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How To Overcome Owner’s Guilt

December 11, 2020 |  

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Todd Kaufman and his partner Justin Searls started Test Double, a custom software development company, in 2011. The business was a success from the start and grew more than 25% a year. By 2019, Kaufman and Searls were generating more than $10 million in annual revenue and putting more than $3 million to the bottom line each year. An outside valuation consultant suggested if they ever wanted to sell, Kaufman and Searls could get around 6.5 times profit for their business or around $20 million.

That’s when the partners had a realization. Given the value of the company they had built and the fact they had been able to pull out profits along the way, the partners had already been rewarded for the risk they had taken in starting Test Double. Kaufman and Searls reasoned it was now time for their employees to benefit from the next stage of Test Double’s growth. Kaufman and Searls decided to sell their shares into an Employee Stock Ownership Plan (ESOP). They agreed to sell their shares to their company (which transferred the shares into the ESOP) for $23 million, which the company paid by taking out a loan for 20% and getting Kaufman and Searls to loan the business the rest. Now the company takes its profits and pays down its debt to the bank and the founders.

It’s a complex sale structure, but one Kaufman speaks passionately about, as you’ll hear in the episode. Listen now and discover:

  • The mechanics of how an ESOP works.
  • The pros and cons of an ESOP.
  • Benchmarks for when an ESOP might make sense (and when it doesn’t).
  • The surprising upside of being a “lifestyle business.”
  • Why Kaufman got concerned when their profit margin surpassed 25%.
  • A definition of Discounted Cash Flow (DCF).
  • Why so many founders suffer from “owner’s guilt.”
  • How to get a bank to loan your service company money (without signing a personal guarantee).
  • The 15% rule and how it impacts the value of your business.
  • The unexpected downside of open-book management.
  • What interest rate replacement warrants are and how they can contribute to your take from the sale of your company.

Our guest

Todd Kaufman has developed a lifelong passion for software. Graduating from The Ohio State University in 1998, Todd began working professionally as a software developer. As he gained experience via product companies and consultancies, Todd was able to expand his impact as a software developer, technical architect, and agile coach. The experiences eventually led him to co-founding Test Double in 2011, a consultancy focused on improving the broken industry of software development. Test Double's focus on hiring highly communicative, creative, and adaptable software consultants has led to rapid and sustainable growth over the last nine years. From two consultants in 2011 and $10k in revenue, the company has expanded to over 60 billable consultants and more than $14M in revenue in 2020, earning Test Double a spot on the Inc 5000 five years in a row. The company has recently completed a transition into a 100% ESOP owned business, resulting in the value of this rapidly growing being shared across all eligible employees and providing a non-disruptive path for exit when the time is right for the owners. Twitter: @toddkaufman. LinkedIn: https://www.linkedin.com/in/testdoubletodd/

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Transcript

John Warrillow:

Hey, before we get into today’s episode, I want to take a second and describe a new project I’ve been working on for the last year or so. It’s a book called The Art of Selling Your Business: Winning Strategies and Secret Hacks for Exiting on Top. It’s coming out on January 12, 2021. What I’ve done is distilled down some of the best practices, hacks and ideas, and strategies of all the episodes we’ve done here at Built to Sell Radio. There’s more than almost… More than 250 of them now. What I tried to do is codify the best ideas into this book. It’s divided into three sections: everything you need to do before you get started, how do you drum up multiple offers for your company, and then finally, how do you punch above your weight class and in negotiation to sell? To get a copy, just to go to BuiltToSell.com/selling. Here’s the next episode.

John Warrillow:

I really enjoyed this interview, and truth be told, I wasn’t expecting to. It’s with a guy named Todd Kaufman who is a really smart guy, and that’s not why I was not expecting to enjoy it. It was because we were going to talk about ESOPs. Now, that’s a term that you may have heard before, but my own impression of an ESOP was kind of a convoluted mess quite frankly, a way to sell your business over time that took forever, and had all sorts of downsides to it. Well, Kaufman really disabused me of that fact. He went into to describe many pros to using an ESOP as a way to sell your company, and also some of the downsides as well in candor and great detail. If you’ve ever thought about this as a potential exit option, selling your business effectively to your employees, here to tell you the way he did it is Todd Kaufman.

John Warrillow:

Todd Kaufman, welcome to Built to Sell Radio.

Todd Kaufman:

Thanks. Thank you for having me.

John Warrillow:

It’s great to be chatting with you. I should put my headphones on. That’s my bad. I forgot to do that. While I do that, can you tell us a little bit about Test Double? I love the name, by the way, but for folks who don’t know you guys, what it is that you do?

Todd Kaufman:

Yeah, we do custom software development for our clients. Sometimes that take the form of a smaller business who maybe doesn’t have a full-time development staff and they need something built. We’re happy to work with them to make sure that software is constructive to spec under budget and within their time constraints. In other cases, we help a lot of bigger businesses scale. So, maybe they’re running into challenges with “We’re struggling to get over the hump with our Series C round to meet all of the needs of the new users that we have coming on.” We could help them kind of overcome those obstacles. Really, anything with custom software, we’re eager to help out.

John Warrillow:

Got it. What’s your billing model? Are you time and materials? Are you project-based? How do you charge customers?

Todd Kaufman:

We’ve done both. We tried to be easy to work with, and usually that lines up with open-ended time and materials contracts. So, we find it’s a good level of healthy pressure for us to deliver if we know that at any point you can just say, “Hey, we’re done here.” That also means that companies don’t have to necessarily book us for six months, or nine months, or 12 months. They can start working with us, and just within a week’s notice let us go.

John Warrillow:

Got it. So, the people that you have, everyone from software engineers to user experience people, I’m assuming they all have different hourly rates that you bill out based on…

Todd Kaufman:

Yeah, we do have different rates. It depends a lot on the needs. Some of the harder problems of, “Hey, how do we get this system that’s been built by 50 engineers to scale so that it can meet the needs of 100,000 users?” That’s probably a different capability and skillset than someone who has, “Hey, I have $50,000.00. I need a mobile plat build.” So, we’ll charge accordingly, but typically our consultants have 10+ years of experience, so they tend to be more of a kind of a premium offering.

John Warrillow:

What’s your approach to recruiting employees? I’d imagine software engineers, software developers, designers, these guys are in hot, hot demand. What’s your approach to recruiting?

Todd Kaufman:

In the past what we’ve done is try to meet them where they are. We do a lot of conference presentations. My Co-Founder, Justin Searles, he’s really made a name for himself in a lot of the tech companies just by sharing valuable insights and what we’ve learned along the way in our careers. That’s a great natural draw to bring candidates in.

John Warrillow:

So, conferences… Yeah, big live conferences where tech guys and gals meet and he’ll do a presentation.

Todd Kaufman:

Exactly. It garners interest. I think we’re both pretty open about what it’s like to work at Test Double, and what our clients are bringing to us as far as challenging projects and how people have an opportunity to learn.

John Warrillow:

Let’s say I’ve got an offer from Google and I’ve got an offer Test Double, how would Justin convince me to come to Test Double and not take the fat check from Google?

Todd Kaufman:

That’s definitely a tough pitch because the Googles and Facebooks of the world definitely throw a lot of money around. With Test Double what you get is a level of autonomy and a level of work/life balance that probably doesn’t exist at the Googles and Facebooks of the world. I used to take it as an insult when people called us a lifestyle business, but now I wear more as a badge of honor. We want our people to be able to go their kids’ soccer games, and baseball games, and things like that. I think that level of autonomy and balance is key. We’re also just a company that is a good accelerant for growth. We have a lot of really talented people here. There’s always someone that you can learn from.

Todd Kaufman:

Consulting is interesting because it provides a nice variety of life. You get to see a lot of different problems with different customers across industries, and you start to see those patterns and what you can do to fix those issues. It just tends to help you level up in your career I think a little bit faster than working for say a product company.

John Warrillow:

I’d love to explore a little bit around this whole lifestyle business thing. What was it in the past that irked you about being labeled that way?

Todd Kaufman:

I think in the context it was definitely more of a pejorative. We were actually approached about acquisition from a customer early on, and they were… I think what they were trying to say was that, “Hey, we could have a much bigger impact if we worked in this product,” that was a VC-backed, high growth startup. They kind of termed it as, “Or, you could continue just doing this lifestyle business that you’re doing.” It felt like a punch below the belt a little bit, but I was communicating with another co-founder and CEO who runs a similar business. He was like, “You are a lifestyle business. You should embrace it: the fact that you’re not having to work 65 hour weeks to build something, the fact that you’re not having to fly all over the country chasing private equity, and things like that.”

Todd Kaufman:

I enjoy the fact that we have a steady growth, highly profitable business where people can work 40 hours a week and then go spend the rest of their time with their families.

John Warrillow:

Talk about the growth rate and the profitability, if you don’t mind, to the extent that you can share. How fast do you typically grow year-over-year? What are sort of the margins you’re working with? Can you share any of that data?

Todd Kaufman:

Sure. From a growth rate perspective, we’ve probably gone up about 25-50% year-over-year as far as size goes. That’s been steady growth for us, which is good. It doesn’t feel like we’ve ever outgrown our ability to support our employees, which is good. There’s been times where maybe we’ve strained that a little bit, but we’ve tried to always bring on people, bring on clients at a steady pace so that we can make sure we’re always delivering an exceptional level of service. From a profitability perspective, we’re targeting typically 20-25% net profit. Anytime it’s outside of this, we want to understand why and we want to see what we can do. Typically, if it’s a higher profit margin that means we’re trying to figure out ways to get that back to employees either via a level of service and support internally, or via higher salaries, et cetera.

John Warrillow:

Gotcha.

Todd Kaufman:

If it’s below that rate, we have to look at what’s going on. This year, it dipped below that. A lot of that was rate pressure, and things like that from COVID.

John Warrillow:

Got it. So, if I heard you right, when you go north of 25% you guys don’t all celebrate and crack a bottle of champagne. That’s a warning sign for you.

Todd Kaufman:

Exactly. That probably means that the business is maybe under-valuing employees, and we want to make sure to turn that around. That can pretty quickly lead to attrition, and that can lead to a lower level of service for our clients. When that number is north of 25%, it can turn around really quickly if you’re not making sure to reward your employees for doing all the hard work.

John Warrillow:

Got it. I know you’ve done a lot of work around valuing the business, but as you started to think about your next steps as a company, how were you thinking about the value of the business? Did you have any sort of benchmarks? Did you have evaluation done? What was your technique there?

Todd Kaufman:

We knew kind of towards the end of 2018 it started feeling like any exit for myself or my co-founder would take time, or it would be really jarring to the business, like acquisition or merger, something like that. We felt like we wanted to at least start planning for this, knowing that neither one of us was going anywhere for the next five or 10 years. To that end, we actually were approached about a couple of different M&A opportunities. We found a local consultant who actually specializes in M&A activity, and one of the things that he does is his count of cashflow evaluation. He was able to provide us some sense of, “Hey, here’s what the business is worth,” at a pretty reasonable rate. Then he was able to apply that to some of the other M&A opportunities that we could evaluate, “Hey, is this a good deal or is this something that we should pass on?”

John Warrillow:

Can you provide a definition for discounted cashflow evaluation, what that entails?

Todd Kaufman:

For us, it was a lot of past financials. What he was using then was kind of the level of cash that we’re generating consistently, and the level of growth that we’re experiencing, what would that look like as an investment opportunity compared to other alternatives. There were some discounts also made for marketability, where we’re not necessarily in a huge business, we’re not necessarily a product business where it’s easy to put a value on the assets. We’re a services business. Other than 50 or so laptops, we don’t have a lot of assets, right?

John Warrillow:

Right.

Todd Kaufman:

That was what he was using to provide that valuation.

John Warrillow:

What multiple of your profit did that DCF render? If you ran all the numbers, did you get a multiple of pre-tax profit that he felt was kind of reasonable?

Todd Kaufman:

Yeah, he basically felt like it was a range, and I think that’s accurate. That depends on the buyer. You can probably get a higher multiple if you’re going a PE route. You can probably get a much lower multiple if you’re going merger acquisition with a comparable company. Or even in our industry, a lot of times you’ll see an acquihire, where people are just buying you for the head counts that software developers are in need, as you mentioned earlier, they look at Test Double and they’re like, “Hey, that’s a 50 person hiring event if we could pull it off,” but that’s also probably the lowest multiple that we would receive.

Todd Kaufman:

In the middle, it was somewhere 6.5% of EBITDA.

John Warrillow:

6 times-

Todd Kaufman:

6.5 times. Sorry.

John Warrillow:

Got it. Got it. Got it. So, 6.5 times EBITDA was sort of where he thought it might land.

Todd Kaufman:

Exactly.

John Warrillow:

Okay, so let’s get into the sale itself. You mentioned you’re at roughly 50 people.

Todd Kaufman:

Yes.

John Warrillow:

I’d love to explore a little bit around what triggered you guys to get on the front foot, because it sounds like you’ve sort of had a few, very somewhat superficial conversations, but then what changed? What made you go from, “Oh, maybe one day. We’re four or five years away,” to getting on your front foot and really starting to put some heavy work into it?

Todd Kaufman:

Yeah, I think really just being inundated with the different options that were out there. It felt like it was something that we needed to research and put a little bit more time into. In 2019, this was largely the main strategic project I worked on, was to figure out, okay what are we going to do? I think the impetus for that was a couple of reasons. One, we really strongly feel like our purpose, our mission as a business, is never going to be done. Our mission is to improve the way the world builds software because the industry is still broken in a lot of ways. It’s like an [inaudible] to it, right? Like you’re never going to actually be done with that mission, so we felt like okay, the business should be sustainable in the long term, and that means it will outlive myself and my co-founder if we do it right.

Todd Kaufman:

The second piece was we had started to see the outside’s contributions that he and I made in the early going, we’re now dwarfed by 50 team members who are all delighting our clients on a daily basis, who are all recruiting other people and to help [inaudible] our clients, and really carrying the weight of the organization more on their shoulders and less on ours. We thought there was an equitability standpoint that needed to be addressed. We knew we wanted to get shares into our employees’ hands. We were just maybe a little bit confused about how we do that.

John Warrillow:

I want to push back a little bit on that, and not in an argumentative way, but I think there’s a lot of people listening that would be like, “Okay, Todd. Hold on a second, you guys put in all the sweat equity and that’s the way capitalism works, dammit.” Like if you take the risk you get the reward, and all this equitable stuff, that’s for people in Poor Land to worry about. This is capitalism, dammit.

Todd Kaufman:

Yeah.

John Warrillow:

Rebut that sort of way of thinking.

Todd Kaufman:

It’s honestly something that we went back and forth on a number of times throughout the years. A lot of our peers would refer to it as under-skilled and kind of dismiss it that way, like “Oh, you’re just suffering from a bout under-skilled.” I’m like, “I’ve been suffering from it for like two years now. When does this go away?” With us, I think it’s different for different types of businesses, first of all. Some businesses are more inherently risky. Some businesses are more of, hey, somebody may be cultivating an idea over a period of years and really kind of built the foundation or the core of that and were able to should be compensated disproportionately for that.

Todd Kaufman:

I think with us, we felt the transition from hey, we took a lot of risk, no doubt about it. We’ve worked a lot of hours and put a lot of time and energy into this business, and we felt like we should be rewarded for that [inaudible 00:16:28]. We just felt like that payoff has a timeframe. At some point when you see a lot of others who are really advancing the business forward closing new deals, referring in new clients, and then delighting those clients, you have to take a pretty hard look to say, “Okay, what is my involvement here? Have I been fairly compensated for my involvement over the past nine years?” in our case. We felt like that was the case. We felt like, “Okay at this point, the first nine years, great. We appreciate the compensation that we’ve received for that effort. Now we want to see our employees get rewarded for that same amount.”

John Warrillow:

And that brings us to how you chose to sell the company, where I want to go there next. Before though we do, how much… I’m assuming because it was not a very capital-intensive business in your own admission, “A bunch of laptops is all we kind of need,” are you and Justin… Justin is the co-founder, right?

Todd Kaufman:

Correct.

John Warrillow:

Yeah, so I’m just doing the math and 50 people, and 20% profit, there’s a lot of cash that is sort of the business is generating. Are you guys able to pull that out in the way of dividends or salary along the nine-year run? Or are you having to reinvest that along the way?

Todd Kaufman:

A combination of both. Typically, the company profits we were able to just pull out. We’re a LLC taxed as an S-Corp in the US. Basically, we are receiving profits throughout the years as owners draws. Some portion of that goes to pay tax on all of that stuff, and then the rest we were able to keep. There was a decent portion that just went to us as income, and we paid ourselves fair salaries for the roles that we were playing, but it became disproportionate that the profits the business was making was more part of our income. There were also times where you do need to invest still as a services company.

Todd Kaufman:

We’ve been remote even before COVID, so we’ve been remote the entire nine years. We don’t have that big office space or anything like that, that we needed to invest in. Sometimes you don’t realize the supporting roles that you need until your kind of stuck in it, and then you take a dip in profitability so that you can get really talented engineering management in place, so that you can get a professional level of HR in place, so that you could hire a sales person or a recruiter, or an account manager or something like that. We’ve made those higher strategically throughout, and you would see kind of dips in profitability along that way. But those investments by and large have all paid off by helping us scale and in furthering our growth.

John Warrillow:

Got it. So, you guys pull up and say, “We’ve been fairly compensated over the last nine years, and for the next traunch of our growth, for the next stage of our growth we want other people to participate in that.”

Todd Kaufman:

Yeah.

John Warrillow:

I guess one option is to sell the company, although that gives a huge windfall to you and encouraging the new buyers to incentivize or make shareholders of your employees. Did you guys think about that? What were the options on the table? You mentioned 2019. This was your major project, so what options did you consider?

Todd Kaufman:

I think that we’ve made the Ink 5000 like five years in a row, which means-

John Warrillow:

Congratulations.

Todd Kaufman:

On average, I… Thank you. On average, we get about two emails per week of PE or VC funds reaching out to see if we’re interested.

John Warrillow:

Right. Working from the same list.

Todd Kaufman:

Yeah, exactly.

John Warrillow:

Just looking down it. Yeah, yeah.

Todd Kaufman:

Yep. So, those are always flattering, of course, so we do take a look at that. It would have been a higher outcome for Justin and myself. What we felt it lacked was that path for sustainability, because one, your kind of conceding your culture at that point. You’re letting a PE or a VC firm kind of own what is the focus. I think in 2020 had we done that, the focus would have been on slashing expenses whenever we started to see some bench. I think it would have hurt our culture, and it definitely wouldn’t have transferred equity into our employees. We also looked at merger and acquisition options. Those can be risky. If you can find a similar company, I think that aligns with your purpose and if the sum is greater than the parts, and the finances work out, like you have to have all of those things, then that can be a good outcome.

Todd Kaufman:

We just didn’t see one of those materialize. Beyond that, we were looking at other ways just to get maybe we can sell shares to our employees. That was an option. The problem with that is, it puts more of an onus on the employee to have some level of liquidity, or access to cash, or access to credit. We felt like that was inequitable. We didn’t want somebody who maybe didn’t have great credit, who maybe didn’t have a lot of access to cash, who was a great member of our team and delighting our clients, we didn’t want them to be left out or disproportionately affected with this transaction.

Todd Kaufman:

The ESOP was really the only one that we felt kind of scratched the itch of Justin and I get fairly compensated, the business’s culture and purpose would remain intact, and the employees would be equitably rewarded with ownership.

John Warrillow:

That’s the avenue you chose to go down, and sell it via ESOP. It’s the first time in something like 300 episodes, as I was mentioning to you before we hit record, that we ever talked about an ESOP. This is exciting for me, because I know nothing about ESOPs. You’re going to be my education here. I’ve heard the term. I know Jack Stack does something. It’s all very hazy for me. First of all, decode the acronym. What does the word ESOP stand for? What do the letters ESOP stand for?

Todd Kaufman:

ESOP is Employee Stock Ownership Program. This came out of the same ERISA legislation I think in the ’70s to allow and encourage companies to transfer ownership to a broader base of the employees. That’s it at a high level. We can dive into more details.

John Warrillow:

Please do.

Todd Kaufman:

The important part is to understand our… Basically a trust is formed, and the trust is responsible for managing allocation and compensation of shares of the ESOP over a period of time. What basically happens is as people work at Test Double, there’re allocation events that happen on an annual basis. Assuming you’re eligible, you get some portion of shares. It’s basically the company is transferring its shares from it to this ESOP trust, and then the ESOP trust assigning those to people. It has to be done in a fair way. For us, that’s based on compensation. So, the shares were split based on compensation throughout the year.

John Warrillow:

So people who earn more get more shares in the ESOP.

Todd Kaufman:

Exactly.

John Warrillow:

Higher paid people.

Todd Kaufman:

Exactly.

John Warrillow:

So you and Justin effectively sell your shares in the company to this trust, is that right?

Todd Kaufman:

I would think of it this way, the company buys itself from Justin and I. The company then enters into an agreement to gradually transfer ownership of itself to the ESOP. That tends to happen over a long period of time, for us it’s 35 years, because you don’t want to be 10 years down the line still growing and still hiring people, and have no shares to allocate to people. Over a longer period of time, like 35 years, that means people are starting to retire. As those people are retiring, or just resigning, or being terminated, whatever the case may be, their shares are coming back into the pool that can then be dispersed in the next wave of employees. So, it’s kind of a perpetual motion machine of allocation of shares if you do it right.

John Warrillow:

Okay, so the part I’m digging in or trying to understand is so you and Justin own 100% of Test Double before this transaction, as I understand, is that right?

Todd Kaufman:

Correct. Correct.

John Warrillow:

So you then effectively sell those shares, because your individuals. Todd’s a guy. Justin’s a guy. So, you sell those shares to an entity called your company, effectively.

Todd Kaufman:

Right. The company baseplate, I’m presenting an agreement with us for a valuation. Now, there’s a lot of structure around this. So, a valuation firm is another entity that was part of this transaction, and they’ll be a part of every year providing a valuation of Test Double’s worth. So, they take into account everything. They come back and say, “Okay, here is what Test Double is worth,” and that affects share price and everything like that. For this first event, that meant that kind of was negotiated, but that was what Test Double was worth, so that’s the amount that the company is going to pay Justin and I.

Todd Kaufman:

We did that in a mixture of seller and bank financed. So, we were able to take some money off the table via bank loans. Those bank loans also funded all of the expense of ESOP, so that didn’t have to necessarily hit the company immediately in one month. Then we have seller-based financing for largely, like 80%, of the value of the company that the company will just continue to pay off throughout the years.

John Warrillow:

So you are effectively financing the sale of the business? So you’re-

Todd Kaufman:

Exactly.

John Warrillow:

Okay. With regards to the bank loans, you mentioned 20%, so the bank was willing to essentially loan your company that money. Did you have to sign a personal guarantee for that bank loan?

Todd Kaufman:

We did not, and you have to find the right bank to make this happen. First of all, we used a capital firm to help us negotiate all of this. Mazera Capital is who we used. They’re very familiar with ESOPs. They probably do 25 ESOP transactions a year. They have a lot of banking relationships. They know a lot of trustees. They know a lot of valuation firms. So, paying for them to have all these connections was pretty instrumental to our success. Finding a bank that invests in a company that has good profit margins but zero assets is nontrivial. They found one that was extremely savvy and understood ESOPs very well, understood what they meant and how high the likelihood of repayment was. That was Fifth Third in our case. They were able to give us a loan for $4.75 million that was basically unsecured by assets, other than just the company entity itself.

Todd Kaufman:

That required a lot of due diligence, but again, that’s been a great relationship. It’s been odd, I think the healthy pressure of knowing that you have some sizeable outstanding debt makes you focus on really running the business in an efficient way.

John Warrillow:

I’m assuming that the way Fifth Third structured is they are first in line in the event of some sort of default by the company that they would get paid back first, is that right?

Todd Kaufman:

Exactly. They’re primary, and Justin and I’s sellers notes are subordinate.

John Warrillow:

Okay, got it. If I’m doing the math right, they loaned you $4.5 million, which equates to 20% of the overall value, is that right?

Todd Kaufman:

Exactly. Our valuation was at $23 million.

John Warrillow:

Got it. Got it. Got it.

Todd Kaufman:

That was a higher multiple than what I had described before, because we were doing as a company somewhere around $3.5-$4 million in EBITDA prior to this.

John Warrillow:

Got it, so three and a half times six and a half is around 20, is that right? I’m just doing the math.

Todd Kaufman:

Yeah, it was a little bit uptick there. The good thing was, again our capital partners helped us provide a lot of documentation on why we were valuable. As you go through this process, you start learning about the things that the banks care about that others have seen, that weaken your valuation. For example, we’ve always known that customer concentration is something to keep an eye on. They’re really diligent about understanding, “Okay, how much accounts receivable? Is that your biggest customer? What is the percentage of the overall?” We’re trying to keep that below 15% based on these conversations.

John Warrillow:

That was the point at which their eyebrows would get raised at the bank when your biggest customer equated to more than 15, 1-5% of your-

Todd Kaufman:

Exactly, yep.

John Warrillow:

Got it.

Todd Kaufman:

When you start seeing a lot of customer concentration, it’s just an inherent risk so you have to be aware of that. We’ve always been aware of that, but it’s something that you manage more a little bit differently. It’s not like you want to fire that customer, or that you want to turn down additional work. It just means you need to apply a little bit more effort to finding new customers and building up around it.

John Warrillow:

Got it. Got it. Okay, so if I’m understanding the rough math here, total valuation of the company was $23 million, which is almost six and a half to seven times EBITDA. You guys got four and a half upfront. You put that in your jeans. They can’t touch that. That’s your money.

Todd Kaufman:

Yeah, think more four went to the two founders and half went to closing costs involved with EBITDA.

John Warrillow:

Okay.

Todd Kaufman:

The interesting thing is you pay for a lot of lawyers, your own lawyers, the bank’s lawyers for some reason, the lawyers for the trustee, a valuation firm, a trustee itself, the capital firm that helped us. There’s a lot of people involved in the event. It can expensive quick, which is one of the drawbacks of ESOPs. That’s something to be aware of. It will be expensive even if you’re a smaller business.

John Warrillow:

Yeah, all the administrative and frictional costs, et cetera. Okay. So the balance, the 80%, you agreed to finance. Do you get an interest rate on that financing?

Todd Kaufman:

We’d have good interest rates on that. We’re basically compensated with both interest and with interest rate replacement warrants.

John Warrillow:

Oh, wow. What is that?

Todd Kaufman:

The interest is easy to talk about first. That’s paid quarterly, and the business just pays interest to us basically. As we pay off one bank loan, we’ll go and re-up another bank loan. That will be paid towards the principle of the seller’s notes and then we just kind of repeat that process and go again.

John Warrillow:

What rate is that at, Todd?

Todd Kaufman:

4%.

John Warrillow:

Okay, so you’re doing a lot better than you get just putting your money in the bank and getting .5% or whatever.

Todd Kaufman:

Exactly, yep.

John Warrillow:

Okay, so you-

Todd Kaufman:

Those waiver placement warrants are different though. You can think of these almost kind of like stock options or phantom stock. Basically, they are payable replacements for an interest rate, assuming the business is growing and doing well, and becoming more valuable. Basically, we get a certain amount of shares of the company, or like stock options, for the two co-founders. At the point when those notes are paid off, then we kind of look back and say, “Okay, here’s the value of the company,” and now I compare the value of the company when we closed. The difference in those are exercisable options for us, and those can be sizable. I think they were projecting that at about 8% actually of the notes. So, those are a sizable thing that doesn’t drastically impact the business’s cash flow in the current day, but rewards the owners for pretty generous loans at the end of it.

John Warrillow:

Yeah, yeah. That’s really interesting. I’ll have to Google that later. You’re going way beyond my pay grade here in terms of explaining stuff. Okay.

Todd Kaufman:

Believe me, things I’ve learned in the last year, it’s too numerous to list.

John Warrillow:

Is that right? Yeah. Okay, so the 80%, I get it. So, you’re getting an interest rate and these interest rate replacement warrants, which is great. How many years is the company going to take to pay you back effectively?

Todd Kaufman:

We just closed on April 30th of this year. So, you wake up on May 1st and you’re like, “Hey great, we just sold the business.” Now it’s like, “Okay, I have a business now that I’m still running, that it’s saddled with debt in the middle of a pandemic and a recession.” It’s like, what are we doing here?

John Warrillow:

Perfect.

Todd Kaufman:

Yeah, exactly. It was a healthy refocusing of efforts. We’ve already paid off over half of the loan to the bank. A company our size, we project we’ll probably do about $14.5 million in revenue this year looking at somewhere around 25%. That’s about $3.75 million in profit. So, we’re seeing we are growing too as a company. We’re targeting $16.5 million next year. We think this thing can get up to 150 people, which will be about three times their size, without a lot of changes. In that case, we would probably pay this thing off in about six, maybe eight years at most. Even if we just stayed flat, we’re talking probably eight, nine years, 10 years at most to get out from all of the debt.

John Warrillow:

What I’m hearing you say is there’s no fixed timeline. It’s a bit fluid based on how… Yeah, there must be some minimum amount that the company pays-

Todd Kaufman:

For the bank, yes.

John Warrillow:

For the bank loan, okay.

Todd Kaufman:

Exactly. That first note was amortized over five years.

John Warrillow:

Okay.

Todd Kaufman:

There’s also clauses in there that we have to pay excess cash basically to pay that down, but we’re well ahead above that. Then when you get to the seller’s notes, the good thing about seller’s notes is you can be extremely flexible with repayment on this stuff. If the company had really fallen on hard times and cash flow was a problem this year, we could forgive the interest payments to the seller’s notes, or at least defer them to a later date. That would basically give the business the flexibility and time it needs to pay the stuff back. The seller’s notes, there’s not a hard date that they have to be paid back on. It’s more of just the clause that now as you pay off the bank loans, it’s in the business’s best interest to renegotiate for lower rates. We’ll repeat that process as these are paid off, go out to banks again, and see if we can get another $4 or $5 million loan and pay down the seller’s notes, and we’ll probably repeat that process four times or so.

John Warrillow:

Got it. I find this really interesting. With regards to the… I lost my train of thought. I’ve got so many questions going through my head right now. In the case of an ESOP, I understand there is a kind of a third party… It’s like an administrator. What is that, like a chairperson, or what-

Todd Kaufman:

That’s exactly what they call them, is third party administrators.

John Warrillow:

Administrators, okay.

Todd Kaufman:

Yep.

John Warrillow:

Is it their decision whether or not to pay off the seller notes? Do they have to say, “Well yeah, we’ve got the cash to do that. We want to accelerate or decelerate,” are you at sort of arm’s length from that decision to pay off the seller’s note, or what, get what I’m asking?

Todd Kaufman:

A little bit, yeah. Basically, that was one of the clauses involved with negotiating the establishment of the ESOP. It was basically the company will, as these loans are paid off, go out and get more loans to pay off seller’s notes and use that because it’s in the best interest of the company. I think that clause is basically meant to cover that.

John Warrillow:

Did you consider how the ESOP structure would affect the sale of the company the next time around? If you guys grow to 150 employees and whatever it is, $20, $50, $30 million in revenue and the decision is taken to sell the company, that the employees would all essentially benefit from that sale, did you guys think about what, if any, implications being an ESOP would have on the liquidity or saleability of the company?

Todd Kaufman:

We did, because then it’s not just a decision that Justin and I make. At that point, basically any M&A type event, then the trustee wants to represent the interests of the employees. So, the employees would have a voice in, “Okay, is this a good deal or not?” That’s something we at least wanted to keep that option open, and the ESOP doesn’t include that, which is good. I think we felt comfortable that in either case, if we were pitching our employees the sale through the ESOP that, “Hey, this is a good idea,” or if we were trying to pitch our employees outside of the ESOP, you still have to convince people it’s the right thing to do and it’s in their best interest, et cetera. I think it’s a lot easier honestly with an ESOP because they’re going to stand to have a financial award at the end of the day.

John Warrillow:

I want to ask a personal question, and you can tell me to go to hell if it’s too personal, but I notice a wedding ring.

Todd Kaufman:

Sure. Yeah.

John Warrillow:

I think I see pictures of kids in the background. In any event, I’d love to go to the pillow talk with your spouse when it came to this decision, because on some level this decision affected your whole family, not just you personally, because you had offers to sell to a private equity group for cash, and all the money’s there in the bank, and away you go. In this case, you certainly got rewarded, but it’s going to presumably take time and there is more risk associated with that. You’ve loaned the money, you’re second to the bank. What’s your wife think, I guess is what I’m asking?

Todd Kaufman:

Yeah, yeah. One, I think… My wife worked for a number of years. She is probably more well equipped to run this business than I was, so she’s been an awesome sounding board throughout the years for any decision let alone this one. I think it was great to talk through it with her, and just understand that it’s not just for us personally and financially, but also for the business. I think she’s seen the challenges of being a 50% owner and founder and CEO of the business. It’s a lot of stress and time, and energy that you have to put forth. I don’t know that that’s shrunk a lot since the ESOP is closed, but I think we see a path now that aligns with our own personal goals. One of the benefits of the ESOP is that you separate saleable company from involvement with the company, right?

Todd Kaufman:

Justin and I are both still involved in the company. He’s CTO. I’m CEO. We’re still day in and day out working to make Test Double an even better software consultancy. Now we don’t have to align our end date with the company with some type of transaction. That’s already taken place, so we can focus on building a resilient company. When it feels like we have a better leadership team in place to run this thing than us, then it may be time to move on.

John Warrillow:

What were your employees’ reactions when… First of all, before you announced the ESOP were you getting pressure? You mentioned that you and Justin were like, “You know what, we’re kind of getting too well rewarded for running this company. At some point we got to pull up and say we’ve been rewarded for the risk we take. We got to start sharing some of this stuff,” were you getting pressure from employees saying, “Hey guys, come on, I just won that big deal. Give me a fair cut at this. I’m leaving to go to Google because I’m not getting paid.” Were you getting pressure from people to start sharing some of the spoils?

Todd Kaufman:

Yeah, it’s a good question. I don’t think that we saw a ton of direct pressure, but as you mentioned, competition for software engineers is extremely tough right now. So, you have a lot of just big offers from other companies. A lot of times, those will come with RSUs or something else.

John Warrillow:

What is an RSU? Restricted Stock Option?

Todd Kaufman:

Restricted… Exactly.

John Warrillow:

Stock Unit, I guess.

Todd Kaufman:

Exactly. That would be maybe a longer team thing that we didn’t really feel like we had. We’ve always been open books with our people. I publish our consolidated version of our income statement every month to all the employees so that they could see what’s going on in the business. We also always had some means of aligning their interest with the profitability of the company. That was typically a bonus pool where basically 10% of the company profits twice a year were distributed among the employees who worked here. We felt like those pieces were important, but the numbers were getting big enough where I think people were starting to look at it and be like, “Hey, we made $3 million last year, and I got a $12,000.00 bonus check. Where is the rest of this going?” It’s like, “Well…”

Todd Kaufman:

So yeah, I think that it’s a fair piece. I don’t know that we had a ton of direct pushback, but we definitely felt competition for people services. Now I think that what people see is, again they’re a little bit I think probably just skeptical because there are so many bad deals out there with regards to equity, especially with startups. We have all probably been burned in one way, shape or form in the past. They’re treating this very skeptical. One thing we did was we did a cash contribution in 2019 to try and jumpstart this, to try and accelerate this. People, as soon as the program was launched, had a pretty sizable balance, almost 25% of their annual compensation in the plan already as cash ready to move forward.

Todd Kaufman:

Now the challenge is they’ll get some Chairs this coming year, but the valuation of the company will be depressed while it has as much debt as it does. It won’t be the same guy-

John Warrillow:

Why would that be the case?

Todd Kaufman:

Before as a services company, we were highly profitable making $3 million a year. Now as a services company, we’re highly profitable but we have $20 million in debt at that point.

John Warrillow:

Sure, but your multiple was based on EBITDA, Earnings Before Interest Tax Depreciation Amortization.

Todd Kaufman:

It’s also based on the fact that we had zero debt.

John Warrillow:

Okay.

Todd Kaufman:

People always take that account as well. The whole picture is going to show that, and the whole picture shows now, hey the company is still highly valuable. It’s still growing. It’s still very marketable. It’s just got a different balance sheet than what it did before this transaction. The shares will be depressed for the first few years, but then it’ll take off like a rocket as we grow, and as we pay down that debt. It’s probably a little bit of a leap of faith for the next two or three years for people to see what this connection means for themselves. But they didn’t come here for an ESOP anyways. I think the people came here because of the things I’ve mentioned earlier: the autonomy, the ability to grow, the variety of life that consulting brings.

Todd Kaufman:

We’re telling them, “Come for those things. Stay for the retirement on steroids,” which is kind of what ESOPs are.

John Warrillow:

Got it. Going back to this idea of publishing your consolidated financial statements, what went into the decision to do that, even prior to the ESOP?

Todd Kaufman:

Probably my own personal scars. I think in many ways Test Double is a reflection of the scars that Justin and I had at other companies that we had worked with. One of the companies I worked at, I think in my first week or two, I was in a leadership position. We were talking about the financials within that group. It didn’t come up in the interview process, but we start hearing about one of the founders moving money out of their 401K so that we can make payroll. I’m like, “Whoa, what are we doing here? What is happening?” You see that manifest itself in a bunch of short-term decisions. A client that you know you’re probably not going to delight, that you have to take on just so that you can get money coming in the door so that you can make payroll, all these little ways that you can make decisions in the short-term interest of the business but have negative longterm effects.

Todd Kaufman:

I saw those firsthand, so I was trying to shine a light on it with everybody else in the company like, “Hey, I want you to make decisions in the best interest of the company in the longterm. For you to be able to do that, you have to understand where we are financially. It’s a huge piece of the puzzle.” That’s what we’ve been trying to do. What’s interesting, as we’ve grown we’ve hired people who used to be CPAs and things like that. They’d come in and they’d start talking about accrual with some of our other employees, and you’d see the level of financial competency kind of grow within the business. Now when we’re doing budgeting and strategic planning, having 20 people involved is a good thing because they’re all thinking about those things.

John Warrillow:

When you started sharing the profitability, it was more, it sounds like in an effort to communicate how solid the business was, and how profitable, and how well run it is… Am I putting words in your mouth? Was that part of the motivational-

Todd Kaufman:

That’s definitely a big part of it. We wanted people to know one, “Hey, this is what the business is doing.” We even told people, “Hey, this is what we’re keeping as far as a runway in cash in accounts receivable on hand so that you don’t have any reason to worry. We’re a small business, but we have you covered. You’re going to have plenty of time to find something else should things start going sideways.” That was what we were trying to communicate, but I think we also wanted people to be able to speak up. If we’re seeing profits go above that 25%, I want people to know, “Hey, this is the situation that we’re in. What do we do with this stuff now?” I want to have that discussion with people now too. What is the balance of paying down debt faster versus increasing salaries at Test Double? I think that should be a group discussion as an employee and a company.

John Warrillow:

Yeah, and it sounds like there are also some downsides because publishing your profitability when it’s a few hundred thousand dollars makes people feel good, and when it’s a few million dollars they start to look around and say, “Hey, wait a minute.”

Todd Kaufman:

That can definitely be the case, especially with this year. We’ve had some challenges just because we took a conservative approach when COVID was running rampant. In April, we had 25% of our workforce didn’t have a client. We’re starting to see okay, profitability was negative and trending to stay that way, which would have meant “Hey, we need to make some tough decisions here.” We froze salary adjustments for the year. We said, “Hey, we’re not doing the profit-sharing bonus anymore,” and people were still I think a little bit upset by that because they look in arrears and see, “Hey, we were profitable this year. Why did they do those things?” You have to try to at least explain, “Hey, we didn’t know what was coming. We didn’t know how quickly this stuff would bounce back.”

Todd Kaufman:

Really, from April through July it wasn’t great months of the company’s history from a cash perspective. I think it’s all about trying to get people a higher level of understanding of not just what’s in their best interest, what’s also in our company’s best interest, and what’s in our client’s best interest, and balancing those three is where I want to get all of us to really be comfortable.

John Warrillow:

Have you ever seen Jack Stack’s Stuff?

Todd Kaufman:

Yeah.

John Warrillow:

Have you seen A Stake in the Outcome and-

Todd Kaufman:

Yep.

John Warrillow:

Great books co-written by Bo Burlingham. I had an opportunity to see him speak, this goes back years ago, and I remember him talking about the importance of educating your staff about financial reporting and how it’s oftentimes one of the secrets to making an ESOP work, and also one of the downsides of not being successful either with open-book management in general or an ESOP specifically is… You’ve got a 23-year-old software engineer who knows nothing about running a business, and you’re all of a sudden throwing out these numbers to them, and they can kind of pick and choose things they hear. It’s like giving the keys to a 16 year to a Ferrari. It’s a little too much. What have you learned about training employees on the numbers? What mistakes have you made? What coaching would you give other entrepreneurs considering this stuff?

Todd Kaufman:

I think first and foremost, don’t assume that what you’ve learned is widely understood. I think if anything, if I could go back I would spend a lot more time articulating the why, the how, what this means for people, doing it in ways that they appreciate and understand because-

John Warrillow:

Specifically what though would you communicate on the why and the how? Specifically, what do you think you might like to have a mulligan on?

Todd Kaufman:

Really, what the ESOP structure is, and what it means for people, and what it meant for the business, and what it meant for Justin and myself, and what it means for the employees and just kind of really articulating what that is, and then separately specifically from other decisions that we were making around the same time caused by the pandemic and the recession. I think that it’s a complex transaction. There’re inside loans. That’s the loan from the company to the ESOP. There’s the seller loans, there’s the bank loans. Here’s all this stuff, and you’re confused about what’s happening.

Todd Kaufman:

We’ve had people say, “That seems like Todd and Justin are putting the business in harm’s way by all the interest and stuff on these loans.” It’s like, that’s not the case. One of the other benefits I haven’t even talked about with ESOP is that the company, as an S-Corp that’s 100% owned ESOP now, we have no federal income tax liability. In most states, we have no income tax liability. Assuming that that’s up by 20-23%, that’s a sizable chunk from $3 million to $4 million. That more than offsets any interest payments that we’re making as a result of this ESOP. Again, those are things I’m taking for granted that I didn’t communicate to the people. So, they’re left to kind of with these negative fantasies, when if anything, the business hasn’t changed. It’s still profitable. It’s still doing well. Your work is still appreciated.

Todd Kaufman:

The only thing that’s changed is you’re going to own a piece of it every year. If you’re going to earn a little bit more, then you’ll see the benefits of it.

John Warrillow:

Do you think you’ve made that case successfully? Or are there still holdouts?

Todd Kaufman:

I think by and large… I think with our industry there’s a lot of deep scars from people who’ve… I shouldn’t say feel taken advantage of from people who have been taken advantage of. Those are real experiences and I can’t change the fact that that’s the lens that they’re going to see the world through. All I can do is try to articulate what’s going on here, empathize with their viewpoint and hopefully they, again, stay for the reasons that make Test Double a great company and start to see the benefits of this program a few years out.

John Warrillow:

In your lowest moments, do you ever feel a little bit resentful? Like you’re like, “Don’t you know I could have sold this damn thing for millions and be on a beach on Maui, and not deal with all you people and all your pain. Don’t you understand?” Do you ever feel that sense of resentment boiling up around you?

Todd Kaufman:

I literally said portions of what you just articulated, but I don’t know that it’s resentment as much as just maybe a little bit of frustration that people feel like we’re trying to pull one over on them or people feel like we’re prioritizing our own benefits above theirs or above the business. Really with ESOPs, there are so many structures in place to make sure they can’t be abused by ownership. ESOPs are, in my opinion, the one way that you get really fair and equitable ownership among a broader base of employees. The reality is, people didn’t really need to do anything to receive it. They’re still continuing to work for the compensation package that they agreed to when they came in here.

Todd Kaufman:

I don’t know that “resent” is the right word, but it’s definitely frustrating to try and do something that you feel like is really in people’s best interest that you didn’t necessarily need to do and get pushback. “What’s in it for me?” And it’s like, “Well, the company’s in it for you. It’s right here. It’s being given to you.”

John Warrillow:

Would you do it again if you had to do it all over again?

Todd Kaufman:

Definitely. Definitely. One of the reasons I love getting on podcasts like this and talking about it, and talking about it with other magazine articles and things like that is that I think more and more businesses need to understand this is a huge win for you as an owner. It’s a huge win for your business. It’s a huge win for your employees. Jack Stack was on to something. This is how you apply the great game of business. This is one way that you can do it so that people start to see, “Hey my actions at this client are directly affecting our bottom line, and I’m going to be the recipient of that in some way, shape or form.”

Todd Kaufman:

I think it’s a great tool for alignment with employees and with the business. I honestly don’t see a lot of drawbacks. It doesn’t work for all businesses because there are some cashflow considerations, there’s a certain of business that you need to be I think for you to pull this off. But man, if people are able to take a hard look at ESOP as a strategy, I think they should do it.

John Warrillow:

Again, I’ve heard numbers in and around sort of 30 employees would be sort of roughly a minimum cutoff. In terms of the administer to burden and expenses of that, you need to have a certain size?

Todd Kaufman:

I think some it’s 20 or more employees, I think when we were first talking to people, with a cashflow of $1.5 million or so.

John Warrillow:

Because you had to pay down the debt, and there’s a lot-

Todd Kaufman:

Exactly.

John Warrillow:

You’re going to have some money to-

Todd Kaufman:

I think that it’s just going to be hard to finance the actual transaction costs if you’re not making enough cash. I think you want to be able to pay that stuff off. It doesn’t have to be extremely quick, but you definitely can’t wreck your finances at your business otherwise people are just building chairs of something that’s not worth anything.

John Warrillow:

Got it. Got it.

John Warrillow:

Well, I’m just so grateful for you to educate me on this topic. I know it’s one that I’ve been curious about for a long time. So, I’m really excited to have had the opportunity to speak with you about it. If people wanted to reach out and sort of connect with you, I don’t know if you could point them anywhere to do that, by website? Let’s make sure we let people know about Test Double if they want great custom software developed. Where can they find out about Test Double?

Todd Kaufman:

Yeah, definitely. Our website is www.TestDouble.com. You can definitely find out more about our business there. I love talking about this stuff. Again, I’m still at the novice level of ESOP understanding. So, I’ve learned a lot if I [crosstalk 00:56:27]-

John Warrillow:

Wait a minute, what does that make me?

Todd Kaufman:

I don’t know, but if I’ve misspoken on anything, hopefully somebody can correct me and we can add that to the show notes or something. Yeah, I love talking about this. I love just hearing from other founders some of the challenges and better paths for pursing exit strategies and more broad ownership to us specifically. If people want to talk to me about it directly, they can reach me on my email which is, Todd@TestDouble.com.

John Warrillow:

Awesome. There you go. Right through the horse’s mouth. Todd, it was great to meet you. Thank you for sharing.

Todd Kaufman:

Yeah, it was great to meet you as well. Take care. Thanks.

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