#325: How ESOPs Work: Myth Busting, 1042 Tax Deferrals, Warrants, Executive Comp Plans and More with Keith Apton and Miguel Paredes

Ep.#11 [THEME FIVE]

As 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.

In part one of this episode, Keith Apton, the managing director of UBS’s ESOP Capital Group, talks about some false narratives with ESOPs, such as, “If I sell to an ESOP, I won’t get as much cash for my business.” He then talks about the 1042 tax code and discusses how converting the business from an S Corp to a C Corp could defer the gains at the time of the transaction and potentially indefinitely through estate planning. Keith tees up the topic of warrants and how they act as a form of rolled equity that can be as lucrative as the rolled equity in a private equity sale–except in an ESOP sale, the owner still has control over the direction of the company. Keith finishes this segment of the episode by sharing a story of what he thinks would change if S Corps had the same tax benefits as C Corps.

In part two of this episode, Miguel Paredes, president of Prudent Fiduciary Services, is a trustee and shares stories about how a trustee keeps the employees’ best interests in mind without screwing over the seller, and even more so, being a partner that can help everyone get what they want out of the business during the transaction, and most importantly, in the future.

Miguel goes deep into the mechanics of how warrants and SARs (stock appreciation rights) plans can be used to reward key executives with additional future equity based on the value they help create. He explains how exponential growth can happen when warrants for the seller are combined with SAR plans of the key executives and aligned with all the employees' incentives to grow the equity value of the company for their ESOP account.

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What You Will Learn

Part 1:

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:

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.

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Bio:

Keith Apton:

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.

Keith has been a member of UBS’s Pinnacle Council since 2018, which consists of the top 2 percent of advisors nationally at UBS. As an active member in the ESOP community, Keith's total participation in ESOP transactions has exceeded $3.5 billion in transaction value across various sectors and industries. Additionally, Keith frequently speaks at national conferences on topics including ESOPs, §1042 rollovers and business succession planning.

Miguel Paredes:

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.

Prior to establishing Prudent Fiduciary Services, Mr. Paredes had a distinguished 12-year career as an employee benefit plan investigator and supervisor with the U.S. Department of Labor, Employee Benefits Security Administration (EBSA). During his time with EBSA, Mr. Paredes conducted and supervised several hundred investigations of ERISA-covered retirement plans, health and welfare plans, and plan service providers, with a focus on Employee Stock Ownership Plans and other investigations involving complex financial issues.

Steve Storkan:

As executive director of the Employee Ownership Expansion Network (EOeX) (www.eoex.org), it is Steve’s job to implement the mission of the EOeX of significantly expanding employee ownership through establishing and supporting independent non-profit State Centers for Employee Ownership. It is the goal of the EOX to have 70 percent of the U.S. population living in a state that has a state center by 2025, which they hope will create one million or more new employee owners.

Interview Quotes:

10:16 - “But complexity should not be a reason not to do a transaction because complexity just means it’s something new.” - Keith

11:14 - “If the client can repeat back everything that you’ve just explained to them, then you’ve done your job. That means they fully understand it.” - Keith

14:45 - “[With an ESOP] the myth is that the transactional costs are greater than an outright sale. You have more professionals involved. But, looking at it side-by-side, it’s going to be equal to, if not lower.” - Keith

17:43 - “Is the ESOP going to net the client more cash in the pocket than an outright sale?” - Keith

23:57 - “You have to have fire in the belly to want to continue to work, to protect the profits because if the company doesn’t remain profitable, all the excel work that we do and the financial modeling of that waterfall, it means nothing because you’re never going to get the back-end of the money.” - Keith

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

54:00 - “A trustee should not be involved in the strategic decisions.” - Miguel

01:05:32 - “The value that the seller gets is the difference between the initial strike price and the growth of that equity value in the company over time, and the payout at the end of that warrant term for the difference between that initial strike price and the equity value of the strike price at maturity.” - Miguel