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ESOP Can Spell Succession Success

By Susan Gosselin

esops-coverstory

When the founders of a company want to exit leadership, most look to sell, but many Kentucky companies have discovered the benefits of another, less common option: becoming an ESOP (Employee Stock Ownership Plan.) Companies that take that leap go from being privately owned, to being employee owned, with profits divided up yearly among employees but placed in a protected fund and disbursed when employees leave or retire.

It’s an ongoing corporate structure many companies say saves them a considerable tax burden, improves employee productivity and ensures jobs stay local. Is it one your company should consider?

“ESOPs are a great thing for companies and a great thing for the American worker,” said Spencer Coates, president of Bowling Green-based Houchens Inc., one of the largest ESOPs in the United States with more than 18,000 employees nationwide.  “We’ve all seen the fallout when companies sell, with the boarded-up plants and deserted towns they leave behind. Turning your company to an ESOP gives founders the payout they want, while still ensuring those jobs stay in place, generation after generation. Companies have more working capital year to year, and communities get to keep their workforce. It’s a win-win-win,” Coates added.

That’s a conclusion many companies have embraced. In fact, according to The ESOP Association, there are 10,000 in place in the United States covering 10.3 million employees – about 10 percent of the private-sector workforce.

How ESOPs work

When a founder turns over a company to an ESOP, a fair valuation of the company is made. The money for the owner payout is borrowed from a bank, and that money is distributed into equal-sized stock shares. In fact, an estimated 75 percent of all ESOPS were created through borrowing money from a bank, The ESOP Association reports.

Employees are given certain amounts of the stock, based on a percentage of their annual income. Each year, the profits of the company are divided up into shares and placed into this fund. Employees often must become “vested” into the program, earning the full amount after they have achieved full-time status or hit a service milestone.

When an employee leaves the company or retires, they receive their payout, which can usually be rolled into an IRA or paid in cash with taxes deducted. As profits are plowed back into the fund, the value of the employee stock increases. And that money can add up.

According to The ESOP Association, a 39-year-old organization, the average account balance for an individual employee in an ESOP is $113,318. Numbers like that are possible, the association reports, because the average annual contribution an ESOP company makes, per employee, is 11.8 percent of the employee’s income.

Though the company is an S corporation and not an ESOP, Doe-Anderson Advertising in Louisville knows well the benefits an employee stock plan can have. Despite the cutthroat nature of its industry, 102-year-old Doe-Anderson has become one of the oldest continuously running advertising agencies in the U.S., largely due to its employee ownership, said Todd Spencer, president and CEO. 

“Having an employee ownership fund allows us to greatly reduce our tax burden. The extra liquidity it gives us really helps. We hold out a certain amount of that stock money for use in potential payouts. But between our insurances and the cash value of the plan, we have plenty of money for investing in new equipment and facilities, or simply floating payroll and accounts payable while we are waiting for our clients to pay us. It’s a great safety net for the company and one that most ad agencies don’t have,” he said.

Doe-Anderson became employee owned in 1958, when Warwick Anderson put up seed money for the plan. Employees “buy in” to the fund with their own money, and the value of those stocks increase as the company makes profits. Fifty-seven of its 125 employees have bought into the plan. Their stock value has grown enough over the years to see several stock splits.

The value of the original $12,500 in employee stock Warwick Anderson purchased would have appreciated to a worth of $21 million in today’s money, had it stayed in the plan, Spencer said.

ESOP-powered tax benefits

Companies that participate in ESOPs get a whole lot more than the love of their employees. The potential tax benefits can be compelling. Companies that contribute cash or new shares to their ESOP can deduct that amount. For “leveraged” ESOPs, the money a company spends to pay back the loan that created the ESOP can be deducted from taxes, as well.

The tax benefits also extend to employees. Employees only pay taxes on ESOP money when it is disbursed. And even then, employees can roll over a distribution into an IRA with tax advantages or other retirement plan. If they take the distribution, contributions are taxed as income but any gains accumulated are taxed as capital gains.

Alan Taylor, director of BKD Bowling Green, leads a practice that helps companies make the transition to becoming an ESOP. He is quick to emphasize the tax benefits and extra governance that comes with this type of company structure.

“Company earnings are not taxed under an ESOP when the company is taxed as an S corporation and 100 percent ESOP owned, and that leaves companies with the ability to grow, because they have greater cash flow,” Taylor said. “Companies can use those tax-free dollars to grow the company, and ultimately build the stock’s value. But it takes a great deal of planning and oversight. For instance, at BKD, we help companies plan out five years ahead and longer to accurately predict the amount of money coming out in disbursements, and help them wisely invest in the right assets that will produce the most revenue.”

Companies with an ESOP must have a carefully ordered board with independent directors as well as a strong financial reporting system. This board functions similar to most company boards, and is responsible for strategy and policy making, among other things. An ESOP also has a trustee, who has a fiduciary responsibility to the ESOP participants. Employees are not legal stockholders in the traditional sense, and generally do not influence directly how the business is run.

It’s a strategy that has often served as rocket fuel for growth. When Houchens began its ESOP in 1988, it was a grocery store chain with 50 stores. It has since become one of the largest employee-owned companies in the United States, owning all or part of more than 40 companies spanning the industries of grocery, construction, insurance, wealth management, technology, healthcare, manufacturing/distribution, and restaurants. Houchens acquired Hilliard Lyons, the Louisville wealth management and financial services firm, in 2008.

John Megibben, Louisville vice president and region leader with Cincinnati-based Messer Construction, credited that company’s ascent to $1.2 billion in revenue to the firm’s switch to an ESOP in 1990.

“When we created the ESOP, we were in just one region, with $100 million in revenue and 100 employees. Now, 26 years later, we are in nine regions, including Louisville and Lexington operations. We have more than 500 members,” Megibben said. “Year over year, we’ve grown at least 8 percent a year. It’s allowed us to not just have inflationary growth but intentional growth.

“In a business like commercial construction, 70 percent of our business is repeat customers,” he said. “That’s because our customers know when they work with us, they aren’t working with employees – they’re working with owners, and it shows.”

The employee engagement effect

Employees who work at ESOPs feel invested in their company’s success, an effect that can be measured. Recent surveys and journal articles cited by The ESOP Association show employees who are employee-owners were four times less likely to be laid off during the Great Recession, and ESOP companies had a $44,000 per employee sales advantage over their non-ESOP peers.

A full 83 percent of the association’s members report that becoming an ESOP had a direct impact on the company’s productivity. It’s an opinion that is shared by all the interviewees for this story.

Megibben said when Messer made the transition to employee ownership, its turnover plummeted from 7 to 8 percent yearly to 4 percent or less.

“Our turnover is less than half the national average in our industry. So I’m pretty sold on ESOPs,” he said. “It takes the rhetoric out of owners versus workers. It takes the focus away from who is getting what, and puts it back on the customer.”

Normand Desmarais was part of the founding team that created Covington, Ky.-based Tier1 Performance Solutions, a consulting company that helps clients through talent development, strategic change and organizational evolution solutions. He took his payout and now serves on the company board. Tier1 made the leap to being an ESOP in 2001, Desmarais said, and never looked back.

“Being an ESOP has made us stronger, and creates a terrific environment with long-term stability for our consultants,” Desmarais said. “The people who stay with us get to fully benefit from the company’s success. And it makes TiER1 very attractive when we’re recruiting. Overall, it works for us. We’re growing at a rate of about 25 percent a year, 15 out of the last 16 years. We’re estimating by 2020, we’ll have 500 people across the U.S.”

Should your company do it?

Despite the many benefits of employee ownership, experts warn it’s not the right choice for every company.

George Thacker, managing director of New York-based CSG Partners, a boutique investment bank that specializes in ESOP transactions, said the choice isn’t always clear-cut. There are some general disqualifiers.

“Is your company over-leveraged already? Is your company young, or in a very young and fast-changing industry?” Thacker said. “Do the owners want to exit within three to 10 years of founding the company? Then creating an ESOP might not be the right thing for you.

“ESOPs work best when a company is already consistently profitable, and in a business that can benefit from a long-term, stable business strategy,” he said.

Andrew Jacobs, member of Stites & Harbison LLC’s Lexington law office, agrees.

“Companies who do well with employee ownerships have a lot of things in common. First and foremost, they have strong earnings, and they’re not publicly traded,” Jacobs said. “They often have older owners who are looking to transition. They might not have kids or grandkids that want to take on the company, or perhaps they’re having issues with estate tax. They have strong management already, and have a strong commitment to keeping their people employed in the same place they’ve always been.

“They want an orderly handover, one that can be carefully planned and seamless. With the right structure and the right legal representation, companies like these can reap the great advantages of employee ownership,” he said. “Give employees incentive and they’ll share in your success. When they do well, you’ll do well.”


Susan Gosselin is a correspondent for The Lane Report. She can be reached at [email protected]

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