Todd Kaufman - Co-Founder and CEO of Test Double: ESOPs, Strict Profit Margins, and Building an Ownership Mentality

Todd Kaufman 00:00

We want people to have an ownership mindset, right? Like we don’t want just Justin and I to carry all the weight of the issues of the business as we grew. It’s hard for me to see everything that might be an opportunity for improvement in the business, right? Like you just can’t do it past 20 or so people. We’re at 125 people now. I want every single one of them to have the mindset of being an owner.

Callan Harrington 00:23

You’re listening to That Worked, a show that breaks down the careers of top founders and executives and pulls out those key items that led to their success. I’m your host, Callan Harrington, founder of Flashgrowth, and I couldn’t be more excited that you’re here. Welcome back, everyone, to another episode of That Worked. This week, I’m joined by Todd Kaufman. Todd is the co-founder and CEO of Test Double. Test Double is a software agency offering consulting services in development, product management, and infrastructure. Their experienced consultants embed within your team and help solve problems from strategy to execution.

Callan Harrington 00:56

Todd has been a software engineer for over 25 years, focusing on building systems that deliver business value and scale without excessive costs. Prior to Test Double, Todd worked as a vice president at Pillar Technology. I learned a ton in this conversation. What Todd built at Test Double is one of the best examples I’ve seen of aligning the people within the company to the long-term vision of the company.

Callan Harrington 01:18

We talked about how ground-up networking and how building each of the founders’ personal brands led to those initial client engagements and speaking engagements that were ultimately responsible for the early success of the company. We also discussed Todd’s philosophy about how a CEO’s role changes as the company grows. He shared that his North Star is finding the alignment between the stuff he loves doing, the stuff he’s good at doing, and the stuff the business needs.

Callan Harrington 01:42

This is one of the most common topics that comes up from founders who have really scaled their companies and how they made that transition from founder to true CEO. And I loved hearing Todd’s breakdown around this. With that being said, we probably had one of the most interesting segments that I’ve had on the show when we spoke at length about the benefits of implementing an employee stock ownership plan, which is also known as an ESOP, to attract and retain top talent.

Callan Harrington 02:12

Todd shared a tactical breakdown of how he set up the plan, the cost-benefit analysis that led to that decision, and the big impact it’s had on employees having an ownership mindset. If you’re unfamiliar with an ESOP, essentially, the employees hold all the stock within the company, and it’s an exit strategy that a lot of founders can use that is different than selling your business to private equity or being acquired by a more strategic company within the space. It’s a really unique way of doing it that has its pros and cons. And we dove into all of these because it’s one of the most unique ways to sell a business. I just learned a ton from this conversation. So with that, let’s get to the show.

Callan Harrington 03:01

Todd, we’re going to dive into how you, ultimately, I’m going to say, first exited this business. But what kind of kicked off the run where you started to get real interest in acquiring this company?

Todd Kaufman 03:25

We were first approached about acquisition. I think it was maybe in the fourth year of the business, or right around 2015 or so. It was from a VC-backed startup software company that was, like, wildly growing, and it was very much a Startup Grind kind of mindset—so long hours. They believed in the vision but had already pivoted a couple times and would wind up pivoting a bunch more afterwards. We actually went out to dinner with two of the people from the VC firm, in addition to the two founders, so they were very much trying to articulate why we should be spending our time on their business and not necessarily on our own. And at some point, it came out that we were a lifestyle business, and it was used very much as a pejorative, like it was not a compliment. I don’t think at the time we were taken aback a little bit by that, but it was easy for them to say because they had already made a bunch of money in the private equity or VC space. These were multiple founders who had already exited, so they already had, like, millions in the bank, and were kind of, like, looking down on our small, like 20-person consultancy at the time, telling us why we should be doing more with our time. Interestingly enough, like, fast forward nine years later, and they’re out of business, and we’re still going strong and growing and growing here. So it’s been wild to see the two paths diverge, I guess, from that point forward.

Callan Harrington 04:41

Did you find in the earlier stages of the business that you had a lot of these types of situations, a lot of acqui-hire type of situations where they’d want to acquire you, put you into some sort of executive position, run that piece of it, and they just didn’t take the actual consulting business seriously?

Todd Kaufman 04:59

Yes, that’s exactly what they would do, almost every single one of them. And we started getting them probably at least annually. About from that point forward, some years, there would be more than one. We were never really seriously entertaining it. We had learned pretty early on the way to suss out, like, whether they really valued us as a consultancy or not, was to start, like, talking financials early, because they would basically start extrapolating, like, “Okay, well, there are 60 consultants, and we’d pay 25% of salary to a headhunter for a full-time hire. So at our rates, like, they would start doing the math, and that would be the offer.” And for us, at the point where we had 60 consultants, like, the business was largely profitable—like, very profitable. So we would do the math in our head and be like, “Well, we could take that as an exit right now, or we could just wait 18 to 24 months and make that as individual profit as the two founders of the company.” So like, yeah, we’re just going to keep doing what we’re doing. We’re not that interested in selling and then just being back where we started.

Callan Harrington 05:56

Before we go further, I want to pull this back a little bit. You had been in a number of software consulting companies previous to founding your own. What was it that drew you to that industry?

Todd Kaufman 06:10

Yeah, I worked for a product company right out of college for about six years, and when I left that company, I had largely felt that my learning had plateaued. Interestingly, that company had also six different CIOs and five different company names in the time that I was there, so a lot of us came to the same conclusion, which was, “Let’s leave this company, because they’re kind of a mess.” I felt like I really wanted to be in an environment where I was learning a lot, and I think consulting is a great opportunity for that. But after doing consulting for a couple years, I really started feeling like the ability to jump into different industries, different code bases, different teams, and organizations, and really see all the unique challenges that they have was interesting, but also seeing the common problems that they all had and being able to start pattern-matching and really being able to start applying a true consultative mindset to those organizations. That was like a superpower to me. I was really excited about doing that.

Callan Harrington 07:06

That’s one of the things I realized really quickly, because I spent most of my career working at tech companies, and then the first time I went into consulting businesses, when I started my own. And I told a bunch of people, I said, “Look, at the very least, spend one year, two years in consulting. You’ll be shocked at how much that will hone your skill sets, and what new types of skills you have to learn in order to effectively deliver.” Did you find that to be the same case?

Todd Kaufman 07:30

100%. Yeah, I agree with that completely. My kids are actually getting to the point now where I have one in the workforce and one who’s got two more years of college before entering the workforce. So I find the advice that I’m giving them now is, like, what I would tell my younger self. Networking is huge. Making connections, like maintaining those relationships, like getting out, going to user groups, conferences, you name it, those relationships are immensely valuable. It’s just a much broader net that you cast. Then, when you’re looking for work, and if you have a good network, then when you go into consulting, like, the world’s your oyster. You can come into a variety of different environments. You have a lot more opportunity. And I do think that, to your point, the skills that you need to do consulting well are different, right? You can’t solve surface-level problems. Consulting really is, “Hey, can I get to the root cause of these things?” Like really adopting more of a Deming kind of systems thinker mindset—that’s huge. But also, if you’re doing it on your own now, you’re accountable for sales, right? Like, now you’re accountable for continuing to develop relationships and figure out ways to help shine a light on people’s problems and let them know when you can help solve those things. Because that’s, in essence, what a sales funnel is, whether you’re an independent consultant or whether it’s a business like ours that’s 125 people at this point.

Callan Harrington 08:40

You’ve talked about this before, how the company that you founded, Test Double, is kind of a manifestation of trying to fix the scars that you collected from the past. What were some of those scars?

Todd Kaufman 08:54

There’s a lot of them. Some of the bigger scars that we saw, that company in particular that we worked at, was very focused on Agile and processes. And we had started to see that this whole Agile transformation movement was like 90% snake oil and 10% value, and that really didn’t sit well with us. People started focusing so much on the process and the communication patterns and things like that, and they were talking a lot less about good software development practices. So we would see these teams that were doing retrospectives and standups and planning meetings in a very healthy way, and the software they produced was still garbage—like maintenance issues, bugs were into production all the time, etc. So we felt like, one, our skills aligned much more with the software side of the house, but also, it just felt like people were way too focused on some of these things that honestly didn’t matter that much. So like, if you see, like, the safe diagram for, like, the scalable Agile framework for enterprises or whatever, to me, it’s just like somebody trying to sell you something that you likely don’t need. That really didn’t stick well with us. So we wanted to kind of move away from that and to really provide something of value, which we felt when we looked at the ways that the industry was really broken. People still ship really low-quality software, so it has defects from day one. It has a boatload of features people don’t use. The project more than likely came in over budget, came in, like, months late. In the miracle that it didn’t, it’s probably going to be a maintenance nightmare for years and years to come. So that was like, really, I think the biggest one that stuck with us. We didn’t want to focus on anything else. We wanted to focus on really building high-quality software and helping others learn how to do the same thing.

Callan Harrington 10:30

Did you guys look to do this somewhere else first, or were you wanting to start a business?

Todd Kaufman 10:36

I had had that idea, actually, for probably about six years prior to starting Test Double. Probably didn’t have the combination of ignorance and courage that I needed in the right proportions to do it, but we had talked about building kind of what we were envisioning within the company that we worked at at the time. It really just didn’t make a lot of sense, though. Neither one of us had an equity stake in that business, so we were going to go through this whole process of building up a whole new line of business within an existing company, and then what? Like, have it be wildly profitable for someone else? Honestly, we felt like, if we’re gonna do it, let’s do it.

Callan Harrington 11:10

So six years, that’s not a short time. What was the final straw that was like, “Okay, we do need to do this”?

Todd Kaufman 11:16

We were both in a pretty dark place on the same project, and a lot of what we saw with this project was there was overpromising in the sales process, there was a really, like, surface-level relationship with the client, there wasn’t a lot of trust. The company was not very conservative from a cash perspective. So, like, you had to jump at anything that came into the pipeline, and that oftentimes put the consultants primarily in harm’s way, not anyone else. All of those problems, like, led to it being a really miserable place for the consultants to do work. So we felt like we had no guarantee that our next project together wouldn’t be the exact same way. We both kind of came away at that moment of, like, we can always fail and get another job. That’s not going to be a problem for a software developer in 2011. We felt like it would eat at us for the rest of our lives if we didn’t take a jump and at least give it a shot.

Callan Harrington 12:05

So you founded Test Double. You’re getting this opportunity to do it your way. One of the things I’m curious about is, you’re talking about Agile transformations, and I know how well this is marketed. I know how well this is implanted in a lot of people’s brains, and a lot of CIOs will essentially stake their claim on Agile transformations. How did you cut through that noise?

Todd Kaufman 12:26

Big organizational change is super hard, and it usually comes from the top down. It’s never a groundswell—like, it’s always, typically, precipitated by a new CIO or a new CEO coming in, and this is their moment to spark change. We’ve rarely ever sold to the CIO or the CEO. Instead, we work from the ground up. We met developers where they are. That’s who we were, so, like, that’s who we knew. We went out to conferences, talked to developers all the time about what worked, what didn’t, what we were seeing. We both did that for the first few years. Justin got really good at it, and he spoke to big audiences at nationwide conferences and things like that, and it really just kind of resonated with the people closest to the problems of software development. So we’ve kind of, like, eschewed tradition and not sold to the executive level primarily. Instead, we sell to the Director of Engineering, and we get influence from the staff, like engineers at a lot of these organizations, who know of us, advocate for us, and then convince a VP of Engineering or someone to pull us in.

Callan Harrington 13:28

What does that look like in practice? I am super curious. I mean, of course, I’ve heard starting low and then going high, but this seems really interesting for a services business in particular. So how do you do that?

Todd Kaufman 13:39

So when you’ve been in the industry for 24 years, or 26 years, or something like that, at this point, a lot of the people that I started working with as peers coming out of college, they’re VPs of Engineering and CIOs and CTOs. So some of it’s just natural progression, but you spend a lot of effort getting those first clients—a lot. Like, we would both give a ton of talks, and you never know whether something’s gonna come from it or not. We both work our networks a lot. Like, a lot of meetings, a lot of effort, just to get one or two clients per year. But then you do a really good job working with them, and you touch maybe 20 engineers, and then those people leave, and they go somewhere else, and they think, “Hey, we’re having the same problem we had at this last company. I should reach out to Todd and Justin and see if they have anyone who can come in and help us.” And then you keep doing that year over year, and all of a sudden, it winds up becoming a flywheel that’s spinning. So probably 75 or 80% of our revenue comes from people who worked with us in the past. It’s either extensions, expansion, or it’s referrals to other like-minded businesses.

Callan Harrington 15:26

So two questions as a follow-up on that. One, how did you get those early speaking engagements? Two, how do you maintain those relationships?

Todd Kaufman 15:35

On the early speaking engagements, you gotta have something meaningful to say. I mean, you have to have a hot take of some form. I think Justin was always very good at being extremely thoughtful and reflecting on past experiences and kind of weaving that into, you know, just his personal experiences with a lens of trying to be selfless and sharing what he learned with others. I think that always resonated with people. I was always fairly snarky and kind of comical in how I described what I saw at all of these dysfunctional organizations, and that also resonated with people, which was good. But yeah, you had to try to build up some content and deliver it as far and as wide as you possibly could. That’s the hard part. Again, Justin got much better at this than I did, so he was able to really parlay some early success into some bigger opportunities, and he took a lot of pride and put a lot of effort into every single one of those engagements. If he was speaking at RubyConf or RailsConf, he probably had, you know, 80–100 hours of preparation before those talks.

Todd Kaufman 16:32

As for maintaining relationships, for me, I mean, I’m always just trying to connect with people. I’m kind of a people person. I’ve always stayed in touch with people, whether it’s loosely over LinkedIn, just “Hey, how are you doing? What’s going on?” or via email. We go out a lot to where our clients are. So we’re typically traveling into San Francisco, Denver, Chicago, New York every year, and just doing small get-togethers with people who used to work with us, or clients who used to work with us, or existing clients, or what have you. Just trying to stay front of mind, hear how people are doing.

Callan Harrington 17:07

What does that look like? Are you organizing a group dinner, a golf outing? What does that look like?

Todd Kaufman 17:12

The golf outings, to me, were never a big thing. They’re kind of limiting—you don’t always have people who are golfers and things like that. But everybody eats. So we typically try to do small round-table dinners. We find if we get 15 to 20 people at a dinner, that’s a good size. Those things are just a great way to kind of keep in touch with people. So we try to do that a decent amount.

Callan Harrington 17:30

Are you covering the cost? Are you splitting those?

Todd Kaufman 17:35

No, we cover the cost.

Callan Harrington 17:36

You cover the cost. Are they mostly clients in your relationships? Do you have them bring other peers? What does that look like?

Todd Kaufman 17:40

Both. So we’ll ask people, like, “Who else would be great to attend?” We let them know, “Look, it’s not a sales pitch. It’s just networking.” We’re trying to get like-minded tech leaders in the same room just to talk about things, right? There’s no set agenda; there’s no presentation, nothing like that. So we’ll have usually a mixture of existing clients. Then we also get a lot of people who just are, “Hey, this is a past client we used to work with. I know they’re in New York, so I’ll invite them to this thing.” “Hey, they know somebody who also now works at a big company in New York that could be a good prospect for us. So yeah, definitely get them on the list and have them show up.”

Callan Harrington 18:13

What does follow-up look like from there? Are you actively following up?

Todd Kaufman 18:17

Yeah. So we’ll follow up. Typically, I try to keep my eyes and ears open for, like, what are people running into? Are they in between jobs now? If they’re looking for a job, okay, great. Follow up, let them know, “Hey, if you can share your resume, we see clients who are hiring a bunch, we’d be happy to introduce you.” Or if they mentioned they had a challenge at work, like, “Hey, if there’s something you want to bounce off of me, that’s great.” Or if that’s something that we can help out with in a paid engagement, obviously, that’s great. So we’ll do a lot of those types of follow-ups. But honestly, like, we hired a good salesperson last year. She’s much better at it than I am. So now Jackie actually does, like, the vast majority of all of our follow-ups. She does a good job with that.

Callan Harrington 18:51

I’d love to talk about your service model here. Did you go through a number of iterations before you landed at where you are today? Or did you know right out of the gate, because I know you wanted to do this differently than how this was sold and how this was delivered before. How did you get to that point?

Todd Kaufman 19:06

Yeah, I think we’re going through maybe a little bit of an evolution right now as well. So we weren’t too different starting out. I mean, in the early going, you, in essence, you probably do whatever it takes to get your bill rates. So we were pretty flexible in the early going, to say the least. I think as it evolved, we started forming some more concrete opinions on how it should work. So one, software is hard to estimate. Businesses change. A company can get lucky and go on a hiring spree, and all of a sudden, they don’t need your services. So we honor that by being open-ended in our contracts. So any client could fire us—seven weeks’ notice, like, that’s it. We think that that accurately reflects what the buyer is dealing with as a changing environment. And it also is a little bit of a standing behind our brand and saying, “Hey, if you’re ever not seeing value out of the engagement, let’s high five and move on.” That’s fine.

Todd Kaufman 19:45

That was one maybe big change that we did probably four or five years in. We predominantly have been weekly billing, and the mindset there is really just like, we’re not one of these companies that time-shifts people onto multiple projects. I think context switching is the biggest killer of productivity. So if you have a need, okay, great—get enough work so that it’s meaningful for somebody to spend 40 hours a week on that work and then bring us in. We’ll jump in and do that. If it’s less than that, we’re just not a great firm for you because it makes scheduling harder on our side, makes our team struggle because they’re trying to figure out what’s the priority, etc. It’s a whole can of worms that we don’t want to deal with, frankly. So our weekly model is a set rate. We prorate it down for any time that’s spent on PTO or training or anything like that that’s away from the client engagement, but that’s just kind of made it simpler for our clients.

Todd Kaufman 20:40

The big benefit for our team, though, is we can let them know you’re not being micromanaged. If a client is really demanding and saying, “Hey, you need to work 60-hour weeks,” time and time again, that causes us to have a conversation with them about how, like, “No, this is not the balance that we try to create for our employees.” I let clients know we’re not micromanaging it. Like, I don’t know exactly how many hours any of our team works. I don’t really want to know. I want you to be delighted with the value that you get from the engagement and feel like you’re getting a good return on your investment. We also let the clients know, typically, our week has about 10% of the time focused on sharpening the saw as much as it is cutting wood, right? We want about 10% of our weekly time to be focused on individual growth and improvement. That may be learning a new technology. That technology may be useful on your project; it may not. That’s just part of what we do as software developers. We have a value of continuous improvement. Otherwise, we just wind up falling behind with new technology like AI and some of this other stuff, right?

Callan Harrington 21:41

Are you building that, like a Toptal, where it’s automatically, kind of—how does that?

Todd Kaufman 21:47

No, it’s just the weekly rate. The weekly rate. So sometimes people don’t even do anything different than just work on your engagement because maybe your engagement is using a new framework or something like that that is helping them grow. Other times, they may be focusing more of that time in concerted chunks. The weekly rate is the weekly rate.

Callan Harrington 22:06

Gotcha. How often are you invoicing?

Todd Kaufman 22:08

We do semi-monthly now. So we do twice a month.

Callan Harrington 22:12

Okay, so that makes sense. So you’ve got the service model down, you’ve grown this thing quite a bit. As I understand it, you were going 30–50% growth year over year for an extended period of time, made Inc. 5000 multiple years in a row. Offers start to come in. What I’d love to talk about is the ESOP. And for our listeners who aren’t familiar, it’s an employee stock ownership plan, one of the most unique ways, I think, you can exit a business as a founder. Why did you start thinking about this at all?

Todd Kaufman 22:34

I would throw out it’s one of the more complicated ways to exit a business as well, so there’s a lot of questions on ESOPs that’s all natural. I’ll do my best, acknowledging I may not have all the answers here. We started looking at it for a few different reasons. I think, one, as a services business, we started feeling like our contributions as founders were maybe starting to be overshadowed by those of our employees. So, as I talked about our model, where in essence, our team delighting clients is the biggest driver of future deals, okay, well, then Justin and I shouldn’t be owning 100% of the profit of the organization, right? The team is actually responsible for delighting the clients and for growing our future business by virtue of those engagements.

Todd Kaufman 23:16

So we felt like there was a pretty significant discrepancy with what the owners were seeing as far as the profits of the business and what our employees should have been receiving as far as equity. So that didn’t sit well with us. Again, that was one of those things—the last two consulting companies I worked at prior to Test Double—it was a problem I had with both of them. I really didn’t have a stake in the game, so I left. I was thinking, “Hey, if we want to retain people, we need to make sure that they’re on equal footing and that they have a say in the outcome here.”

Todd Kaufman 23:45

There were other things too. I mean, we felt like separating ownership from employment was an important thing. So separating ownership from employment means, hey, if one of the founders decides that they want to move on, you don’t have to, like, start running around to banks to try to get enough money to buy them out. And that’s, in essence, what happened. Justin left within three years of us converting to an ESOP. So those were some of the concerns. It felt like, as well, the business was successful. It was growing. Our mission as a business is to improve how the world builds software. It felt like that would never be done in our lifetime. So it felt like for the foreseeable future, this company should keep going on, whether or not Justin and I worked in it. So all those things kind of led us to trying to figure out something that would allow the business to pay the employees their fair share and keep running without either one of us into the future.

Callan Harrington 24:34

Alright, couple questions on this. So, if I’m hearing you correctly on this, you got to a point where, as the founders, you took the risk in the early stages, got it to this point, but now you’re at a point where you felt that you were getting overly rewarded for what you were contributing at that point?

Todd Kaufman 24:59

100%.

Callan Harrington 25:00

Okay. Playing devil’s advocate—shouldn’t you be? Because you took the risk.

Todd Kaufman 25:06

Yeah, I mean, at some point, that risk has paid off, though, right? I don’t necessarily know that if the business runs for 100 years from now, we should still get 100% of the reward for that business. The risk was a risk, but we don’t have a unique software idea or, like, a patentable service model or anything like that that we felt was so unique and earth-shattering that we should be entitled to the profits of it in perpetuity. We created something that was awesome here. We took on some risk for sure. We had a lot of, maybe some unique lenses to view the services business that we built through, and those things do make Test Double a special place for sure. But we also felt like, at some point, if you want the best people—which we do—you have to make it worth their while.

Todd Kaufman 25:53

And the other aspect of that too is, like, we want people to have an ownership mindset, right? We don’t want just Justin and I to carry all the weight of the issues of the business as we grew. It’s hard for me to see everything that might be an opportunity for improvement in the business, right? You just can’t do it past 20 or so people. We’re at 125 people now. I want every single one of them to have the mindset of being an owner. So when they see, like, “Hey, this person actually had a really bad interaction with a client,” okay, cool. I want them to go talk to that person about it or at least escalate to somebody like, “Hey, we probably need to have a conversation about how we communicate here,” or something of that nature. I want people to be aware of that and not feel like it’s someone else’s problem. Like, “Oh, it’s just the owner’s problem because this is their business.” No, that’s not what we wanted. We wanted it to be our business, right?

Todd Kaufman 26:50

So sure, we took on a risk. I think probably within five years of the business running along, we had been rewarded pretty heavily for that risk. Because, like I said, the risk wasn’t that huge for us. It’s a services business. If you’re doing it well, you’re getting paid probably within your first 60 days of being in business. So then we wanted to see that money kind of get parceled out to the rest of the employees so that they would adopt more of the mindset that we had when we started it.

Callan Harrington 27:28

I’m going to tie this back to something that you mentioned earlier. You mentioned that when these offers were coming from these companies, they were essentially looking at it like, “We would pay this much to recruiters, so here’s going to be your offer.” And you said, “Well, if we wait 12 to 24 months, we’re probably going to make that anyway in distributions.” Could that same argument be made here? Because I understand it—you guys took a piece of this upfront, and then essentially over the next, I think it was like 30 years or something like that, you’re continuing to get paid out on that. Couldn’t you have done the same thing?

Todd Kaufman 28:06

So the ESOP’s a little bit weird. There are actually two loans, or three in our case. So think of it this way: the company buys itself from the two founders, and the way that we did that, we leveraged a bank to help with the transaction. But in essence, we had lawyers on both sides, and we had a trustee from the ESOP set in place something that allowed the company to buy itself from the two founders. That will largely be done, I would say, within the next three years. So like from April 2020, which is when we closed, to probably somewhere in 2027, that transaction is done.

Todd Kaufman 28:46

Separately, the company then establishes a different loan that’s called the inside loan with the trust. So all the shares of the company are now held in a trust. The employees participate and get shares from that trust. So every year, over 35 years, we allocate a number of shares into the trust from the company, and that’s what you’re referring to. And that’s a really long window. The reason they have it long is because they want the shares to be recycling every year. So 35 years means it’s long enough where people will either be leaving for their own reasons or they’ll start retiring, and those shares will come in for newer employees who can then participate in the plan. So it’s kind of like a perpetual stock machine, in essence, is what you should think of. That’s at a high level how the ESOP works. Does that make sense, or no?

Callan Harrington 29:33

It does make sense. I’d encourage all of our listeners to listen to your episode on Built to Sell with John Warrillow. I thought it was an excellent episode. They went into all the weeds on this, and he is way more savvy at being able to ask these questions.

Callan Harrington 29:45

You know, I look at this from the standpoint of—it’s why I was always interested. There’s a great book called Small Giants that talked about these companies that wanted to be great, but not necessarily growth at all costs. They wanted to grow sustainably, not just be as big as they possibly can for the sake of being big and exiting. One of the challenges of those companies is perpetuation. When do you sell? Sell to private equity? Forget that, that’s out. And there’s nothing against private equity, it’s just that is their model—they have to make returns for their investors. So one of the ways to do this is an ESOP and essentially distribute this company to your employees.

In theory, this should provide more owners, like you had mentioned. I mean, I could be wrong here, but yes, you’ll get way more money upfront if you were to sell this the private equity route, and then likely in three to five years, get a second bite of the apple when they sell it again, and you’d make even more. One of the things I’m kind of curious about, though, is as a large early shareholder before this went into an ESOP, over the years, will you end up making the same, if not more? Essentially, they’re also incentivizing you to stay, run this business, run it at a very efficient level, but you also have more freedom to do a little bit more of what you want, which you might give up if you sold to private equity. Are those true?

Todd Kaufman 30:45

So we looked at basically all equity shifts through three lenses—the founders, the employees, and the business overall. And I think it’s important to think about it from those three personas because you can maximize in any direction. We could just gift stock to people, right? That would be great for the employees, not so great for the owners. In essence, you’re giving up what you did take on as risk and what you spent a lot of time building over the last 15 years. We could sell to a PE firm, and that would maximize our profit. Justin and I likely could have both exited the business by now with more money than we’ll have made from the ESOP.

The challenge is that company is going away—the mission of the company is, at least. The mission of the company, as soon as you have one of those transactions, pivots from “improving how the world builds software” to “making the most return on investment for those investors, full stop.” And it happens with public companies too, right? It’s the frustrating thing with public companies—they start to get more focused on making sure they beat quarterly earnings so that they can drive the share price up, instead of really contributing something meaningful to society or the world at large.

Todd Kaufman 31:45

So we felt like we wanted to balance all three of those perspectives for the ESOP. Justin and I got a fair return on our investment. I mean, it was roughly six-and-a-half times EBITDA the year that we did it. So it was good. Was it the best possible one for us? No. Could we have made more with a PE firm? For sure. But we’d have to look at ourselves in the mirror every day and be comfortable with the fact that we sold out for our own best interests and left everybody else at the company to fend for themselves. That wasn’t what we wanted to do.

For our employees, they don’t have to buy in, right? They don’t have to go through some convoluted stock option cash approach or anything like that. They just get shares awarded based on salary in an equitable way. If we assess salaries in an equitable manner, all the shares get distributed and allocated based on the same formula. So that problem is solved—it’s equitable.

And then for the company, it gets to continue on solving these problems for clients, knowing that regardless of who owns it as an ESOP, we’ll have people here who are aligned with the purpose and who also stand to benefit from the success of the company. When you talk about businesses that want to go on for not just decades, but for centuries, there are very few approaches that really work. There’s generational—you can have fifth-generation family running a business—or there’s something like the ESOP. The ESOP just seemed to fit all three personas very well for us.

Callan Harrington 33:12

How do those shares become worth something? Do you have to sell this ultimately?

Todd Kaufman 33:16

So that’s one outcome. You could sell, and the shares that are allocated from the ESOP would basically each get their piece of whatever that transaction is. The other way is you leave, or you retire, or—hopefully this doesn’t happen—you’re deceased while employed. Those things all trigger payouts. Say you acquire 100 shares in your employment here, and let’s say you’re fully vested, and then you leave to go find another job that you want to work at, and our share price is $100. You now have $10,000 of value that you’ve generated.

We pay that out over a period of time. We try to be as aggressive as we can. So we want to convert those shares into cash and pay you out as quickly as possible because we want the people who are in the business to get the benefit of the growth of the share price over people who’ve left. If we didn’t, we have up to, I think, six years to start paying you out after you leave. But if our share price goes up each of those six years, your balance keeps going up. So instead, what we do is take cash out of the company annually, and anybody who’s left, assuming we have enough cash to do it, we pay them out. We buy their shares back, and then those shares get redistributed among people who are still in the business.

Callan Harrington 34:28

What’s the downside to this? I mean, that sounds ridiculous, honestly. It sounds like such a great setup. I have to assume you probably have to take on additional debt because if you’ve got a lot of people, it’s not like this is the case, but let’s say you’ve got a number of people leaving at once, and you’ve got six years, and maybe the business doesn’t have enough cash, but it’s got enough cash that it can get a note. So I’m assuming those are some of the things. What are the big downsides?

Todd Kaufman 34:52

Yeah, there are protections, even for some of those things, too. One of the nightmare scenarios I was thinking of was, “What if, for some reason, some other company became very enamored with our people and just went on a recruiting binge and hired all our people? Then we’d have to pay them out a big amount, and we’d be much less valuable because all our people left.” But you don’t have to pay them out early. You can wait six years. So if they torpedo the value of your company based on everybody leaving, okay, then your obligation to pay them is much less because the stock price goes down.

We do a valuation every year by a third party that sets the stock price. Probably the biggest downside: there are some upfront costs. So I think it’s probably $250,000 at a minimum to pull off an ESOP. You have to pay for a trustee, you have to pay for a third-party administrator, you have to pay for a valuation firm, you have to pay for lawyers to set all this stuff up. If you’re trying to do a bank loan to finance it, you have to probably find somebody to find that bank, and you have to pay for their lawyers—all of this stuff, right? So it’s not cheap to set up.

Todd Kaufman 35:54

But I haven’t even hit the biggest benefit, in my opinion. As an S corp that is 100% owned by an ESOP, we now pay 0% federal income tax and zero income tax in most states. The money we’ve saved in income tax in year one more than offset the cost of the ESOP.

Callan Harrington 36:12

How does that work, or should we even get into that?

Todd Kaufman 36:15

This isn’t me admitting to tax fraud or anything. It was part of ERISA. So, literally, all of the 401(k) governance that was passed—this was a piece of it. The incentive was provided to companies to share ownership among all the employees. That was the big benefit: as an S corp, you don’t pay any federal income tax.

Callan Harrington 36:34

How has this impacted the business?

Todd Kaufman 36:37

I think it’s been positive. It’s weird because you don’t know what the amounts are going to look like when you start—it’s hard to even guess. So we really didn’t know, like, how would balances grow? Are people going to be millionaires in three years and want to leave, or are they not going to see anything? What’s going to happen?

What we really saw was that it started a little bit slow because the company value goes down immediately. You, in essence, take on debt equal to 100% of the company value. So you almost reset at zero. Our first year, we had pretty good growth, so our share price jumped a little bit. And then we had two really good years of growth, so it jumped a lot. Now we have balances in six figures four years in.

Todd Kaufman 37:17

So is it like some of the scratch-off lottery tickets you can get working for other software businesses? No. But it’s more like retirement on steroids for us. The benefit to the employees, too, by the way, is that when they get paid out from the ESOP, they can roll over those funds tax-deferred into another retirement plan. So you can, in essence, not pay tax on any of that until the point where you cash it out from your retirement.

Callan Harrington 37:42

In essence, you’re incentivized to stay at the company as long as the company is continuing to grow, and as, in your shoes, you’re incentivized to make this company continue to grow and be valuable because that’s just going to lead to more people staying. Is that accurate?

Todd Kaufman 37:57

Yeah, I think it glosses over a point, though. As a services business, we’re just highly profitable. So if we didn’t grow at all, we would continue to pay down debt. Every dollar of debt that we pay down winds up showing up in our enterprise value, so it causes the stock price to go up further. You could conceive of some future state of us being like the Apple of services businesses, where we’re just sitting on this mountain of cash. Every dollar there could be invested, or it could be just sitting there adding to your enterprise value. So, even if we didn’t grow, you could still see the share price go up and up and up just by virtue of us being a profitable business and a well-run business.

Callan Harrington 38:43

Let’s talk about profit a little bit. As I understand it, you try to shoot for 20–25% profit margins, and if it goes above that, that’s a problem.

Todd Kaufman 38:52

I wouldn’t say it’s a problem. It’s an opportunity, maybe. We target 20–25%. Again, some of the scars that we had at other consulting companies—when you run really lean, so a lot of consulting companies are at 5–10% profitability. When you do that, you have years like the last few or like the COVID year, where all of a sudden the business changes—clients fire you or push back on rates. You have no other lever to pull than to start laying people off.

Todd Kaufman 39:29

I take a lot of pride in the fact that we’ve never had layoffs. Last year was horrible. I think our revenue went down 11%, profitability went down like 40-some percent. It wasn’t a huge problem for us because we had a healthy enough profit margin to start with that, okay, our profit margin dipped to like 15% or something like that. That’s fine. We’re still making money. We didn’t operate as we thought we would, but we didn’t have to take any drastic action either.

The flip side is also true. If we’re making consistently above 25% in profit margin, it’s a signal to us that, hey, you should probably be repurposing these funds elsewhere. So either invest them in ways that will help grow the business, whether it’s sales or marketing or what have you, or feed it back to the employees. And we did that. In 2021, it was a really good year for us. I think we did five different salary band adjustments upwards because we kept seeing, hey, we’re able to push up rates, and we’re highly utilized, and we’re growing. Let’s keep pushing these back into employee salaries so that we can stay competitive in what’s a really competitive market right now for software developers.

Callan Harrington 40:26

You built this company. You essentially already exited the company. You’re leading the company, and the co-founder has since moved on. What’s next for you?

Todd Kaufman 40:39

I always encourage people in any job that they’re at, the Venn diagram you want is stuff that you love doing, stuff that you’re good at, and stuff that the business needs. So if the things I’m doing day to day continue to be in the center of those three circles, then I’m happy. I don’t need to move on or do anything else. If it starts getting out of whack, we probably need to start looking at, okay, am I getting pulled into something that I’m just not good at, and we need to hire somebody for that role? Or is it just like, hey, running this business at the size that it’s at is not something I love doing, in which case we need to start looking for a new CEO. Maybe both of those are something that’s coming, but I don’t see it anytime soon. To me, I want to continue to add value where I best can, doing the things that I love, which oftentimes is in the sales process, talking with our clients, and really getting a better understanding of what they’re seeing, what challenges they’re facing, and trying to help our team figure out solutions to those. That’s still a big part of what I love doing. The flip side, though, is—and this is maybe something I’m not as good at as I want to be—developing a leadership team that can really help scale this business beyond what it’s at right now. Because, frankly, that’s something that I haven’t always been good at, but it’s what the business needs right now. The business can’t be single-threaded through me or anybody for a critical aspect of the business. At this point, we have too many people working here for that to happen. I don’t know. That’s a non-answer, I guess, to your question. Ultimately, I’m not looking for anything new. I still love working with the team that we have at Test Double, and I feel like I’m doing things that are valuable day in, day out. If that ever starts changing, we’ll have to figure it out.

Callan Harrington 42:23

It’s interesting. You say it’s a non-answer, but to me, that was probably one of the most thought-out answers I’ve heard to this. I’ve seen that Venn diagram before, at least a version of it. I love the idea of, as long as I’m still in the center of those three circles, that’s a really good way of looking at it.

Todd Kaufman 42:33

Yeah, and I think people struggle too. Even our team has questioned, like, are we just growing for growth’s sake? And I’m like, no. I think growth presents a ton of challenges. It’s been a challenge for me to help get the business to the size that we’re at. There could be a state where we just say, you know what, we’re fine at the size we’re at. We have to figure some things out before we want to try growing again. But at the same time, if we’re true to our purpose, like, we want to improve how the world builds software, it’s tough to do it as an agency of 125 people. You have to be able to take on some bigger problems. You have to be able to help some of those big businesses downtown that line the skyscrapers. You have to help solve their biggest problems—hopefully not with Agile transformations, hopefully with more meaningful work.

Callan Harrington 43:16

We’ve come full circle.

Todd Kaufman 43:17

Yeah, you have to be able to have a bigger impact if you’re being true to the mission. So that’s still what drives me.

Callan Harrington 43:23

Last question I have for you—and you actually already answered this to a piece of it—but if you could have a conversation with your younger self, age totally up to you, what would that conversation be? What advice would you give them?

Todd Kaufman 43:33

Don’t ever be afraid to be curious. Don’t ever be afraid to think of things differently. I think when I’ve had the biggest moments of growth in my career and in my life, it’s been when I’ve been humble enough to know that I don’t have all the answers, but also to sense that something was amiss and to try and search for different approaches or different ways of doing things.

Callan Harrington 43:53

Yeah, it’s almost kind of trusting your gut that something’s off on this.

Todd Kaufman 43:57

Yep. I didn’t do enough of that earlier, and I find more now that I try to follow that as much as I can.

Callan Harrington 44:03

It’s amazing how oftentimes we just can’t put words to what we’re observing and what our brain’s processing, right?

Todd Kaufman 44:08

Exactly. I think the more we push against “this is always the way we’ve done it” or “this is just how it is,” I think that’s when you see true innovation happen.

Callan Harrington 44:16

I love it. Todd, this has been a blast. Thanks for coming on today.

Todd Kaufman 44:20

Thank you, Callan. It was great.

Callan Harrington 44:28

I hope you enjoyed Todd and I’s conversation. I love talking about how Todd implemented an ESOP and created an ownership mentality among all employees of his business. If you want to learn more about Todd, you can find him on LinkedIn—links are in the show notes. Also, if you liked this episode, you can find me on LinkedIn to let me know. If you really want to support the show, a review on Apple Podcasts or Spotify is very much appreciated. Thanks for listening, everybody, and I’ll see you next week.