Transferring Ownership of a Midsized Firm: How HdL Made Its ESOP Work

Posted on October 2, 2018

With 70% of small and midsized business owners poised to retire, the owners, their families, their loyal employees, and their customers deserve a structured and effective succession plan.  Here’s how one company did it right.

Originally posted on Forbes online: https://www.forbes.com/sites/robertsher/2018/09/25/transferring-ownership-of-a-midsized-firm-how-hdl-made-its-esop-work/

Some 70% of owners of small and midsized U.S. businesses will retire in the next 20 years, selling or passing on $10 trillion in assets (California Association of Business Brokers). Yet 58% of 200 such firms surveyed last year by Wilmington Trust don’t have an ownership transition plan for the business. That’s a recipe for trouble for owners who don’t want to sell their business to another company and yet want it to keep going after they exit to fund their retirement.

These owners may have the option to sell it to employees through an Employee Stock Ownership Plan, known as ESOP. It can be a viable choice: Owners can fund their retirement, keep their firm independent and watch employees carry on their legacy. However, moving to an ESOP isn’t risk-free. The new owners must be strong leaders, and the business must generate enough cash to fund itself and buy out the old owners.

If owners of midsized businesses fumble, it could become a widespread problem in the U.S., given that tens of thousands of Baby Boomers looking to exit and that midsized businesses account for 34% of U.S. GDP and 33% of employment, according to Ohio State University’s National Center for the Middle Market. Moving to an ESOP requires exceptionally strong planning. The story of HdL Companies, a Southern California-based professional services firm, is a case example of how to do it right.

How HdL’s Owners Solved Their Transition Problem

To successfully transfer ownership, a strategic approach is required: identifying the next generation of leaders and owners, getting their buy-in to invest their lives into the business and finding a way to fund the buyout. And founders must truly hand the reins of leadership over.

Consider HdL Companies, which was founded in 1983 by Robert Hinderliter, with co-owner Lloyd de Llamas joining in 1987. Today, the Brea, Calif.-based company is a successful growing business with 80 employees in five offices focused on maximizing local government revenues by providing a variety of compliance audits, analytical services and software products in California and Texas.

In 2005, both Hinderliter and de Llamas turned 65. They wisely started looking for an exit for themselves and their families that would leave the business independent, able to serve customers well and allow the employees to continue flourishing. In 2007 they formed an Employee Stock Ownership Plan (ESOP) and sold 33% of the business to the company’s employees.

Both owners knew that handing over some shares would not be enough. A successful transition involves a culture of ownership with its new leaders, where ownership is emotionally important to them, and full delegation of all the tasks and responsibilities that owning a business entails is understood.

Truly Transferring Ownership Makes It Real

Many owners talk about sharing legal ownership but never pull the trigger. They make earnest yet empty promises that create resentment rather than high performance. Getting some ownership—even two to five percent—into the hands of the next generation of leaders makes it real for them. All parties to the plan need a timeline and structure that shows how ownership levels can be increased.

• Transparency Is Vital

To be truly motivated as an owner, new owners must fully understand how and when they will cash out. Feeling like they are working for themselves is a powerful performance enhancer. The company needs regular valuations and reports that detail how much each owner’s equity increases (or decreases) each year. They must understand this well enough to explain it to their spouse (and they will need to). After all, owning shares in a company that will never generate financial returns does nothing for motivation or retention.

• Choosing The Right New Leader

Ideally, the next leader is selected based on their true potential to be a great leader of the company and is groomed for years before the transition. Sometimes, two partners can lead jointly and effectively, but it is challenging. Having a team of four or five lead as equals is counterproductive in a business world where fast decisions are crucial. Without a qualified leader who is enthusiastic about the role, succession and ownership transition will fail.

Don’t flirt with failure by picking an emotional favorite that can’t effectively lead the company. If no one in the management team is qualified, hire from the outside. But do it well in advance to verify the new leader will excel and fit into the culture. That could easily take one to two years, and if it doesn’t work, you must start over again.

The ideal leader will naturally develop followers in the company and will tend to make excellent decisions. Give him or her the CEO title and the authority that comes with it. Interfering founders will hobble the new leader. Many founders find this difficult, but it is essential that they shift from “management mode” to “board mode.” In the latter, they are part of a board that holds management accountable to results, but not meddling in how management gets those results.

HdL’s owners chose Andy Nickerson as its next generation leader. He joined HdL back in 1992 and had a succession of roles with increasing responsibility. He was trusted and respected throughout the company.

• Consolidating A New Team Around The New Leader

Transitioning ownership and leadership is also an opportunity to update the management structure. For any business to grow through midsized, it needs an empowered leadership team. They must be eager to follow the new leader, not longing for the “good old days” of founder leadership. Transition does not require replacement of the entire old management team, but the new leader must have the authority to shift the culture to fit their style and preferences.

That means some current managers may not fit well. Growth may require new leaders. Most founders feel that the new management should lead the same way they did, but the truth is, there are many styles of leadership.

But no management team should be allowed to run amok. The business needs a solid board of directors to help navigate any leadership change. The founders often sit on the board (especially while they still have ownership), but talented outside board members should be added. Management must create both a strategic plan and an operating plan for board approval and the board must continue to hold the management team accountable for execution of that plan.

Making Succession Work At HdL

In 2010, Nickerson was excited to be named President of HdL. He said, “With employees owning 33% of the firm and my new position, the transition to new management was unmistakably underway. The early completion of the ESOP 100% buyout of the founders in 2012 made it clear that the future was ours to create.”

By mid-2013, Nickerson’s stewardship at HdL had borne fruit. HdL had paid off its note for buying 33% of the shares and revenues were up. Three long-time leaders who joined in the late 90’s and early 2000’s had solidified around Andy’s leadership.

With the approval of the founders, Nickerson and his team undertook growing the company to the next level. That made some of the older ESOP participants nervous that their ownership might be put at risk. Jeff Schmehr, HdL’s CFO and CAO who joined the firm in 2005, says, “When we became a 100% ESOP, our near retirement aged employees lobbied hard for an ultra-conservative growth strategy. We wanted to minimize the risks but knew our employees were better served by supporting both the core business and developing new growth areas. Now I receive phone calls from these retirees congratulating our team on a job well done. I think we are on the right track.”

At HdL, strong opportunities beckoned requiring more leadership bandwidth. So, between 2013 and the end of 2015, Nickerson hired five more leaders. Two of them led new business units to deliver more services to local governments. Others took key responsibilities off the President’s shoulders, so he could step up and be more strategic.

With the larger leadership team, HdL needed a more disciplined management practice. In May 2016, Nickerson and Schmehr brought in an operating planning tool called the One Page Business Plan, adding clarity and accountability to key corporate objectives. The board began developing too, and from 2016 through 2018, the company added three new outside board members.

One of the new business units, offering services to governments to better manage legalization of cannabis in California, grew dramatically, requiring management and leadership skills suitable to manage a startup through high growth. In October of 2017 HdL made its first substantial acquisition, expanding to Texas through its acquisition of Sales Tax Assurance (STA). By the end of 2017, HdL had tripled its top line since the start of the transition in 2007.

Be Strategic About Ownership Succession

Ownership succession planning requires a strategic approach that starts several years before the transition point. Founders must be thoughtful and realistic, then move steadily to transition the business for a new future. As Nickerson says, “From a macro-perspective, taking 10 years to change our company into a team-led growth machine seems slow. On the other hand, it felt like each year at some level our culture and leadership changed. We took it slowly, one step at a time, even though we were eager to arrive where we are today. In the end, we have preserved the best of what Robert and Lloyd created along with new energy and high expectations.”

Every company at every stage needs a leadership bench, a source of prepared leaders it can call on to lead and manage its future. With 70% of small and midsized business owners poised to retire, the owners, their families, their loyal employees and their customers deserve a structured and effective succession plan. With this transfer of ownership and wealth reaching critical mass, they must act wisely – and soon.