by Lee Eisenstaedt
Continuous Education is Critical to ESOP Success
A Conversation With
Managing Director, Financial Advisory Practice Cognient Advisors
Dan Bayston joined Cognient Advisors in 2009 as managing director after a 25-year career
with the financial services and business valuation firm of Duff & Phelps. Dan sits on the board of several ESOP companies and is able to offer unique insights into what makes an ESOP successful and how ESOP culture plays a role in the company’s achievements. He considers strong leadership and a commitment to continuously learn and grow vital components of success for any organization.
Leading With Courage Academy: When you get up in the morning, what makes you smile? Dan: Seeing my kids at breakfast. My family, to me, is the highest priority. If you were to ask me what I think my accomplishments have been, I always think about being a father and my family before my professional accomplishments. What makes me happiest is still being friends with them. My kids are 15 and 13, so they’re still in their formative years. It’s exciting to see them look at the world and the opportunities that are out there. I think kids today are much more focused [than previous generations], but I don’t know whether they’re much more curious than I was at their age despite having much more information at their fingertips. My kids are still at the age where they want to hang around with dad, but I know that won’t last much longer.
When I was growing up, I just wanted a job when I got out of college. An organization’s purpose was a secondary or tertiary concern to me and my peers. That’s changed. Now, a primary concern of younger people is the company’s purpose and how they fit into it. What are you seeing?
A couple of the companies that I serve on the board of, for example, a civil engineering company, are finding that when they’re interviewing new engineers, they’re having to talk about the work the interviewee may have to do for the oil and gas industry.
Some of these millennials are asking questions about fossil fuels and their impact on the planet. They want to understand how the company rationalizes their work and why that’s an important thing, and would they be required to work on projects that are supporting the fuel industry? It’s something that didn’t occur when I was first looking for a job. Much like you, I was just grateful to get one.
Young people today are very different in the way that they approach life decisions and their career development. I think companies have to revisit this whole concept of what their vision is and how they can respond to some of these environmental and social issues. Employee engagement has become much more of a priority. (Note: this conversation was conducted before COVID-19 was declared a pandemic and before the racial justice movement became the national issue it is today.)
What’s the most important thing I should know about you professionally?
One of the things that I like about the work that I do in the employee stock ownership field is the fact that you’re helping employees that would not otherwise have an opportunity to have an ownership stake in the business that they work for, have an equity stake in their company. That’s gratifying.
How did you get to where you are today?
When I came out of undergrad from the University of Illinois, I worked for a firm called Duff & Phelps. They had a large equity research department where they wrote detailed investment reports on public companies. I was hired as their automotive analyst and also did work for the home building industry. Their approach to looking at public companies was more fundamentals-based as opposed to valuation-based. I spent a lot of time analyzing the strength of the management team, market share, the economic outlook for the industries and their competitive landscapes.
I did that for four years and then was faced with the opportunity to go back to graduate school to get my MBA on a full-time basis. Duff & Phelps approached me and said, “if you stay with the company, we’ll pay you for your education plus if there’s something else here you’d like to do, let’s explore that.” They had a small consulting group that did some work for private companies. This was in the 1980s and the ESOP world was just starting to develop. I decided that it’d be in my best interest to stay with the firm, have them pay for my education and do something a little bit more challenging.
Duff & Phelps financial consulting blossomed into an ESOP advisory service and my partners and I grew it from a staff of 20 people to ultimately a staff of 150 before we sold it. We worked with private business owners trying to establish and understand their goals and objectives from a shareholder perspective, an owner perspective and a parent perspective. Our specialty became utilizing an employee stock ownership plan structure to accomplish those goals. There probably weren’t that many people doing this in the early 1980s; it was still a pretty new business.
So, when did you form Cognient?
I worked for Duff & Phelps through 2008 as it went through several ownership transitions. In one transition, we combined with a much larger organization headquartered in New York. Since I was one of the original partners, it became clear to me that their business strategy was different than what my business had been in the past. They were no longer interested in small or mid-sized private companies. They were interested in working for large, public companies. At that point in time, four of my former partners and I formed Cognient Group to go back to our roots of helping private companies and family businesses understand the value of their businesses and help them strategize ways to monetize those businesses.
So, you’ve been doing that for the past 12 years?
Yes, and what we have found is that there’s been a strong demand for independent third parties to provide solid financial advice on how an ESOP structure might work.
What sort of sacrifices or compromises did you have to make to get where you are today and were they worth it?
I didn’t start a family until I was older. Unlike my parents, who had me when they were 21, my first son was born when I was 43. I like the fact that I’m an older father. You know, that gave me some advantages. There was that period of time in my career when I was solely focused on my career development and probably missed some opportunities to do other things personally. But at the end of the day, I’m actually at the point in my career where if I need to take an afternoon off you go to a function of one of my kids, I can do that. Whereas if I was in my 20s and 30s, I would need to keep my nose to the grindstone. So, I don’t feel like I’ve given up much.
Did you eventually go to grad school?
While I was at Duff & Phelps, I was admitted to Northwestern University’s graduate business program, which I went to at night. I was fortunate that I did not yet have a family. Some of my classmates had small kids, so they had more than a full-time job on top of going to night school - I don’t know how they did it. When you go to night school, it becomes a significant time management challenge with all the commitments you have at work, the personal commitments you have and then you have school on top of it.
I recall when a day student joined one of our night classes. We had a team project and the professor separated us into groups and told us the date we would make the final project presentation.
The day student said, “Well, let’s get together next Tuesday and just kind of brainstorm on how we want to approach it. And maybe the following Friday, we can kind of start to assign responsibilities for things. Then, the week after, we can get together again and start talking about how we might draft the presentation.”
I had to interrupt him to say, “We don’t have time for that. Over the next 20 minutes, we’re going to decide what we’re going to do, who’s going to do it and we’ll get together one time to have everyone bring their stuff together and finish the project.” And I know he was a little taken aback, but that’s reality when you’re working a full-time job. You don’t have an endless amount of time to get projects accomplished.
How did you develop as a leader?
I’ve always been involved with other organizations, so in terms of leadership, it’s not just been leadership through the corporate perspective, but leadership through being involved in different organizations and taking on leadership roles within them
For example, today, I serve as chairman of the board of trustees of Sacred Heart Schools in Chicago. We have more than 700 students, which means we’re dealing with lots of different constituencies: parents, alumni, faculty, etc., but it’s all volunteers and it’s a mission-driven organization. So, you have to be focused on the fact that not all of your decisions are going to be objective, simple financial choices, that you sometimes have to make decisions that aren’t necessarily the best financial ones, but they are consistent with the organization’s mission.
How much of your time do you spend on ESOP versus non-ESOP companies?
I would say close to 90%. With private companies, a lot of times we might start by doing an evaluation for a business owner of the alternatives for monetizing the equity value of his or her business. Now, the ultimate way to monetize it is to sell the business. But not every business owner wants to do that. Some have companies quite frankly are not good candidates for either a strategic buyer or a financial buyer given either their size or their particular market niche. ESOPs offer a great alternative to be able to have the employees step into that role as a buyer for that sort of business.
How did you come to sit on so many ESOP boards?
At the same time that I left Duff & Phelps, I had been approached by one of my former ESOP clients about coming onto their board. The company’s chairman said his board of directors was dominated by management as opposed to independent board members. That became my first corporate board seat, which led to other opportunities from a governance standpoint for ESOP companies.
I usually get recommended by an ESOP trustee to sit on the board. It’s all through referrals and networking. You can’t just present yourself to a company and expect a seat. Having a trustee recommend you is how to get in with an ESOP company.
As far as your journey of learning and educating yourself about governance, how did you pick it up?
By becoming involved. The first board I sat on I knew how they worked functionally, and I knew about their fiduciary responsibilities. What I didn’t realize or appreciate was the very vast array of issues that a board member has to deal with in corporate governance. It’s something that I’ve learned by experience and asking a lot of questions as opposed to formal training.
You are just a board member, right? Or do you do some trustee work as well?
No, I would never serve as a trustee. As a board member of the company, I represent all shareholders. The trustees are there for all the employees. Trustees can’t sit on the boards of companies, so they want to have comfort that somebody is on the board who is knowledgeable, not just about ESOP issues, but about business strategy, holding management accountable, etc. That’s a role I fill.
What’s the distinction between the role of trustee versus board member?
The rules are very distinct and different between a board member and a trustee. A trustee has a well-defined fiduciary responsibility to the ESOP participants. A board member has a fiduciary responsibility to shareholders and all stakeholders of the company. A trustee is legally liable and responsible for the oversight of an ERISA plan and as a result needs to have a solid working understanding of the related regulations.
I think it’s harder today for single individuals, those unaffiliated with a larger organization or institution, to fill adequately the role of ESOP trustee. This is because the US Department of Labor (DOL), over the last number of years, has been very critical about the decisions that some ESOP trustees have made and the quality of documentation been maintained. If you’re not an experienced ESOP trustee, either as an individual or as an institution, when the DOL audits your ESOP plan, you’re likely to face significant criticism.
Some companies choose not to have an independent trustee. They will have one or several employees act as trustee of their plan. That’s particularly common for smaller companies that are more cost conscious. I would argue, however, that most of internal trustees probably don’t fully understand their responsibilities as an ESOP trustee or the liability involved in that position.
An independent trustee may not be the cheapest, but it’s the highest value. I’ve always described it to clients like it’s an insurance policy. You’re hiring somebody to come in, even if he or she is just coming in for the initial transaction. Because if you’re the seller, which hat do you have on? Do you have your seller hat on or do you have your trustee hat on? As an independent trustee, it’s much easier to answer questions about why the company paid a specific purchase price and other questions about the transaction that could, and usually arise. If you could look and say, that was handled by somebody who was an experienced third party, you take the burden of the liability off of yourself. Third parties also tend to have deep support and more resources behind them which is rare in the case of an internal trustee.
How do you balance multiple people wanting control in an organization?
I think one of the misconceptions of the people that join a board of directors of a company is that it’s just all going to be a nice relationship and that you’re never going to lose sleep. That might be the case for a few companies out there, but it’s not the case for the majority of them.
I once served on the board of directors of a 100% ESOP company that was struggling financially. I was the sole independent director. The other three directors were the CEO/Chairman, vice president of marketing and the CFO. I started to challenge business decisions. I challenged management compensation. The then chairman and president did not regard kindly my challenges, but I was doing the right things. I stayed on the board and eventually replaced him when he was removed from his position.
You’ve seen a lot of transactions. What makes the ESOP transaction in your mind so special and unique?
I think what makes it unique is how inclusive it is. It provides benefits to all of the employees since an ESOP cannot be set up to discriminate against any of them. When ESOPs are well-communicated, successfully integrated into the culture of the business and used to motivate employees, they can work quite well. But if an ESOP is just put in place to buy out a selling shareholders’ interests and if the employees don’t get much information about the company, it’s probably not going to work out as well as it otherwise could.
I think the most significant risk for ESOP companies at the beginning is that they’re typically carrying a lot of debt. That’s because many ESOPs are financed with borrowed money. It’s like any other type of debt-based transaction; you want to make sure that the amount of leverage on the balance sheet is commensurate with the ability of the company to pay back the debt, both in good times and in bad times. If a company is over-leveraged and it’s in a very cyclical business when it heads into a downturn, like today, you can find that the ESOP equity value is wiped out and you might find that the employees lose their jobs.
Have you ever come into a situation where the ESOP exists, but it wasn’t being managed particularly well and had to help turn that situation around?
I’ve had to help several companies that I’ve been on the board of make the transition to being an ESOP. I think one of the benefits of having someone involved on a board level with ESOP experience is that they can give guidance to the management on how to better communicate the scope and benefits of the ESOP plan and how to more effectively integrate the ESOP into the company’s culture.
ESOPs don’t usually become successful in the first couple of years, it’s a long-term plan and commitment. To realize all the benefits of the ESOP, you have to have an action plan of what you’re going to do, when you’re going to do it, and what success looks like. These things don’t happen just because you now have an ESOP and employees get account statements. You can’t limit your communication to saying “instead of a 401k balance, you’ve now got an ESOP balance.” You’ve got to be much proactive and consistent in terms of your communication with stakeholders.
I had someone tell me, you don’t create the ESOP to create the culture you want. That culture has to be there from the get-go and the ESOP is just going to leverage and magnify it. Do you agree?
I do. I’ve often said to clients that you do not put a square peg in a round hole. So, if I’m working with a family run business where the patriarch of the family has a hard time sharing his equity ownership with his children, chances are putting in an ESOP in which they share the equity ownership with the employees probably isn’t going to be all that successful.
So there are certainly red flags that I think you have to pay attention to. You can change the culture to some extent, but you’ve got to have the basic values and habits in place to start with.
Any other red flags you’ve seen?
From a financial perspective, a red flag would be a very cyclical company that already has a lot of debt. Taking on additional debt to establish the ESOP is probably not the smartest thing to do.
Another red flag is ownership that is very resistant to sharing the stock among family members. Another is companies that have high employee turnover, such as some service businesses, are probably not the best fit for an ESOP. You’d like to have companies that have a sustained and loyal workforce.
What sort of mindset do you think the leader of a successful ESOP has to have?
I think they have to have good business judgment and understand that their constituencies and shareholder base are more diverse than ever before. Now, I am also a firm believer in communicating the ESOP plan to the employees so they understand it’s a unique kind of retirement plan program. For example, instead of having a portfolio that’s invested in 20 different stocks or mutual funds, they have a retirement program that’s invested in one asset and that’s the company’s stock. They have to demonstrate and promote the attitudes and behaviors that has everyone thinking and acting like owners,
Employee-owners also need to understand that participating in the ESOP doesn’t give them the right to go into the president’s office and share with him or her how they think the company should be run. It doesn’t give them a vote on policies and procedures, strategy, new products, etc. It also doesn’t give them the right to see the company’s financial statements, to inspect the accounting records, etc.
Most of the time, I hear, “Don’t invest all your 401k in the stock of your company that you’re working for.” And we’re advocating doing just that in the case of an ESOP. What’s your comeback to an employee that asks about this?
They’re right to be concerned in some respects. When ERISA was established in 1974 it was based on the idea of promoting diversification of retirement assets. So, when people ask me why the Department of Labor is so negative on ESOPs and keeps such a close eye on them, it’s because an ESOP does precisely the opposite.
Yes, ESOPs are invested in a single asset. But I prefer to look at the ESOP as creating an opportunity that doesn’t typically come along for most employees. There’s always some risk when you’re invested in one asset as opposed to many, but it’s like anything -- there’s a risk-return tradeoff.
One of those tradeoffs is how the typical ESOP outperforms its competitors with regard to sales growth, profitability, employee retention, and other key business performance measures.
Is there any advice you’d give someone going into an ESOP leadership position for the first time?
I would say the most important piece of advice I would give for a leadership team in a new ESOP company is to continuously learn more about ESOPs. You can do that by regularly attending ESOP industry conferences and forging friendships with other ESOP leaders. The most valuable resource that my clients tell me that they’ve gotten out of attending conferences is meeting other executives and hearing from them about their successes and what they would have avoided or done differently. Be curious and don’t hesitate to ask what you may think are “dumb questions” because ESOPs are complex. They’re complex for professionals like me and they’re wildly complex for management and leadership.
When you say they’re complex, it goes beyond the technical, right?
Yes, they’re highly regulated by the Department of Labor and the regulations are sometimes a moving target. There’s also a lot of interplay between employees as owners and effectively using the ESOP trust as a compensation incentive and retention program.
Can you tell me about the hardest decision-making moment you faced as an advisor?
I think the hardest decision comes down to working with companies that are trying to evaluate what’s the right alternative. Working with the owner, trying to understand his or her priorities and then trying to give them advice as to which path they should follow. It’s probably the most difficult decision they’ll make.
At the end of the day, they’re going to have to answer these two questions: What’s the best path for me and what’s in the best interest of the company? If you sell to a strategic buyer, a significant amount of control is lost. There might be significant disruption in the company going forward such as relocation, layoffs, and changes in leadership. If you sell to an ESOP, it might have an opportunity for tremendous ultimate returns to the employees, but that does not come without some risk. The company has got to make the right business decisions over time and try to balance the competing interests.
Is there a particular type of business that tends to work better as an ESOP?
I have found that professional service-related businesses tend to be, in my experience, more successful at becoming ESOPs. This may due to how their employees have a bit more formal education and tend to understand the risk-return trade-off more quickly and better. They have a more balanced understanding of how making investments in retirement assets can be a positive thing for the business.
Engineering and architectural firms, software developers, and consultants - they all seem to appreciate the balance between the risk and reward of an employee ownership plan.
ESOPs, no matter how successfully they are communicated or how much management tries to integrate them up into the culture of the business often aren’t viewed as a meaningful program until employees hear about their peers and colleagues who receive a large check from the ESOP when they retire. Sometimes that’s when the light bulb goes off that this is an excellent program. So, it takes a lot of communication, patience, and persistence. It doesn’t happen immediately.
What do you think about the future of ESOPs?
I think that ESOPs are going to continue to evolve. The most significant risk ESOPs have, particularly an S-Corp, is the fact that there are substantial tax advantages available to the company. One needs to be aware that our government is always searching for additional sources of revenue. However, that’s been the case ever since ESOPs came out and they’ve survived this long. I would expect that they’re going to continue to survive.
One of the ESOP companies on whose board I served saved enough money from not being a taxpayer, because we were 100% S-Corp, to build a new plant. Now, if my competitor knew that I had this special tax advantage because of my ownership structure and that I was able to save $15 million to either modernize my equipment or build another plant, they might make an argument that that’s unfair and put pressure on that the same structure should be available to everyone. It already is available to everyone, but it is a choice that comes with its own risks and rewards. I will say the ESOP community has done a stellar job in making sure that they have a voice at the table whenever there are proposals for a cutback on ESOP tax benefits.
Do you think the number of ESOPs will grow?
I don’t expect this is going to grow. I mean, when I think about my client base, every year we add new ESOPs, but every year we also lose companies that are being sold. So I think the net effect over time is the number of ESOPs will be stable. We’re not likely to see a big boom.
What has to change for the number of ESOPs to grow?
Well, I think one of the big benefits to owners of C-corporations, when they sell their company, is they have the opportunity to defer the capital gain on the sale. That’s not a benefit that’s provided to S-corporations. So, if suddenly legislation was adopted that allowed S-corporation business owners to defer that capital gain, that might be an incentive to increase the number of ESOP transactions.
What are a few resources you would recommend to someone gaining insight into becoming a better leader of an ESOP?
Attend ESOP regional and national conferences. There’s not just educational seminars at these conferences, but they offer the opportunity to network with other ESOP business owners so that you can ask them the very specific kind of questions about their unique management challenges.
What are you doing to ensure you continue to grow as a leader?
Always being curious. I try to be active as a director in organizations that talk about multiple aspects of being a director, not just necessarily an ESOP company director. Being a lifelong learner means having a passion for learning, so I’m always looking for ways to improve myself, to be more self-aware, and to better understand what’s going on around me.
Leading With Courage Academy works with owners and leaders of employee-owned (ESOPs), family-owned, and privately-held organizations who want to build healthier, thriving, sustainable organizations. Get in touch with us to learn more about our succession planning process, leadership assessments, and workshops that are designed to help you create a culture of Ownership, Leadership, and Character-based Capitalism: (312) 827-2643.