Sharing the Wealth: How ESOPS Turn Employees into Owners and Companies into Industry Leaders
“Sharing the Wealth: How ESOPS Turn Employees into Owners and Companies into Industry Leaders”
A primer on ESOPs is presented. What are the benefits? What are the costs?
High-flying technology stocks have helped lead the employee-ownership trend by passing out stock options to valued employees, but it’s not only large, public, fast-growth companies that can benefit from making employees owners. Employee Stock Ownership Plans, or ESOPs, make this option available to smaller, closely held businesses as well.
The concept of employee ownership isn’t new — Sears Roebuck pioneered the concept in 1916 by funding its pension plan with company stock to motivate employees while providing a retirement benefit. Then in 1974 Congress passed the Employee Retirement Income Security Act (ERISA), which established ESOPs as a type of tax-qualified retirement plan. The motivations were twofold: to provide retiring business owners a new way to plan succession, and to promote employee ownership by providing tax advantages to ESOPs.
The benefits, however, have been greater than anticipated. Research by the National Center for Employee Ownership (NCEO) shows that when employee ownership is combined with a management style that encourages employees to share ideas and information, companies grow 6 percent to 11 percent faster per year than they otherwise would. Employees benefit as well; 31 of the 100 companies Fortune named to its 1998 "Best 100 Companies to Work For in America" list are at least 10 percent employee owned.
It’s no surprise then, that both large and small companies are sharing equity at greater rates than ever. More than 10,000 companies of all sizes use ESOPs, which are often funded when a closely held company uses pretax dollars to buy shares from an existing owner. Once the ESOP owns 30 percent or more of the company’s stock, sales of stock to the plan can qualify the seller for a tax-deferred rollover of the gains into reinvestment of other stocks and bonds.
Reasons for ESOPs
Besides the tax benefits for the owners, companies that use ESOPs reap multiple benefits: retention of employees during a tight labor market, increased company growth, and employee productivity, and money to refinance debt or any other business purpose. The original intent, to enable a smooth succession when an owner retires, is still a common motivator.
"[Without ESOPs] a lot of small business people would be forced to sell to outsiders or bigger companies or competitors or whatever when they get ready to retire," says Jim Heinz, vice president of Colle & McVoy, a Minneapolis marketing communications firm that began an ESOP nine years ago. "Now there’s a very simple and a very solid way to transfer ownership in a company to your employees. Say you have a husband and wife team that has started a business, and now they’re getting ready for retirement. They want to have some assurance that their company will continue in the manner that they set up. Now they can transfer that ownership over time to their employees."
When owners are looking at succession issues, they find that "their best buyers are their employees," says Perry Phillips, president and founder of ESOP Builders, a Mississauga, Ontario, company that helped import the ESOP concept to Canada in 1991. That was what Galer & Hults, a closely held Philadelphia-area janitorial supplies distributor, found. H.E. Galer III, the second-generation president and CEO, helped implement an ESOP in 1996 to allow a transfer of funds to the company’s principals by expanding ownership to employees. The result, he says, is deepened employee commitment, better customer service, and increased profitability.
"It can be a good way for owners of a closely held business to take some of their chips off the table, to cash in a portion of their company, yet keep the stock in hopefully friendly hands and keep control of the business," agrees David Morse, the head of executive compensation and retirement at Whitman Breed Abbott & Morgan, a New York City law firm. "It’s also a way of incentivizing their workers to make them owners because owners do act differently than regular employees."
Other uses and types of ESOPs have developed. Libby Perszyk Kathman (LPK), a Cincinnati packaging design firm, used a leveraged ESOP in 1995 to repurchase its stock from Young & Rubicam, the giant advertising holding company that had bought the company years earlier. A leveraged ESOP is funded when the company borrows money from a bank or other qualified lender. The loan may be made to and paid back by the ESOP, or the company may borrow directly and lend the money to the ESOP, but either way the loan is discounted, since both the principle and payments to the ESOP are tax deductible.
Says LPK president Jerry Kathman, "After serious discussion we recognized that the Employee Stock Ownership Plan option provided a reasonable return to the original investor-owners as they stepped out. At the same time it was the ultimate empowerment tool for everybody who was here. It was a win-win situation so that we could maintain our cherished independence."
Both LPK and Colle & McVoy are communications companies, and this isn’t a coincidence.
"Probably about 90 percent of our clients are technology or knowledge-based companies," says Phillips. "The main reason that they’re putting ESOPs into place is to attract and keep their key people. There’s such a demand for technology people in all industries, and ESOPs are one way to keep them."
A knowledge-based company, explains Phillips, is "any company whose assets leave at night. If they don’t come back the next day, you’ve got a major problem." That makes employee retention a matter of the company’s life or death.
Kathman agrees with that assessment. "We are truly knowledge workers. We have a company of individuals making entrepreneurial decisions every day," he says. "This is an environment where individual initiative makes or breaks a business relationship."
By providing not only a psychological sense of "ownership," but also actual ownership, employees are motivated both to increase profits and stay to reap the rewards of growth. Since its ESOP, LPK has had only three employees leave in an industry where company-hopping is an accepted norm. Similarly Castek Software Factory, a Toronto-based component-based application developer, has experienced only 5 percent attrition while nearly doubling revenue and staff annually since its 1996 ESOP.
"People typically are less likely to leave a company if they have some equity in the company," says Heinz. "We still have people who leave for career or personal reasons, who either move out of state or go to another shop. That’s going to happen, but typically we see lower-than-industry norm turnover. An ESOP is a great retention tool. It’s also a good magnet, and we use it as a recruiting tool."
LPK uses the same strategy in recruiting the brightest minds out of colleges and from other companies. "When we tell them, ‘You know, you’re not a renter at LPK, you’re an owner,’ it usually closes the deal for us," says Kathman.
Elements of an ESOP Culture
An ESOP culture thrives best in what NCEO calls "Theory O," an ownership style of management that reaps dividends in faster growth and increased employee retention. Kathman freely admits that LPK was predisposed for a successful ESOP.
"We had what we now call a pre-ESOP culture," he says. "We were a very open environment so employee stock ownership was not the only motivator, but part of the total commitment to principles that this firm held from the beginning to share the wealth, share the information. It was a logical next step."
Without that "pre-ESOP culture," the process is trickier, according to Kathman. "A lot of owner-operators who run something of a dictatorship would find the transition to trusting and creating an environment of sharing information a delicate cultural shift."
Phillips agrees. "We look at implementing ESOPs as really a cultural change in the company," he says. "It’s a process. We bring all the technical issues to the table, but we also bring the process of making sure the employees understand what an ESOP is, what it means to them, so there are no surprises from the management group or from the employee group. You need an economic environment where the management group really cares about the future of their employees and is willing to take the action that’s needed to move some of that empowerment down to the employees."
If those elements aren’t in place, for example, if the owners aren’t psychologically ready to share control, an ESOP won’t work out. Many don’t.
"ESOPs aren’t for everybody," says Heinz. "Some companies just don’t like it. It’s not part of their culture, not part of their philosophy, so they try it and turn around and buy all the shares back and bury the thing."
Although some companies think that ESOPs are an easy way for owners to cash out or to bring a failing company back from the brink, the reality is far more complicated. Morse says that 50 percent of closely held corporations that approach him about ESOPs end up rejecting the concept when they hear how involved the process is or what the limitations of the program are.
"ESOPs are not a magic bullet," says Phillips. "If you’re selling buggy whips and the buggy’s going by the wayside, ESOPs are not going to save you."
Setting Up an ESOP
If you’re interested in pursuing an ESOP for your company, take the following steps.
1. Find a qualified consultant to design the ESOP.
The consultant, who may be a financial adviser or investment banker, will work to integrate your ESOP goals with laws and regulations and make sure that your company can meet the financial obligations posed by the ESOP. You may need to bring other professionals into the mix as well.
"You’ll need a good attorney experienced in ESOPs, and you’ll need also a financial adviser who can evaluate the value of the shares of stock that you’ll be contributing to the ESOP or selling to the ESOP," says Morse. "Those are the two most important things. An accountant wouldn’t hurt either. Besides making sure that you comply with the letter of the law — there’s a lot of complex rules under ERISA and the Internal Revenue Code — the role of the people is to make sure that everyone’s doing their job, and the transaction is structured in a way that makes economic sense for the owners."
When looking for an adviser to design your ESOP, let the previous experience of candidates guide you.
"Find out how many times they have done an ESOP, who they have done it for, and what industries they have done it for," advises Phillips. "The reason is that every company has a different culture, and the more companies that you see, the more you’re able to fit the ESOP model into that particular company."
2. Identify what kind of ESOP you want.
You and your consultant will need to determine:
- Who will participate in the plan
- How stock will be allocated to participants
- What vesting schedule you will adopt and how the ESOP will make distributions
- How you will allocate voting rights
- Whether your ESOP will be leveraged or cash-funded
3 . Value the firm’s stock.
An initial estimate of fair-market value must be done by an independent appraiser during the feasibility stage. For privately held companies, fair-market value is the price at which a security would trade if a company’s stock were publicly traded on an active exchange.
Warns Morse: "It’s very important that you deal with the ESOP on an arm’s length basis. Even if you’re giving away the stock, if you appraise it at too high a value, you can actually get sued by your employees or the Department of Labor for short-changing them. A lot of owners seem to think that they can do that because this is an addition for their employees. They’re not paying for it, so it’s a windfall for them, but that’s not the way the law works."
The appraiser must also report to existing stockholders (if applicable) on how the ESOP will affect the value of their stock and the company’s financial condition. For smaller public companies, an ESOP often dilutes existing equity interest in the corporation.
4. Develop a plan to repurchase the stock of departing employees.
Repurchase obligation can be one of the most difficult aspects to manage once the ESOP is underway. In privately held companies, ESOP participants have a "put option," which gives departing employees the right to sell their stock to the ESOP in return for a fair-market price, either in a lump sum or installment payments. If many employees retire or leave unexpectedly, this can cause cash-flow problems, even forcing an ESOP leverage.
Colle & McVoy avoided this problem through careful planning.
"We’re a cash-funded ESOP and we have not, to this point, had to leverage our ESOP," says Heinz. "Every year we put our contribution away, and we’ve mapped out long-term what our exposure’s going to be when people will be retiring. We tried to accrue enough money so we can satisfy these repurchase obligations when they come up, and so far we’ve been able to do that. About 12 senior employees over the last seven, eight years have retired, and we’ve been able to buy back their stock and distribute those shares to the current employees."
Ironically, repurchase obligations are most difficult to honor for companies that have been most successful, since the repurchase obligation grows as the value of the stock grows. Other factors include the size of the annual ESOP contributions, the change in the value of shares between the dates of contribution and repurchase, the vesting and distribution provisions of the ESOP, and employee turnover.
5. Draw up a formal plan document.
Once the feasibility and design stage is complete, an attorney or consultant can draw up a formal ESOP. The plan document should include:
- the plan’s purpose
- eligibility requirements
- participation requirements
- company contribution
- investment of assets
- account allocation formulas
- vesting and forfeiture provisions
- voting rights and financial responsibilities
- distribution rules
- provisions for plan amendments
The plan should also identify who will serve as the ESOP’s trustee and who will be the administrator. These positions may be held by someone from a bank, mutual fund company, professional ESOP administration firm or your company.
6. Obtain financing.
If your ESOP will be leveraged, meaning the ESOP will borrow funds to acquire the stock in question, you’ll need to borrow money from a bank, savings and loan, investment banking firm, mutual fund or insurance company.
Before you look for financing for a leveraged ESOP, you should strengthen your company’s financial controls and reporting, since potential lenders will judge your creditworthiness this way. It’s also advisable to add management depth because many ESOPs are precursors to retirement and you’ll want to assure lenders that strong management will continue. (Even so, top managers may be required to stay on for a certain period after the loan is made.) Another smart move is to diversify so that your company is not entirely dependent on key suppliers, customers, products, and/or markets. All of these actions will decrease investment risk, raise your company’s market value, and win your lender’s confidence.
7. Adopt the plan.
Your company must then formally adopt the ESOP plan, which usually includes submitting the related documents to the Internal Revenue Service with an application for the plan’s tax-qualified status. You must adopt your ESOP plan by the end of your fiscal year to claim a deduction for your contributions, but the actual contributions and leveraging do not have to take place until your company files its tax return.
Writer: Kelly J. Andrews
All rights reserved. The text of this publication, or any part thereof, may not be reproduced in any manner whatsoever without written permission from the publisher. This article originally appeared in the Volume 3 1998 issue of Entrepreneurial Edge.