Profiles in Growth - A Whitepaper from The Business Exit Forum
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SES Advisors and SFE&G are members of The Business Exit Forum, a nationwide network of subject matter expert Preferred Advisors who are preeminent trusted advisors to mid-market companies at all ...

SES Advisors and SFE&G are members of The Business Exit Forum, a nationwide network of subject matter expert Preferred Advisors who are preeminent trusted advisors to mid-market companies at all stages of organizational growth and exit.
The featured presenter at the May 13, 2013 Business Exit Forum's Profiles in Growth event was Joe Mattos, a third generation owner of Pro Finishes PLUS, a company his grandfather founded in 1928. He shared his experience of implementing a 100 percent ESOP in 2003. Following the presentation, Joe joined a panel of BEF Preferred Advisors, including Steve Greenapple, Principal of SES Advisors and SFE&G, and with them, took questions from the audience in an interactive panel discussion.

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Profiles in Growth - A Whitepaper from The Business Exit Forum Document Transcript

  • 1. A White Paper from The Business Exit Forum A Special CEO/Business Owner White Paper Profiles In Growth: Joe Mattos The Business Exit Forumʼs Profiles in Growth series showcases middle-market business owners who have exited their companies. Our featured presented at the May 13 event was Joe Mattos, a third generation owner of Pro Finishes PLUS, a company his grandfather founded in 1928. He shared his experience of implementing a 100 percent ESOP in 2003. Following the presentation, Joe joined a panel of BEF Preferred Advisors, and with them, took questions from the audience in an interactive panel discussion. Joe Mattos President, former 3rd generation owner, and present ESOP participant Pro Finishes PLUS Joe was a 3rd generation family owner of Pro Finishes PLUS, a company founded in 1928 by his grandfather. When it became clear no 4th generation family member would take over the business, the three owners evaluated the options and elected to transfer ownership under an ESOP. Ten years later, the company is thriving—and employing many people, including Joe. Pro Finishes PLUS was started in 1928 by my grandfather, just ahead of the Great Depression. But he was smart enough or lucky enough to start the business in Washington DC, because in DC, when the government runs out of money, they just print more. So the business actually flourished through the Depression. Back then my grandfather sold any kind of paint he could get his hands on. In addition to automotive, he sold industrial, commercial, and house paint, which back then was distributed through specialists. He grew to the point where, in 1943 the DuPont — which was and still is the largest manufacturer of automotive paint — came to him because of his reputation and his presence in the industry and asked him to become an authorized distributor, which he did. Shortly after World War II ended, his sons (my father and uncle) came home and followed in their father's footsteps into the family business. Lesson 1: Family dynamics can affect wealth transfer The business prospered, growing with the post-war boom. We expanded into the Maryland and Virginia suburbs, and then in 1958, my grandmother passed away. Up until that point, my grandfather was sole proprietor. He hadn't thought much about succession planning, but her death gave him a new perspective, and thirty years after establishing the business, he incorporated. He gave his sons stock in the company, and made a decision then that was to benefit me and my cousin 45 years later: my grandfather made it very clear all along that stock in the company should only belong to those family members who actually About The Business Exit Forum: The Business Exit Forum is a nationwide non-profit educational institution wholly dedicated to providing middle-market business owners, CEOs and their executive management teams with access to the best minds in business — so they may grow, transact and transition their businesses in such a way that brings their vision of success to fruition. ©2013 The Business Exit Forum. All rights reserved. TheBusinessExitForum.com
  • 2. A White Paper from The Business Exit Forum worked for the company. My dad and uncle adopted the same thinking when they took over the business. We opened our seventh branch store in 1973, the year I came into the business. My cousin joined a few years before me. We followed in our fathersʼ footsteps, and complemented each otherʼs strengths the way our fathers had. I was an operations guy and my cousin was a born salesman. I also have a brother and sister, who were never interested in the business. Because my grandfather had set the precedent early on, they never held stock in the company. Joe Mattos President Pro Finishes PLUS “My grandfather made a decision then that was to benefit me and my cousin 45 years later.” Lesson 2: Creating the right culture now can pay off later By the late 90s, we were up to 14 stores, and some of those stores were far flung. But managing them was never a problem. Weʼd created a family-business culture, which helped us manage these remote locations in the days before instant communication. We hired people we believed in, who believed in our values—and they tended to stay with us for a very long time. My cousin and I were third-generation owners of the business, and by the mid-90s we began looking at the fourth generation and who might step up to take over from us. I have three daughters, none of whom had any interest whatsoever in the business. My cousin had a daughter and she had no interest in the business, either. In the mid-1990s I was in my mid-40s. My father passed on, but my uncle was still around and in the business. We were looking forward 15-20 years, and that was key. At that time, we were one of the largest distributors in the country. With 14 stores and around $50 million in sales, we were a very attractive target to purchasers. We were approached many, many times to sell the business. When offers started coming in, we asked ourselves if we were in it for the money or because we loved the business and the culture weʼd created. I have been happy to go to work every single morning that I've been with the company, and most all of our people can say the same thing. We are very proud of that. When we looked at the potential buyers, we did not have much confidence in any of them keeping that culture in place, so my uncle, my cousin and I decided we were not looking to just make as much money as possible. We wanted to ensure continuity for this very special organization. Lesson 3: ESOPs give owners flexibility in the transfer We started thinking about ownership transfer in 1995, and it took us eight years before we started the ESOP. Back then ESOPs were less- 2
  • 3. A White Paper from The Business Exit Forum “That stock will be there for them when they retire and are bought out, giving them funds to roll into an IRA and to live happily ever after on.” well-known alternatives. Finally in 2000, my CFO was at a seminar. The speaker asked this question: “What do you think the income tax rate is for an S Corp under an ESOP?” My CFO heard the answer “zero.” He brought that back to me and that's what really started us looking at ESOPs and we decided we could sell the company to our employees. This would allow my uncle to take cash out for retirement, and for my cousin and me to maintain that culture. We were about 50 years old and did not plan to retire, so we could continue to run it, build a management team to carry us into the future, and give it to the fourth generation, which turned out to be the employees. We put together a 100 percent ESOP in 2003, borrowing about half the money from the bank and taking back the other half in notes. We are paying off the ESOP over 15 years. Every year I go out and deliver the statements and administrative communication about the ESOP, telling everyone about how many shares they received that year and what their account value is worth. I show them high-level financial statements and walk through the six things that must be managed properly to ensure success in our industry. This way, all of the qualified participants have at least some idea of how their job affects the performance of the company, which affects the value of the stock. That stock will be there for them when they retire and are bought out, giving them funds to roll into an IRA and to live happily ever after. ➧ Joeʼs Keys for Growth Growth 1. ESOPs give ownership flexibility in the transfer: Pro Finishes PLUS owners went through a long process of analyzing options before deciding an ESOP would best serve each stakeholder. 2. Creating the right culture now can pay off later: Having the right people, processes, relationships and leadership in place helped ensure the success of Pro Finishes PLUS's ESOP. 3. Family dynamics can affect wealth transfer: Prior to the ESOP, Pro Finishes PLUS was owned by three family members, each with different immediate and long-term goals. 3
  • 4. A White Paper from The Business Exit Forum “We asked ourselves if we were in it for the money or because we loved the business and the culture we’d created.” Interactive Panel Discussion Q&A: Highlights Panelists:" " David Garbarino" Senior Vice President BB&T " " " BEF Preferred Advisor " " " Commercial Banking " " ESOP Specialist Steve Greenapple" " Partner, Steiker, Fischer, Edwards, and Greenapple Mark Schweighofer" Principal Stein Sperling " " " Corporate Law Adam Goddard" Senior Vice President Morgan Stanley " " " Wealth Management Jack Skeen" " " Owner Skeen Leadership Group " Moderator: " Executive Coaching Host: John Starling" " " " Founding Partner Smith Growth Partners President, The Business Exit Forum Growth Specialist Question: What negatives came out of this for you or your company? Joe Mattos: It's a question along the lines of what would you do differently? I've been mulling that over, and I honestly don't think there is anything I would do differently. There are a lot of ways you can make the ESOP favor certain people, but I made sure that we did ours in a very plain-vanilla fashion that went along with our culture. There were no special deals. No one got anything special, and I think that has been a key to its success. To the highest degree possible, the ESOP reflected our corporate values. Question: What is your plan to totally exit, because you really havenʼt exited? 4
  • 5. A White Paper from The Business Exit Forum Joe Mattos: It wasn't my plan to exit operations; it was my plan to exit ownership. We quite consciously focused on the ownership transition rather than a management transition. We performed an acquisition about three years ago, and one of the reasons was to bring in some younger managers in our same industry. She is 40. I'm 60 and I want to work as long as I'm still having fun and contributing. I'd like to help her focus her management team. The ESOP was very helpful in attracting them to us. Question: Has anyone on the panel seen a circumstance similar to Joe's in which the former owner stays employed at the company? Steve Greenapple Partner Steiker, Fischer, Edwards, and Greenapple BEF Preferred Advisor Steve Greenapple: Thatʼs a typical practice. In many cases, management stays in place. An ESOP is an ideal tool to develop another tier of management. Good people are attracted to join and stay with the company because they get the benefits of ownership. An ESOP can draw in people who are committed to the long-term. Question: Conventional wisdom holds that banks are not lending. Could this deal be done today in 2013, and is every bank equipped to deal with ESOPs? BEF Preferred Advisor David Garbarino: The short answer to the first part of the question is, yes. Our own lending grew 33 percent and 26 percent respectively in the last two years in Baltimore. And this is growth in the loan portfolio. You can get a loan in today's environment. Banks in general are looking to lend for the right reasons. Because of the size of the loans we do, we are a little more careful to consult closely with the client in order to size the ESOP loan properly. The answer to your other question is, no—not every bank can handle them. These transactions are fairly complicated. Question: Over time, youʼve probably had participants leave employment. They have to be bought out, correct? And where does the buy-out money come from? David Garbarino Senior VicePresident BB&T Bank Joe Mattos: We have a fund set aside for that repurchase obligation, but it basically comes out of operating cash flow. We also have some flexibility because of the income tax status. The ESOP is a tax exempt shareholder. For example, about a year ago, we sold a piece of property that had appreciated significantly for a considerable profit, without tax. That helped us to build the fund. 5
  • 6. A White Paper from The Business Exit Forum Question: S corporations have an advantage in terms of taxfree income after the transaction, but C corporations have a great advantage to the selling shareholder up front. Did you ever have a discussion about considering a C corporation conversion? Dr. Jack Skeen Owner Skeen Leadership Group Joe Mattos: We put a twist on how we did our transaction. We leveraged the company before doing the ESOP. We had valuations done for purchase planning purposes and had a pretty good idea what the company was worth, so we went to the bank and borrowed 50 percent of the money to buy the shares back from me and my cousin. Now the company owned all the shares. We used the built-in equity in the company to reduce tax liability. When we compared that to the other options, it was a fairly simple way to go. BEF Preferred Advisor Steve Greenapple: If you sell shares of a C corporation to an ESOP, you can elect not to recognize any gain on the sale. In order to accomplish this, you have to reinvest the proceeds of the sale in like-kind investments, which is the debt or equity of the U.S. operating company. Question: If you were to convert to a C Corp for the transaction, how long would it take to convert back to an S Corp, and what are the tax consequences? BEF Preferred Advisor Adam Goddard: Five years. The company would pay tax, but it would have a huge deduction of principal and interest. A C corporation has the benefit of deferred tax. Let's say you have $10 million in gain, and you buy qualified replacement property. You can borrow against that 90 percent and pull tax-free money out of a company. BEF Preferred Advisor Steve Greenapple: You don't have to guess what the difference between C and S status would mean to you. Your transaction analysis should illustrate what it would look like if you stayed an S or converted to C and did a 1042. The lines generally cross at some point. Adam Goddard Senior Vice President The Capitol Bay Group at Morgan Stanley Question: Did you consider selling less than 100 percent under the ESOP? Joe Mattos: We considered a number of things, but the cash benefit of the zero tax liability helped us decide how to fund the plan. This 6
  • 7. A White Paper from The Business Exit Forum decision making illustrates one of the benefits of having only three owners. We could make decisions very quickly, without having to create buy-in from a group. Question: What is the fastest ESOP you've ever done? BEF Preferred Advisor Steve Greenapple: Last year, due to the change in capital gains tax, we got very busy at the end of the year. We started on December 4 and we closed at about 7:30 p.m. on New Year's Eve. This was a good-sized deal involving twists and turns with charitable trusts that made it especially interesting and advantageous to the sellers. John Starling President The Business Exit Forum Question: Does a company have to be a certain size before an ESOP makes sense? BEF Preferred Advisor Steve Greenapple: The tax advantages to an S corporation are so huge that Congress established a special rule to make sure that people don't take advantage of it for personal benefit. As a result, it is mathematically impossible to have an S corporation work with fewer than 11 employees. In the real world, anything less than 20 employees is cutting it very close. Generally we think of 50 employees as being the minimum for an S Corp. I have one company that stayed a C Corp. They would've loved to have become an S Corp but they had only 14 participants. If you shrink below a certain number, you have to convert to a C Corp anyway. Question: Any threats to this favorable tax situation for S Corp ESOPs on the horizon? BEF Preferred Advisor Steve Greenapple: It comes up every time Congress looks at taxes, but as of now, the only bills pending are ESOP favorable. BEF Preferred Advisor Mark Schweighofer: I agree. Congress seems to want to promote employee ownership. ESOPs are not the right fit for every organization. It does depend on size, culture, the ability to service debt load, and the ability to fund buyouts when employees leave. For the right company, however, an ESOP is a great way to go about it. Question: When an ESOP is not the right fit, what other options do you recommend? BEF Preferred Advisor Mark Schweighofer: For a traditional exit event, by working with some of the good folks in this room and finding a strategic buyer, you can really drive a premium. It's really never too early to start thinking about an exit. One of the great things about an ESOP is that it gets everyone on board early. There are other methods to do that, including stock option plans. You lose 7
  • 8. A White Paper from The Business Exit Forum some of the tax advantages of an ESOP, but you can transfer real equity to employees by this and other means. Nonqualified deferred comp plans come in one million and one flavors and are probably the most common alternative in situations where ESOPs are not a great fit. Question: What is the cost to operate the plan on an ongoing basis? Joe Mattos: We have to have a valuation done every year, and in addition to that, the administration of the plan costs just a few thousand dollars. Iʼd say less than $15,000 on an ongoing basis. Mark Schweighofer Principal Stein Sperling Question: From the employee standpoint, it sounds like a great deal. Was it difficult to convince the employees, and if so, what were their concerns? Joe Mattos: Our culture was really a perfect fit for an ESOP, so we didn't have much difficulty or many concerns. One thing I learned in studying ESOPs before we started ours is that good communication is key. First, I made sure all of my management team was very well-versed in what the ESOP was all about. They already knew the financial situation of the company and what factors made us successful. Then, I made it a point to hold small meetings with the employees, walking them through the ESOP idea. What I found in my research, and what we actually saw in our own case, was that it took four or five years before the employees totally bought in. I assumed this was because their initial annual statements were not worth very much. Around the time average account values hit about $10,000, they got it and were increasingly bought in. Question: It sounds like the culture really determines the success of an ESOP. What if you want to do an ESOP, but culturally your company is not ready? BEF Preferred Advisor Jack Skeen: That's a great question. People tend to develop a sense of entitlement quickly. Business owners do nice things for their employees, and after a while it doesn't feel like an extra benefit to them—it feels like a requirement, and people get angry when it doesn't happen. If you create a culture where people really understand what you're doing, and you articulate and exemplify your values, employees will believe you are honest and treat you fairly in return. BEF Preferred Advisor Steve Greenapple: Joe's company is a poster child for how an ESOP should be; he created real engagement and involvement. An ESOP's benefits are maximized when it can be used not just as a financial tool but also as an HR tool. We have clients who approach it differently and want to 8
  • 9. A White Paper from The Business Exit Forum know what they have to share with employees. The answer is: you have to give them a summary plan description and you have to give an account statement. The account statement must show the number of shares and the amount vested and the value per share. They never need to see the financial statements or valuations. Question: If the bank is essentially cash-flowing the ESOP, the bank is basically betting on the management teamʼs ability to service the debt. What makes a bank feel confident that the plan will have the ability to make good on its debt? BEF Preferred Advisors from left to right Dr. Jack Skeen (far left) Owner Skeen Leadership Group Deborah H. Diehl Partner Whiteford, Taylor & Preston L.L.P. Harvey Widger Founder Fulcrum Transitions Frank S. Jones, Jr. (far right) Partner Whiteford, Taylor & Preston L.L.P. BEF Preferred Advisor David Garbarino: Banks walk a fine line. Our goal in the covenants is not to go over that line and try to tell the management team how to run the company. We already bet on them to win. One of the most important things we do is redistribute capital, and we do it in as efficient a manner as possible. We are very careful about who our clients are and with whom we are doing business. In regard to the covenant, if the risk associated with that loan changes, we will need to have a new conversation. Question: If you're doing a valuation every year, and one valuation seems too high or too low, do you get a second opinion? BEF Preferred Advisor Steve Greenapple: The trustee is actually responsible for determining the value, even though there are financial advisors helping with the valuation. Every now and then we get a valuation that management challenges. There will be a conversation, but in our experience typically the people who are doing valuations do it very accurately. We would typically not recommend getting a different valuation from a different provider because it's very rare that two valuation companies will determine the same valuation. What we will recommend is having a peer review of the valuation every so often wherein the valuation company looks at the methods as well as the inputs that are used in determining the output, but not comment on the output itself. Question: Do you ever have situations where the employee owners of an ESOP have a problem with the way the former owner and current manager are running the business in terms of their fiduciary responsibilities and so forth? BEF Preferred Advisor Steve Greenapple: Situations where the value of the stock drops sharply after the ESOP can happen as a result of macro or micro economics. If your whole management team is killed in a plane crash, something bad happens to the value of your stock. There are stock drop cases, but if the company management has acted appropriately, courts generally find in favor of the company, saying this is a risk of capitalism. 9
  • 10. A White Paper from The Business Exit Forum Joe Mattos: From a practical point of view, this is why I have a majority of outside directors on my board. If we are screwing up running the company, I have directors who will stand up and make changes. BEF Preferred Advisor Steve Greenapple: It is also important to understand that employees do not own the stock directly. The trust does. It's a retirement plan. People cannot vote on the stock or transfer the stock or walk away with the stock. All they get to do is receive the financial benefit of the retirement plan when they retire, die or become disabled. The only exception is, if you want to sell the business, you have to ask the participants. Generally speaking, the trustee has the right to overrule irrational decisions on the part of the plan participants. ➧ Panelist Companies Steiker, Fischer, Edwards, & Greenapple www.sfeglaw.com BB&T www.bbt.com Stein Sperling www.steinsperling.com Skeen Leadership Group www.skeengroup.net/ Capitol Bay Group at Morgan Stanley www.morganstanleyfa.com/ capitolbay Smith Growth Partners www.smithgrowthpartners.com DISCLAIMER: The views and statements expressed in this white paper do not necessarily reflect the views of The Business Exit Forum, and any other person involved in the making and distribution of this white paper does not warrant the accuracy, reliability, currency or completeness of those views or statements and does not accept any legal liability whatsoever arising from any reliance on the views, statements and subject matter of the white paper. The white paper and the views and statements expressed in the white paper are not substitutes for independent professional advice. Readers should exercise their own care, skill and diligence with respect to the reliance upon and use of any information contained in the white paper. Readers should not act or refrain from acting on the basis of the views and statements expressed in the white paper without first seeking appropriate professional advice in respect to their own particular circumstances. TheBusinessExitForum.com 443.965.9251 © 2013 The Business Exit Forum. All rights reserved. 10