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.