them [to the ESOP] he doesn't have to pay capital gains taxes on it. And then that cash flow stream comes into it [the company, with] no taxes of ordinary income. The most ideal platform to start acquiring companies is an ESOP, far better than any other structure. And that's what we're trying to get these businesses to do.”

Larry shared an incredible use case for the ESOP as an estate planning tool. He says, “Many business owners…haven't done estate planning. So they built up that company, and they got all this equity value that's locked in that stock. And they gotta pay lots of taxes both on the sale and upon death. So what we do, just give you an example, we'll do a transaction where they'll sell 49% of the company to an ESOP, keep 2% for themselves. Post transaction, when the debt is on the company, [from funding the ESOP] they'll then gift to a family trust the other 49%. And now, since they're gifting a minority piece, [because] they started the company as valued here [at a relatively high value]. They put the debt on the company from the transaction, [which temporarily reduces the company value]. Now they're gifting a minority piece. …You're able to make that gift for practically zero.” As the participants in the ESOP retire, the company, owned by the next generation, buys that stock back from the retirees. As the ESOP’s ownership percentage shrinks, the business can eventually become family owned once again. Liquidity and family ownership all in one.

And we’ll end on a “high” note with Kaplan’s thoughts on how this can benefit the tax burdened cannabis industry. I’m getting the munchies as I listen to him explain, “The problem with being a cannabis retailer is that…there's a section of the tax code called 280E. If you're a cannabis retailer, you cannot deduct any of the expenses. So whatever your gross profit margin is [that’s also] your profit. That's what your taxable income is. So even though there are a lot of these retailers that are making a profit, they're not generating any positive cash flow, because they have to pay everything out in taxes. And it's killing the industry. And until there's federally approved legislation, you're not going to see this change. And so what we've been trying to promote within the cannabis industry, is if you're starting a new company, we're trying to convince business owners to create your business as 100%, employee-owned S Corporation.” He breaks this down as follows, “Now I've got 100%, employee-owned S Corporation, it's not paying any taxes. It's not subject to 280E because it doesn't pay any taxes. …So now all these employees, right, are sharing in the upside. So the problem…is that people, it's complicated. And yes, you're gonna give away some of the upside, right? …But the tax benefits are so huge that at least you will be generating cash flow and then sharing it … and then everybody does better. I think it's a great idea.” I certainly agree with Larry here!

If your brain isn’t too foggy from this “blunt” of info, then the story's moral should be clear. Every business owner needs to explore the multi-faceted, thing-a-ma-bobby tool known as the ESOP. If done carefully and in the right situation, Employee Stock Ownership Plans can create wealth for both owners and employees. They can also provide alternative financing options, reduce and even eliminate taxes, and provide efficient estate planning.

P.S. My boyfriend says he hasn’t opened the hatchet thingy because he needs the hatchet-thingy to get through the damn packaging!

Della Kirkman, CPA - In less than ten years, she went from single mom serving tables at Cracker Barrel, to buying her first business, growing it, and later selling it to achieve a level of wealth and independence she had only dreamed about. Della is the publisher of the Shift-N-Gears.com bi-weekly newsletter, designed to help people buy, grow, and sell small businesses. The free newsletter is part of a more extensive, developing educational platform encouraging women to pursue their dreams of entrepreneurship through acquisition by buying a profitable business that can support their lifestyle rather than the hard, risky path of the startup.