Welcome back to The Upstream Leader Podcast. My name’s Jeremy Clopton. I’m excited for a conversation that may be a little bit more educational today than some of our typical sessions and interviews where we’re talking about leaders and their journeys. We’re going to be talking about ESOPs and what that means in public accounting. I know we’ve talked a little bit about private equity in the past, we’ve talked a little bit about mergers and acquisitions. So we thought, you know, it makes a lot of sense. What about ESOPs? We’re seeing some firms go in that direction. I’m not the expert on that, so I’ve got one of the experts on that with me here today, I’ve got Michael Bannon. Michael, welcome to the show.
Yeah, thanks for having me, Jeremy. Excited to have the conversation here.
Yeah, I think this will be a good conversation. So you’re a managing director at CSG Partners. I’m going to start off the conversation the way I do every conversation, which is: tell us a little bit about how you became the leader that you are today.
Yeah, that’s an interesting one. So let me go back. I would say it probably starts with my very first job out of school. I went to school in Wisconsin. And immediately, as everyone does, decided to take a job in Asia to invest in private equity for a German firm. And so it was—
A natural transition.
Obvious, about half of Wisconsin-Madison goes that route. But I would say that it all started there. I had a very good mentor at that firm. I probably didn’t recognize how much of a mentor he was until more recently. We were flying around different countries, different hotels, stopping in Subway in Malaysia, and random food, whatever we could do. But also, you know, talking about how he built our office, how he implemented things, focusing on investment acumen, everything we possibly could, but he took a lot of time to mentor me.
Fast forward a little bit, I’m now back stateside in New York working at CSG. As you start as a junior team member, you’re really focusing on everyone above you, taking the pieces that work for you personally, but also that you respect, and discarding things of other leaders—no one’s perfect—putting them aside, etc. And then as you start becoming a leader yourself, it’s just a completely different role reversal. More recently, I’m asking myself more: if I were the junior team member with me, what would I be keeping and discarding, right? But also, I have a newborn at home and recognize how much time that original mentor had allocated and invested into me, and trying to do the same for others. Nothing special, but I think that’s how most professional services, and especially advisory services, work—people to people.
Yeah. There’s so much power and value in a mentor. And I like what you said there about really trying to reflect on that now: If I was the junior team member, what about what I’m doing would be helpful and what would be discarded? That’s such a great approach to continuous learning, continuous development for you, obviously further along in your career, but still recognizing, hey, I can get better, I can improve. Very good approach there. I appreciate your thoughts.
So let’s transition a little bit. You said you took a career initially in private equity, and now you’re with CSG, who specializes in helping not just accounting firms, but helping organizations get into ESOPs. And, you know, for the listeners, we’ve talked a lot on this podcast about folks taking ownership over their careers, which is more of a personal—how do you approach leadership development and growth? But you’re truly out there helping people take ownership over the firms and the industries or the organizations that they’re in. Talk to me a little bit about ESOPs and, just at their core, what are they, how are they structured? How does it empower the individuals that are in a firm that may be looking at or going the ESOP route?
Yeah, so at the very base level, an ESOP is a qualified retirement plan that allows employees to earn stock in the private company they work for. So it’s something if you’re an employee, you’re a staff member in an accounting firm, you’re joining, you get a 401(k) after a year, you probably qualify, right? Alongside that, you might get this weird thing called an ESOP. And you say, what the heck is an ESOP? And it stands for Employee Stock Ownership Plan. And basically what happens in those firms, it means that the owners of that firm have decided to transfer stock or sell stock to a trust that you are now a beneficiary of. So as you progress throughout your career, you earn stock in that private company that you work for, that firm, in your retirement account, at no cost to you. And so it truly is employee ownership. It’s critical to communicate across the platform: How are we improving our stock price each year? What can I do in my role to improve productivity, to improve client retention? Thinking about accounting specifically, be as responsive as possible to clients? All of that comes through when you actually understand the more I do this, the more my stock price is going to go up, and the longer I stay, the more shares I’ll accumulate and actually build up true wealth in a private company. It’s very powerful.
Yeah. So thinking about—there’s a lot of different directions I’m going to go question-wise probably, but let’s go with the accountants direction first, let’s hit the numbers. You mentioned stock price, watching that. I’m thinking about a lot of firms in our profession, they may not even necessarily share revenue numbers or financial performance with those that are outside the equity partner, maybe the income partner room. Does this require that a firm essentially share more financial information with the entirety of the firm? And before we get into, I guess, the nuts and bolts of why someone would do that, how do you get leaders on board with increased transparency in a profession that’s not exactly always known for transparency?
Yeah, I think—well, look, when you set up an ESOP, there actually isn’t any additional required financial disclosure to the participants, the staff members. If I’m a staff member and I receive my 401(k) slip each year, it’ll say how many shares I’ve received that year in total, how many shares do I have, what the value of those shares are, and how much vested I am. For the leaders, your leadership team really has a decision as to how do we communicate the ESOP? Many decide that we need to share some of our KPIs that may have historically been at the leadership level to incentivize some of that ownership mentality and share each year our stock price is up X, our KPIs moved up 30%, revenue’s up 30%, so your share price might be up 45%. Others choose to communicate just in daily tasks: what are we doing this year within your team to improve our performance? I think most teams and groups have their own KPIs that they’re tracking in order to roll up into the firm as a whole, but it doesn’t actually require that disclosure, it’s a spectrum. Some firms may decide to just stick with the slips, some go all the way out to open book management where you open the books to the entire firm. I’d say that’s very rare because I think that can create so many rabbit holes and distract from the actual performance of the firm, honestly.
Yeah. No, that’s incredibly helpful because I could see that being a big—right out of the gate, it’s a huge sticking point of, hold on a second, we barely tell them how much revenue we have, let alone let’s just open the books up. But you’re saying, hey, you don’t have to do that, you can still drive value. So let me go back a little bit further, I guess, then, and accounting firms in particular: Why do you see them going the ESOP route rather than maybe it’s traditional partner succession or private equity or M&A? At some point along the way, they’re saying, hey, we want to transfer ownership, whether it’s all, some, and maybe that’s a little bit of it, but why do you see that accounting firms choose this route over some of the others?
I’d say the first point is, and it kind of ties into what attracted me to ESOP so much in the first place. Remember, I was working in private equity—great, very interesting, very dynamic. I joined CSG, honestly not knowing what ESOPs were, trying it out, trying to understand what this vehicle is. But when I really understood what we were doing is when the firm clicked, and our founder told me, look, what we’re really doing is middle market businesses. When you’re in private equity as an investment bank, sell side investment bank, you’re going to do one deal with the client, whoever you are representing, you’re going to do one deal, maybe a couple with them. The private equity firm that’s buying the firms in that industry, the companies, you’re going to do 10, 15 deals with them, and so there is always an inherent conflict of interest. Private equity firms have repeat transactions—they do transactions all the time—they have the best attorneys on staff, they know exactly what the strategy is, they know exactly what they need to do to generate returns for their investors. And that’s exactly what I was doing previously.
With an ESOP, it’s entirely flexible. It’s a blank slate. As a seller of a business, as an owner of an accounting firm, you have this vehicle where you can create your own transaction. You have partners such as CSG, your attorneys that are helping you structure the deal. Whether it’s a minority transfer sale, a majority sale, figuring out your tax structure, what is the optimal go-forward tax structure for the firm? How do we create management incentive plans for future generations, not just current partners? What about the staff? How do we incentivize our staff? Precisely because we know our staff better than anyone else, how are we going to use these up to incentivize them? And so it’s basically taking all the tools that corporate finance, private equity, M&A advisors have, but applying it to your own objectives and your own firm without anyone from the outside coming in to tell you what to do. And so that’s what’s—it’s really a platform and vehicle to accomplish those goals. There’s all bells and whistles, there’s tax savings, there’s all sorts of stuff we can go into, but really the core piece is you are designing your own future and you’re able to continue to operate that future.
Okay. So do you often see the current partners will sell a majority of the firm? Is it more often a minority interest? What do you see in the accounting profession as far as the way it’s commonly approached or even professional services more broadly?
So for professional services, it’s usually a minority sale to at least begin. Professional services, whether you’re talking about medical, dental, architecture, accounting, generally have higher EBITDA multiples. What’s being paid by private equity firms out there. And with the ESOP, you want to ensure that that is shared across generations, so if you start with 30% today, and maybe you do another 19% in a couple of years, and at some point maybe you go to majority, you’re creating more and more on and off ramps that you have control over. With the ESOP, there’s no buyer saying, okay, or owner saying, now we have to go out and sell another stake. Your leadership team is deciding when we should create those on and off ramps to motivate the younger partners, but also motivate the senior partners and make sure that everyone’s aligned. So I’d say in general, the majority start with a minority state and build up over time. There are very enticing tax benefits when you get to 100% employee ownership, the firm would become 100% income tax free at the federal level in perpetuity, and I would think about 35 or 37 state levels. And so that is, you know, many times you’re structuring in a way to get to that long-term goal and using other ESOP deductions in the interim to minimize taxes along the way.
Okay. So do you see that that is often the goal—firms that are going this route—is getting to that 100% and perhaps partners then just have more shares, I guess is how that would work out than staff would or however that would be, but do you see that as the goal is to get to 100% so that you do have not only the incentives that you talked about, but also then, the tax benefits?
Yeah, the tax benefits are big, the fact that you have more stock for employees to share is big. And then yes, of course, in accounting, it’s very different. You have to set up a separate pool for partners, it’s a larger class than if you took a widget manufacturer and there’s one owner and one, maybe two or three C-suite members you have to take care of. In professional services, you always have to create an incentive pool that’s significant for the partnership class, whether it’s income or equity partners, or split in between. Again, going back to the point I made earlier, all of that design is decided by the leadership team, and so ultimately you’re deciding how you want your new hire to come in, invest into the ESOP, accumulate shares. If you have income partners, once you become an income partner, what do you get above those shares? And once you get to equity, even if you’re 100% tax free with the ESOP, what do you get as an equity partner at that point? And usually it’s a large pool of synthetic equity above and beyond the ESOP itself.
Okay. So are you seeing—we talked a few episodes ago on this podcast about how we started this show back in 2021, and we were talking about some of the changes. Private equity, as it turns out, is one of those big changes in our profession in the last five years.
Absolutely.
As much as everybody’s talking about it, and it has just become so commonplace, it’s hard to believe it’s only been a handful of years that private equity has really successfully been in public accounting. Seems like ESOPs have been around a little bit longer, maybe not as high profile and as much glitz and glamour in the press about it, so to speak. But have you seen an increase in interest in ESOPs since private equity entered the space? And if so, what have you seen—why firms are choosing this over private equity in the last few years? I know you talked broadly about the reasons, but have you seen more of an interest in this as private equity’s played a bigger role?
Yeah, I mean, to your first point, about half a percent of the M&A market is ESOPs, so it’s not on anyone’s radar. Broadly speaking, selling your business means selling to a strategic buyer, or private equity, maybe some sort of internal transfer. ESOPs, if you’re lucky, you have an advisor that knows what an ESOP is and at least brings it to the table to you. That’s different in accounting. So what I’ll say is private equity followed a very similar track with medical practices starting 2013, 2014, up until 2019 roughly, there was a lot of M&A activity in that space. We weren’t introduced as much as we are in accounting. In accounting, ESOPs are much more prevalent because every single transaction we work on has an accounting partner on the deal. You have your assurance partner, you have your tax partner because of the tax-driven strategy where they’re intimately involved on the front end in terms of working with us and structuring. We usually need clients to get audits, we need QVs. They know us, we know them, and so now it’s—private equity’s moved into accounting, and so that raises the question, hey, if private equity’s here, what about ESOPs? And to your point, ESOPs, there have been ESOPs in accounting for 20-plus years, not super high profile, not the largest firms until more recently.
So yeah, a lot more managing partners are reaching out to ask, what would this look like for us? We’re a fiercely independent firm. We don’t have any interest in doing a private equity transaction, at least today. So what could an ESOP deliver in terms of helping us grow in a tax-advantaged way to compete with private equity-owned firms, to compete with larger, consolidated firms and kind of create an independent alliance of firms that do not want to sell to a third party today, but want to remain CPA owned and operated.
Yeah. So what’s an ideal firm look like for an ESOP transaction? Is it the $100 million-plus firms? Is it $5 million firms? Is it 25 people? 500 people? What’s kind of an ideal fit for an ESOP transaction?
Honestly, I’d say it’s mostly right in the middle of the spectrum you just gave. It’s probably $20–25 million revenue up to, you know, $100-200 million. Above that, there are so many partners involved that the design of an ESOP can become like herding cats, to some degree. And then under $20–30 million revenue, the cost and the implementation of an ESOP may be too much. And taking on outside financing, managing this plan, having an outside trustee, putting together valuations—it can just add administrative burden to those firms. Somewhere in the middle is a sweet spot in terms of size, and the second and probably most important piece is that you have a leadership team that has a strategy, knows exactly where the firm’s going, isn’t sitting around scratching their heads, wondering, what do we do now? They know what the strategy is, and so all you’re trying to do is plug the ESOP in to help turbocharge that strategy. It’s not a strategy in its own right, just like private equity isn’t a strategy in its own right. You’re going to private equity because you need to cash out partners or you want to acquire other practices. So again, you need a firm that has a leadership team in place, has their strategy, and wants to look for tools to implement that strategy.
Okay. So the ESOP would help with a capital infusion, I guess, since you’re selling part of the firm to that trust, so to speak, or I guess not so to speak, I think. As I understand, right, that’s how that works. So it helps with a capital infusion, like you said, another method to be able to compete with those private equity-backed or consolidated firms because of that. Is that fair?
Yeah, exactly. So if you have a firm and you’re retaining, let’s say, $10 million of retained earnings each year, whether you are about to go to private equity or if you’re a standalone practice or you’re preparing for an ESOP, if you do nothing as a partnership, you are going to incur $3.7 million federal tax on that, and depending on your state, maybe another million dollars, let’s say, so $4.7 million tax. With the ESOP, you’re able to wipe that out. So now you’re retaining $10 million and you have $10 million to allocate however you see fit. Maybe if your goal was to cash out partners, you probably took on debt to cash out those partners. So maybe some of it goes to pay off debt. If your purpose for the ESOP wasn’t to cash out partners, it was for growth, then you have $10 million to use for expanding operations in geography, self-financing, at least a part, or if not all, of acquisitions of other firms. You have so many—expanding service lines, right, if you’re trying to expand your advisory services, you need to pick up some high-profile partners to help you kickstart a couple of practices, you have the opportunity to do that.
It’s really freeing up cash flow that otherwise would go to the government. It’s very interesting. It’s turning what the advice that a lot of accountants, tax accountants, give to their clients, but flipping it back and looking internally, which again, you know, I’m in professional services. We don’t do enough of that. We give plenty of advice. We hate looking inside and applying it ourselves.
Yeah, it’s easier to tell other people to do it.
It’s hard.
Yeah, it’s easier to tell other people to do it than to do it ourselves. Well, Michael, we’ve talked about it from the leader standpoint. If you could talk a little bit about the impact that this has on all the other levels throughout a firm. So when they go on ESOP, it’s been implemented. We got through the—which most people probably wouldn’t see all the challenges that go with that, that’s going to be leadership and some folks in the administration are going to see that. But say we’re a couple years on, we got through that and everything’s working well—what is the impact on team members at all the other levels in the firm once an ESOP is in place? Because I would imagine when you’re trying to get people to take an owner’s mentality, being an owner would have to help with that. Does being a part of an ESOP help, or is it so small that people are like, eh, I’m not really an owner? Talk a little bit about what you’ve seen there.
Yeah, it comes down to the culture and communication. If you are a couple years in, dollars are starting to build up. If you don’t have any communication about the ESOP, it’s probably around year five, year six, where at that point the numbers speak for themselves, but then you’re five or six years behind the ball. So just in terms of statistics, ESOP accounts are about two and a half times the entire retirement wealth that a non-ESOP household has. So that account alone is massive over time. Productivity increases in firms about 3.5% in the first year after an ESOP, and then 2.5% every year thereafter. Turnover is half of what it is in non-ESOP companies. And then going back to prior to the ’08 crisis, until now, firms that are ESOP owned are half as likely to go bankrupt as non-ESOP firms.
Oh, wow.
And again, there are so many different reasons for all of this, but if you are focusing in on the employee side, the staff member side, the employee owner side, it works because of communication, understanding what the benefit really is, understanding that it’s not a get rich quick scheme, just like starting a business isn’t get rich quick, right? You might get lucky, more likely than not, like all of your clients, you’ve built up a business over your career and then you cash out at the end, right? And so that’s exactly what it is: It’s a retirement plan, you build up significant balances in a tax-deferred retirement account, and you cash them out when you leave the firm or retire.
The retention is huge, right? Especially in professional services, we do ESOPs for widget manufacturers, construction firms, etc., and retention is big there too, but when your firm is built off of human capital as opposed to securing contracts and finding customers day in, day out, to sell your widgets to, you need to incentivize that human capital. And that’s why, by far, the ESOP has the greatest impact in professional service companies that adopt them. You understand, you know what your value is. You’re building it up. You understand that the owners of the firm have invested into you to share in that ownership. And you also know, you look around the room and you say, if anyone here isn’t pulling their weight, I don’t want them here. So eventually you create this very solid core of people that are pushing the firm forward and focusing in on how do we individually build our share price.
Yeah. Like you said, communication and culture become so critically important in that it’s not like an ESOP itself does all this. You’ve got to communicate about it. You’ve got to be talking to people about the benefits, how it’s incentivizing them, helping connect them to what they do and what it means from a value for the share price and all of that, which, you know, it’s a tool that facilitates that conversation and then facilitates that value transfer, it sounds like, obviously at the end of the day when somebody cashes out. But yeah, so important, the communication piece. Like you said, there’s no get rich quick scheme by starting a business, there’s also no shortcut to communication. It’s not like you can just say, hey, we’re an ESOP now. Figure it out. This has all got to be good, still got to talk about it, still got to sell it. Still got to help people understand the value.
Yeah.
Michael, this has been an incredibly helpful conversation. If somebody’s listening in and they’re like, all right, I’ve got to learn more, how could they get in touch with you to learn more about ESOPs and what you all do at CSG?
Yeah, feel free to check out our website. We have a big library of resources there, CSGPartners.com. If you go to our team page, you’ll find my contact info there. Feel free to reach out and peruse the resources, see if there’s anything we can help out with.
Awesome. Well, Michael, thank you so much for joining me today on The Upstream Leader. I’ve enjoyed the conversation.
Thank you, Jeremy. Take care.
