As the U.S. population ages, many leaders are beginning to think about preparing their business for the next generation. The business can be sold to a third party, gifted to heirs, or sold to management or employees through an employee stock ownership plan (ESOP). While ESOPs are not the most widely used option — there are only about 10,000 throughout the U.S. — they can be very beneficial for both business leaders and employees.
“Employees benefit from the increasing value of the business because they’re partial owners,” says Brian Bornino, CBA, CFA, CPA/ABV, director of valuation services with GBQ Consulting LLC. “There’s a lot of uncertainty about how people will retire, with the lack of pensions and Social Security being questionable. So having control of your own retirement and owning part of the company where you work is good for employees.”
Smart Business spoke with Bornino about why an ESOP is a good option and how to determine if it’s right for your business.
Why is an ESOP a good option to consider?
There’s a strong desire to try to keep jobs local. When you sell the business to your employees, jobs are locally controlled, whereas a third-party buyer may move the jobs across state lines, to a different city or even a different country.
Owners who built their business also have a pride factor and want there to be a legacy for the business. They would prefer an option other than selling to a third party that will integrate their business into the third party’s business, in which case their life’s work goes away.
There are also many tax advantages to an ESOP. A handful of academic studies has shown that employee-owned companies tend to outperform those not owned by employees.
What are the tax advantages of forming an ESOP?
The most powerful tax advantage of an ESOP is the ability to create an income-tax-free entity. If the ESOP owns 100 percent of an S corporation, the tax liability arising from corporate income flows through to the shareholder, which is a tax-exempt trust. That’s a very powerful advantage for savvy management teams, as a business that doesn’t have any income tax liability can invest that savings — which is often about 40 percent — and redeploy those dollars to grow the business through acquisitions, investment in equipment, hiring new people or paying dividends. That’s where a lot of the incentive is for management. They’re trying to build and grow the company, so if you can take out the largest expense item on the company’s profit and loss statement, that’s a major motivator.
Another key tax advantage is tax-advantaged financing, as the principal payments on ESOP transaction debt can be structured to be tax deductible (whereas typically only interest on debt is deductible).
These tax advantages also benefit the selling shareholders. To the extent that the selling shareholder is the one financing the deal, these advantages often result in the shareholders geting repaid quicker because the company has more cash to repay them. It becomes a lower risk proposition for the selling shareholder.
How do you determine if an ESOP is the best option for your company?
It starts with defining your goals for the transition of the business. The typical options are the outright sale of the company to a third party, selling or gifting it to your heirs operating in the business, or selling it to management or employees through an ESOP. You have to decide which of those you want to pursue. If you don’t have heirs in the business, that obviously eliminates that option. The sale to a third party makes the most sense if the company doesn’t have adequate management to run on its own. There also may be a strategic buyer that could help you maximize the purchase price, which makes a third-party sale more attractive.
The decision of whether to pursue an ESOP starts with the selling shareholder. If there is a desire to preserve a company’s legacy by keeping it independent, as well as reward employees who helped build the business, then an ESOP is often an attractive option. Because employees don’t put up their own money to buy the shares, virtually all employees will likely be on board, as they’ll get the benefit of owning the business. Obviously there will be skeptics, but by and large, most employees will be excited about an ESOP.
You also need to convince management of an ESOP’s benefits. On occasion, management may prefer to buy the company without involving employees, but the economics of management buyouts are different and management often cannot compete against the ESOP option.
What types of companies are most favorable to an ESOP?
Employee-oriented companies are often the best candidates for an ESOP, such as service companies, engineering or architectural firms, consulting firms or other companies where employees are critical assets to the business. ESOPs also make sense from an employee morale standpoint because you’re trying to attract, retain and motivate highly skilled employees, and employee ownership is a way to do that.
It also works for more traditional manufacturing and distribution businesses. Many times they have an easier time financing the transaction because they have the equipment and assets to borrow against, compared with service businesses that have to raise money for the transaction. Any business with a strong team, consistent cash flow and an interest in rewarding, attracting and motivating employees is a great candidate for an ESOP.
Brian Bornino, CBA, CFA, CPA/ABV, is director of valuation services with GBQ Consulting LLC. Reach him at (614) 947-5212 or firstname.lastname@example.org.
Insights Accounting & Consulting is brought to you by GBQ Partners LLC
Ron Calhoun was planning to discuss plans for his company’s 100th birthday back in 2006 when the discussion with the board of directors took on a more serious note. After the birthday plans were nailed down, it was time to talk about the future ownership of the wholesale distributor of residential building supplies and HVAC equipment.
The second generations of three families owned the company that was founded in 1907, but no third generation descendants had an active role in the business.
“We were looking to dilute the stock down to the third generation,” says Calhoun, president and COO of Palmer-Donavin Manufacturing Co.
That was not the best scenario for continuation of the company — it made it too likely that the company would dissolve.
Palmer-Donavin was doing well enough. Revenue for 2011 was $163 million, down a bit from a high of $174 million previously, and better than 2010’s $147 million. About 230 are employed company-wide.
Calhoun got to thinking and remarked on how much his predecessor, Bob Woodward Sr., put an employee focus on the company during his 60 years with the company.
“The culture of our company is very much an employee-oriented culture that he developed through his policies and compassion for the business and people,” he says.
“We talked about where a company goes. Do you go to a private equity firm? Do you go to a strategic buyer, and then what happens to the company, what happens to the management and the people?
“I think from our ownership and board perspective, they wanted to maintain the integrity of the company and the people, and felt an obligation to management and the people to see that the company could go forward.”
The proposal that was the best fit was an employee stock ownership plan. It would be a way to give back to the people who helped build the company. After talking to a number of people in the industry who had taken their companies in an ESOP direction, it was time to decide.
The leadership settled on the ESOP as a succession plan for Palmer-Donavin. The company was sold in 2007 to the ESOP and went from being 100 percent shareholder-owned to 100 percent ESOP-owned private company.
“It’s been interesting along the way, and because of our past, I think we transitioned into it very well, and we got everyone’s goals aligned,” Calhoun says. “We have been very successful since.”
But just because the papers had been signed doesn’t mean the work is over. Here’s how Calhoun faced the challenges ahead of him.
Make the ESOP fit
From the perspective of a company’s vendors and customers, the transition to an ESOP is virtually invisible. But from the board of directors and managerial areas, it is quite a bit different.
ESOPs are rarely used to rescue a company in financial trouble but are most often used to provide a market for the shares of departing owners of companies, to reward and motivate employees or to take advantage of loan incentives to acquire new assets in pretax dollars. ESOPs, in nearly every case, are a contribution to the employee, not an employee purchase.
In preparation for the transition, company owners usually will need to hire an attorney and an investment banker to appraise the company, set a value on its shares, put together a share allocation schedule and arrange financing if needed.
Once the Palmer-Donavin board of directors voted to go the ESOP route, one of the next steps was to hire a trustee who would represent the employee-owners when voting.
“She represents the ESOP employee owners,” Calhoun says. “She votes their stock and is completely independent of the board, so she provides a true independence in the association of the employee owners of the company.”
When selecting a trustee, it is a matter of hiring a pro. Through the process of interviewing, you should be able to find a professional trustee to meet your needs. Then take him or her through a meet-and-greet process.
“You should go around with your trustee and your chairman of the board to employee meetings to tell them about the changes that are coming — and that the decision was made to sell the company,” Calhoun says.
An administrative committee should be formed that is responsible for the management of the ESOP and the shares. They will work closely with the trustee and keep the trustee informed of business concerns. They work together as far as share redemptions and things of that nature and any reporting that is necessary.
Most important of all, the trustee votes for the shareholders and attends the annual meeting of the board of trustees. This is one of the major points employees will need to know.
“The trustee votes on matters on behalf of the employees; for instance, the trustee would vote for the election of directors representing the employees,” Calhoun says. “The trustee votes if there is a decision to sell a majority of the assets of the company or a major event.”
The Department of Labor and the Internal Revenue Service require an annual valuation of the shares and the trustee hires a third-party evaluation team to perform this duty.
The most common method to allocate the shares to employees is in proportion to their compensation, although different formulas may be used, such as years of service or a combination of the two.
Another question to be answered is when the employee becomes vested in his or her shares.
“What we did — that the trustee and our attorney said we should not do but we felt that going through this transition we should — is that we gave pre-ESOP vesting to all employees so the vesting period on the ESOP is six years,” Calhoun says. “They recommended that we take that and have every employee start over at the time we implemented the ESOP, and we just didn’t feel good about that, and we allowed them their previous time with company to vest. So if they were with us six or more years, their ESOP shares vested at 100 percent when they received them.”
The company leadership wanted to continue the tradition of being an employee-friendly organization.
“The culture of our company has been an employee-oriented one,” he says. “Bob Woodard had what we called an appreciation plan. If the company was profitable, all of a sudden all of the employees would get an extra week’s pay or a bonus would show up in their paycheck, and they didn’t know when it was coming. It was just kind of random.
“Now with the ESOP contribution, shares get distributed every year. It is really kind of based on the same thing — shared distribution is based on each individual’s income level but done on a regular basis.”
Educate the employees
One of the largest benefits of an ESOP is the ownership culture and the pride that the employees take in being employee-owners. While some employees will feel the honor right away or early in the transition process, others may be doubtful of the benefits and will need time and attention to work it all out.
“The challenge for the company is how you educate the employees to understand what the ESOP is,” Calhoun says. “It is a very difficult concept for everyone to grasp, so we spent a lot of time on it.”
One useful tool is a communications committee that will take on the assignment to tell employees on a regular basis what is happening with the company and the ESOP.
“We publish what we call The Owners’ Manual every quarter,” Calhoun says. “It talks about the different aspects of the business and different educational pieces that we put in there to help the employees understand better what’s going on with the company, what’s going on with their investment in the ESOP and the business strategy.”
The first message to be communicated is that the biggest advantage of an ESOP is that it will offer employees the chance to create the ownership culture of everyone in the organization.
A communication tool that Calhoun found helpful was to set up a company intranet site to encourage questions from employees about the ESOP. These are posted on the site with a response, usually from the human resources department or someone else in the organization that has more expertise in an area.
“I think there were a lot of people who were very nervous about it, that were skeptical. But I think hopefully those concerns have been satisfied over time,” Calhoun says.
“It’s a learning process. As far as each year when we have to go through like the redemption of stocks for people leaving, those types of things get a little cumbersome and you want to make sure that you do that through the right process. It’s very regulated.”
When employees leave the company, they receive their stock, which the company has to buy back from them at its fair market value.
Efforts to spread the word about the ESOP should be frequent and creative.
“You can do different things such as lunch with the CFO, to small individual meetings, to having an ESOP committee, which is made up of employees from all the different areas and sections of the business,” Calhoun says. “They meet at least on a quarterly basis. They are charged with doing some things to bring an awareness, and ownership awareness among the employees. They have come up with some different types of games and things that can be used at company picnics or all-employee meetings that help communicate the message.”
Increase your company value
For a company going through a recession, having an ESOP adds a whole new dimension and a new tool to operate the business.
“Our business went down from a high of $174 million before the downturn to $147 million, and during that time we had 320 employees; we are down today to 233,” Calhoun says. “Many of those changes were just through attrition, but we did have everyone look at their departments and evaluate what are the tasks that we need to do, and what can we do to improve ourselves and where we have redundancies to try to cut out that duplication.
“I think through managing through that type of a downturn in our business — everybody focused extremely well in that and agreed to take on more than their share to keep the ship going forward. It was a pretty seamless transition through that, and we were able to maintain our profitability through those times.”
In the long term, ESOPs provide a convenient way to which bonuses can be tied. A rewards-for-profit plan focused on return on assets encourages employees to meet goals and rewards them when the goal is achieved.
“A rewards-for-profit plan replaces the typical profit-sharing plan,” Calhoun says. “Initially, employees had been able to see the company value grow because of debt repayments. Now it’s just like when you own a house, you build up equity by paying off the mortgage. Well, our mortgage is paid off, so we now have to increase the value of the house. We’ve got to see how we can grow our top line revenue and our bottom line profits in a sustainable way that will increase our value.”
How it works is an ROA or a profit objective is set by the board, based on abilities. It runs on a continuous 12-month basis and is paid quarterly to the employees.
“Then based on a formula, whether you are at 100 percent of the goal or 125 percent of the goal, the employee gets one week’s pay. If you are at 90 percent, it’s 90 percent of one week’s pay. If you are at 150 percent, it’s 150 percent of one week’s pay. It’s been very effective.”
How to reach: Palmer-Donavin Manufacturing Co., (614) 486-9657 or www.palmerdonavin.com
president and COO
Palmer-Donavin Manufacturing Co.
The Calhoun file
Born: West Lafayette, Ohio, just east of Coshocton
Education: Ohio University. I got a bachelor’s degree in business administration from the College of Business.
What was your first job?
For my very first job out of college, I was a bartender at Maumee River Yacht Club. I was able to network that into a sales representative position for the National Gypsum Co., selling drywall in the Columbus market.
What was the most important business advice you ever received?
My mentor and former company president Bob Woodward kept saying it’s the people who make the company and the company is nothing without the people. I think that’s so true. Also, without integrity and honesty, you have nothing. You have to have integrity and character in everything you do.
Who do you admire in business?
Outside of Bob Woodward, I think one person I admire most is probably John McConnell of Worthington Industries. Actually, my father retired from Worthington Industries. He had always been an hourly factory worker all his life and went through working on union organizations and went through strikes and closing of facilities. He got a job later in life with Worthington and retired there. He always respected Mr. McConnell. The policies and programs the company had for all their employees created quite a loyalty among the employees and allowed my father to retire. He is 85 today and is and doing well — I think it’s the culture that is built within an organization. I recently was fortunate enough to talk to one of the board members and get some insight as to how they did some things.
What is your definition of business success?
Business success is creating a vision that people can trust and fulfilling that vision where everyone prospers.
Most business owners don’t start a company thinking about the day they’ll retire and leave the company in someone else’s hands. The business they founded is a large part of their identity and their life. But when they’re ready to retire or reduce their role in the company and welcome new ownership and leadership, it’s a relief to know they’ve left their enterprise in good hands. An excellent way to do that is with an ESOP, an employee stock ownership plan.
An ESOP isn’t just an ideal vehicle to transition ownership and boost the founder’s liquidity; it’s also a superb opportunity for business owners to save on federal income taxes while encouraging employee productivity.
Creating and administering an ESOP is a smart move for many forward-thinking business owners, says Bill Norwalk, a tax partner at Sensiba San Filippo, a CPA and business consulting firm with four offices in the San Francisco Bay Area. He has nearly 30 years of expertise advising company owners on ESOPs and tax-related matters.
Smart Business recently asked Norwalk about vital details of ESOPs that savvy business owners should know.
What is an ESOP and which businesses should consider one?
Simply put, it is an employee retirement plan. It’s a tax-exempt trust that gives workers shares in the company that employs them.
Key factors for a company considering an ESOP are profitability and size. A business needs at least 25 employees and should have an independently appraised value of at least $4 million to make it worth the cost and effort to set up an employee stock ownership plan. There needs to be a significant payroll — I advise at least $1 million — because payroll generates the contribution to the retirement plan that provides funding for the stock sale.
ESOPs are especially beneficial for owners interested in liquidity with a solid history of earnings and the ability to attain financing. The company also needs a capable management team with a clear vision and succession plan for when the owner/stockholder is ready to sell his or her shares and leave the business. The owner’s day-to-day activities as an employee also need to be transitioned prior to his or her departure.
How popular are ESOPs?
There are about 11,400 ESOPs and other profit-sharing plans invested mostly in employer stock with about 13.7 million participants, according to the National Center for Employee Ownership. The value of those assets is an impressive $923 billion. Small businesses are most likely to create ESOPs; 72 percent of the ESOP Association members, a national non-profit membership organization, have less than 250 employees.
But I’ve helped companies of all sizes create ESOPs. One of my clients is a profitable business, which has a stock value of approximately $6 million. After years of hard work, he wanted to retire but remain involved in the business on a limited basis. He agreed to sell 30 percent of his shares to the business. He was able to defer the gain on the significant amount of cash he received because he reinvested the funds into qualified replacement securities, which is stock or long-term debt in U.S. companies. So he gets a steady return from a diversified portfolio, and he has reduced his day-to-day involvement in the business’s daily activities.
His company benefited too. It saved significant income taxes because of the money it contributed to the plan. The value of the shares owned by the plan increased, benefiting the employees, who will, over time, vest in those shares.
How does an ESOP aid a business owner?
An ESOP can help owners in several ways. It provides liquidity while they continue to work in the business overseeing the company’s transition to new ownership. The ESOP provides reliable cash flow for a retired owner, who’s been able to sell the business without paying federal income taxes on the sale. The owner benefits from being able to replace company stock with securities that yield cash, deduct interest and principal on loan repayment and ultimately create a company that pays no federal income taxes. That’s a significant advantage in any marketplace.
A business owner often leaves profits in the business to help it grow. The value tied up in the business is often the owner’s largest asset. Founders feel a sense of personal responsibility to the employees who helped build the business, and they want to see the business flourish long after they leave. At some point, they are ready to reduce their involvement in the business, retire, or preserve value outside of the business for their heirs. In the right circumstances, an ESOP can help achieve each of these goals.
What are some advantages of an ESOP for employees?
It’s free money. In fact, retiring employees can end up with more value allocated to them by the company through an ESOP than through a 401(k). A company can even offer a 401(k), in addition to the ESOP, in certain circumstances.
We serve a 100 percent ESOP-owned company that pays no federal income taxes because it is taxed as an S corporation. Because the income is allocated to the nontaxable trust that owns the shares, it is exempt from paying federal income tax. A portion of the tax savings leads to higher compensation for employees and a larger amount of profits available to distribute to the trust, which enhances the value of each eligible employee’s retirement.
Do you have any final words of advice?
An ESOP can be a tremendous opportunity and one that I recommend to clients for tax savings and as part of a succession plan. However, it’s not right for every business. Working with an accountant who is a trusted adviser who knows a business owner’s long-term goals, both for the business and personal retirement, is crucial to evaluating this opportunity.
Bill Norwalk is a tax partner at Sensiba San Filippo LLP. Reach him at (925) 271-8700 or email@example.com.
Sue Burnett, founder and president of Burnett Staffing Specialists, had never heard of a staffing firm doing an employee stock ownership plan until a friend told her about a staffing firm in Missouri that decided to do one. Intrigued by the news, Burnett investigated the possibilities for her and her husband, Rusty, who serves as CFO and executive vice president, to do an ESOP in their company.
“We thought that this was something that might be an option for us,” Burnett says. “Rusty and I really have no plans to retire, and we weren’t looking for an exit strategy because we weren’t ready to exit. At the same time, Rusty turns 70 this year and I turn 65, so our staff — particularly our younger staff — were wondering what is the future of the company.”
Burnett thought an ESOP was the perfect situation, because she didn’t have to leave the company or retire. It was a way to give back to the people who helped her build the $64 million company.
Smart Business spoke to Burnett about what went into her ESOP decision.
What are some of the advantages of doing an ESOP?
I think that the advantage of it is that now my staff knows what the future of the company will be. I think there was a feeling of relief that we were not going to sell the company No. 1, and that No. 2, we were going to continue on with the company. It gave my management staff a real vision to be able to see into the future that they will be able to run the company without us. With a management staff that’s young, it made them feel like there was really something to work toward, because they are now owners of the company. It is definitely a long-term way to retain staff and particularly management staff.
For me personally, it was a tremendous feeling of relief from the standpoint that now I know that the company is in good hands. The people that helped build it will be the leaders of the future for it and I can stay for as long as I want. It was a way for me to ensure that the company will continue into the future and my staff won’t be worried about what is going to be happening.
Are there any disadvantages?
From an employee standpoint, there’s nothing but positives. They are being given stock, and it’s free. It’s a retirement situation for them. As the company continues on into the future for all of these people who are fairly young, when they retire, if the company is still in business or if the company is sold, whatever happens, their stock will be worth a lot of money. There is no downside for the employee whatsoever. ESOPs have shown growth faster than normal companies because the employees become very committed and excited that they have ownership in the company.
Why would other CEOs want an ESOP?
I do think that for the owners, it’s a wonderful exit strategy, but they have to look at it as a long-term exit strategy. If you want to just sell the company and leave, then that would not be the best thing to do. In our case, it will take about seven years or so to allocate the stock, and we will certainly be involved during that period of time. There have been some ESOPs that I’ve heard about where the owners basically did the ESOP and then left. That was not as successful, because the management team could not keep the success going and the owners didn’t get paid off.
How can you tell whether an ESOP is right?
It is an expensive thing to do because there is a cost. You need to make sure that you’re willing to take on that cost. There are a lot of attorneys involved and a team of people that work on it. You have to have the financial ability to be able to do the ESOP. Also, you have to recognize that the money of the ESOP really just comes from the profits of the company.
I think that if you’re too young and you want to continue to own the company, you shouldn’t consider it. I see the ESOP as more of an exit strategy for people who want to transfer ownership and perhaps stay involved in the company but maybe not for 20 years. The ESOP decision is an owner’s decision.
HOW TO REACH: Burnett Staffing Specialists, (713) 977-4777 or www.burnettstaffing.com
One morning in January, Ric Selip asked his wife for his last goodbye kiss as the owner of Grand River Rubber & Plastics Co. Later that day, he signed purchase agreements and transition documents for his Ashtabula company.
Fortunately, Selip was (and is) confident about the move because the buyers are a pretty familiar group – his employees. The company is converting to an employee stock ownership plan (ESOP), a transition that will mean minimal operational or cultural changes and continued financial stability.
In the press release, Selip said he, co-owner/executive vice president Joe Misinec and senior vice president Donald Chaplin - who will all continue to manage the company during the transition - are “confident we have chosen the very best people - employees right here in Ashtabula County - to carry on the legacy, success and great work of this company.”
Smart Business spoke with Selip about the benefits of ESOP.
Tell us about the impetus behind turning Grand River into an ESOP.
My partner Joe Misinec and I have been running Grand River Rubber & Plastics for 35 years. While we looked at other options, the ESOP option offered us a smooth transition to the new leadership team. The improving economy of 2010 further proved it was time to put the leadership and direction of this great company in the hands of the next generation. We have always recognized that our people are our greatest asset. We have many long-term employees who have been with us every step of the way, and we wanted to share the future with all of them. There was no additional bank financing taken on to complete the transition. We will hold the note and be paid as cash flow allows. This was important in that we did not want to, in any way, put the company under any financial stress. This is how we have always run the company and will until we exit stage right, as they say.
How does this benefit you, as owners?
As owners, we were honored by the fact that the employees have chosen us to continue to run the company through the transition. By transitioning the company to the employees, it will not only allow the company to maintain a strong balance sheet, but allow us to secure our future personally. Until the ESOP loan is paid by the employees, we will still manage the company. Additionally, we do not have to be distracted by a strong culture change – a change that would undoubtedly come from an outside buyer.
What challenges did you face in both making this decision and executing it?
Statistics consistently show that employee-owned companies outperform non-employee owned companies. Our challenge was educating our workforce as to the benefits of ESOP. In early 2010 we brought a small group of employees to the Ohio Employees Ownership Center Conference. If we learned nothing else from that day, it was: “If you expect employees to act like owners, you need to start treating them like owners.” We embarked on a consistent program of employee education on the benefits and risks of this potential course.
What benefits does this create for the company?
The benefit for our company is a smooth transition without financial stress or the worry that might come from an outside purchaser. Our community, vendors, suppliers and customers can rest easy knowing a strategic plan is in place – a plan authored and executed by owners and executives they have always known.
How will your role change in the new organizational structure, and have you developed an exit strategy for your personal involvement?
Our goal is to continue to operate the company through the better part of this new decade. This will be an exciting time of teaching to lead and learning to trust in our employees. We firmly believe that this plan will be successful as the employees can move forward with their destiny in their own hands. Our plan is to stay though the transition and the completion of the ESOP loan.
How to reach: Grand River Rubber and Plastics, www.grandriverrubber.com
Dustin S. Klein and Brooke Bates contributed to this article.