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EPISODE 8 · Financing and valuation

Why Contractors Sell to an ESOP, and When They Shouldn't

Jeremy Garrett · Lazear Capital Partners

Jeremy Garrett grew up around his dad's electrical contracting company in Lake Orion, Michigan, which his father ran for more than 40 years before selling it to his employees. Today Jeremy is Managing Director and Detroit Market Leader at Lazear Capital Partners, where he has spent about nine years helping owners sell through ESOP and M&A transactions after 17 years in commercial banking. He joins Chuck Mazzanti to explain why construction fits employee ownership, how a trustee can pay up to fair market value, how the 1042 exchange and a tax-free S corp change the math, and how to include union employees. His core lesson: an ESOP lets an owner sell at fair market value without taking on a new boss, so run the feasibility numbers before assuming it leaves money on the table.

About Jeremy Garrett and Lazear Capital Partners

Jeremy Garrett is Managing Director and Detroit Market Leader at Lazear Capital Partners, where he has advised business owners on ESOP and M&A transactions for about nine years. Before joining Lazear, he spent 17 years in commercial banking with super regional banks in the Michigan market. Before banking, he worked in his dad's electrical contracting company in Lake Orion, Michigan, a non-union shop doing commercial and industrial work throughout Southeast Michigan. His father ran the business for more than 40 years and sold it directly to his employees. Jeremy has worked on ESOP transactions for union and non-union contractors in Michigan, Ohio and Pennsylvania.

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Learn more about Lazear Capital Partners

What We Covered

Growing up in his dad's electrical contracting company in Lake Orion, Michigan, and its sale to employees after more than 40 years
Why earthmovers and vertical builders have so few outside buyers, and why an ESOP gives them a built-in one
How an independent trustee can pay up to fair market value, and how the 1042 exchange keeps roughly $25 million on a $100 million sale
Why an S corp owned by an ESOP pays no federal income tax, and how that gets the seller paid faster
Younger owners who sell to an ESOP, stay on as president and keep control of a three-person board
Why no business owner wants a new boss, and the private equity seller Chuck had lunch with who now has one
Earnouts, post-sale remorse and the value of a price locked in on day one
A $100 million example: $40 million at close, a $60 million seller note paid over three to six years and a 12% all-in return
Calling the surety first, and why over-leveraging or stripping out working capital puts bonding capacity at risk
Including union employees, the competing earthmover who pushed back and why Jeremy has never seen withdrawal liabilities cut an ESOP price
When an ESOP is the wrong fit: under about $2 million in EBITDA, heavy existing debt or a 10 to 15 times market multiple
Stock appreciation rights worth 10% to 15% of enterprise value, a free 30-day feasibility study and a four-month close

Key Takeaways

Don't assume you're leaving money on the table. The trustee can pay up to fair market value, and Jeremy says valuation is the biggest misconception about ESOPs in construction.
Run the after-tax numbers. On a $100 million sale, the 1042 exchange can keep roughly $25 million of capital gains tax in the owner's estate, and an S corp owned by an ESOP pays no federal income tax going forward.
Selling doesn't have to mean a new boss. Younger owners can stay on as president, control a three-person board through two insiders and still participate in the ESOP.
Protect your bonding capacity. Call the surety before anything else, don't over-leverage the company or strip out working capital, and expect a seller note that typically pays about a 12% all-in return.
Don't let a union workforce scare you off. Most unions only require notice 30 or 60 days before closing, and Jeremy has never seen withdrawal liabilities discount an ESOP price in the contracting space.
Know when an ESOP is the wrong answer. Less than about $2 million in EBITDA, heavy existing debt or a market multiple of 10 to 15 times are all signs to take a different path.
Use stock appreciation rights to build the bench. A SARs package worth 10% to 15% of enterprise value can recruit key leaders without reducing the seller's price.
Get the feasibility analysis before you decide. Lazear does it for free in about 30 days, and closing typically follows in about four months.

Full Transcript

Jeremy Garrett: You know one thing I've never heard from any business owner I've ever done a transaction with? That they want a new boss. That is never something I've ever heard from any business owner. That's just not something that's desirable. Business owners are business owners because they wanted to take charge, they want to be in control, they want the responsibility that comes along with that. They don't need a boss, they don't want a boss.

Chuck Mazzanti: Welcome to the Construction ESOP Collective. I'm Chuck Mazzanti, Senior Vice President at Christensen Group Insurance, and this is the show where we explore the wins, challenges, and real-world lessons of employee ownership in construction. Each episode brings insights from CFOs, former owners, and employee owners who are building something bigger together. Let's get into it.

Chuck Mazzanti: On today's episode, I have Jeremy Garrett, managing director of Lazear Capital Partners. He helps contractors sell to their employees through an ESOP transaction. In this episode, we discuss why construction makes such a good fit for selling to their employees through an ESOP transaction, as well as when a contractor shouldn't go the ESOP route.

Chuck Mazzanti: Hope you enjoy it.

Chuck Mazzanti: Jeremy Garrett, managing director and Detroit market leader of Lazear Capital. Thrilled to have you on the Construction ESOP Collective podcast.

Jeremy Garrett: Yeah, thanks for having me, Chuck. I'm excited to be here and talk construction ESOPs.

Chuck Mazzanti: Yeah. Something you and I are both pretty passionate about, maybe a little biased, but that's all right. And just to set the stage, if you could tell the audience who you are and how you ended up at Lazear.

Jeremy Garrett: Yeah, so again, Jeremy Garrett, managing director, Lazear Capital Partners. I've been with the firm for about nine years. I think my nine-year anniversary was in August of this year. And before joining Lazear Capital Partners, I spent about 17, 18 years in commercial banking with some super regional banks in the Michigan market.

Jeremy Garrett: Before banking, though, I actually spent some time working for my dad's business, which was an electrical contracting company in Lake Orion, Michigan. And I really got to understand the ins and outs of the contracting world and what contracting business owners go through every day. And so I think it was a great start. And today I'm proud to be able to help business owners, both in the...

Jeremy Garrett: Contracting space, but in other spaces as well, help them sell their business and monetize their otherwise illiquid investment. So, very exciting.

Chuck Mazzanti: Yeah. Is your dad's electrical contracting outfit still in existence, or what's going on?

Jeremy Garrett: He ended up selling it directly to his employees when he got out, which was about 10 years ago. But he had that for over 40 years of his life. And so during those 40 years, there were some serious ups and downs in the economy and the market. And we lived it at home, and when I was working with him during college.

Jeremy Garrett: It's not an easy sport. Contracting is not an easy sport, I'll tell you that right now.

Chuck Mazzanti: No, it's not for the faint of heart, with the cyclical nature, and they're exposed to a lot of stuff, man. I have nothing but respect for our contractors out there. Awesome. So that's an interesting perspective. So you saw your dad's company go ESOP. Were they a union shop as well?

Jeremy Garrett: Yeah, no doubt.

Jeremy Garrett: He was a non-union shop, smaller shop. And they did primarily commercial and industrial work all throughout Southeast Michigan. But non-union, though. And since I've been in the ESOP space for the past nine years, it's interesting, because we've done a number of union shops. We've done a number of non-union shops as well.

Jeremy Garrett: There's a lot of different things to think about when you're selling a company that's got union labor inside of it. That's for sure.

Chuck Mazzanti: Yeah. And we'll definitely get to that. As we were talking before I hit record, that's probably the number one question I get: hey, can you talk about union construction with ESOPs, both when the union labor force does not participate in the ESOP and also when they participate? So we'll definitely get to that.

Chuck Mazzanti: In your view, Jeremy, why do you feel construction is so ripe for employee ownership? It's a third of all ESOPs, and I feel like it's picking up momentum with the, quote unquote, silver tsunami. So from where you sit, why do you think construction goes so well with employee ownership?

Jeremy Garrett: Well, I think there are a number of drivers that encourage business owners in the contracting space to sell to ESOPs. One of those drivers is the fact that there are just not a lot of buyers for contracting companies in general. And I'm being pretty generous with that term. In certain spaces, residential HVAC...

Jeremy Garrett: Lawn care, landscaping, there are lots of buyers right now, lots of private equity firms trying to tap into those different spaces of the contracting industry. But generally speaking, for earthmovers and vertical construction companies, there are just not a lot of buyers out there. And so what you've got with an ESOP, an employee stock ownership plan, is a built-in buyer. So your employees are there.

Jeremy Garrett: The ESOP is all upside for the employees of the company. And so having that guaranteed buyer, which is your employee base and this ESOP concept, is one reason why business owners choose ESOPs to sell. Another reason is that with contracting companies, the value of the company really walks out the door every day. The employees are what binds the company together.

Jeremy Garrett: And they create value for a company. And many of the business owners that I work with say all the time, listen, I want to reward the people who have allowed me and helped me build this company over time. I want to reward those people. And that's really the true value of a contracting company: the people.

Jeremy Garrett: What happens is, when you announce the ESOP and people start to understand the benefits of an ESOP, especially in the contracting space, they start to stay longer. There are statistics that show for every one person that leaves an ESOP firm, four people leave traditionally owned firms, privately owned firms. And so you can provide the glue to bind everybody to the company, and take care of and reward the people that have worked for you for a long time.

Jeremy Garrett: Those are all important things to business owners in the construction space. They really feel like their employees are more like family, truly like family, than just employees. And so the employees and the value that they provide is a big benefit to business owners in the construction space. And then three, very important for any business owner...

Jeremy Garrett: The value overall, on an after-tax basis, from selling to an ESOP typically can far outweigh what that same business owner would get from a sale to a third party. And so value is always going to be an important concept for any business owner looking to transition their company. And the tax benefits, we won't get deep into those today, I'm sure.

Jeremy Garrett: But not having to pay taxes when you sell your company, and having the company be able to operate indefinitely without paying federal and state income tax, those are huge tax benefits. And the federal government, Congress, allows for those two tax benefits. They want to encourage more ESOPs to be formed. And so the tax benefits cannot be overlooked when a business owner's looking to sell their company. So those are some of the reasons it typically boils down to...

Jeremy Garrett: When we're talking to business owners and they're making the decision to go forward with selling their company to an ESOP.

Chuck Mazzanti: Yeah. No, I appreciate that perspective, Jeremy. There are a couple things I want to dig into, because you brought up a point about the value, and I think everyone thinks if you go ESOP, you're leaving money on the table, right? It's kind of a charity thing to a certain extent. So you said they could come out ahead. That's something I want to get into. But first, a note I want to add.

Chuck Mazzanti: Neither of us are tax providers, I don't think. I'm one once a year on Halloween, but that's about it. But people pooh-pooh it, or they think they have to be hush-hush around the tax benefit, but you don't have to hide from it, to your point. The federal government and the state governments understand, and they want that benefit. It's not like you're playing some nefarious game.

Chuck Mazzanti: It's fully out there, and employee stock ownership plans are one of the few things in today's polarizing political environment that both sides of the aisle agree on. They think it's a huge benefit to America, and the more ESOPs, the better for our country in general. So that's some color commentary I wanted to provide around taxes.

Chuck Mazzanti: Can you explain what you mean? Everyone says you're taking a haircut if you go ESOP. So how do you figure they're coming out ahead of the game in some instances?

Jeremy Garrett: Yeah, so with an ESOP, the buyer ultimately is the employees of the company, but what happens here is an ESOP trust is set up to buy the shares of the company, and that ESOP trust is governed by a trustee that's hired. And it's going to be an independent third party.

Jeremy Garrett: The trustee is buying the company on behalf of the employees without the employees really knowing about the transaction until it closes. Kind of a unique scenario, right? So you've got somebody buying a company on behalf of the employees. They never know anything's going on until the company has actually traded hands. And so when you look at the value that is paid...

Jeremy Garrett: The trustee can pay up to, and not more than, fair market value for the company. Fair market value is a pretty broad term, but generally it's what an arm's-length buyer is willing to pay for a company. And so it can pay fair market value for the company. So you get equal to, sometimes a little bit more than, what you would get from a sale to the market.

Jeremy Garrett: That's kind of a starting point. Beyond that, though, are the tax benefits that I was talking about. A business owner that sells his or her company to an ESOP can elect what's called the 1042 exchange. This exchange allows for a permanent deferral and ultimate avoidance of any capital gains on the sale of a company. So look at taxation when you sell a company.

Jeremy Garrett: When a business owner sells a company and has to pay capital gains tax on it, and let's say that sale price is $100 million, they would normally have to pay $25 million in taxes. Well, with an ESOP, that business owner electing a 1042 exchange pays zero federal and state capital gains taxes. So they keep almost $25 million.

Jeremy Garrett: What would otherwise go to the federal government and state government, they keep in their estate. And so when you compound that tax savings of roughly $25 million, 25%, plus the fact that they're getting fair market value for the company, plus the fact that post-closing there's a tax benefit if the company is an S corp that's owned by an ESOP.

Jeremy Garrett: S corps are a pass-through entity. They never pay taxes. That tax bill goes up to the owners via a K-1. And when that income hits the ESOP trust, the owner of the shares of stock, that ESOP trust is considered to be a qualified retirement plan. It does not pay taxes, it's a tax-exempt entity, and that's how you end up with a completely tax-free...

Jeremy Garrett: S corp organization into perpetuity, from the time of close and beyond. And so when you factor in the fair market value, plus the tax benefit of 1042, plus the fact that the company's not going to pay taxes in the future, that owner can get his money much more quickly. It's really a profound outcome for most business owners. Game changing.

Chuck Mazzanti: Yeah, that's huge. And then isn't there upside? Correct me if I'm wrong, Jeremy, but let's say you have a younger owner, right? Late thirties, early forties, and wants to utilize the ESOP, but he or she doesn't want to get out of the game. They want to stick around, right? They still have another 20, 25 years left in the tank.

Chuck Mazzanti: But they want to get some chips off the table, or whatever their reason is, right? To sell to the ESOP. Isn't there a benefit, even if they don't go 1042, to get a second bite at the apple with the upside of the growth of the company, for your non-traditional seller? I'm not the 65-year-old guy selling who wants my money, I'm the younger guy or gal that wants to get some money but also wants to participate in the growth of the company.

Jeremy Garrett: Yeah, definitely. So younger selling shareholders that may want to work for the next 10 or 20 years post-closing, typically what they're looking for there is to diversify their assets. They're looking to turn an illiquid asset, being the company, into liquidity. So typically they want to go and...

Jeremy Garrett: Either buy real estate, buy other companies, or do something else in addition to the company that they're running. But you're absolutely correct. What they can do when they sell is continue working there and running the company for as long as they want. A business owner that's 35 or 40, we deal with them all the time. They maybe want to continue working for 10 or 15, 20 more years.

Jeremy Garrett: They can do that. They can keep the president role. They can remain on as chief financial officer, whatever they want to do. And what they can do in the meantime, during the time that they're working, is continue to collect a great wage. They can also get the benefit of the ESOP participation, which I think is what you were asking. And that participation in the ESOP can build up to...

Jeremy Garrett: Several hundreds of thousands, maybe into the millions of dollars, over the long haul. I've got transactions in Michigan that I closed six, seven, eight years ago, where many of the higher earners in those companies have several hundreds of thousands of dollars in ESOP participant values already. And so, yeah, a business owner can continue to work at the company.

Jeremy Garrett: They can continue to control the board of directors. That's another unique benefit of an ESOP. So instead of having a new owner and a new boss, like you do with private equity, these business owners that are selling that are younger can continue working there. They can be on the board of directors. They can control the board. Typically we're going to set up a three-person board, and you'll have two insiders and one outsider.

Jeremy Garrett: The two insiders therefore control the strategic direction of the company. And so when you look at an ESOP transaction shortly after close, what people don't want to have happen, what the employees don't want, what the selling shareholders don't want, what the trustee doesn't want, is big changes, right? The trustee stepped in, the employees stepped in. They bought this company because of the value...

Jeremy Garrett: That was inherent in it historically. And rapid, large changes post-closing are unnerving for everybody. And so with an ESOP, many of my business owners, six months, a year after closing, will call me and ask me, Jeremy, is something supposed to be changing here? Because it feels like it's always felt. And that's the way a successful ESOP should operate. It should feel like it always has in the past.

Jeremy Garrett: But if you think about it, instead of a single owner or two owners of a company, now you've got maybe 100 owners in the company. Now you've got 100 people that are excited, and they understand that over time, the harder they work, the more value they're going to create for themselves and their families, versus all of that value going to the existing owners, the selling shareholders of the company. So, yeah, young selling shareholders can definitely participate...

Jeremy Garrett: In the ESOP that's set up, for sure.

Chuck Mazzanti: Yeah, I think that's one of the lesser-known facts about a benefit of an ESOP, in this case for contractors, but for anybody selling their business: the control piece, right? If you go private equity, even the best-run private equity firms, their sole purpose is to get as much value out of that as possible and eventually flip it, right? And generate that alpha.

Chuck Mazzanti: If it's not performing well, let's say you go right into a downturn of the market and they're looking to flip it, a dollar saved is a dollar earned. So they're going to do rash things, maybe not even because they want to, but they have to, to generate that value. Versus with an ESOP, you're still the owner. Like you said, in that case, the younger guy or gal, you're still steering the ship. And so you get to choose:

Chuck Mazzanti: How you're going to operate, how you're going to weather the storm, how you're going to take care of your fellow employee owners. And I think that goes to the point you made earlier, that for every person laid off in an ESOP-owned firm, there are four in the traditional firm. That goes back to that principle. So I think your points are well noted, and it's very customizable, from young to old, to getting all your chips off in a 100% transaction...

Chuck Mazzanti: To maybe going partial ESOP and stair-stepping your way up based on your needs and wants. You're not getting that in a strategic sale. You're not getting that in a private equity sale. You're not getting that in selling to a publicly traded firm. An ESOP is the only vehicle that I'm aware of that has this much customizability for the contractor.

Jeremy Garrett: You know one thing I've never heard from any business owner I've ever done a transaction with? That they want a new boss. That is never something I've ever heard from any business owner that we have sold to private equity, since we do M&A, or to an ESOP. That's just not something that's desirable. Business owners are business owners because...

Jeremy Garrett: They wanted to take charge, they want to be in control, they want the responsibility that comes along with that. And the successful business owners that we're dealing with, they just don't need a boss, they don't want a boss. So an ESOP is a great fit for them to continue to run the company the way that they see fit.

Chuck Mazzanti: Yeah, 100%. It's funny. I was talking to a buddy that sold to private equity. I told him there are other options, but I don't fault anybody for choosing how they're going to exit. It's their business at the end of the day. But I had lunch with him last week, and they're maybe about four years post-close of the private equity sale. And he made multiple seven figures personally. And he can't stop complaining about how he's got a boss now.

Chuck Mazzanti: And how his customers aren't seeing the same white-glove service he was used to giving when they were steering the ship and owned the company, but he's just an employee now, right? Of the PE firm. And so I was like, so-and-so, you got that bag of money, though. He's like, yeah, I mean, that was great the day after, but now it's just a pain in the butt dealing with this stuff day to day.

Chuck Mazzanti: Answering to clients on why we're dropping the ball. And so your point's well noted. Nobody likes a boss, and at some point they forget, like, I got all that money. But unless you're exiting the next day, you've got to deal with it.

Jeremy Garrett: Yeah. There are studies out there. I think the stat, from I think it's the Exit Planning Institute, is 75% of business owners who sell their company have buyer's remorse. And there's a whole number of things that cause that. It's the new owners not running it the way that they ran it in the past. They're not giving raises, they're not hiring.

Jeremy Garrett: A whole slew of things can happen, or they just don't like the buyers, right? And there's some friction there. Many transactions, particularly third-party transactions in the contracting space, will come with earnouts, which means that if you sell your company, you get some money down at closing and the rest comes over time. The problem with that scenario:

Jeremy Garrett: You've now handed over the reins of control to somebody else who bought your company. And I'm talking about private equity or a strategic buyer. You've handed the reins over, somebody else is controlling the company, and you're sitting there hoping that your contingent money, that's contingent on them performing, gets paid. And many times it may not. And so that's one of the key differences between an ESOP sale and a private equity sale.

Jeremy Garrett: With an ESOP sale, on day one, you're going to lock in a price. And then it's just a matter of making sure that the company is profitable enough to be able to pay the selling shareholder off. And so that's how an ESOP works. There are no hurdles that you have to hit in the future. There's no magic to it. It's just, here's the number that we locked in for the sale of the company. And then, so long as the company's profitable post-closing...

Jeremy Garrett: The selling shareholder will get all the proceeds from the sale over time.

Chuck Mazzanti: And because it's construction, right, a lot of these contractors are heavily bonded, and so that's something they have to anticipate with the balance sheet flipping. And we've done a really good job, at least at our firm and other firms. I think by and large the bonding community understands ESOPs well enough now, and they know when it's structured correctly and when it's maybe not.

Chuck Mazzanti: Can you talk about the benefit to the selling shareholder of seller financing? And are they able to generate some interest for doing the seller financing, at least a piece of it, to preserve bonding and those sorts of things?

Jeremy Garrett: Yeah, so the key thing with companies that have bonding in place is you have to recognize that the surety provider is a true partner of the business, meaning that to win projects in the future, many companies need bonding capacity. And you have got to make sure that you're paying attention to the structure of the transaction.

Jeremy Garrett: You want to make sure that bonding capacity isn't minimized or reduced as part of the transaction. In our transactions, the first thing that we do is reach out to the bonding company, to the insurance provider, to make sure they understand the transaction's coming and that they're on the same page as we are with structuring the transaction. The one thing that you don't want to do with an ESOP transaction, if you've got bonding in place:

Jeremy Garrett: Trying to over-leverage the company or strip out too much working capital as part of the transaction. In the transactions that we work on, typically we will get somewhere between 1.5 and 2.5 times EBITDA for the selling shareholders at closing, and then the rest comes over a number of years. And here's the way that works.

Jeremy Garrett: Let's take an easy scenario. A $100 million transaction. Maybe the company's doing $20 million in EBITDA. The owner gets $40 million on day one, and the rest comes in the form of a seller note. That's $60 million in a seller note that's paid typically between three and six years post-closing. And the structure of that seller note is going to be...

Jeremy Garrett: Typically about a 12% all-in return. Many times we'll carve that return up into two pieces: seller note interest and then interest rate replacement warrants. So we'll carve that return up, but essentially the seller is going to get 12% on the seller note. So getting some money at close is great for a selling shareholder, but the 12% is not too bad either. So we try to structure our transactions...

Jeremy Garrett: Where everybody's comfortable and everybody wins: the bank, the surety provider, the business owner, the employees. All sides are coming out winners, where there's not too much friction during a transaction and we're not trying to press too hard for over-levering the company or getting too much debt on the balance sheet. It's a bit of a teeter-totter there, but over the years we've devised different strategies...

Jeremy Garrett: To make sure that both sides are happy, all sides are happy.

Chuck Mazzanti: Well, I think that's the key, not to give you a plug, but it's legitimate. That's the key: partnering with people that understand these transactions and also understand construction, because construction's a different beast. And so you need to partner with people that understand it, that understand the difference between a heavy civil contractor versus a mechanical contractor versus a roofing contractor. There's nuance not only to construction but to the type of trade.

Chuck Mazzanti: And so I think, pick your service providers wisely and make sure they have experience in it.

Jeremy Garrett: Yeah, and the difference between a general contractor and a self-performing company: that working capital fluctuation as you're heading into and out of projects is critical to understand as you're looking for bank financing, line of credit availability, to make sure that you can withstand those ups and downs through cycles. Capital expenditures for heavy industrial, heavy civil type companies...

Jeremy Garrett: It's critical to understand: how much CapEx has that company spent historically? Is that enough to support the backlog coming up? And if not, you have got to layer in financing or cash purchases for new equipment. So there are a lot of considerations, and you're right. Different segments of the contracting industry, their cash flows behave much differently. And you've got to plan for that.

Chuck Mazzanti: Yeah, 100%. Well, I want to transition to the union piece. You mentioned it at the beginning of the pod. Let's start with a union contractor that goes ESOP and does not include the union workforce. Can you walk us through what that looks like at the transaction level? And then how does it become a house divided? Is it the union versus...

Chuck Mazzanti: The back office? What does that look like?

Jeremy Garrett: Yeah, so I'll start off by saying that in over 50% of the transactions that I've worked on, the selling shareholders have actually included the union as part of the ESOP. And when you back up and think about that, they've already got their retirement benefits through the union. They're collectively bargaining on those every few years.

Jeremy Garrett: This ESOP comes in alongside the union benefits that they're receiving and acts as almost a secondary retirement benefit for those employees inside the union. And so it can be a real windfall for employees at these companies with unions, at least the union employees. So, the ones that include the union:

Jeremy Garrett: There are a couple of different threads, common threads, that I see, and one is the culture. If you include the union, typically you've got a really strong relationship and strong culture, whereby the union employees are thought of no differently than the employees that are in the front office of the company. And so you've got that...

Jeremy Garrett: That feeling that they want to take care of all their employees that have helped the company get to where it's at, union and non-union. And so that's one thing, the cultural fit. The second thing is there are some financial incentives for business owners to include the union up front during the transaction. And I won't get too technical on it.

Jeremy Garrett: But there are some tax benefits of including more employees at the company inside of the ESOP rather than fewer. The other thing I'll say, in addition to inclusion, is you can choose which employees to include, because inside of these union companies, there's a lot of churn at the lower levels of the company. And so what you can actually do is have the ESOP benefit apply only to certain titles and above.

Jeremy Garrett: Foreman, superintendent, you name it. You can set it up in a way where only those employees and above are included inside the ESOP. And so you can reduce some of the churn that happens at those lower levels of the company. So there are lots and lots of different ways to structure the ESOP, to include or exclude the union. The benefit, I guess...

Jeremy Garrett: Which makes some sense to me, for maybe not including a union, could be that if you did not include the union workforce in the ESOP, then all the ESOP benefit would go to the front office or the non-union employees. And the thought there, from the business owners that I speak to, about not including the union is they've already got a retirement benefit plan.

Jeremy Garrett: It's very fruitful for them. And so they're already governed under that plan. Let's provide a hypercharged retirement program for the non-union, maybe front office, employees of the company, and only keep it to them. Unless the company's resold at a later date, there's really no financial benefit or negative...

Jeremy Garrett: To including or not including the union employees. So from that perspective, it's net neutral. There's no negative impact to the non-union people from including the union people. But there are lots and lots of different ways you can skin that. The unions that I've worked with, that we've done transactions with, have generally viewed the ESOP as...

Jeremy Garrett: A way to strengthen the union, meaning that the union's going to be stronger if it's not only got the benefits from the union itself, but also another qualified retirement plan alongside of it. So the smart union leaders that I've dealt with on many transactions see the ESOP coming as a benefit for their members, a benefit for the union itself.

Jeremy Garrett: And it's viewed very favorably. I will say that we've never had a union say no to the inclusion of an ESOP. And in fact, most unions only have a notification clause, not a consent clause, as part of their participation in an ESOP.

Jeremy Garrett: Because of that, we typically only have to notify the union 30 or 60 days before the transaction closes. And then, if the union's included, they'll automatically be included on the day of close and beyond. But there are lots of nuances, lots of things to think about, lots of mathematics behind it. And what I think it boils down to is, what are the goals of the selling business owners?

Jeremy Garrett: What do they want to see happen? And really that guides our direction of what to do and how to structure the transaction.

Chuck Mazzanti: Yeah, that makes a lot of sense. And what I'm hearing from the contractors I'm dealing with that are ESOP-curious, or the contractors that did go ESOP, is they thought, for whatever reason, you just can't get the union employees in. Do you think it's more nuanced within Michigan? Or have you had a scenario, Jeremy, where...

Chuck Mazzanti: You went to the union to let them know, hey, the XYZ contractor is now employee-owned and the union workforce is part of the ESOP. Have you had a conversation where that specific union was taken aback and didn't know? And they were maybe riled up about it, but then you had a conversation, and once they understood it, they realized that's just an additional benefit and not a competing type of thing against the union? Because ultimately it could be done.

Chuck Mazzanti: You said 50% of your transactions include the union workforce in some capacity in the ESOP. And so I'd like to go on the offensive and make sure that all the unions across the country understand that this isn't taking away from them, but this is additive to their respective unions. So I'm curious if you have any stories around that.

Jeremy Garrett: I do have one interesting story. So we had an earthmoving client that did include all the union members as part of the ESOP. The notification went out to the union. A competing earthmoving company sat on the union and raised their hand and said, hey, wait, we don't feel like you can add...

Jeremy Garrett: The ESOP retirement benefit to these union members. And obviously you can, and you could in that situation. But what they didn't want is the company that was coming into the union to have an ESOP benefit when they didn't provide that benefit. And so they thought of it as:

Jeremy Garrett: Well, this company, Company A, is going to have this ESOP benefit, and all of our employees are going to want to work at Company A because they've got the ESOP benefit in addition to their union benefits. And I don't necessarily think that's unfolded the way that they thought it would. I think it's been a great benefit for the employees that have been at the earthmoving company that we did the ESOP transaction for. But it's not like...

Jeremy Garrett: It sucked all the employees away and they all went over to the company that's got the ESOP benefit in place. I will tell you, if I was a union member and I had the opportunity to go work at a company with an ESOP, I'd probably choose that route, in addition to my collectively bargained benefits from the union. So that's one scenario where...

Jeremy Garrett: We only got pushback because a competing firm was in the union leadership, and as we were setting the ESOP up, there was a little bit of pushback. But it got done on time, as we expected. We didn't have an issue. It didn't go to a lawsuit or anything like that. And it was a very smooth transaction for everybody.

Jeremy Garrett: We've closed a bunch of companies with unions in place in Ohio. So it's not just Michigan, it's Ohio, Pennsylvania. We've got one going on right now. And each state's a little bit different, but I think when you step back as a union leader and think about the reason the union's in place, how could you say no to another benefit for your employees?

Jeremy Garrett: If anybody could explain to me why or how somebody in the union would say, no, it's too much benefit, too rich for our employees, I'm all ears. But otherwise, they really do view it very favorably. But you've got to make sure you send the notifications. If there's consent, you have to get consent. So there are different things you've got to do. And also, structuring it in a way...

Jeremy Garrett: That aligns with the day-to-day operation of the company and the reward and benefit that the selling shareholders want to give to the employees: you really have to think about all aspects of the union if you're going to include it. The one thing that we haven't talked about yet that comes into play with unions is withdrawal liabilities. So many times, when you go to sell a union company to a third party...

Jeremy Garrett: That third party's going to say, okay, we're going to pay you this, but you've got withdrawal liabilities of X. So we're going to pay you this minus those withdrawal liabilities. It turns into a negotiation. Third-party buyers are going to try to discount that company's value by the withdrawal liability as a negotiating tactic. With an ESOP, we're very upfront with the trustee and the valuation firm that they hire.

Jeremy Garrett: And I've never seen a discount for withdrawal liabilities when we've sold companies to an ESOP in the contracting space. And so from that perspective, if you look at just that alone and say a company's got a very large withdrawal liability, and you can sell and not have that discount for the withdrawal liability, it could be a huge benefit for the selling shareholder.

Jeremy Garrett: And really, the reason why they don't discount the value by the withdrawal liability is there is no intention of getting rid of the union or moving to a different area. That's just not part of an ESOP. That's just not what happens with ESOPs.

Jeremy Garrett: They use what's been done historically as part of that future success. And there is no intention with an ESOP sale of either moving out of state or abandoning the union. That's never a consideration with an ESOP transaction.

Chuck Mazzanti: Well, that's a good point, right? The purpose of the union is for the benefit of the union member, right? To protect them. And so it shouldn't really differ whether it's Ohio, Pennsylvania, Detroit. Chicago's a huge union place. I think it's like anything: transparency, following the collective bargaining to the T, not giving them a surprise after the fact.

Chuck Mazzanti: But then just explaining to the different union leaders why this is a benefit and additive, as opposed to someone selling to private equity. Sure, there are plenty of good PE deals in the construction space that get them extra capital and knowledge sharing to grow the company. But I would argue that there are also differences that detract from the company. So then maybe you have fewer...

Chuck Mazzanti: Union employees 10 years later, or they exit the market because it's not making as much money as some of their other markets across the country. And to your point, the ESOP is structured so that it's like, hey, we're doing everything we did prior to the transaction, post-transaction. We just want to do it even better. And you can look at the NCEO studies and Rutgers and all these different think tanks that have empirical evidence on...

Chuck Mazzanti: Reduced turnover and better profit margins and all these different things. And so I think that's maybe a gap in the market that I'm going to try to tackle with people like you: getting the unions to better understand the benefits of ESOPs, and why they could benefit their specific union, and that it's not a competitor.

Jeremy Garrett: Yeah, I think in the state of Michigan, I've probably done a transaction with almost every single union. And so the union leaders across Michigan are well aware of ESOPs and what they can provide for their employees. So we've got them up to speed. Ohio, we do a lot of transactions down in Ohio, so we've got that state covered, and they understand it well. In Pennsylvania, we encountered one of our first...

Jeremy Garrett: Consent requirements for a transaction, which is very uncommon. So we're going to work through that with the client and do what you're talking about, which is just educate. Educate the union leadership on what the benefits of an ESOP are. And I think when they see the track record that Lazear has provided for so many contracting companies across the United States, I think they'll get on board.

Chuck Mazzanti: Yeah. Well, success leaves clues, right? So let's follow the good transactions that are 5, 10, 15 years post, and they're benefiting the union, right? And there hasn't been this withdrawal and all these different things. So, no, that's great. We've touched on it a bunch, but I'll ask you flat out: what is the biggest misconception about ESOPs within the construction space?

Jeremy Garrett: The biggest misconception is probably the valuation. I think a lot of business owners think they're going to leave money on the table. It's almost too good to be true when they're shown the numbers, and then once the transaction closes, their eyes are wide open.

Jeremy Garrett: And our clients in the construction space are our best advocates, and they are our best referral generators. And it's because once they see it and are living it, they believe it. And so I think the biggest misconception is the value piece of things. That's probably by far the number one.

Chuck Mazzanti: Yeah, from where I'm sitting, I would agree with that as well. Who would not qualify, or who shouldn't really think about an ESOP in the construction space, whether it be trade or size or EBITDA target? What are a couple of things where you're like, hey, if this is you, maybe an ESOP isn't the best path forward, at least right now?

Jeremy Garrett: Yeah, so three things, I think. The first one is you need some scale to be able to do an ESOP. So I tell all my clients, and prospective clients, you should have at least a couple of million dollars in EBITDA to do an ESOP, because then the company's got some meat on the bones. It's typically got a management team, a finance department, all that in place.

Jeremy Garrett: And so $2 million in EBITDA and above, I think. The areas where I don't think an ESOP fits real well are when a company is already very leveraged, so a lot of debt on the balance sheet. And the reason I say this is because at closing, most business owners would like to put some money in their pocket. I would, if I was a business owner.

Jeremy Garrett: I have encountered situations where there's a lot of existing balance sheet debt. The owner sees the outcome of closing on the transaction, and no cash goes into their pocket at closing, and that's undesirable. The scenario that I talked about earlier, a $100 million transaction, $40 million in pocket on day one, that's a lot of money. That's a nice payday...

Jeremy Garrett: For a business owner, a nice chunk down on the transaction. And so companies that are over-leveraged to begin with are not great fits. The other area, and this is great for business owners: companies that demand really high multiples, 10, 12, 15 times in the market, I do not think should do an ESOP. And the reason for that is...

Jeremy Garrett: With those companies, if you can trade for 12 times your EBITDA, that's 12 years of EBITDA. I'd advise any business owner, friends, family, I would advise anybody the same way, which is: take that money and put it in your pocket. If you care about your employees, cut them a check on the way out the door. That's what I would do in that scenario. So in a very high multiple trading company, again, residential HVAC, weirdly enough...

Jeremy Garrett: Lawn mowing and landscaping companies right now, in those trades, I would totally just sell the company and cut checks to the employees. If you sold at a 12 times multiple, I wouldn't doubt if it would take you, a business owner, 15 years to get paid back. And that's too much risk. It's too long of a horizon to get paid back.

Jeremy Garrett: Our business owners, as I mentioned, that are selling for five to six times EBITDA are typically getting paid anywhere between three and six years from close. A very manageable, short time frame doing an ESOP. So those are a few scenarios I've seen where I didn't think an ESOP really fits: over-leverage, or if your company's going to sell for a really high multiple in the market. A lot of people think, too, that you have to have a management team in place. This might be another...

Jeremy Garrett: Misconception with ESOPs: they think that because I don't have a management team, I can't sell to the employees or an ESOP. Totally not true. And so what you can do in that scenario is actually close on the transaction and then use the ESOP as the tool to get people interested in your company, because of the great benefits that the ESOP itself provides.

Jeremy Garrett: But then also, alongside of that, you can layer in management incentive programs. We call them stock appreciation rights, or SARs. And you can layer those in alongside of the ESOP benefits to have a really supercharged retirement benefit for key leaders at these companies. So you can entice somebody from a competitor to come over and say, hey, listen, you're going to be an ESOP participant, you're going to get access to these SARs.

Jeremy Garrett: That works great for business owners that are looking to build out management teams, and you do not have to have the full management team in place at closing. The trustee's still going to pay full and fair market value for the company, with or without a wide and deep management team in place.

Chuck Mazzanti: On the SARs piece, it's talked about at the deal level, of course, but in ESOP-curious circles, not too many people get into the weeds, and we don't have a ton of time to go super deep on it. Maybe that's Jeremy part two. But is that totally customizable? I'm thinking through it, and it's like, all right, if I don't have all my ducks in a row from a management standpoint, and maybe I want to...

Chuck Mazzanti: Take my money and run once I'm fully paid back in that three-to-six-year time frame of the seller note piece. Realistically, what is that looking like? Can I poach a competitor's CFO because SARs could be so much above and beyond? And then the ESOP part is additive, and then I'm paying in line with what the market will yield for that type of CFO? I know every deal's different, but can you put a target on it, or just an example of what a SAR...

Chuck Mazzanti: Yeah.

Jeremy Garrett: A SARs package is going to equate to roughly 10% to 15% of the enterprise value of the company. So again, using the $100 million sale price, $10 million to $15 million can be allocated to the management team. Those vest over a time frame of typically up to 10 years.

Jeremy Garrett: And so from years 5 through 10, they'll start vesting and getting paid. And so 10% to 15% of the enterprise value of the company goes to the management team on a non-dilutive basis, meaning that if the company was going to sell for $100 million, if you layer in $10 million to $15 million of stock appreciation rights, that does not bring down the value that the selling shareholders get. So it doesn't reduce it from $100 million to...

Jeremy Garrett: $90 million or $85 million. They still get $100 million, and the management team gets $10 million to $15 million in stock appreciation rights off to the side. And then from there, business owners can divvy that up amongst key leadership. They can give that to one person. They can give that to 10 people. On average, we typically see business owners dividing that up over three to five people, but it varies wildly.

Jeremy Garrett: I think we've seen it all. And that's how the management incentives can be there to, like you said, go and poach some top talent in the market and bring them over. And then at that point, everybody wins. The employees win, the company wins, and the selling shareholder begins to shed his or her responsibilities off to those people. And it could be a great way to exit.

Chuck Mazzanti: Close.

Chuck Mazzanti: Well, that could be the missing piece, right? If they're growing at a 15% to 30% clip, but they haven't been able to get that one key operational person for whatever reason, and now they could do the SARs, and that's the straw that broke the camel's back, so to speak, to pull them over. That could open up Pandora's box in a good way to help the company scale, for some of those key executive leaders where it's just such a hyper-competitive...

Chuck Mazzanti: Market to get those people. So, no, I appreciate you sharing that. And I guess the last question I have for you, Jeremy, is this: let's say I'm a $100 million heavy civil guy sitting on the fence. I listen to this podcast, you got me intrigued. What's your honest advice? What does this entail? Do I need three years of lead time? Am I going to have to spend six or seven figures to do due diligence on this? And if I don't go that...

Chuck Mazzanti: Route, is that just money gone? What would you tell me if I'm looking to do it? Just give me honest feedback on what it would look like: time frame, money.

Jeremy Garrett: If you're on the fence, you've been thinking about it for a while, you're a business owner, you want to see what it would look like, how much money you'll get, how long it's going to take to get the money, what the benefits are to your employees, the management team incentives, all of that, I would have us prepare a feasibility analysis. That ESOP feasibility analysis we do for free.

Jeremy Garrett: And we do that within a time frame of about 30 days. And that will give you all the answers you need in terms of what this ESOP outcome is going to look like for me and my employees and my management team. And so in 30 days, you'll have the answers that you need to know whether it's a fit. If it is, and you want to move forward, we sign what's called an engagement agreement. And from that day to closing, it should be about a four-month time frame. So, pretty quick to close.

Jeremy Garrett: This is not a year-long process at all, not even close. Four months to close on an ESOP transaction, after that initial 30 days to diligize the transaction and make sure that we understand all aspects of the company. So that's what I would recommend. If you're on the fence, talk to somebody like us, and we're happy to do that for any business owner out there. And I think that's a smart move. And if it's not...

Jeremy Garrett: Something that's a fit today, and it's going to be a couple of years down the road, that happens all the time. We've got business owners we talked to five years ago that are now doing transactions. So whenever the time's right for the business owner, that's when we're ready to act.

Chuck Mazzanti: Yeah. So inside of six months, that's kind of surprising, in a good way. And the thing I tell people most times: you're only going to sell a company one time, right? And so you've never done it before, you have no experience. Despite how successful you are in business, you don't have that learned experience unless you've been in M&A or you came from somewhere else. But let's pretend...

Chuck Mazzanti: You inherited the company or you started the company. You just don't have experience in it. And so you should turn over every rock. Talk to the private equity. Talk to the strategic. Talk to a publicly traded firm if they're trying to buy you. But vet out ESOPs too, and you'll find out if it's a fit or not. And if it's not, that's okay. But you should look at every option before you pull the trigger, because once you pull the trigger, it's really hard to unwind, especially with strategic or private equity.

Jeremy Garrett: A lot of transactions that we do on the ESOP side are transactions where somebody tried to sell the company to a third party. They were sold on the fact that they could sell the company for many times more than what they were actually going to achieve in the market. And so an ESOP can be a great backstop for somebody that's gone through that process, tried to sell, and couldn't sell to a third party.

Jeremy Garrett: An ESOP's a guaranteed buyer. So, a great backstop for a transaction. And again, if a business owner likes what they see in the feasibility analysis, once we complete that, to get to closing, we really use that as a roadmap. So it's almost, I wouldn't say certainty, but as close to certainty as possible that they will achieve whatever we put into the feasibility analysis in terms of the outcome of...

Jeremy Garrett: Price, bank financing, the time to get paid off, and the benefits to the employees. So, yeah, the feasibility is a key thing to get done.

Chuck Mazzanti: Yeah, simple and easy. Thirty days. It's well worth it. So, Jeremy, it was a pleasure having you on. I think there are some serious insights that are going to be gleaned from your episode. So I appreciate it. I had a blast having you on. I'll have the link to Lazear's website and your LinkedIn.

Jeremy Garrett: They can reach me by email, jg@lazearcapital.com, or call me on my phone. It's 248-881-4457. So reach out anytime, even if it's just a conversation to kick the tires. I'm happy to talk to anybody about what to do, and maybe there's a way I can connect them with somebody that might help them grow the company...

Jeremy Garrett: To the point where it'll reach what they want to achieve on the sale. So, lots of things I can do and help provide. But I really appreciate you having me on today, Chuck. This has been great. I appreciate the work that you and Christensen Group do, and it's awesome. So thank you.

Chuck Mazzanti: Yeah, the feeling's mutual, my friend. Until part two.

Chuck Mazzanti: Thanks for listening to the Construction ESOP Collective. If this was useful, follow the show and share it with a colleague. Join the conversation with me, Chuck Mazzanti, on LinkedIn and find all episodes at constructionesopcollective.com. Until next time, keep building ownership one conversation at a time.

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