A Unique Exit Strategy for GovCon Firms

Government contractors often struggle with exit and succession planning. Novation requirements, Anti-Assignment Act obligations, and set-aside designations can limit a company's M&A options. Even if a GovCon firm wants to remain independent, traditional buy-sell arrangements can be complicated and inefficient. Employee stock ownership plans represent a meaningful alternative to third-party sales and internal buyouts. ESOP strategies offer shareholders tax-advantaged liquidity while creating meaningful incentives for firms and their employees. Recent legislation has even singled out ESOP-owned companies for preferential treatment in certain DoD contracts. In this episode, I sat down with David Blauzvern from CSG Partners to discuss how to determine if ESOPs are a good fit for your company, the pros and cons of the ESPO model, and much more.

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Read Transcript Here:

Mike: [00:00:00] Hey everybody. Mike LeJeune here with Game Changers for Government Contractors, and today we're going to be talking about an interesting topic. I don't think we've ever covered ESOPs on here before, so it's interesting that we'll be covering that today. I have David on here with me. David, why don't you hop in, tell everybody a little bit about who you are and what you do.

David: Hey Michael. Thank you for having me. David Blauzvern and I'm with CSG Partners. We are an investment bank that specializes in ESOPs. ESOP is short for employee stock ownership plans. They are a way for owners of privately held businesses to get liquidity from the value of equity in their business into the hands of their employees at no cost to the employees.

And it comes with significant tax benefits, not only for the owners that are selling their equity to the ESOP, but for the company, the employees, the management team, and really the next level of succession planning at the company.

Mike: That's awesome. I want to make sure that we don't get out of this [00:01:00] episode without talking about the tax benefits. That wasn't necessarily on our radar to talk about today, but I definitely want to make sure we talk about that. For those that have never heard of one of these before, you kind of gave the definition a little bit. Can you give us a little bit more overview on what the ESOP is and maybe how those kind of come about?

David: Sure. An ESOP is a ERISA retirement benefit plan. Essentially what happens is you will sell the value of your company for fair market value to a trust. Fair market value is essentially what a financial buyer can pay for your company. It's not what a strategic buyer can pay for your company. But they can match what a PE firm is willing to pay for your company.

So on average, you could say companies sell to an ESOP for anywhere to a six to nine times multiple of your EBITDA. And essentially what happens is, you're doing a leveraged buyout of your own company. There are no changes in the day-to-day operations of your business. The ESOP trustee is not [00:02:00] coming in to tell you how to run your business. They don't know how to run your business. Their job is to be a fiduciary for the employees to make sure that you are making decisions that are in the best interest of your employee base.

The two main benefits from a tax standpoint are: If you think about your typical third party sale to a PE firm or third party strategic buyer, you're going to pay capital gains tax on that sale. Now, when you sell to an ESOP, as the seller, you have the ability to ultimately eliminate the capital gains tax that's due on the sale via what's called 1042. If you're familiar with 1031 in the real estate world, 1042 was created in the tax codes specifically for ESOP transactions. So if you have a third party buyer that's willing to pay you a seven times multiple for your company, and an ESOP can pay you a seven times multiple, ?right off the bat, you're ahead of the game economically. Because after tax, you're yielding that seven times versus maybe four and a half, five times after you pay capital gains tax [00:03:00] to that third party.

The other tax benefit from the company's standpoint is that whatever value you sell your equity for to the ESOP, that equals a bucket of tax deductions that the corporation can use to offset its corporate income in the future. So let's say you sell to an ESOP for $50 million, you can essentially now offset $50 million of your pre-tax income at the corporate level.?

So you have the tax benefit from the seller's standpoint, but then you also have it from the company's standpoint. It allows companies to grow their operations significantly faster than you would in the status quo. Most of our clients that we deal with from day one, maybe you're an LLC or an S-Corp and you're paying pass through taxes on your income, anywhere from 40 to maybe 51, 52% if you're out of California, and if you can reduce that almost to zero it's a significant benefit

Mike: That's [00:04:00] huge!

David: Absolutely. From the company's standpoint, why would you do an ESOP? Well, it's succession planning. It's getting equity in the hands of your employees. We have a lot of owners that will come to us as they're getting bigger in size and they're trying to incentivize their employee base, but they don't know how. Or maybe they're doing it in a way that is currently economically not the most sustainable down the road.

And when you sell your equity to an ESOP, it's a non-discriminatory plan. Every employee participates in that plan from day one. Let's say you sell a hundred percent of your stock to an ESOP trust. It's not as if you're giving a hundred percent of your company to the employees on day one. You are going to have a hundred percent of your stock sitting inside of a trust in a suspense account in two categories, unallocated stock and allocated stock. And the idea is that over a 20, 30 year time horizon, the stock is going to become more allocated than unallocated [00:05:00]. And your employees will vest just like they do in a 401K plan.

The great thing from an employee standpoint is unlike a 401K plan, it has zero impact on their W-2 compensation. It's not as if an employee has to say, I want to set aside 5% of my compensation for this ESOP plan. Instead, it's a free benefit that is given to every single employee at no cost to them.

So what does that allow the company to do? One: powerful retention tool with what's going on in the labor market today. And it's a powerful recruitment tool to incentivize folks to come over to your company because you're providing this free benefit that many folks aren't today.

Narrator: If you're struggling with your government contracting business, I want to encourage you today to go sign up for a free coaching session with me. You can go in the description of this podcast. There's a link to my calendar, and you can go pick a time where we can sit down for 30 minutes, talk about what you're doing right, what you're doing wrong, what you should change. And then if coaching makes sense for you, I'll [00:06:00] actually go over the options on how you can get started with coaching, so we can take your business to the next level.

Now, let's get back into this episode.

Mike: Several questions based on what you said. The first one: I can imagine the average listener who's kind of tuning in their car today, the first question on their mind is, well, where does the money come from? Where does the money come from that funds this, so to speak?

David: Absolutely. Most of our financing comes from third party lenders that you would all know the names of. It's your senior lenders, the B of A's of the world, JP Morgan, Wintrust, Fifth Third Bank, everywhere from the big banks to the more community and regional sized banks. What we do in what we call our feasibility study is we analyze if a company is worth, let's say, a hundred million dollars, and you're looking to sell a hundred percent of your company. Nine times out of 10, we're not going to be able to raise you $100 million.

What we do is we analyze how much money can we [00:07:00] raise on a nonrecourse basis to the seller so that any liquidity they take out of the business, they're de-risking their net worth out of their company. And that if the company were ever to decrease in performance for whatever reason, nobody can come after them for the money they took out of their business.

On average, I'd say we raise anywhere from 50 to 60% of the sale value as cash at close from a third party lender on a non-recourse basis. So in that example, let's say you get $60 million from a lender. The other 40 million is what we call a seller financed portion of the transaction. It's an IOU, essentially from the company that the company will pay back to you usually over a five year time horizon.

Mike: Hmm. and so again, just for people that are not familiar with this, does the owner in that situation get that $60 million?

David: Yes, on day one of the ESOP closing, you will receive the $60 million from that third party lender. And then after that, the company still owes you another [00:08:00] 40 million. So when you think about the fact that the company's corporate income can become tax free, you're able to de-lever that 60 million that you borrowed and pay down the 40 million that you're still owed much faster than you would in a company that is still paying taxes.

Mike: That makes sense. One of the things, you said this a couple of times, if you were to sell a hundred percent. So you can actually do this and not sell a hundred percent?

David: That's correct. That's the great thing about ESOPs. The first thing we do with any client on day one is understand their objectives. There's a hundred ways that you can structure an ESOP transaction. You can sell anywhere from 30 to 49% of your equity, or you can sell a hundred percent of your equity to an ESOP. It all depends on what your goals are: whether you're looking to retire, maybe you have kids coming up in the business, you have a management team that's going to take over. We want to understand those objectives on day one so that we can tailor the [00:09:00] transaction around those objectives.

Now, you brought up a minority sale. Many deals, I'd say most deals that we're doing today, are actually minority ESOP transactions where you sell anywhere from 30 to 49% to the ESOP on day one. The reason for that is it's a first bite at the apple. It's a way for you to de-risk your net worth outside of your company. And then you always have the option in the future to sell more to the ESOP. Or just because you have an ESOP in place doesn't mean you can't sell to a third party years down the line.

Mike: I assume part of that too, like in the government space would be: Let's say I'm currently in a program or I have a certain status and I need to maintain 51% of the business. Maybe I just want to be safe and keep 60%, then that's one way to do that and leverage that.

One of the things as you're talking here, that I think a lot of people would be curious about is the pros and cons of the whole thing. You've talked a lot about the pros already. I mean, there's a lot of pros on this. [00:10:00] I assume there's some cons. What do those look like?

David: There are absolutely pros and cons. Con number one I would say is that an ESOP can't pay more than fair market value. Fair market value again, if you're familiar with the two types of buyers: In the M & A world, you have a financial buyer and a strategic buyer. A strategic buyer has a way to pay a premium above fair market value, and an ESOP can't do that. An ESOP can only pay you what a financial buyer is willing to pay for your company.

Another con is that the transaction process is highly structured. It takes anywhere from four to six months to really put an ESOP in place. It's a regulated transaction. You want to make sure that you're following the right process, you're hiring knowledgeable advisors in the ESOP space, and that you're negotiating the purchase price for the ESOP in a way that is proper in our marketplace.

Another con, which is again another reason why [00:11:00] some folks just opt to do a minority transaction is that there's only so much money you can raise for an ESOP transaction. An ESOP is a leveraged buyout of your own company. So we're going to look at your cash flows. We're going to look at your balance sheet. And there's going to be a cap on how much non-recourse financing we can raise for a transaction.

So if your company, again, is maybe worth a hundred million dollars and we can only raise 40 million based on your balance sheet and your cash flows, ?maybe you want to consider only selling 40% and then selling the other 60% down the line once you've paid down that debt.

Another con I would say is that it requires ongoing maintenance. We have clients that, for whatever reason, maybe never had debt in the past. And they need to know what it is to monitor and deal with a bank on a monthly or quarterly basis. And you also have a trustee that is going to be a part of your company on an ongoing basis. You'll meet with them annually. You'll tell them about the operations of your [00:12:00] company. It's another party that you have to deal with post transaction.

Mike: Where does the trustee come from?

David: There's a number of trustees throughout the US that are very reputable in the ESOP space. What happens is you will actually set up what's called an ESOP selection committee, and that committee doesn't include any of the actual sellers or shareholders of the company that's establishing an ESOP. That committee's sole job is to interview and select a trustee to represent the employees. The committee does not learn about the value of the company, how much the shareholder is making. Their sole job is just to interview and select a trustee.

Now once that trustee is in place, the trustee's job is to negotiate the value of the ESOP transaction with the company's financial advisor and the shareholders. They're going to hire their own valuation firm to represent them as the trustee, and we're going to negotiate back and forth on that concept of fair market value. Post [00:13:00] transaction, they're going to run what's called an annual valuation update for your company.

That annual valuation is what allows you to know the value of your company stock. The reason you need that is because every year you're going to allocate stock to all of your employees. Just like you have a third party administrator for maybe your 401K, you're going to have one for your ESOP as well. And every year your employees will receive a statement from that TPA that says how many shares have I been allocated and what are those shares worth?

And if you think about, if I'm an employee that maybe has a W-2 compensation of $75,000, it's very hard for me to save up over a 10 year time horizon $500,000 in my retirement account. It's very realistic in the ESOP world where the company's growth can actually lead you to have a very meaningful benefit in a retirement account that you wouldn't have otherwise been able to save by yourself.

Mike: Given everything you just said there, all the people that are hired and [00:14:00] brought in through the transaction, it leads me to wonder, what is the minimum threshold that you typically see for a company, whether it's employee size, revenue size, or a mix of the two, to even consider this as an option. There's a lot of money that needs to be laid out in the process here. So what do you see typically, on the low end, for people that are considering some of this?

David: On the low end? We usually look for clients that have a minimum adjusted EBITDA of at least $3 million. Like you said, sometimes it becomes cost prohibitive if you're below that mark. Now that doesn't mean there haven't been times where we'll do a deal for a company that maybe has 2 to 3 million of EBITDA if things make sense. But usually that minimum is around $3 million. The cost of doing an ESOP transaction is typical to the cost of doing an M & A transaction. It can be anywhere from let's say, 2 to 3% of your company's valued for all deal parties to [00:15:00] get the entire transaction done. Now, the nice thing is that when you establish an ESOP, it comes with a lot of tax benefits. There's also retroactive tax benefits that you can sometimes take to the prior tax year, which sometimes may help offset up to a hundred percent or more of actually putting that ESOP in place.

Mike: The number was a lot lower than I thought it was going to be. That's a good thing for folks to hear.

Another question I think employees might have on this is: I don't know what the vesting period usually looks like on these. But let's say I've been working for the company for five years, eight years, and I just decide I'm done working here. There's another offer somewhere. Am I able to cash that money out or does that wait till my retirement? How does that work for an employee that does decide they're going to leave?

David: So on day one, you are going to establish what the terms of the ESOP plan looks like. 9 times out of 10, usually the way it works is that an employee vests 0% in year one, and then 20% each year [00:16:00] thereafter. So by year six of employment, you are 100% vested in the stock that you've received.

Now, let's say you leave the company and you have stock within your ESOP just like you would for your 401K plan. If you receive that money, you can roll it over into another retirement plan. Or if you want to, you can take the cash and pay the penalty just like you would if you took money out of your 401K.

Mike: That's really convenient that it doesn't take that long. And then I assume, like when you set up the rules, you get to determine who gets what, at what levels, so like senior leaders and different positions, different things like that. Or does everybody across the board get a same stake in the company? How does that typically work?

David: I'm glad you brought that up. Again, it is a non-discriminatory plan. Every employee will participate in the ESOP. You can't pick and choose, I want this group of employees to get more than this group. The way it works is that it is based on your proportion of payroll to the total payroll of the company. So Michael, let's say my W-2 comp is [00:17:00] $50,000, and your W-2 comp is? $100,000. Every year, you'll receive two times as many shares within the ESOP than I would.

What we do to address the fact that it's non-discriminatory: Many times owners will say, well, what do I do about my C-suite or about my key folks that I really want to incentivize because they're going to be running this company after I leave? We will layer in on top of the ESOP participation, a phantom equity plan so that you can get more equity in the hands of your key employees.

Mike: Hmm. I like that. That's a good way to do it. I assume based on the way you phrased some of this, I don't think everybody understands the preferred buyers and things like that and. I've seen the preferred buyer transactions. I actually saw Microsoft make many of those back in the day. They were like, Hey, I know this company's only worth a hundred million, but we're going to pay 250 because we want the market to add more value to this product that we're buying.

I saw things like that happen a lot in the early [00:18:00] 2000’s and I think it kind of spoiled some tech people to think, well, I can get a 10 or a 20 multiple on my company. And it's like, it doesn't happen as much now, at least in our current financial situation in 2023, as it did back then.

And so I can see how a couple of things: One, if you're not positioned for a preferred type of buyer, and number two, if you're not really positioned for a buyer. There are a lot of companies that I see. That are really attractive to the owner and to that C-suite, maybe even the employees, but they're not attractive or at least not that attractive to outside buyers. Because they're like, ah, I don't necessarily like your industry or something about the business model. You know, maybe it's selling to the government, whatever it may be. And so, if it's not an attractive type of business, this is a great way to actually exit the business without having to worry about that.

That's the other thing that I've seen. We've done a lot of M & A stuff over the last few months [00:19:00] with clients that are trying to buy companies or trying to sell their company, and it's been a nightmare for them. It's kind of like buying a house a little bit where they think they've got a buyer. And as they're going through the due diligence, there's nothing wrong with the company, but the buyer says, I'm just not comfortable, not a good fit with these three things. Yeah, it's not a good fit. It's not a bad company, it's just not a good fit for me. So then they go right back on the auction block, you know, and they take five years to sell their company.

Meanwhile, they've checked out mentally before they even put it on the market, right? And so it's not a good thing for the company. So this six months is a relatively quick way to exit your company if you're thinking, Hey, I'm done with this and you meet the criteria. Which, I guess that might be a really good question as we start to kind of round up here is, what are the base criteria for being able to do this?

David: I think it's that level of EBITDA. Beyond that, if you came to us and you were an owner of a company, but you know [00:20:00] that if you left your company's earnings would fall off a cliff, an ESOP's not a good fit for you. The trustee is buying the company on behalf of the employees knowing that there is an ongoing benefit to the employees based on the projected cash flows.

So if you're going to sell to an ESOP: One, you can certainly retire on day one if that's your goal. But you need to have a management team in place that can continue to run the business or folks that you are grooming to be that next C-suite at the company so that the company can continue to be a company.

I think those are really the only requirements. You can tailor the transaction to meet all sorts of objectives, but the biggest thing is really making sure that if your goal is to leave or if you have a five-year time horizon, you want to be grooming that next level of management.

I'm happy you brought up the third party offers because we certainly have clients come to us that are already out to market. And what we'll do is we will analyze. A lot of us are sort of tax nerds on our [00:21:00] end, and we like to analyze the after-tax cash flow to the shareholder and to the company, not only for an ESOP transaction, but compared it against other third party offers.

Now sometimes, like you said, folks do receive anywhere from a 15 to 20 times multiple for your company. Even though you cannot pay taxes with an ESOP, I would still say take the money and run. Right? An ESOP can't do that.

Mike: Yeah. that's great. One of the questions you answered earlier was about can you sell eventually to a third party? Thanks for answering that one earlier. Because I've seen that happen. In fact, there was a, I think it was CHI Overhead Doors in Illinois, which was not far from where we used to live. That was a big public transaction where they sold for a couple of billion dollars and they were in ESOP.

And so, I assume, because I've been through sales before, I assume when an ESOP sells to a third party like that, that everybody becomes vested immediately and they get checks. Is that typically how that works when a third party swoops in and buys the ESOP?

David: Yes, that's correct. Let's say you sold 30% [00:22:00] of your company to an ESOP, and then down the line somebody offers you a hundred million dollars for your company. Well, the ESOP will get 30 million, you'll receive 70 million for the other 70% you didn't sell. All of the employees will split based on their proportion of participation in the ESOP, those $30 million, and it's a very significant benefit for them.

In the GovCon space, ESOPS also provide unique benefits that companies and other industries don't benefit from. One of the major ones has to do with ability to get refunded by the government for certain costs that actually have to do with the ESOP. Now, in order to allocate stock within an ESOP, the company makes a non-cash contribution to the ESOP plan. I say non-cash because it flows through your financial statements, just like depreciation does. You're not actually spending money, but it triggers a tax deduction at the corporate income level. That tax deduction, that item that's flowing through your income [00:23:00] statement can be used as a portion of your qualifying cost on a contract.

There's different requirements, but sometimes that non-cash expense can be a part of what you're actually refunded by the government. Which also, one: enhances your cash flows because you're netting more money from that contract. And two: may give you a bidding advantage because you know that your costs will be a little bit less than a non-ESOP owned government contractor. That's a key benefit I just wanted to point out.

Mike: Yeah, that's a big one. Is there anything we missed today on this? I know this is a really big topic, but at a high level, is there anything we missed that we need to cover on the way out here?

David: No, I think we hit all the big ticket items.

Mike: Good. This is a lot of education in about 25 minutes on ESOPs. It does become a very viable strategy. Like you said, I can see companies that are only 10, 20 employees, but they are hitting that 3 million mark EBITDA. Like you were saying, this is a viable strategy for them, I would think.

The only thing, and [00:24:00] this might be my last question, is: in the government space, in addition to your core team, a lot of times you use contracted positions where somebody is an employee, but they're on a contract and they're only going to be on it for 12, 24, 36 months. You may have some option years, but if you lose the contract, they're gone unless you can find another place for them. Do those employees still get to participate in something like this, or do they get to participate until they're let go? How does the ESOP handle that situation?

David: As long as you are a W-2 employee, you are in the ESOP plan. Okay? Now, if because of a contract that ends after a year, you're no longer an employee, you'll have whatever shares you may be vested in, in that one year, but otherwise you wouldn't be in the plan.

Mike: That's what I thought. I just wanted to make sure that they still participated even though they're contract employees that way.

A lot of great information. As always, all your contact information will be on the website for folks.

[00:25:00] Thank you so much David, for coming on and talking about this. I would encourage anybody if, you're trying to figure out an exit plan and you don't know if this is a good fit: reach out to David and his team. Let them have a conversation with you and see if this is a good way to go.

Thank you again. I really appreciate you coming on and talking about this.

Narrator: I really hope you enjoyed the podcast today. If you did, I would really appreciate it if you would like and subscribe to the podcast and screenshot it and tag me on LinkedIn or whatever social media you use. So thank you again for joining us today, and we'll see you next time.