Philip Derrow has experienced the good, the bad and the ugly when it comes to employee stock ownership plans.
As the longtime president and CEO of Ohio Transmission Corp., he runs what was the second ESOP ever formed in Ohio. He also has bought and sold ESOPs, including OTC — the parent company of OTP Industrial Solutions and Air Technologies — to Chicago-based private equity firm Fontenac Capital in 2013.
“I would strongly caution anybody considering transitioning majority ownership to an ESOP ownership to have a lot of conversations with people who have done it, that have tried to exit it after they’ve done it,” Derrow says. “They need to talk with people who have experience on all sides of that particular topic.”
Dealing with ESOP ownership adds another layer of advisers to the deal process, he warns. “It can get really messy.”
We spoke with Derrow, who has sold his business to three different PE firms and has bought 27 companies, about ESOPs, openness during transactions and two important rules when making deals.
The intersection of culture and ESOPs
ESOPs are an option for primary ownership to take some chips off the table, particularly if they want to share the ownership or give the opportunity to their associates. That’s what we did, and it was the right thing for us to do culturally. But you have to be committed to making it part of your culture, and after it is part of your culture, whether you’re an ESOP or not is less important than the culture that underlies it.
In the early 2000s, our associates chose to focus less on ESOP ownership than on 401(k) benefits. We gave them a choice between one or the other, and most of them chose 401(k), so we had been diminishing our ESOP value for some years at the employees’ choice. Even after we went away from 100 percent ESOP ownership to significantly less than 100 percent, the culture of openness and open book management had already become ingrained.
In an ESOP, there are two more advisers because you have the company’s attorney that represents the company, the company’s accountant that represents the company, the ESOP counsel that represents the ESOP and the ESOP trustee that represents the ESOP. You have two more people, and they don’t necessarily have the same interests as the company.
It can get really messy. Unfortunately, our experiences there are even more painful than our experiences with the other two advisers.
Transparency is key
The overriding key principle for us is openness during the transaction. That doesn’t mean while you’re still in negotiations, you tell the other parties exactly what you’re willing to settle for. What it means is — particularly as part of the diligence process — you hide nothing. It’s going to be found out anyway.
We hold absolutely to the ‘Don’t lie to anybody’ rule. If somebody asks a direct question, you give them an answer, even if you didn’t want to answer.
Find a good cultural fit or run away
Rule No. 1 is if it’s a bad cultural fit, you can’t pay too little to make up for it. You can’t get a good enough deal on price to make up for a bad cultural fit.
The minimum time to change culture is three years, in our experience. Those three years are going to be very costly both in money and time, and there’s no guarantee it will be successful. So, unless you pick it up for free and have extra time on your hands, don’t acquire a company that is a bad cultural fit.
We’re able to assess a cultural fit really early in the process. We don’t even get to the LOI [letter of intent] stage until we have a good sense that it is likely to be a good cultural fit. The only true cultural failure we had was one of our very first transactions. It ended up failing, but fortunately, it was a very small company, three or four employees. We were able to bear it, but we learned.
There always will be some cultural differences. One of the ways we deal with those differences is what we refer to as the Business Hippocratic Oath.
We have a policy of first do no harm. What that means in practice is we change nothing right off the bat. We rarely change the name. We never change pay plans. We almost always have to change insurance, just because it’s almost impossible to keep the previous plan, but we work hard to make sure that there’s no harm that results. We don’t change reporting structures. We don’t change phone numbers. We don’t change email addresses.
Eventually things change just because eventually things change anyway. If those changes are good, then they’re good. But we don’t make changes that are bad for employees because that’s bad for us.
Get the right lawyer and accountant
Rule No. 2 — and the thing that causes the most trouble in the transaction process — is sellers who don’t spend the money and the time to get competent advisers. By far the biggest problem we have in transactions is sellers that are not well prepared and are not well advised.
Unskilled advisers want to do a good job, but they don’t have the ability to. So, because they tend to make up for lack of skill by trying to be zealous representatives for their client, they just make it more difficult. It ends up costing more. It ends up taking longer. It doesn’t benefit anyone.