The Exit Myth That Can Take 20 Years to Pay You
Is an ESOP a real exit for a PT business owner? Paul Martin walks through the ESOP, the employee ownership trust, a staff buyout, passing the business to your kids, and stepping back, and shows who is still carrying the risk after each one.
Full transcript
Generated from the episode audio and lightly edited for readability.
On the day you close a deal with a third party, something happens that a lot of owners never really think about. You're handing over your business, and they're handing you a big check, and right then, at that moment, the risk changes hands. And that's what an exit really is. It's an exchange of risk.
Now, there are a lot of other options out there, and some of them sound pretty attractive. I'm sure you've all heard of an ESOP or an EOT. Or you can pass your business down to your kids. You can have your staff buy you out or just step back and let your team run the business. I've been doing this for over 27 years, and none of those options give you the true exchange of risk that you get when you partner with a third party.
So let's walk through each one of these and look at the exchange of risk that does occur.
So when you partner with a third party, and whether that's a strategic partner that's backed by private equity, it could be a large privately held company, it could be straight to a private equity firm or straight to a family office. Typically, they're putting down a big chunk of money at closing. Now, you may carry a small note for three to five years possibly, you may roll some equity, and in a lot of the deals that we do today, you will, and that's fine.
That's kind of the piece that you chose to keep that hopefully will grow in the future. But the bulk of your value, it's in your bank account the day you close. So in the future, if we have major reimbursement cuts, or your best clinical director and staff therapists leave, or if a competitor opens up across the street, that chunk of money that you got paid has already been invested while that is happening, and it is making money.
So hold on to that because everything else I'm gonna talk about today, you're still the one carrying the majority of the risk. Let's start with an ESOP. What an ESOP stands for is employee stock ownership plan. Sounds sexy, right? Think of it as a retirement plan for your employees that buys your company.
So what will happen is the company will borrow the money, a trust buys your shares, and over time, those shares get passed out to your employees. And look I'm gonna be fair here it can be pretty sexy. Your staff become owners. Your name and your culture stay in place, and there are definitely tax advantages.
Depending upon how your company is set up, you may be able to defer the capital gains on the sale. And once an ESOP owns all of an S corporation, the company generally does not pay federal income tax. So for a rehab company with very few hard assets, that can appear on the surface really attractive. But I promise you, there are some guardrails around it.
First and foremost, the price. This is the way it works. An ESOP has a trustee, and that trustee is legally required to protect the employees. They cannot pay more than fair market value, and that's set by an independent appraiser, okay? A strategic partner can pay for what your business is worth inside their company and with their umbrella around you.
The ESOP can't. So in almost all cases, the ESOP number comes in significantly lower than what you get from a competitive process with multiple third parties at the table at the same time. Secondly, it's complicated and it is expensive. You have attorneys, you have the trustee, you have the appraiser, you have the plan administrator, and literally setting it up can run and can be a couple hundred thousand dollars.
And then you have a new valuation and administrative costs every single year after that. So the company needs to have a valuation placed on it every year after that. It becomes regulated, it's regulated like a retirement plan because that's what it is. And then third, and this I think is the big one, where does the money come from?
Banks don't lend a lot against a physical therapy business because there aren't a whole lot of hard assets, and those that aren't worth a whole lot. So a big piece of your price usually comes as a note from you, and it gets paid out of cash flow of the business over potentially many years.
So who's producing that cash flow? It's your staff, okay? The same people that work for you now that you are going to rely on in the future now to run your company. And there's one more piece that a lot of people miss. When employees leave or retire, the company has to buy back their shares. It's called a repurchase obligation. And in a business with the kind of turnover that we see in therapy, that can start to add up. So again, an ESOP, yes, it can be sexy, okay? And it sounds really cool, but it really is full of risk. Secondly, and I have not seen any of these, especially in the United States, but I have had a couple people ask me about them, so I think it's worth talking about.
It's called an EOT. That's an employee ownership trust. I'm not an expert on this here. They've been really big in the UK for a while, and I think you're starting to hear more about them in the United States. So it's a little different. A trust buys your company and holds it for the benefit of your employees, and usually holding it for the good.
So the employees don't put in any money, and they don't get shares that they can turn around and sell. The trust owns it. The appeal of this is that it's simpler and cheaper than an ESOP, and it isn't regulated like a retirement plan, which is definitely a plus. But folks, here in the United States it does not come with any tax breaks that an ESOP has.
And how does the trust pay you? Do they go out and borrow money? No, the trust pays you out of the profits of the business. And in most cases, the large majority of your price is a note that could be paid out over five years, seven years, ten years. And keep in mind, I use the word majority of your price.
There's notes in third-party deals, but they're minority. They're the small part of the overall purchase price. In this case, it's a large part, and that could be paid out again five, seven, or ten years. So think about what that means. Very little cash at closing, and your payout depends on the future profits of a company that you don't control anymore.
It's run by the people who have never really run the business before. And so in a couple of years, if it hits a rough patch whose payments are going to slow down? They're going to be yours. That really is not an exchange of risk. You have kept almost all of the risk. Now, the third, and this is one that I will tell you many physical therapy business owners have thought this is the American dream and this is the business dream, is to transition your business to your staff.
And again, it comes from a good place. You have someone that's been a clinical director for you, maybe a couple of your senior PTs, and they've been with you for years, and you trust them. So why not let them just buy you out? So let me walk through how this actually works. Most of them are young, and a lot of them still have student loans, so they don't have a whole lot saved.
So the big question, and the big question you have to ask yourself before you start into this process is: Where is the money coming from? Now, somebody, who knows, at a cocktail party or something, they'll say they can get an SBA loan. As that's a small business administration. And sometimes they can, but they're going to put money down.
They're going to personally guarantee it, and many times that's gonna be with their house if they own one, and the bank is looking hard at a business that has no hard assets. The large majority of the assets of a physical therapy business are goodwill, and you can't put that down as hard assets against borrowing.
So in a lot of cases, what they can borrow is against your accounts receivable. And again, as that's the money that insurance companies owe you, and that has, some risks of its own, especially a bank will say it has a lot of risk. So if collections slow down, that line of credit can get really squeezed.
And then whatever they can't borrow, that becomes a note from you, and I've seen this be as much as 80 to 90% of the overall deals, and that money can get stretched out over 10, 15, or even 20 years. Think about that, 10 to 20 years. Think about how old you're gonna be when that last check shows up, and that's if it shows up and here's the other piece.
There's a reason that you are the owner and the boss, right? Being a great clinician is not the same as running a business, as you got payroll, there's payer contracts, there's recruiting, there's the referral relationships. It's managing cash, it's managing a staff, and a lot of really good physical therapists have never really had to do any of that.
And now your retirement is gonna depend on them figuring that out when you're no longer there. Look, I'm not saying it never works. We have done that. In fact, the one that we did most successfully the physical therapist that was buying the business did have a very rich uncle, and that's why I commonly use the rich uncle phrase.
And look, every once in a while, there's somebody on your team who has family that has real money. And that can give you a real exit with a lot of cash at closing. Am I saying it never happens? No, I'm not saying it never happens, but it is few and far between. And then finally, passing it down to your kids is a lot of the same risk stories that we've been telling you already.
It's the same money problem, the same question on whether or not they can run it or not. Plus, it's family, which makes it a really hard conversation that will continue to get much more difficult over time. So the last piece, and this is pay your people, and just pay them more and step back. And some owners I've seen go this way, and they've developed and they've really worked on developing leaders.
You pay them well, you give them real authority, and then you simply, with them knowing this is coming, you're gonna take more time off, more vacations, and then you enjoy the cash flow that is left. And look, if there aren't any problems, this can be a form of an exit. And I've seen it work for short periods of time.
But it's good until there's a problem. Your key director or your key therapist leave, a payer cuts your rates or drops you. You lose a big referral source. Who gets that phone call? It's you, 'cause it's really in essence still your business, and you are right back in it. And you're back in it why?
Because you never exchanged the risk. You just stepped away from it for a while. So what does all of this mean for you? When you put all of it side by side, here's kinda what with an ESOP or an EOT or a transition to your staff or your kids, you're usually looking at a lower price, significantly less cash at closing, and you're still betting on the future of the business.
You just aren't the one running the business anymore. With a third party, you're getting what the market says your business is worth at the time you take it out in a competitive process, and the bulk of that money comes on day one, the day you close. That's an exchange of risk. I give you my company. I might be coming along with it for a period of time.
I might have some equity. I might have a little bit of risk in there, but you give me a big check. That is an exchange of risk. Now, does that mean every owner out there should partner and sell to a third party? No. You have to look at your own goals. You have to look at your family. You have to look at your team.
You have to look at your timing. And all of that is exactly what we do when we do an outside-in assessment. We try to lay out all the options for you with real numbers that you have ever dreamed about so that you can see what you'd actually walk away with and then how much risk you would still be carrying.
So trust me, it's a lot easier to make that call when you can see it. When you can actually see it, then you believe it. Thank you for joining me today, and if you have any questions on this topic or you'd just like to talk through which option may make the most sense for you, just click below. Let's talk.
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