On January 1st, 2021, Lullabot became an ESOP (Employee Stock Ownership Plan) company. Now that one year has passed, we wanted to share the progress, go over some of the challenges, and keep looking toward the future. Here is a Q&A with the two people who put in a lot of the work to make the ESOP transition a reality: Seth Brown, Lullabot’s CEO, and Karen Stevenson, Lullabot’s COO.
The benefits of an ESOP
Why did Lullabot start this journey to be an ESOP?
Seth: Matt Westgate, one of Lullabot’s founders, began looking at ESOPs as a way to provide an exit to owners of closely-held private companies who wanted to leave, retire, or transition without selling the company and changing the culture.
An ESOP allows the transfer of company ownership to its employees with some cool features:
- It doesn’t create an undue tax burden on employees.
- It doesn’t require employees to purchase shares of the company outright.
Karen: Matt wanted employees to end up with something tangible after their time at Lullabot. To have a little pot of money waiting for them at the end of the road. An ESOP is a tool for providing that.
Seth: Exits for the original owners are one of the biggest pitfalls for private companies. If you get an exit wrong, everything you worked on for years and years could vanish. Turning over the company to a third party could change everything about Lullabot. Or it could be a talent acquisition that strips the company for parts to plug in elsewhere, not caring about our clients, our book of business, or the non-engineering employees.
We felt Lullabot was worth preserving beyond just its monetary value. We wanted the company to be around longer than our careers and continue to be a great place where people want to work. A lot of companies don’t make it past the point of the original owners leaving, so it’s a big hurdle we’ve jumped. Now Lullabot has a chance to serve future generations.
Karen: Even if you find someone who wants to buy you and keep the business intact, they’ll spend a bunch of money to acquire you, which means there is a lot of pressure to come in and start cutting costs and getting more stringent about all kinds of things. It would totally change the company.
There are even stories out there of owners who sold their company to the employees but without the structure of an ESOP. And without that structure, things can go wildly wrong.
Even though it is still early, have there been any noticeable benefits?
Seth: No federal taxes! This was the earliest, most immediate benefit. We can use these tax savings to do other things, including paying off our debt, which will help increase our stock price, which benefits all of the new employee-owners.
We hope the ESOP expands our culture of ownership, accountability, and purpose. Most of our employees were already financially literate and brought a lot of ownership-like energy to the company. The ESOP adds some extra kindling.
We hope it will have a good effect on attracting talent and retaining talent. But this is a long game. Talking with others in the ESOP community, it’s around years 6-10 where meaningful growth and wealth become apparent. It starts to have a noticeable impact on people’s lives, and thus, their motivations and attitudes.
You decided to keep a 401K as a benefit. Why is that rare for an ESOP, and why did you feel it was important?
Seth: We didn’t feel like we could take a benefit away from our employees, especially in the early years of the ESOP. Lullabot’s stock price won’t make significant gains until we get that debt paid off. It will take time to build that value, and we didn’t want to slow down or impede employees’ wealth-building while we build that value back.
And the 401K is somewhat liquid. It has an immediate cash value even though it is meant for retirement. Hopefully, it’s invested in a diversified manner. The ESOP stock is 100% concentrated in Lullabot’s success or failure. Having both felt like the right answer.
Karen: Technically, the ESOP is a retirement plan and therefore can be either a replacement for or addition to benefits like the 401K. In some ways, an ESOP is similar to companies with retirement plans that contain stock in the company itself, as some big public companies have.
The challenges of setting up an ESOP
What have been the most difficult challenges so far?
Karen: The process of getting it all set up turned out to be far more challenging than we expected. We were told what to expect in terms of time commitment, and everything was underestimated. It was a huge amount of work to get everything pulled together.
Because we were selling to an ESOP trust, you need to do all of the same kinds of due diligence that would be expected when selling to a third party. And this is a good thing. Of course, we want to verify that the price makes sense and everything is correctly set up. But it required more personal involvement than we expected.
Seth: Since ESOPs are only for United States employees, we wanted some kind of phantom stock for our international people. Even though we were told a lot of companies did this type of thing, it turns out that they don’t. For each country where you have employees, there is a different maze to navigate. It’s something we are still working on and will still be working on for a long time.
Karen had to dive back into her CPA background and figure out ESOP accounting because our lawyers didn’t know.
Karen: An ESOP is a US vehicle designed for US employees. As soon as you have non-US employees, it gets complicated really fast. We still would have moved forward if we had known. We will get where we intend to go, but it’s still the most significant unresolved piece.
What was the time commitment you expected versus the actual time you spent working on it?
Seth: We expected the occasional week where we had to concentrate on the transition. Instead, there were months where we spent 10-20 hours per week on ESOP-related tasks, on top of our other responsibilities. We had been prepped for having an occasional due diligence call, some paperwork, and then we’d be an ESOP.
But everything ended up being more time-consuming.
- We had to organize our financial house in a consumable way for a potential buyer.
- We had lots of forecasting work, including forecasting out for ten years.
- We ended up self-financing, but we also had to investigate other options, which meant talking to a lot of banks.
And it turns out that banks and insurance companies aren’t used to dealing with ESOPs. Simple things like renewing insurance or securing lines of credit suddenly plunge you into new rounds of due diligence. The world hasn’t caught up with ESOPs, even though they have been around since the 70s.
Any pleasant surprises throughout the process?
Seth: How brilliantly designed the whole fabric is. It works to protect all the interested parties involved in an ESOP transaction. Owners get made whole for the business they are selling. They might not get top-market value, but they get a fair representation of an arms-length transaction between an interested buyer and an interested seller.
And the employees are protected by the exhaustive due diligence and everything the trustee does. There’s even some haggling. At some point, we were in this weird situation where you are both the buyer and the seller, at least if you are an exiting owner and planning on staying on for the next chapter.
The system is designed to protect against all of the loopholes and all of the potential ways you could cheat the system. For example, owners can’t take a bunch of cash upfront and leave the employees holding an empty bag. It ensures the continuity and stability of a company in a way that ensures fairness across the board.
It really feels like they thought of everything.
Karen: We had an excellent third-party trustee who knew exactly what questions to ask. The attorneys on our side structured the ESOP in a way that increased our chances for success. There are lots of ways to structure an ESOP, and we had some good guides to navigate us through that maze. Everyone wanted to make the company succeed.
Seth: The NCEO (National Center for Employee Ownership) has also been a bright spot. They pointed us toward SES and helped us find the right people to help us execute. At every step along the way, they’ve had the resources, the books, the conferences, the training, and more to help us make good decisions.
What are the different ways to structure an ESOP?
Karen: One of the first exercises we did was go through a checklist of questions: do you want to do this or that? There is a whole matrix of options for everything about the ESOP. You really need an attorney who understands ESOPs to sort through it all.
- Percentage of the company owned by the ESOP
- Vesting periods for the stock
- Rollover policies
- How to handle different retirement ages
- How repayment obligations are managed
- Stock saved for future employees (sometimes ESOPs distribute all stock to current employees)
- And much more
Each of these categories has many options. There is a huge range of differences.
I went to the NCEO conference later and listened to a lot of presentations that compared different ways to set up ESOPs. If it’s structured this way, it’s better, and if it’s structured that way, you’re going to see some challenges. In every case, we’re structured the better way.
Seth: It’s like building a house that you want to last a long time. If you do everything right, the foundation isn’t going to sink, and the walls will remain straight. Lots of little pieces of craftsmanship that add up. How do you not have huge repurchase obligations too early when we can’t afford them? How do you avoid taking on too much debt that might be impossible to crawl back from?
A good builder will foresee potential problems when building a house. You need someone similar when structuring your ESOP.
Day-to-day running of the ESOP
Lullabot has an internal committee run by employees all about ESOP communication. What is the purpose of this committee?
Seth: We call it the Employee Ownership Communications Committee. Nearly everyone in the ESOP community recommends something like it. It’s probably the second most common committee, second only to the Compensation Committee. There’s even a book that outlines why one is important and how to implement it. Empower employees at the company by promoting financial literacy, celebrating ownership, and helping keep everyone informed.
The mission statement from the committee’s charter is:
To create a team of educated, enthusiastic, and highly engaged employee-owners, while strengthening Lullabot’s culture and ownership values.
I’m the executive liaison for the committee, which means I’m a non-voting member unless there needs to be a tie-breaker. But the committee has a budget to do things like creating an owner’s manual, fleshing out the FAQ work that has already been started, and helping communicate stuff to the rest of the team.
What other things were added as a result of the ESOP?
Karen: We had to add external board members to our Board of Directors. Previously our board consisted of only internal people. External board members provide some balance and help ensure things are fair, equitable, and well thought out.
Seth: The external board members also make up the Compensation committee which controls the salaries of the leadership team. I can’t set my own salary as CEO. This is one of those things that have been figured out over the years to help prevent abuses and mistakes.
Any extra ongoing costs for management?
Karen: There are some additional costs and work. For example, each year, we’ll go through the distribution process that allocates the shares to employees, and we are paying third parties to do that work and maintain accounts. Everyone will have a portal to look at their shares and the value they represent. But the tax savings are so big that it covers our costs for maintaining the plan. The savings also provide money for other things, like paying down the debt.
Knowing what you know now, would you do anything differently?
Karen: We would definitely still do it. It would have been nice to know more upfront, like the time commitment. I think this will be a great thing for Lullabot, and while it’s still early, I feel really good about it.