Transcript | PULSE Episode 05
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Adam:
I'm Adam Smith, founder of Wisdom Board. And I'm pleased to host this episode of the Pulse podcast series, a collection of inspiring personal conversations with founders, CEOs, entrepreneurs, and board experts. Wisdom Board is a fast growing digital leadership platform offering curated, valuable content that incorporates services, deep knowledge resources and an expensive network of private company management. Wisdom Board was founded in summer of 2020 is dedicated to enabling board directors and their members and stakeholders to enhance forward success.
Adam:
Today we are joined by James Steiker, the founder of SES ESOP strategies, and it's really a pleasure to have him on the show today. James, welcome to the Wisdom Board Pulse Podcast.
James:
Thanks, happy to be here.
Adam:
You've been quite busy over the years being one of the foremost experts in advising private owners and business leaders in their small midsize companies to consider and execute esop Strategies. Just for our listeners, if you could share a little bit on the original genesis and definition of the ESOP, that would be great.
James:
Sure. ESOPs are actually a creature dating back really to the 1950s, if you will, where a fairly creative investment banker figured out that average working people could acquire companies by using retirement plan assets. So he constructed a rather Jerry rigged approach to do this that worked and got approvals - fellow by the name of Louis Kelso. And he was a very enthusiastic advocate believing that ESOPs were the way to save the American economy from destruction by capitalists and even takeover by communists. So he wrote a book at one point, How To Turn A Hundred Million Americans Into Capitalists advocating the ESOP idea.
James:
And it would have been a footnote except that he was contacted or met on an airplane as the legend goes, Senator Russell Long from Louisiana, head of the Senate tax committee, son of the notable populist Sealy Long who was noted for saying share the wealth in the '30's. And Russell Long being a good Southern populist, but not believing in confiscating wealth from others, thought what ESOPs were a terrific non-confiscatory way to broaden economic ownership and became an enthusiastic advocate.
James:
And when Congress implemented the rather extensive retirement plan law called the RISA, which was really the first major regulation of retirement plans, Senator Long advocated and made sure in his role as committee chair, that ESOPs included as a legitimate structure. And then we had about a 12 year period of tax bills being passed every year or two and as head of the Senate tax committee, he buried a good tax break for ESOPs in virtually every bill.
James:
So by the time I arrived on the scene in the mid '80s, beginning my career, ESOPs had become a somewhat tax-favored strategy for owners of closely held companies to sell their companies internally rather than externally.
Adam:
That's fascinating for those that are students and passionate about the private equity space and considering the legends in the space. Kelso's a name of that's very well known and respected given his founding of the Kelso and Company in 1971. And it's interesting to look at his background as well because he was a part-time economist when he was at the Navy and he wrote a whole manifesto on new capitalism and the fallacy of full employment. And then only later when he found another economist buddy named Mark [Corner Adler 00:04:12] he began to actually produce paperwork and then incorporated that into Kelso and Company when they did their first ESOP of a newspaper chain.
James:
Yep. Back in about 1955 or so. And yeah, he was very interesting. I had the pleasure of seeing him speak very late in life and some of the more prominent folks doing ESOPs in the early days came out of Kelso and Company. Of course, the reference to him as a part-time economist when said either with appreciation or critique, depending on one's point of view. because he was considered fairly far out of the mainstream.
James:
But one of the things he said back then that's certainly relevant now is that for all of the things that Marx was wrong about in the 19th century, he was right fundamentally that money was going to find capital more readily than labor. And that capital would become more valuable and labor would become less valuable. And we would have de-stabilizing income inequality as a result.
James:
And of course in the 1950s that didn't look all together obvious. Now it looks a little bit more interesting as an insight. And of course, his approach was how do we deal with this without throwing out the baby with the bathwater and how do we have an economic system that has more broad-based ownership and participation?
Adam:
Don't get me started with my name being Smith, because not only do I have to keep up with what you're saying, but I think we're all, unfortunately, trying to write the next chapter of what the invisible hand in laissez-faire economics works in an open economy.
Adam:
Actually, Kelso was struggling with the name of his book called The Capitalist Manifesto. It says here that they were struggling to come up with a better term than universal capitalism. And then later came up with the name called binary economics, which I don't even frankly know what that means. But I know that today everybody wants to be on the better side of the track in terms of bringing our society towards a more balanced capitalism and stakeholder capitalism. I like to differentiate conscious capitalism from stakeholder capitalism.
Adam:
But maybe walk us through a couple of more stories or case studies of an ESOP where you brought some of these capital restructurings to the solution of a family-held business or a family office-held business and how'd that work for them.
James:
Well, I think there's a whole bunch of examples out there of companies. And one of the ones here in the Philly area where it's got a fairly prominent evangelical supporter of employee ownership is New Age Industries, which has nothing to do with new age. It happened to pick that name up well before the era of gems and crystals because they make flexible, basically highly sanitary tubing for the pharmaceutical and food industries.
James:
And Ken Baker is the son of the founder. And Ken, I think decided early on that he wanted an alternative to selling his company out to the highest bidder. Be it strategic or be private equity. If you want to hear a critique of private equity in mildly profane terms all you have to do is poke him a little bit and you will hear it. He started the ESOP road back 15 years ago and sold essentially 30% of his company to the ESOP and sold 20% 6 years later for twice as much as he got for the 30% and sold the remainder a couple of years ago for some multiple of the share price of the second transaction.
James:
He attributes a lot of the success to the fact that he got people involved and they have a culture and a belief about being an employee-owned company. He will point out readily there is a bust of his father in the lobby. And as he says, if we had sold it to somebody else, the jobs might be in China, that bust would be in the trash. So he takes great pride in having preserved the opportunity and the wealth creation.
James:
And he's very quick to point out he did very well for himself in the process that he did not give away lots of what he and his family had achieved to do this. But now he sees lots of people benefiting. They've created 20 or 25 millionaires already at the company. If you were there at the beginning and you're retiring now, you've got a pretty good chance of having a seven-figure retirement.
Adam:
That's great. And given the empowerment of the ESOP to the broader employee base, what happens when there is knowledge and desire of the benefit of the ESOP but there is not enough leadership to actually go down that road? So who's making the decisions in the ESOP and how do you guide your clients at the board level or the management level, given our focus on governance and [inaudible 00:09:41] corporate governance let's say in terms of stakeholder capitalism? Of course, it's more quirky binary capitalism that Kelso came up with?
James:
You've caught me fresh on the topic because I am teaching a curriculum that's spurred on stakeholder capitalism. That is the fact the title, of course. What you see is in ESOP companies, there's a misnomer that suddenly we've become something more akin to a cooperative and we're going to assemble the troops and vote every time we want to buy a new piece of equipment or nobody's going to want to sweep the floor because they're owners and owners don't have to sweep the floor.
James:
And in reality, ESOP companies are in form traditionally managed. They have a board of directors, they have senior management. Obviously, if one is going to sell the company internally to an ESOP, it becomes really the onus of that founder to initially identify an appropriate board with the appropriate expertise, and also to make sure that there's good success or management if they're the active senior management of the company.
James:
What distinguishes successful ESOP companies is really not so much the governance structure, as much as the management behavior and employee participation that's involved. There's a lot of data out there, particularly the National Center For Employee Ownership has assembled a lot of this data, readily available on their website, which I will cheerfully plug, that tells us that companies that combine employee ownership with a high degree of participation and involvement of employees at the job site slash shop floor level meaning letting people have input over things they are directly around and have knowledge about basically results in companies that are significantly more successful, both measured by productivity and by profitability relative to their non-employee owned peers.
James:
So that's really the secret sauce. A lot of folks speculate on why this is. Again, the intuition of many owners is that, well, they now have a stake in the action and therefore they'll work a little harder or a little smarter because they're owners and that doesn't really seem to be in real life the mechanism. It's not clear that the ownership levels are high enough that one sees such a direct connection between personal wealth and behavior.
James:
What does seem to be interesting is that employees care much more about the behavior of their fellow employees. It creates a culture. If you imagine a traditional company, everybody's an individual free agent. They are not playing together on a team. It's a little bit more like a golf tournament where everybody is playing their own ball. And when you create an ESOP company, all of the sudden what other people do matters to your personal wealth.
James:
And so you see a lot more team-oriented behavior and also a lot more cultural weeding out of the weak or the unwilling folks. In other words, if I'm sitting in a desk and the guy or gal next to me is on ESPN or Facebook and social media all day, or watching porn or doing whatever it is that people do with computers when they don't work, in a non-employee owned company I mostly view that as management's problem. Why aren't they making these guys work better? And in an ESOP company it matters now with what the other folks are doing. I'm not going to be so willing to pull my weight if others aren't. And I feel like they're free riders on the creation of value in the company.
James:
So at the board level, you want people who are sensitized to this. And you need a board that gets that you have to do the traditional management and board functions of oversight and accountability, but you want to make sure your management team is taking advantage of the engagement and involvement of the owners.
Adam:
So let's say we have a hundred million dollar private company and a thousand employees and there's a couple of founders and a board of directors and they want to empower the organization and they don't want to involve a private equity partner, or they don't want to sell, or they don't want to leverage up just extensively with leverage. They want to really create an equity option plan to create a greater incentives, involvement by the next level of management. But there's only so much equity that you can issue to the C-suite or the top management.
Adam:
So the ESOP [inaudible 00:14:52] is a fascinating structure, because you can go through the whole organization and you can use your financing capabilities to accomplish that. So walk us through the actual transaction mechanisms for the ESOP. And then if you can also share with us down the road when the company is able to grow and double or triple in size, how does that the governing body of the organization think about monetizing that equity?
James:
Sure. Well first of all, obviously the challenge with management buyouts as opposed to ESOPs, as you alluded to, are twofold. One is chronically management doesn't have any money. Very few companies have paid their management well enough that management's in a position to offer cash.
James:
So management is going to have to borrow a boatload of money. And the problem with borrowing a boatload of money is you got to pay it back. And the problem with a management buyout is you've got to have earnings, you've then got to pay taxes, and then you've got to pay it back. And then it's taxable income. The whole thing has been taxable to the sellers. So we've made the government more than a 50% partner in our cashflow, when all is said and done.
James:
In an ESOP buyout, what we have going on is we are creating a trust. That's a retirement trust for the benefit of employees. We are using the credit of the company to borrow money and we're using that money to buy some or all of the ownership from the existing shareholders, perhaps with the selling shareholders providing some of the financing, depending on what kind of a transaction we're doing.
James:
What we know then, and what motivates us from the tax side is that when the debt has to be repaid back, the company can make tax deductible contributions to the ESOP that it can use to repay debt. So we have a tax deduction, functionally equivalent to the principle repayment of the loan, which is different from all of us who have mortgages or do management buyouts where we've got to use after tax dollars to repay principal.
James:
We also have a tax break for the selling shareholders potentially if we are become a C corporation where if they take what they get and invest it in stocks or bonds of any other domestic operating corporation they can indefinitely defer capital gains tax on the transaction. So we have about the only way to turn a dollar of corporate profit into a dollar of individual shareholder investment without paying the toll collector at either the corporate or the individual level.
James:
And finally, we have a wonderful tax break for S-corporation ESOPs where as we know if we're a shareholder in an S-corporation, we get this nasty document at the end of the year called a K one, telling us, well, our corporation didn't pay any taxes but we have to pay taxes on our share of the corporate income. Well, an ESOP is a tax exempt retirement plan trust. So unlike us, who weep a little bit gnash our teeth, the ESOP takes the K one and fundamentally throws it away because it doesn't pay any taxes on its share of corporate income. So if like Ken Baker's company, we have created a hundred percent ESOP owned S-corporation we have fundamentally created a tax free organization.
Adam:
Despite people's patriotism in our country, I think most people would prefer to pay less taxes. So that's something that they should follow up with. And I think as a side note, given, we have a couple of minutes left, is that those that are interested in learning more about the ESOP they can of course be in touch with Jim and his team at the company. But also their website has a section of ESOP news and knowledge.
Adam:
Also, I noticed that there is support of this concept by a range of characters, not just capitalists and financial types but there's Mark Cuban and there's others that are very much about empowering employees. And there's was also a gentleman at KKR who said a great job I think, Pete Stavros for a various amount of ESOP transactions. Maybe you can make a comment on some of the recent KKR activity or other large ESOPs going on. And maybe even that could be relevant to this SPAC structure as well.
James:
I think the first interesting point is that ESOPs have historically been hugely bipartisan with the strongest support, ironically, coming at each of the polls of the parties. Now there's the biggest supporter of ESOPs in the Senate, Bernie Sanders. Biggest supporters in the house, historically Dana Rohrabacher was the most notorious fellow. And he was pretty much at the other end of the world from Mr. Sanders.
James:
When we do trade association things, we get all sorts of interesting bi-partisan characters. One of the things you will know is if you go to some of those events you know that half of the time you will be holding your nose depending on what your beliefs happen to be about who's ever talking. Because you're going to be seeing people with strong views from each side of the political spectrum.
James:
And we are getting some more attention from what I call the sort of more conventional finance world. What the fellow at KKR is doing is wonderful. I'm part of a not-for-profit that's trying to do more creation of ESOPs by supporting state employee ownership centers that will provide more information. Because frankly, the biggest enemy of ESOPs out there is ignorance.
James:
I mean, when people ask me why doesn't everybody do this? These tax breaks sound great. It's good. It's all of that. Well, it's not a fit for every owner and every company. Or not even a fit for most owners in most companies, but it is a fit for a good number. But our biggest enemy is ignorance. ESOPs are complex, they are different. They have a different rhythm and style.
James:
The advisory community, unfortunately we are not as successful in being as well paid as the people who promote private equity and third party sales. So it's not surprising that the corporate finance community is more encouraging of sales to other people than sales internally to ESOPs. So we have a huge education barrier to overcome.
James:
What we're seeing is that over the medium term the internet has turned out to be a great thing for ESOPs. When I would go speak to a group 20 years ago in the pre everybody knowing how to use Google days, I'd have to start with what is an ESOP and describe what it was. And very often I might have somebody that'll walk out saying, "What do you mean? I can't own my employees?" They thought employee stock ownership was an ownership plan for them. And now of course, when I talk to people about ESOP's the ones who get to me have typically, already been all over the internet looking at varying pieces of information.
James:
So I think we're in a bit of a growth period. We have the so-called silver tsunami of baby boomers retiring and figuring out what to do with their companies. We're a good cultural fit for a lot of them. Not because of progressive politics per se, but because baby boomers are retiring in a very different style than the last few generations. It's much more of a evolution often from CEO to board chair, to board member and working at a reduced rate.
James:
And of course, most of the folks who are successful entrepreneurs are often quite allergic to the idea of working for other people. That's how they started their own company in the first place. I mean, the standard story is I needed a job and I didn't want to work for anybody else. And so for those folks selling internally where they can remain involved and preserve the legacy of the company ... That's not the only goal. Obviously, money matters and all sorts of other considerations come into play, but we're pretty good cultural fit for the baby boom generation. And that's why I think we're seeing a fair bit of growth.
Adam:
That's great. Well, you've been very in explaining to me and all of us that will be hearing this podcast over the future to learn more about the ESOP structure. Maybe they should come up with a revised branding campaign. Everybody gets equity or something like that.
Adam:
But going back to your initial reference to the heritage of this modern economic structure, if it was up to Kelso who I think is now passed, their original classical economic paper was called the First Fundamental Theorem Of Welfare Economics. I don't think that would have gone over very, very well.
Adam:
But it is interesting. I would say anyone who has a more wonky economic interest should look into the binary economics that he was pretty early on in that modified capitalism where there's more balance and more motivation and equity being distributed out in terms of to dividends like an LLC structure essentially to the employees.
Adam:
And lastly, I would reference that in terms of where you're going teaching about stakeholder capitalism and we're thinking about caring capitalism, conscious capitalism, and the Wisdom Board wanting to suggest and empower the boards of these private companies that could be doing ESOPs to think more broadly than just the profits. Because ultimately if the organization can empower their employees and redistribute and redirect their profits wisely into making a stronger company then the company can not only be worth more, but not also survive and sustain itself more robustly in the future.
Adam:
(Silence)
Adam:
That's great. Well, your colleagues in Waco and others are really enjoying working in this area and making the economic lives and the cultural hour and empowerment of the organizations more robust for your clients.
Adam:
Lastly, it's interesting that the number of those involved in ESOPs appears to be something quite large in terms of the percentage of workforce. I calculate something like 7% or 8% of the workforce is actually involved in ESOP at 11 million people. So when I think about that and back to the original definition of the corporation, thinking of the historical context of these definitions is originally defined as the body of the people in terms of the Latin definition of the corporation.
Adam:
So it's interesting to tie that back into your mission and congratulations on building such a great organization. Jim it's been a pleasure to include you as a guest today in Wisdom Board's Pulse Podcast series. I've enjoyed learning more about your professional career experiences and interest and success at the firm.
James:
Much appreciate the opportunity to talk with you and really, really appreciate being with you today.