2020-10

Strategic Considerations of a Contributory ESOP

 
Chris Staloch and Joe Skorczewski of Chartwell visit the Engineering Influence podcast to discuss how to use an ESOP to drive company performance. 
 
Host:
Welcome to the ACC engineering influence podcast brought to you by the ACEC Life/Health Trust. Today, I am joined by Chris Staloch and Joe Skorczewski from the Chartwell Financial Advisory. Chris is a managing director with Chartwell and has been with the firm for over 23 years. He has spent the past 12 years leading Chartwell's architecture and engineering practice. Joe is a director at Chartwell and has been working with Chris in the practice for most of his 15 years at the firm. We've invited Joe and Chris to speak with us today about some of the emerging trends with regard to ownership and compensation in A/E firms.
Host:
To start, what is the state of the current market? What are engineering firms looking for?
Staloch:
After some initial panic, when COVID first broke out, we actually saw a pretty quick return to what we would call normalcy. We actually managed to close a couple of transactions back in April, much to our initial surprise. We're seeing companies come to us looking for not only traditional third party sales transactions, but also new ESOP formations and a fair amount of just consulting around helping them think through their ownership, advisory issues. We see a number of companies that are currently struggling with how do they infuse enough capital into their organizations as companies transition out some of their previous ownership.
Host:
Are there any specific issues that you see as commonplace in the projects that you're working on?
Staloch:
One of the things that has become a recurring theme for us is that the companies that are privately held have this constant issue of having to transition the ownership of the business. And that's true whether the company is formed as an ESOP or whether they just have broad-based ownership in their organizations. And so what is happening right now is given the demographics of society. we're having a lot of people who are retiring from companies and the amount of capital that is available to come back into the organization through investments by other employees to replace those shareholders who are leaving is oftentimes not significant enough to make it worthwhile and to actually effect those transactions in a manner that you would hope to see on a recurring and regular basis.
Skorczewski:
I have a story to add. There's a client of ours who recently came to us. They do a fun Friday--this was pre-pandemic--morning trivia question. Everybody goes to the chalkboard and answers a question. And the question was if you won a million dollars, what would you do with it? And the answers were: A, I would go buy a boat; B, I would put it in savings; or C, I would pay off my student loans or other debts. And 80% of the firm answered C. The owner of the firm came to me and he said, "Joe, who am I going to sell my company to? My employees do not have the personal balance sheets to buy me out. So what should I do?"
Staloch:
That really speaks to the significant shift in the way the ownership has transitioned in businesses today. We've heard stories from our clients and older folks in these firms, who've talked about how they came to their ownership in the business. And they went out and got a second mortgage on their house and did things of that nature to be able to buy into an organization. Today we're not seeing people having the willingness to do that. Or in many cases, really even having the capability of doing that because of the amount of student debt that they're saddled with when they're coming out of school. For a lot of people, it might take them 10 years to pay off that student debt. They don't have the financial resources available to them to actually invest in these firms. So that presents a quandary for firms.
Host:
What are some of the considerations that companies should take when they're thinking about compensation and ownership questions then?
Staloch:
One of the things that we have seen is companies really trying to understand how they align their compensation programs with what they're trying to accomplish from an ownership perspective. Too many times, there's a disconnect between those things. Oftentimes they're thought about in a sort of vacuum. You have a firm that puts together this great compensation program, but it doesn't necessarily get them to where they need to be from an ownership perspective. And by that, I mean, oftentimes you'll see companies utilize stock as part of their compensation programs, either in the form of a long-term incentive program or as part of their annual bonus structure. But if there are not enough dollars or stock being utilized in those programs to actually effect the transitions of the older folks in the organization, that's not going to really work from a sustainable ownership perspective, if indeed the goal is to maintain the ownership of that company as a privately held organization inside the existing construct.
Host:
So what are some of the tools that firms can use to address these issues?
Staloch:
There's a variety of things out there. Oftentimes we see people think about programs such as stock appreciation rights, utilizing stock options, or Phantom stock. Things of those natures that generally are some sort of what we call synthetic equity. So they're equity-like instruments, but they're not actual equity in the organization. And so people will use those as part of their compensation programs, usually in the form of some sort of long-term incentive program. The other component that we often see companies look at is just going to stock bonuses or setting up programs where a portion of the cash bonus that the company is providing to their employees is expected to be utilized as part of the repurchase, or I should say, the purchase of stock in the organization.
Staloch:
There's an interesting psychological element that we hear people talk about, and management teams have different philosophies on this front. Sometimes they'll utilize stock bonuses as part of the program and they feel like they're, quote-unquote, giving stock to their employees. But if they cut them a check for their bonus, and then the employees need to make a decision to actually turn around and write a check back to the company, to buy stock in the organization, that there's a different sort of mentality behind that for the employees. There's more of a feeling of having skin in the game in that regard. So, so that's something that we see frequently as well.
Skorczewski:
One unique tool that we've seen come back to life is deferred compensation. And again, I'll walk through a particular story. As has been well-documented, the talent war in this industry is real. And further, there's a specific gap of these 10-to-15 year folks, project managers, future leaders of the firms. There's a shortage of them actually dating back to the recession of 2008. Many owners of firms don't want to reach down too far to provide ownership to a 30-year-old, for example, but they really want to retain that individual. But that individual is in high demand, and they don't want to lose them. What we've seen happen in that case is there's can be some sort of deferred compensation plan put into place where you might award that individual, a series of bonuses, $10,000, $20,000, whatever the number is that vest over a period of years, say three or five years. The presumption is that at the end of three or five years, that person would then be in a better position. And like Chris said that award would vest, that person would get paid, and that person would turn around and purchase stock in the company. So it's a way to extend a little bit deeper down into the organization, which can be useful depending on the demographics of your specific firm.
Staloch:
Two other elements of this to add to the discussion. One of the other tools that we've seen companies utilize is their 401K. What they'll do in some instances is create a stock fund inside the 401K of their own company stock that they allow their employees to invest in, or utilize stock in the company as part of their matching contribution to the employees' dollars to get more shares into circulation in the organization. Frequently we're seeing companies look at that as a creative solution. And then the other element that is becoming more common is a contributory ESOP? The idea behind that is that would use the stock of the corporation to make contributions into a retirement plan for the employees. It works very similar to what I mentioned on the 401k front, but it's really in the form of an ESOP and gives the company certain tax benefits that you do not necessarily have with other forms of compensation that are provided to employees.
Host:
ESOPs are usually thought of within the context of transitioning ownership in a company. Can you explain the difference between a traditional ESOP and a Contributory ESOP
Skorczewski:
An example of a traditional ESOP that most have come to learn and know in the industry space is the ESOP can be any percentage of the company, but traditionally, some pretty big milestones are 30 percent ESOP, 51 percent ESOP, and 100 percent ESOP. I'll walk through an example that's been very prevalent in the industry. You have a company that's a C Corp, let's call it a $30 million company. You might have four or five shareholders getting to retirement age and they might own about 30 percent of the shares. In that situation, the company would set up an ESOP. Next, the company would go to a bank, get a loan for $10 million, which is about 30% of the overall value. Then the company would loan that $10 million to the ESOP and the ESOP would go ahead and purchase those shares directly from the departing shareholders. There is, in that situation, an internal loan that's created between the company and the ESOP, and those shares are essentially collateralized and then released over a period of time, let's say 10 or 20 years. That would be the traditional ESOP, a leveraged transaction, which is a significant event in a company's history.
Skorczewski:
Now let's compare that to a contributory ESOP. What occurs in that situation is the company goes and sets up an ESOP, but rather than entering into a transaction, the company simply issues newly issued shares, let's say 3 percent of qualified payroll, and deposits those shares into the ESOP. Over 10 years, uh, you might get to the same spot, where the ESOP would own 3 percent in year one, 6 percent in year two, 9 percent in year three, etc. Over that period, all of those shares are allocated and you essentially arrive at a similar spot. You just get there in a different way.
Staloch:
And I'll just add to that, that one of the reasons that companies tend to think about utilizing a contributory ESOP, as opposed to a traditional ESOP structure, is that in the concept that Joe just described, you are reducing the fiduciary exposure significantly for the trustee overseeing the plan. Because now the trustee is not necessarily making a decision to purchase stock in the company. They're just accepting a contribution of shares into the plan each year. And so the amount of risk that's associated with that type of a model is substantially less than what it would be under a traditional ESOP construct.
Host:
Are there other benefits or reasons why owners and sellers would choose to go with a contributory ESOP versus a traditional ESOP?
Staloch:
Some companies, particularly as we sit here today, are looking for ways to incentivize the employees to go above and beyond and really drive growth in the organization. A contributory ESOP is a way to provide ownership to the employees and start to build that kind of ownership culture without providing direct ownership in the business, which carries its own complexities that go along with that.
Skorczewski:
In addition, as you compare those two examples. In the contributory ESOP, there's a small amount of capital that's invested in the company, but it's not a $10 million transaction. It's a small contribution of shares. So it doesn't impact the balance sheet in a way that a traditional leveraged transaction would. We've seen it work really well with very long runways, meaning folks that are maybe 50 or in their lower fifties who might have 15 years to retirement. They might feel it is just too early for them to sell. Maybe the next 10 years are going to be really good and they may not want to exit or liquidate their holdings so soon. In a contributory ESOP model, the percent ownership changes slowly over time. So you're not timing the market, so to speak, with a particular transaction on a particular date. It's more of a thought-out interval, a process over 10 years. So if you have good years in front of you, or particularly in the environment that we're in today, if the value is low, you might not want to sell today. But a contributory ESOP would put a market in place, communicate to the employees and the company where we're trying to take this entity over time, and provide clarity to all the stakeholders in the firm.
Host:
Finally, what are some of the challenges of utilizing an ESOP in this manner?
Skorczewski:
On the flip side, if we're dipping our toe into the water, we're creating a lot of flexibility for our departing shareholders, but it takes some time to create meaningful balances into folks' retirement accounts. It will not be an overnight success, and communicating to your employees that they own the company while contributing $575 to their retirement account that they're going to have access to in 40 years isn't a big bang out of the gate. But that's okay. It takes time. And that's not the intent. Over the course of a generation, over the course of a decade, you will start to accumulate shares in your account. The value of that will grow. And over time as you communicate that it will work, it can work very well. But the small dollar amounts right out of the gate are sometimes contradictory to someone feeling like they're an employee-owner.
Skorczewski:
In addition, a lot of folks would rather have a dollar in their pocket today than a dollar in their retirement accounts. So knowing and communicating around that would be important. And, and there are some explicit costs of trustees and valuation firms and third party administration. So, just from a dollars-and-cents perspective, you'd want to make sure that you are committed to going down this path. Otherwise, if you do this for a few years and then revert to something else, you'd have spent some fees that could have been gone elsewhere.
Host:
Great. Well, that's, it's been an illuminating discussion into contributory ESOPs. I appreciate you taking the time.
 

Looking into the Future of the Office Market

Carl Shilling, a principal at Stantec, joins the Engineering Influence podcast, to share his thoughts on the current state of the office market sector and how it may change going forward.
 
Host:
Welcome to the Engineering Influence podcast sponsored by the ACC Life/ Health Trust. One of the biggest business impacts of the COVID-19 pandemic has been the transition to working at home for many professional and office workers. In many downtowns and suburbs, offices are dark and empty. Not surprisingly. This situation has raised questions about the concept of the office. Many pundits have speculated that our traditional views on the office must change and that remote work will play an increasingly large role, maybe even a major role in the future. Others promote the benefits of the office, collaboration, teamwork, efficiency, and argue that once the pandemic has abated, we will return to the office. This is an important discussion for the engineering industry and for firms that work in the office space. To discuss these issues and more, we're here with Carl Shilling, a Stantec. He has a principal based in the firm's Butler, Pennsylvania office, and has more than two decades of experience focusing on the sustainability of the built environment. Carl, welcome.
Shilling:
Thanks for having me. I appreciate it.
Host:
So in the initial days and weeks of the pandemic, many companies shut down their offices, and employees began working virtually. Assuming that we eventually have a vaccine for the virus,. do you expect the virtual work environment to perpetuate, will we return to the old normal, or will we find something in between?
Shilling:
We, like many companies, vacated our offices and performed our business remotely. And I will admit, I did not expect it to work as well as it has. The technology has come through. We've been very successful in conducting our business virtually through, like the interview today, Zoom meetings, Team meetings, and others. They have worked very well, but as you're asking, as we're thinking ourselves: What do the next couple months mean? What does the next year mean? How are we going to conduct business in the future? Beyond our personal experience, we have also polled a lot of our clients--over 130 of them actually--to get their perception on what they think is going to happen in the future, so that we can position ourselves to design appropriate space. What we found is that although it's been successful, we're missing the human component. So we're hoping that beyond today, tomorrow that there's still going to be some interaction within the office, whether that's two days a week, three days a week. But people have learned that they can be effective from home, so what we used to be considered a luxury--being able to work from home--is now going to be considered the norm. So I think there's going to be an expectation that we still need the office space where we can go in and collaborate and understand our partners, their in-person reactions to real-life situations, but we also understand that we can be effective from home. And there are some advantages to being home with our spouses or wives or children and conducting business from there. So what we're expecting is that, yes, there's still going to be a demand for office space, but that workers probably won't be coming back five days a week 40 hours like they did prior to the coronavirus situation.
Host:
So, as an office designer, as an engineer, what does that mean in office design? Is this going to change it?
Shilling:
It will. One of the questions that's paramount is do you need the same amount of square footage or space to conduct business that you did prior to entering the pandemic? And what we're coming back with is that the dedicated office space that people are used to having, your cubicle, wherever you do your work, is probably going to change because typically it does not provide the right amount of separation or distancing from coworkers. But if we go into design and expect to be able to provide that, maybe the same amount of square footage works, but we have to reconfigure it so that it still promotes interaction between coworkers. We may need to spread out so fewer people are going to be in the office at any given time. Or it's going to take a larger square footage to accomplish the same thing.
Host:
In your conversations with your clients, what are their concerns?
Shilling:
It's kind of the same thing. How do I get my people into the office safely? How do they interact safely while they're there? We've all been out shopping in the meantime during the pandemic and you see one-way aisles. You see limitations of where we can't all go in at the same time. I think that's what we're going to see. You may go into the office, but you have to enter at multiple points so there isn't a large grouping of people at any one location. When you get into the office, there might be direction, it's probably not going to be arrows on the floor, but there's probably going to be within the design, elements to encourage people to not all go the same way or congregate in the same place.
Shilling:
You're probably going to see people spread out a little more than what you see in today's office, but there are still going to be spaces where you can interact with each other and do your work, There's probably also going to be additional technology within those spaces so that your coworkers and staff that aren't in the office at the time can log in or dial and be a part of the team, whether they're there personally or not.
Host:
You mentioned retail as one area that you can take some lessons from. This is a unique situation. So where have you looked for guidance to make design decisions on health and safety concerns?
Shilling:
I mentioned that we do multiple types of buildings and one of them is health care and doing that kind of design has given us a lot of direction on whether the virus is transmitted through the air or is it mainly a contact risk.
Shilling:
Those kinds of things really go across building types. It's not necessarily just indicative of the office environment. And so the first thing, the biggest risk, is proximity to your coworkers. Now we've heard about six- feet distancing. But given the particle size that you put off wearing a mask, does the mask stop it? As the particles dry, do they float longer than a couple of hours? So we're thinking about these issues between workers. We're thinking about how it is distributed by the air handling systems. There' are many aspects as to how do we keep people safe,
Host:
Focusing on HVAC, what changes do you expect to see in HVAC going forward?
Shilling:
The first thing is ventilation. There are three main bullet points and the first one is ventilation. The minimum that we have to think about is, do the systems within the building provide the minimum ventilation rates required by current code, whether that's the International Mechanical Code, whether that's ASHRAE 62, but a lot of office spaces, for energy efficiency reasons have reduced the amount of outside air, have chosen not to do it when they're not there in off-hours, but I think there's a general understanding out there now that we need to continually ventilate the spaces we're in. The benefit to the personnel outweighs the energy demand on the building.
Shilling:
Number two is filtration. Typical filtration for office environments is like a MERV-6 six, 25-30 percent. I think there's an understanding out there that can the particle sizes that we're dealing with be captured by a filter? It can. We're all wearing masks, right? So masks aren't really a very high particulate filter, but the virus lives in things that are larger, like water drops or things like that. The same thing applies to HVAC systems where if we put higher efficiency filters in, there is a benefit to the office environment. The parallel argument with that is I'm going to need more horsepower and fans to push the air through the higher efficiency filters. So there is an efficiency offset with putting in higher efficiency filters. I'm going to use more energy to do that.
Shilling:
Lastly, there are lots of products coming to market that we all trust, that we've been using, that have a benefit with combatting the virus, whether it is additional filtration, HEPA filtration, whether it's UV lighting, whether it's a technology like bipolar ionization. These are all things we need to have in our toolkit and our approach to making spaces safer that we can employ to respond to the demand that's out there.
Host:
In many office buildings, one choke point would be the elevator because you have to get people up upstairs and the elevator is by its nature, a confined space. What do you see happening with elevators?
Shilling:
I've seen a raft of things coming to light. And again, it's are you dealing with an existing situation or are you dealing with a new design? The most creative thing that I've heard reported to me, and it was experienced by one of our own employees visiting a client site was they entered an elevator. And it was an existing elevator. It was a small facility. The owner had attached a sponge to the wall and put a bunch of toothpicks in the sponge. And whenever you entered the elevator, you were to pick a toothpick and use that to push the button.
Shilling:
That was a very low dollar, very innovative solution to be as safe as they could with what they had. On the other end of the spectrum is we're designing new elevators. There are all kinds of new control technologies out there where instead of going to the elevator lobby and entering an elevator and pushing a conventional button, before you even get to the lobby, there's a panel where you can enter where you want to go. That panel then looks at where are the elevators in the building are, directs you to a specific one, and controls how many participants are in that elevator. That particular car delivers you to the floor without ever having to touch anything within the elevator itself. So there is a lot of technology coming out to address that situation. But we have a whole lot of existing elevators that we're going to have to be creative with. What are we going to do for those specific cases?
Host:
The economic forecasts for the office market are pretty bleak right now. What opportunities does Stantec see?
Shilling:
Again, communicating with our clients, there's a lot of waiting to see what happens. I will say that when I left the office back at the beginning of the year, I never expected that we would be gone this long. It has perpetuated far longer than I ever expected.
Shilling:
I think everybody's in a holding pattern to see where this is going. Is there going to be an additional infection rate here in the fall? As the weather gets colder and the humidity level drops, are we all going to be more susceptible to the virus? I think it's going to be another six months of what we're seeing, but I really think that there is a real desire for offices to open back up and for people to at least get back into the office in some way so that we can continue what we're doing. We're surviving just fine, but we are not thriving. We need to do additional things that we're not doing now, such as getting new people into the workforce. That isn't possible remotely like we're doing.
Host:
From an engineering perspective, is it going to more retrofit and renovation work in the office market in the short to mid-term?
Shilling:
I do. Yes. We're going to have to take a look at the existing systems. We're going to assess them. Are they bringing in any outside air or the right amount of outside air? We're going to look at whether all areas of the office have air distribution. Are there any dead spots?. I think we're going to look at whether existing air handling units can support additional filtration beyond where they're at right now. And then I think we're going to be looking at, can we apply things like UV lighting to sterilize the airflow? Can we employ things like bipolar ionization within the airstream to sterilize the airstream? Ionized hydrogen peroxide has onto the market that can be independent of the air handling system. There are devices that we can just hang on the wall to deliver these ions to the space, to clean the surfaces, to sterilize the air. There are many, many things out there that I think we can apply without spending a lot of money to make the space safer on a broader scale.
Host:
There's been a lot of talk that one of the impacts of the pandemic will be that the downtown business districts will shrink and the offices will move to the suburbs where there's less density. What is Stantec's view on that?
Shilling:
We're not seeing that. We're seeing that companies are still going to make the decision on where they want to locate their offices based upon serving their clients and where it makes the most sense for their office to be. I think what you're going to see is the opportunity for employees to choose whether to go into the office more or less independent of where the office happens to be located.
Shilling:
We are not seeing companies changing their business approach. Some of them are hub and spoke where the hub is within the city and the spokes are into the suburbs. Some, some companies choose to do work in the suburbs. That's where their clients are and where they interact. I don't think the specific office location is necessarily going to change. I think it's going to be focused on the ability to give their workforce the opportunity to say, "I'm going to be there all the time," or "I'm not going to be there all the time." And part of that is attracting new talent. The new generation of employees is going to demand the flexibility to say, "I'm going to work from home" or "I'm going to come into the office." And I think that's where companies will find success, in not necessarily changing the office location, but changing what they're asking their employees to do.
Host:
Great. That gives us some good insight into the office market. I appreciate your taking the time to speak with us.
Shilling:
I appreciate it. Thank you for having me.
 

A Preview of the Fall 2020 Private Industry Brief

 
 
ACEC's Erin McLaughlin joined the podcast to discuss the newly released Fall 2020 special Private Industry Brief, which can be read here.  Erin will be presenting a detailed analysis of the brief during the upcoming 2020 ACEC Fall Conference later this month.  More information and registration details for the event can be found here.