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Suggest who benefitsEp. #325 - How ESOPs Work: Myth Busting, 1042 Tax Deferrals, Warrants and Executive Comp Plans
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Suggest questionAs we continue down this ESOP mini-series, we want to do some serious myth-busting by diving even deeper into the technical details on how ESOPs work.
This two-part episode is all about deal structures, 1042 tax deferrals (similar to 1031 exchanges), seller’s potential to capture future equity growth via the form of warrants (similar to rolled equity), how to handle key executive compensation plans, and the shareholder benefits of transforming a company into an ESOP.
In this episode, you will learn how an ESOP offers great tax benefits and how you can prepare to maximize your tax deductions before switching to an ESOP. Also in this episode, you will learn about the interview process from a trustee’s standpoint and about warrant options to ensure that the best interest of the employees are at the forefront of the deal without screwing over the primary seller.
WHAT YOU WILL LEARN:
PART 1
-How an ESOP valuations compare to a strategic buyer.
-How ESOP valuations compare to a strategic buyer.
-Various deal structures where an ESOP could potentially put more net proceeds into your bank account over the buyout period compared to a strategic buyer.
-How the 1042 tax code works, why it is similar to a 1031 exchange, and when it can be used.
-Why changing from an S Corp to a C Corp could potentially defer, if not eliminate, most taxes in the sale of a company to an ESOP.
-What Keith thinks would happen to the creation of ESOPs if the 1042 treatment was extended to S Corps to use.
-What having good advisors can do to your ESOP sale process and net proceeds.
-How warrants work, how they can resemble rolled equity like a private equity firm, and why they exist as part of the deal structure.
-How the seller’s note works in an ESOP, why it typically equals mezzanine financial rates, and what that means to the seller’s net proceeds.
PART 2
-Miguel’s story about working at the Department of Labor for 12 years overseeing trustees that managed ESOPs.
-Why Miguel made the switch from the DOL to working as a trustee and building a company that helps ESOPs.
-When and how equity options outside the normal ESOP allocation are available for key management.
-A detailed account of how warrants work and why they are used.
-How warrants can act as an incentive plan that aligns the seller, key executives, and future growth of the company.
-How synthetic equity plans (also known as stock appreciation rights [SAR]) can be used for current–and future–key executives.
-The difference between retention SAR plans and incentive SAR plans.
-Selling to an ESOP is a very hands-on transition, and a good trustee should let the owner stay very involved.
-Why an ESOP trustee is more concerned about the financials than operational due diligence when compared to a strategic buyer.
PODCAST INTERVIEW QUOTES: 05:00 - “Complexity just means it’s something new." - Keith Apton
23:30 - “There are more transactions done not as a 1042 than as a 1042." - Keith Apton
22:00 - “It’s important to understand your ownership vs. management roles." - Keith Apton
52:21 - “[A benefit to ESOPs is] being able to keep what you’ve built. Keep that culture and have your employees not only build on what may already be a great culture but take it to a whole new level now that you’re becoming employee-owned.” - Miguel Paredes
54:00 - “A trustee should not be involved in the strategic decisions.” - Miguel Paredes
CONTACT INFORMATION: Connect with Keith on LinkedIn:
ABOUT KEITH: Keith has over 21 years of experience in the financial services industry, with an extensive background in corporate finance with entrepreneurs and business owners. As the founding partner, he heads the team's Private Wealth practice, where he works to determine client needs and match them with the proper resources of UBS, a leading global bank. Keith focuses on solutions encompassing asset allocation, as well as wealth and liability management to create tailored financial plans for his clients. His process entails a disciplined approach to help business owners with sell-side advisory solutions and post-sale financial planning to include holistic wealth management, including tax and estate planning strategies through strategic partnerships. Keith is a nationally recognized leader on ESOPs and Internal Revenue Code §1042 rollovers.
ABOUT MIGUEL: Miguel Paredes is president and founder of Prudent Fiduciary Services. Mr. Paredes holds a Bachelor of Science degree in Business Administration from California State University, San Marcos and a Master of Business Administration degree from the University of Massachusetts, Amherst, Isenberg School of Management. Mr. Paredes holds the Certified Plan Fiduciary Advisor and Certified Internal Auditor designations.
About Ryan Tansom
Dr. Craig Everett is on the show today to dive deep (in a way that a normal business owner can understand) into the world of valuations, where they come from, and how the research he leads at Pepperdine University is helping shed light on the middle and lower private markets.
Dr. Craig Everett is a finance professor at Pepperdine University and contributor to the Pepperdine Private Market Capital Projects and Executive Director for the Pepperdine Most Fundable Companies. In this episode, Dr. Everett explains why it's important for every business owner to understand their cost of capital, why weighted average cost of capital (WACC) matters, and why multiples are so high right now in the M&A space. Expand your financial literacy and learn more about how to view your business as a financial asset in this episode with Dr. Craig Everett.
WHAT WILL YOU LEARN:
-Why it’s important, as a business owner, to understand how to value a business while you own it.
-What drove Dr. Everett to teach finance after years of consultant work.
-What cost of capital truly means and how to use it as a rule of thumb to determine whether you are growing the value of your business or if it is in decline.
-How your weighted average cost of capital (WACC) fits into clearly understanding your multiple.
-Dr. Everett’s definition of Company Specific Risk and all the factors that go into it.
-Why venture capitalists are moving back to early stage companies.
-Why multiples are so high right now.
-Why your valuation varies depending on the exit you are taking.
-Why people are choosing an exit to a private equity deal versus IPO.
PODCAST INTERVIEW QUOTES:
22:30 - “I want my students to sit in on financial meetings and understand what’s going on.” – Dr. Craig Everett
25:30 - “What’s your cost of capital? It’s amazing how many people say zero.” – Dr. Craig Everett
44:10 - “The revenue multiples are crazy right now.” – Dr. Craig Everett
49:20 - “VCs are now moving back into early stage companies." – Dr. Craig Everett
56:45 - “They wanted to come up with a different approach to come up with the cost of capital." – Dr. Craig Everett
ABOUT CRAIG: In addition to being an assistant professor of finance, Craig Everett is also the director of the Pepperdine Most Fundable Companies Initiative, which is a prestigious national startup competition. He is the primary researcher and manager for the Private Capital Markets Project, which publishes a quarterly Private Capital Demand Index and Private Capital Access Index, leading economic indicators. Craig is one of the leading authorities in finance, specializing in private capital markets, entrepreneurial finance, venture capital, business valuation, and financial literacy.