The number of businesses shifting to an employee ownership model has ballooned in recent years, and experts say that trend is likely to accelerate. That could have important implications for banks aiding that transition and for the future of small business lending.
Transcription:
Transcripts are generated using a combination of speech recognition software and human transcribers, and may contain errors. Please check the corresponding audio for the authoritative record.
Chana Schoenberger (00:00):
When banks think about how they work with small and medium-sized businesses, they often think about S spa loans. But a little known corner of business finance has been growing in popularity. I'm Chana Schoenberger, editor in chief of American Banker. Our Washington Bureau Chief John Heltman lives in Baltimore and he's one of those people who does a lot of his own home repairs. This brought him into contact with an interesting banking trend.
John Heltman (00:30):
I want to take you to my happy place, the Waverly Ace Hardware store in northeast Baltimore. Usually I make at least two trips here every week. The first is for the things I remembered, and the second is for the things I forgot.
John Heltman (at Waverly Ace Hardware) (00:42):
We got some storage bins, we got some, oh, here's the caulking aisle. So we got premium kitchen, bath, sealant, lifetime mold and mildew guarantee. Alright, varnishes glues. Do I get any of this?
John Heltman (01:01):
There's something so enticing about the hardware store, the unplaceable, but unmistakable smell that only hardware stores have the sounds of advice being given out in paint cans being sealed, which you're hearing here, the gizmos and the tchotchkes at the checkout, all of it. But I just think what I like about it is that the hardware store is a place where I tend to go when I have an idea for building or fixing something, but I don't quite know how to see it through. I guess what I'm saying is it's a store, but it's not just a store. And in this case, Waverly, ACE Hardware is a different kind of not just a store, it's employee owned, meaning each of the store's employees own a piece of it. That started in 2021 when the store's owners decided to sell their stores to their employees with something called an employee stock ownership plan or esop. Pat Berberich, the store's manager, said that the shift makes a real difference in how workers view their jobs.
Pat Berberich (01:54):
It's great. I have a larger stake in my work. I'm happier coming to work. I'm into it. I think it's cool. Prior to us becoming employee owned, there was profit share, but this is much better. So the longer you work here, the more vested in your stock in the company you get. And so it's pretty good. It turns it in from, it's not just like a paycheck, it's like retirement basically. So there's more there for the employees later.
John Heltman (02:29):
I don't expect that most people feel the way I do about hardware stores, but most people probably do feel that way about some kind of business or store. Maybe it's a coffee shop or a general store or a bar. And in the last couple of years, more and more businesses of all kinds are deciding that the best way for their company to continue to function is to transition to employee ownership. The overall volume of employee owned businesses is still relatively small. The number in the thousands and one estimate puts its share of the total private sector workforce at 12%. But there is at least anecdotal evidence that that number has already started to rise because of the Covid pandemic. And as more and more baby boomers look to retire and sell their businesses. So what do banks need to know about employee owned businesses and how might this trend affect banks' outlook in small business lending? And what can banks do to help firms transitioning to becoming employee owned from American Banker? I'm John Heltman and this is Bankshot, a podcast about banks, finance and the world we live in.
John Heltman (03:33):
Could you guys hold on first? I'm going to pause my notifications on Slack
Josh Golden (03:39):
And I recommend I just did the same thing and there's some possibility just with this all coming the last second, literally yesterday, my sister-in-Law lives the other side. They're having their basement done and the contractor wanted to be really super early, so they decided to stay here. So my normal office is occupied by my sleeping three-year-old nephew. So I'm in our rumpus room, which is not as acoustically sealed as I would like it to be.
John Heltman (04:03):
This is Josh Golden.
Josh Golden (04:04):
My name is Josh Golden. I'm the founder and chair of TXI, a boutique strategy, innovation consulting and software development shop based nominally out of Chicago at this point, but fully virtual since the pandemic
John Heltman (04:20):
TXI might best be understood as a software development company with a consultancy built in. So they help both identify and solve whatever backend data problems a company might have. But like many tech businesses, TXI was founded with a baked in sense of egalitarianism
Josh Golden (04:35):
Right from the get go because it was a company of peers, it was a group of, it's almost like a stereotype in this point, but like a group of white dudes in their early twenties hustling like any young founder, I made mistakes about giving this person equity what I shouldn't have and try to figure it out. It wasn't systematic and it wasn't. I had a founder, co-founder. We had an early split, we blah, blah, blah, buyout all the things that almost always happen
John Heltman (05:03):
Season one of Silicon Valley, basically,
Josh Golden (05:05):
Yeah, season one of Silicon Valley or very low stakes, low drama version of the social network, just the classic stuff.
John Heltman (05:15):
Eventually Josh learned about employee stock ownership plans known as ESOPs and was immediately intrigued and wanted to make it happen for his company. But that's kind of a process
Josh Golden (05:25):
And one of the shortcomings of the ESOP process is that the way your company is valued is fairly straightforward and narrow-minded focused almost exclusively on a quintessential third party valuation based on a DCF
John Heltman (05:42):
That is discounted cashflow.
Josh Golden (05:45):
Or earnings multiple approach, which is fine for stable state family owned manufacturing company in Lexington, Kentucky, but for a more dynamic professional services partnership, hiring people out of Silicon Valley doing techie stuff, it's a little bit stayed. So we had to sort of sit down and actually be like, okay, I guess we need to make our books look like, let's tune a bit more profitability, let's make this more predictable, more systematic, which are all good things to do and probably things we should have done years and years and years before, but due to ESOP process, we had to do that.
John Heltman (06:21):
Employee owned is a term that requires a little unpacking. There are a couple of different varieties and the term itself is a little fluid, but the main varieties that we're talking about here are ESOPs and co-ops. The end result for both a co-op and an ESOP are the same if you work at John's hardware store, you are a part owner in that store and when the profits are up, it's your profits that are up and when profits are down, your profits and the value of your share in the store are down. But there are some important differences. Co-ops as a general matter tend to be smaller with maybe 10 to 20 employee owners like a coffee shop or a bookstore. Co-ops are often established as cooperatives and the employee owners often put up the capital to create the business. ESOPs by contrast, tend to be bigger, say a hundred or more employee owners and generally are converted from traditional business models to ESOPs.
(07:09)
And here's how that works. I'm selling John's hardware store to my employees and to do that, someone often a commercial or investment bank, sometimes a non-bank firm puts up capital to buy the store from me and then divides it into and disperses shares to the prospective employee owners over some defined period, say five years, the profits of the store will go to paying back whoever put up the capital, and at the end of that period, the owner's shares will be vested and profits will then go to them. Actual ESOPs are much, much more complicated than that. So when Josh decided to pursue an ESOP for his company, he called Matt Nels to manage the process.
Matt Nels (07:44):
I'm Matt Nels with Menke and Associates. I'm a managing director on the advisory side of our business. There's a lot of different options available to a business owner that's contemplating an ESOP and figuring out what makes the most sense for him or her or the multiple shareholders that are selling and what's also good for the business and that the management team going forward and make sure you find a path that works for everyone.
John Heltman (08:13):
In other words, the terms of a particular ESOP are highly variable from one to another. In my example, I'm selling a hundred percent of my hardware store, but often a business owner will sell 30 or 60% of the business and hold onto the rest. And that's important because it means that the portion that is for sale will vest faster and require less capital upfront.
Matt Nels (08:31):
It's not an all or non proposition. You could sell five, 10, 30% to the ESOP if you want to, which is hard to do, hard to find someone that's willing to come in as a minority shareholder in a business, an ESOP is willing to do that.
John Heltman (08:46):
But as Josh alluded to earlier, there are some things that are not negotiable in an esop. One is that an ESOP share price has to be based on a fair market valuation of the business. That means that the owner likely has to accept lower proceeds from the sale than they might otherwise get on the open market. Another is that every aspect of the process for sending the terms of the ESOP and the trust have to be arm's length negotiations. And it's no joke.
Josh Golden (09:10):
I experienced the negotiation as a much more bonafide negotiation than I expected it to be on face value. The idea that you hire a trustee who goes and hires their team of lawyer and financial expert to negotiate with you sounds like a per version of a market system on first glance. And I think there have been issues at various points in time in the evolution of ESOP square. In fact, it kind of was, and I'm sure there still are circumstances where the fiduciaries and the categories are a little bit too chummy. But I was not prepared for how thoroughly and how directly this negotiation occurred, and it actually left me feeling like a good tennis match. We really ran, we really left it out there. We did our thing, we played for real, it wasn't making a show of it,
John Heltman (10:10):
But their considerable benefits to the ESOP model as well. Most notably that owners who sell to an ESOP defer any capital gains taxes they might otherwise have to pay. And the post ESOP business is also exempt from paying virtually all federal taxes.
Matt Nels (10:23):
So as an s-Corp, it's a pass through entity. As you know for S corporations, if the ESOP is the sole shareholder, it doesn't have any tax obligations. If it's a hundred companies, a hundred percent owned by an s-Corp esop, there's no federal tax obligations and quite a few states recognize it as well. So there isn't any state tax either. So that's a significant amount of cashflow that would be going to Uncle Sam every year or paid by the shareholders to Uncle Sam, and so that money stays in the business can be used to pay down debt, make acquisitions, expand service or product offering. So it's really tremendous benefit to go that route and it's a way to, as Josh was saying earlier, it's a way to, as that debt gets paid down, that share value's going to go up typically.
John Heltman (11:15):
So to recap, what makes an ESOP good for employees is a kind of retirement alternative built around the profitability of the company that they now own a piece of, and that ownership is subject to less funny business than a traditional profit sharing plan or the ups and downs of a 401k. The tax benefits also can contribute to the continued solvency of the company and by extension the value of the company's shares. The benefit to the seller is that you can keep a stake in the company without having to run it full time and the proceeds are tax deferred, but the specifics of those benefits can vary and employee ownership is not necessarily synonymous with employee empowerment
Julian McKinley (11:50):
In an ESOP, while employees are directly benefiting from the profit that they help create, it doesn't necessarily require that they have a say in the business.
John Heltman (12:01):
This is Julian McKinley.
Julian McKinley (12:03):
I'm Julian McKinley. I'm the co-executive director at Democracy at Work Institute. We are a national think and do tank that works to expand worker ownership specifically for workers who we describe as being locked out of good jobs and business ownership opportunities. Participation can look like many different things. It could look like having representation of your employees on the board. It could also look like having your employees contribute to policies within a company such as pay, such as annual raises, such as workplace safety. And so all of those things aren't necessarily guaranteed with an esop. There are ESOPs who incorporate those pieces, again, not guaranteed. The flip side of that is with the worker cooperatives, that participation, the voice that a worker has in their workplace is absolutely essential. And so the way that it's structured is a worker co-op, each worker has one share and one vote, and that share is equal. That vote is equal to everyone else's. And there are in many cases, committees within the worker co-op structure, again, where people would discuss things like policy. We would discuss things like the business itself, taking a look at the finances. They may even have a community committee where they focus on how the business is positively impacting and giving back to its local community, and they would also have representation on the board. And so that is a critical feature of the worker cooperative structure, again, which is different than the esop In that sense.
John Heltman (13:41):
You'll recall we talked a little bit about co-ops as an alternative to ESOPs at the beginning of the show, but while there are certain conditions that have to be present for an ESOP to work, there are also conditions that have to be met for co-ops to work as well.
Julian McKinley (13:54):
Worker cooperatives as opposed to ESOPs are also generally a little bit of a smaller business and they allow, I think, a available on-ramp for workers who are sort of taking their experience on the job into their own hands. It allows an on-ramp for workers who are having adverse experiences either within an industry or their particular workplace, really say, we're going to set our own terms and we're going to benefit in a more direct way from the labor that we're putting forth.
John Heltman (14:24):
Co-ops also don't have the same tax advantages as ESOPs and also don't have the same degree of support from lenders.
Julian McKinley (14:30):
ESOPs, I think generally have typically far less issue accessing loans from banks to support business growth or what have you. Worker cooperatives is a little bit different because of the emphasis on shared ownership and in particular the personal guarantees that are required to access business loans either for startup or growth. What we have advocated for years within the worker ownership field is for those personal guarantees to not be required for worker co-ops. There was an act passed in 2018, the Main Street Employee Ownership Act, which reduced the bar of entry for small businesses to be able to access SPA loans, specifically ESOPs and worker cooperatives. Still we're finding that with banks in particular, it's a little bit of a challenge providing loans to worker cooperatives because basically they're looking at a group of five individuals and saying, Hey, I need one person to be the owner here so we can really administer this loan as opposed to there being five people. What I would encourage banks to do is take a look at some of the track record of lending that is currently taking place.
John Heltman (15:42):
That is increasingly important because the number of employee owned businesses is growing and very likely will continue to grow into the future.
Steve Kuhn (15:50):
And the reason ESOPs are really right now, why ESOPs I think are gaining in popularity is because the few things, Steve Kuhn, I've been with Fifth Third Bank now for 21 years. I've been in banking for 40 plus years, and my last several years have been in the leveraged lending market. And so right now I run the ESOP finance group at fifth or bank ESOP education over the last several years has been really increased. And also you have a lot of baby boomers that are looking at a liquidity event or a way to retire or sell their business. And also the market that we're in right now, valuations of companies has remained high. So even though we're in somewhat maybe of a recession, valuations continue to stay high. So as long as you have high valuations, willing sellers and willing lenders, the ESOP space is very robust.
(16:44)
So if you're a business owner today, your choices are, I can sell it to a strategic, I can sell it to a private equity firm, I can sell it to my management team, or I can sell it to an esop. And really what drives the sale to an ESOP for the most part is if an owner of a business wants to reward the employees. And typically if an owner is not looking to get all of his money upfront in the sale and he maybe wants to stay involved in the business, or maybe he doesn't want to sell the entire business because of an esop, you can sell 30% to a hundred percent. And that's really what drives ESOPs is that it's usually an owner that wants a liquid at the event, maybe wants to stay involved for a while, but really wants to reward his employees.
Pat Stoltz (17:33):
The piece that's changed the most is just the quality of the education surrounding the process. My name is Pat Stoltz and I'm a part of the wintrust ESOP finance practice. So Wintrust is a Chicago-based organization headquartered in the Chicagoland area. 13, 14 years ago, it wasn't maybe as robust, not to say that there weren't really well-intentioned professionals, but it's a very professionalized space. And I just think the quality of the education from all professionals over the last 15 years has stepped up to the point where I think business owners can really more quickly gauge whether or not this is the right alternative for them. And I think there's been some momentum with that. There certainly are drivers in the population, the age of the population, the baby boomer population, certainly the data behind all of that is really great. I think the numbers are in the neighborhood of 150,000 to 300,000 business owners, and I'm going back probably seven or eight years, will transition their businesses each of the next 15 years, not over 15 years, each of the next 15 years. So it's a very, very significant driver. Lots of the business owners are aging out of their business, and there's a lot of reasons to sell a business. So I think we've seen a very steady level of activity and new implementation, new ESOP implementation activity, and also some mature ESOPs that just continue to have financing needs with regard to maybe acquisitions or other financing needs like repurchase obligation issues and things of that nature. So we've seen a very, very consistent activity level within our practice.
John Heltman (19:46):
Of course, one of the pieces of the ESOP puzzle is capital, and in many cases that capital is put up by banks. Mankey, for example, is an investment bank, whereas Fifth Third is a mid-sized regional bank, and wintrust is a holding company that runs a portfolio of community banks, but it's not something that everybody does. It's a niche market and it's likely to remain. So
Steve Kuhn (20:05):
I think most banks are probably aware of ESOPs, and it really is a niche type of lending. I mean, it's really a small community and it really takes a lot, let's say, to make the ESOP circle work. So in our case, we take probably 30 transactions a year to advisors, more companies that we're financing talk about, Hey, you know what? We're interested in ESOP and at the bank level, we're not experts on tax and structure and all those type of things. We're really more experts on loan structuring and that type of thing. So we involve an advisor early. So I think what really needs to happen is if somebody's interested in esop, you really got to, from a bank perspective, you really have to engage an advisor early because there's so many different nuances and structure ways for an esop, and the advisors can do the feasibility study and figure out what's the best way to proceed.
Pat Stoltz (21:09):
Most of what we see in terms of new implementation activity is driven by our relationships with those investment banking firms throughout the country. So where banks are getting more involved is banks are seeing their clients sell and they're typically getting a phone call and saying, Hey, we're going to pay your loan off. And the banker ends up saying, well, what are you doing? Are you going to another bank? And they say, well, we're supplying our business to either a strategic buyer or private equity. And so the bank oftentimes doesn't even know that their client was entertaining transitioning the business where we've tried to, I think the banks that are doing this successfully are bringing this as a value add. How can we help you? This is something that is important to you to transition your business efficiently. How can we help you and how can we help bridge the gap? If you're going to sell your business one time in your life, you should really be astute on all of the options available to you.
John Heltman (22:19):
In other words, part of the point of facilitating companies towards employee ownership is because it allows a bank to continue to have a relationship with the business, but that's not the only reason. ESOP conversions are also pretty low risk. The National Center for Employee Ownership did a survey in 2013 that estimated a default rate of 0.2% for ESOP firms far below say, leveraged loans, which have a 3% default rate. And the reason for that is probably because of the inherent benefits that employee owned businesses have to offer their employees.
Pat Stoltz (22:52):
It's a really strong level of commitment from the employee base. ESOP is a really great recruiting tool. It's a really great rewarding tool, a really great retention tool, and I think there's just a lot of accountability with the employee base to make things work better tomorrow than they did today. And it's hard to measure that every day. I liken it to your child growing and every day they're growing and then all of a sudden six months down the road, you go, oh my gosh, yeah, they grew like three inches. You don't really see it every day, but over time you see it. And so I think that's been a real driver of the statistics behind the default rate. And the other piece is there's just not a lot of interruption in the business model.
John Heltman (23:44):
I'm going to pull back the financial journalist curtain here just a little bit. Usually with a story like this, what I'm looking for is a business case, some danger or opportunity lurking around the corner that can either cost or save banks money, but employee business ownership doesn't really work like that. The value that is being maximized is the value to a community of having a business continue to exist as it has. And the way it does that is by making the business itself a worthwhile investment of time and labor for the people who run it. What results is, in most cases, a business that continues to thrive. And for many retiring business owners, that's worth more than money
Julian McKinley (24:22):
At the community level. When you have businesses that are in danger of closing, employee ownership again provides an opportunity for that business to stay in a community to continue to provide those services. We know that this in particular is a critical need. I think it is about more than 80% of business owners do not have a succession plan, for example, so they have no idea what they're going to do when they do close the business or when they do decide to leave the business. Oftentimes what happens is A, they're unable to find a buyer for their business or a competitor may buy the business and end up basically selling it for parts, but essentially, the business as it stood, will cease to exist. There's also an equity component here, and that's what we really focus on at Democracy Work Institute, and that is creating opportunities for people who otherwise would not have them to build wealth to afford things like sending their kids to college, like putting down a down payment on a home, creating more stable lives for themselves, and frankly, it's a benefit that they deserve based on the value that they create for business through their labor.
Matt Nels (25:39):
Our biggest challenge in the ESOP community is awareness and then dealing with misconceptions, because unfortunately, there's still trusted advisors, attorneys and CPAs and others out there that are telling business owners, no, you don't want to go ESOP because of this, or You don't want to go to ESOP because of that, or It's too costly, or it's too complicated, blah, blah, blah. And yeah, I mean, it's not straightforward sale to your kid, I agree. But it's not rocket science either. It's just you have to be willing to take the time and understand it and then figure out if it works for you and your business.
Steve Kuhn (26:16):
From a bank perspective, I think what probably needs to be known is that there's ways that companies can be sold, and not everybody knows all the different ways. I mean, everybody probably knows sell to strategic. Everybody probably knows sell to private equity group, maybe management team. But I think probably the thing that most banks don't probably know about is what is the good, bad, and ugly of an ESOP sale? And obviously within any transaction, there's certain companies that fall into a would be a great ESOP sale, certain companies that just wouldn't work, but it's really education and it's really knowing that there's an option, an ESOP option, and does that ESOP option make sense for the business owner?
Chana Schoenberger (27:06):
This episode of Bankshot was written and produced by John Heltman. Our audio engineer is Kellie Malone Yee. Special thanks this week to Fifth Third Bank, the National Council on Employee Ownership, Menke and Associates, the Democracy at Work Institute, Wintrust Bank, Waverly ACE Hardware, and TXI. If you liked this episode, imagine the wonders that await you if only you subscribed to American Banker, which you can do by visiting americanbanker.com/subscribe From American Banker, I'm Chana Schoenberger, and thanks for listening.