When Your Employees Own the Company - Ownership
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SECTION: Ownership

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When Your Employees Own the Company

By Mary Sedor

Article Date: 08-01-2009
Copyright(C) 2009 Associated Equipment Distributors. All Rights Reserved.

Could an ESOP factor into your exit strategy?

As a business owner, would you ever consider selling your company stock to your employees, essentially allowing them to become owners of your company? Do you fear some kind of coup d’état – your employees believing they can make all upper level management decisions?

Employee stock ownership plans, better known as ESOPs, account for approximately 11,500 companies in the U.S. and roughly 10 million employees, or about 10 percent of the private sector workforce, according to The ESOP Association, a national association for companies with employee stock ownership plans.

An ESOP is an employee benefit plan that makes the employees owners of stock in the company. Compared to other employee benefit plans, there are several features that are unique to ESOPs: (1.) Only an ESOP is required by law to invest primarily in the securities of the sponsoring employer; (2.) An ESOP is unique among qualified employee benefit plans in its ability to borrow money, and as a result, “leveraged” ESOPs may be used as a technique of corporate finance, said J. Michael Keeling, president of The ESOP Association.

So why become employee-owned if so few private companies take the proverbial plunge?

Although companies that transition to ESOPs do have to address the anarchistic attitudes of employees, generally speaking, companies with ESOPs enjoy less turnover, have increased employee buy-in and loyalty, as well as higher employee morale, according to The ESOP Association.

“The primary reason is that you can have an ESOP and you’re still very free to mold management style and culture in any way you wish,” said Keeling.

Becoming Employee-Owned

The most common transition to an ESOP occurs as part of the company owner’s exit strategy, says Keeling.

“Eighty to 85 percent of transitions occur when the owner/founder, be it one person or a two-generation family, exits the ownership structure,” he said.

That’s how both Vermeer Equipment of Texas and Stone Construction Equipment became employee-owned companies.

Vermeer Equipment of Texas, based in Irving, was founded by Gary Wiley in 1978. Wiley’s advisors told him to have an exit strategy in place by the time he was 55, so when he was in his mid-50s, Wiley established the company’s ESOP, explained Whit Perryman, president of Vermeer Equipment of Texas.

Perryman explained that Wiley considered selling to a third party, but he ultimately wanted to reward the employees who had helped build his company.

“By selling to an ESOP he helped pay back some of those folks who made it happen in the beginning,” said Perryman. “Gary helped set up the ESOP so that within 10 years – by the time he was 65 – the ESOP loan was paid off and he was able to transition out of the ownership. He ended up getting very good advice.”

Implementing a New Corporate Culture

Equipment manufacturer Stone Construction Equipment of Honeoye, N.Y., transitioned to an ESOP in 1986. The company was founded in 1967 by Alan Stone, and in the early 1980s, Stone became interested in getting his liquidity out of his investment, explained Lynne Woodworth, president and CEO of Stone Construction Equipment.

“In 1981, Stone hired a new management team, and the team was beginning to turn the company around – putting aggressive growth plans in place and changing our manufacturing process,” said Woodworth. “Stone didn’t want to give that direction up, and at the same time, we were changing the culture of our company. He decided rather than sell his company to an investment group, to do a leveraged buyout and become employee-owned.”

Stone Construction Equipment is now 100-percent employee-owned. Over the 10-year period while the company was paying off the ESOP loan, Stone Construction Equipment began an aggressive campaign to educate employees on what it means to be an employee owner, said Woodworth.

“When you become employee-owned, employees begin to think that they can make the decisions about everything,” she said. “It took them a while to understand that they are really shareholders and they don’t make all the operational decisions, but that their management team acts on their behalf.”

Stone also shifted the corporate culture to one of an employee ownership culture, explained Woodworth.

“We really wanted to draw from the expertise of our employees, and we put a culture in place that is based on a participatory environment and our four cornerstones, which reinforced the feeling of ownership,” she said. “Now our employees think of themselves as owners and make decisions based on a set of parameters that owners would use. Our culture became one based on trust, respect, communication and development, and they worked very well together. The employee ownership was a tool to get people to want to participate because the better they did, the better the company did, and the higher the stock value went.”

C Corp. versus S Corp.

Benefits of being employee-owned vary depending on whether the company is a C Corp. or an S Corp., explained Keeling.

C Corps have had the ability to become employee-owned since the mid-80s. The primary benefit is that it encourages the family-owned, private company to sell to the ESOP in tax code 1042, said Keeling.

“There is a provision of the law that if the current owners sell 30 percent or more of the corporation to an ESOP and it is a private company, and the seller takes the proceeds from the sale and reinvests the proceeds in the securities of U.S. Operating Corps., he/she does not owe capital gains taxes – it is deferred until they sell the securities that they acquired with the proceeds,” said Keeling.

Under the S Corp. ESOP law, the ESOP’s share of that Corp.’s taxable income is not currently taxed, said Keeling.

“There is great benefit with a 100-percent S Corp. ESOP arrangement,” said Keeling. “If there’s no owner other than the ESOP, the ESOP pays no taxes on a current basis,” said Keeling. “Uncle Sam recovers his money when there is a distribution to the employees – they pay a tax on the value of the distribution. So theoretically they are not ‘tax exempt,’ but that is the impact on a short-term basis.”

Tangible Company Benefits

Woodworth says having been employee-owned for such a long time, Stone Construction can see the benefit of being an ESOP in their employees.

“We think there are competitive advantages because each and every employee understands that our success really depends on our customers’ success,” she said. “Our employees are probably more willing to go the extra mile, and our customers tell us they see that. We really think it all comes out of that vested interest in the success of the company.”

The shift to employee ownership helped foster a culture of cooperation, flexibility, dedication and commitment, said Woodworth.

“If you look at the length of service of our employees, our average is in the 20- to 25-year range,” she said. “They’ve stayed with us such a long time because they are committed to our organization.”

Perryman agreed that the culture of employee ownership does have an impact on his company.

“One of the big things is that the employees become employee owners,” he said. “It’s a different mindset than just being an employee. It’s similar to how someone might treat a car that you rent differently than one you own. Employees treat the company like they are the owners – they look out for the best interests of the business.”

The main benefit for employees is that an ESOP provides them with a unique retirement benefit. As the company’s stock value increases, the value of the employee’s portfolio increases.

“We have employees who have been with us 15 years, and they are walking away at retirement with a check for over $100,000,” said Perryman. “And they didn’t have to put a penny into it. It’s a unique structure that is truly a win-win for the employees and the company.”

In addition, recent research shows that ESOP companies tend to be more generous with benefits than non-ESOP companies, said Keeling.

“There is evidence that ESOPs provide more than one retirement savings and they are more likely than their counterparts to have a good health insurance plan,” said Keeling.

Also, ESOP companies tend to have more satisfied, happier employees, said Keeling.

“The ESOP companies that are very transparent and open with employees, when measured by a variety of studies, have a higher density of employee satisfaction,” he said.

The Drawbacks

“You don’t just flip the light switch and now you’re an ESOP,” said Perryman.

Transitioning to an ESOP takes time to teach, train and educate employees on its benefits, he said.

“We didn’t do a good job of that early on,” said Perryman. “It wasn’t until we started paying out cash to people after they retired or left the company that we realized this was a real benefit for our employees’ retirement.”

Another hurdle companies face in becoming an ESOP is the increased administrative costs. For example, ESOP companies pay to have the company stock valued each year, as well as pay for a plan administrator and an ESOP trustee. In addition, ESOP companies have to have the cash on hand to cover the cost of repurchasing shares.

“One big issue on an ongoing basis is that when a person leaves or retires you have to buy back their shares in what is called a repurchase obligation,” explained Perryman. “That’s an ongoing liability and you have to be able to fund that most of the time through ongoing cash flow.”

Therefore, says Keeler, companies with fewer than 20 employees are not good candidates for setting up an ESOP.

“Dealers probably need to be in the $7 to $10 million range or bigger...because there are certain costs you have to pay every year, and it would be harder to justify with a smaller company.”

 Another word of warning: Keeling says that the IRS and Department of Labor scrutinize ESOPs.

“I guarantee that if your company is an ESOP you’ll be audited at least once,” he said.

Nevertheless, Keeling says the benefits outweigh the drawbacks.

“I think the biggest drawback is psychological,” said Keeling. “The men and women who have doubts about employees – even in a limited way – becoming owners or decision-makers find reasons not to do an ESOP. It can be a lot of hard work to create that ownership culture and, you need dedication from management; but it’s well worth it.”

Advice for Dealers

For owners considering converting their dealerships to an ESOP, it’s important to find an expert who can help you through the process.

“You need someone who understands the details of the law, the transaction and a lawyer who specializes in ESOP law,” said Keeling. “Also, there should be a dedication to engaging the employees in the heart, soul and mind. The idea is: Now that they have a beneficial ownership, the outcome depends on everyone’s contribution to the success of the company. And companies should be dedicated to educating the employees.”

Perryman says that it’s definitely not for everyone, but as long as you surround yourself with the proper experts, it’s manageable.

“At the end of the day, dealers will always have this transitional issue out there,” said Perryman. “But an ESOP is a vehicle that allows dealers to be proactive in perpetuating the business, and it’s great for the dealership, employees and for manufacturers.”

For more information visit The ESOP Association at www.esopassociation.org or the National Center for Employee Ownership at www.nceo.org.

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