“Wall Street Journal” Highlights ESOPs 2/1/08
Tribune ESOP Much Bigger Than Most 3/30/07
Lane Enterprises, Inc. Announces 100% Employee Ownership
Employees Taking Over at Columbia MedCom Group
Columbia MedCom's owners decided to sell, and its work force decided to buy
Macfadden, Inc. ESOP Launches Transition to New Employee-Owned Company
Jobs Saved by Hedwin ESOP
FGM - The Implementation of our ESOP
Lane Enterpises, Inc., Through Four Ownership Transitions to 100% Employee-Owned. October 2007
Past Articles
Wall Street Transcript, January 24, 2005 Interview with Bob Smiley, Benefit Capital Companies
"ESOP" . . . A Four-Letter Word?
Selling A Business
Russell Long: Dedicated To His Family, His Senate, His Country
FEATURE ARTICLES
“Wall Street Journal” Highlights Employee Ownership
On The February 7th the Wall Street Journal highlighted ESOPs with a full-page of ESOP articles at http://online.wsj.com/small-business/small-business-link. This is one of the best explorations of employee ownership in a major publication in many years. Below are links to the individual articles.
Employee ownership can solve some problems but it can come with its own issues.
• How to Get Workers to Think and Act Like Owners
• Manufacturer Pushes Stock Diversification
• Sale Gives PR Firm the Benefits of Becoming Employee-Owned
• QA: A Homegrown Approach to Business Literacy
• Recommended Reading from an Employee-Owned Company
The articles were the product of a suggestion to the “Wall Street Journal” from Corey Rosen, the executive director of the National Center for Employee Ownership (NCEO). The NCEO is a great resource on employee ownership. I serve on their board and also spoke with one of the reporters. For more information please visit www.nceo.org.
Tribune ESOP Much Bigger Than Most
(See Financial Times, 3/30/07)
The $8.1 billion dollar ESOP transaction for the Tribune, which was announced on April 2, 2007, dwarfs almost every other ESOP past or present. “About ninety percent of ESOPs are in privately held companies and approximately eighty percent of the members of The ESOP Association have less than five-hundred employees,” according to Ron Gilbert, President, ESOP Services, Inc, who was quoted in the “Financial Times” in a Tribune related story.
“Because of the illogical accounting treatment for leveraged ESOPs required since 1993, requiring an adjustment to compensation expense, very few publicly traded companies have or will ever have a leveraged ESOP. “If the Tribune ESOP is finalized, one of the main reasons will be that the ESOP-owned company will operate as a privately-held entity,” states Gilbert.
“We hear rumors all the time of large ESOP transactions that never happen. Individual investors and private-equity groups rarely are willing to ‘share the wealth’ to any great extent with the employees. Sam Zell, who structured the Tribune transaction and will serve as Chairman of the Board, reportedly has a warrant for forty percent of the company, or approximately $500,000,000. The warrant will only have value if the Tribune performs well. If that happens, the employee’s sixty-percent stake would be very valuable, and this is value that will be allocated to employees through the ESOP. “Typically, investors look to keep most all of the ownership,” states Paige Ryan, Director of Western Operations for ESOP Services, Inc. “Mr. Zell is quite the exception.”
A lot has been written about the special ESOP tax benefits that privately held companies receive. The tax benefits are only valuable to a profitable company, and if the company is profitable, then the employee stake can become very valuable. “I do not expect a rush of investors in private equity groups looking to duplicate the Tribune transaction in the near future. However, if several years from now the Tribune is a stellar performer we may see more large Tribune-like transactions, but I would definitely not hold my breath,” concludes Gilbert.
Lane Enterprises Inc. is pleased to announce that it is now 100% employee owned.
www.lane-enterprises.com
The Employee Stock Ownership Plan (ESOP) transaction was completed on July 24, 2006.
Tom Wonsiewicz, Lane’s President and General Manger, said that the transition to an ESOP is a logical extension of the company’s ownership culture. “Twenty years ago, thirty-five salaried employees participated in a management buyout of Lane from Bethlehem Steel. The company has grown steadily and is a major player in the corrugated metal and plastic drainage pipe business. Adoption of an ESOP provides a way for senior employee owners to receive the benefit of their investment, and to extend the benefits of profitable growth to all employees. Our successful approach to business will remain intact.”
According to Mr. Wonsiewicz, the ESOP is being implemented without change to the company’s management, operating structure, its ten operating locations, or plans for future growth. “Lane has been a consistently profitable company, and all the employees have experienced that directly through their annual bonus. We understand that profits are the life blood of a business and that they are not guaranteed—they must be earned. Over the years Lane has a solid record of taking care of its core business and looking for prudent opportunities for expansion. We are about to break ground in Wytheville, VA on our second plastic pipe plant,” said Mr. Wonsiewicz.
Lane is a manufacturer and distributor of corrugated metal and plastic drainage pipe as well as metal powder coating services. It has over 300 employee-owners serving the Northeast and Mid-Atlantic states.
Columbia MedCom's owners decided to sell, and its work force decided to buy
By Robert J. Terry
Staff
From the July 15, 2005 print edition Entrepreneurs
A year ago, with Columbia MedCom Group thriving after a four-year climb back from the brink of failure, the medical marketing company's two principal owners decided it was time to sell. In one fell swoop -- after hours of researching and crafting a creative financing plan -- 70 entrepreneurs were born, as Columbia MedCom's executives and employees bought the company.
.
CEO Susan Torroella and her management team desperately wanted to keep the
Columbia
company's business momentum going. Its two subsidiaries were pushing revenues past $20 million. One, Innovia Education Institute, runs continuing education programs for doctors and health care professionals to keep their licenses current. The other, Medicalliance, does a variety of medical marketing work for pharmaceutical companies and physician practices. And much the way life sciences companies look to stock their pipelines with drugs in all phases of development to best hedge their bets in case one doesn't pass muster with the federal government, Columbia MedCom Group had a good balance of clients. A sale threatened to derail all that. "It was like, oh no, not now, we're having so much fun," Torroella said. "We're on a four-year roll, we don't want to stop it."
Chief Financial Officer Jeff Taylor proposed the bold plan to buy the company. And despite some considerable obstacles, the employees did.
.
Torroella, who joined Columbia MedCom Group in 1998 after holding senior marketing positions for Schering-Plough Corp., valued creating a "culture of ownership" within a company. An entrepreneurial stake in crafting a company's future drove stronger results, she believed; in tough times, that kind of culture enabled companies to weather the storm. Columbia MedCom Group experienced tough times firsthand: In 1998, one of the company's biggest clients had a drug fail in late-stage clinical testing, pulling the plug on future marketing work. Revenues plunged. "It's a proven business concept," said Torroella, who became Columbia MedCom Group's chief executive in 2001. "To really create a culture of ownership, I wanted everyone to have a stake in it." Which made buying the company all the more appealing. But there was a problem: Columbia MedCom Group is a services company. In many cases where a company's equity is transferred to employees, the company has fixed assets, according to experts. "We have desks," Torroella said.
.
"Because this is a service company, and the assets get up and go home every night, the banks feel they'll have a problem getting sufficient collateral," said Rob Gilbert, president of Scottsville, Va.-based ESOP Services Inc., which works with companies on executing employee stock ownership plans, commonly known as ESOPs.
Approximately 11,000
U.S.
companies have been acquired through ESOPs, according to industry research. Those firms employ more than 10 million people. About 85 percent of those companies are mid-sized (50 to 500 employees) and privately held.
Gilbert quarterbacked Columbia MedCom Group's ESOP. Torroella and her three top lieutenants -- Taylor, Kathleen Case and Serena Kim -- each invested six-figure sums (she declined to disclose terms of the deal) of their own money. Loans were procured from Wachovia and Allegiance Capital. And, in a key move, the Maryland Industrial Development Financing Authority (MIDFA) guaranteed a significant chunk of the senior debt. MIDFA is one of the financing programs overseen by the Maryland Department of Business and Economic Development. The program insures up to $2.5 million in these kinds of deals.
All 70 of Columbia MedCom Group's employees were awarded shares in the company. Staffers with six years of employment with the company were automatically vested -- benefits that, along with a profit-sharing plan and other incentives, have garnered Columbia MedCom Group recognition in various "great places to work" polls. The awards are nice. But the main reason for buying the company is to enable Columbia MedCom Group to remain independent as a wave of consolidation among large, publicly held firms grips the medical marketing industry, Torroella said.
Columbia MedCom Group considers itself a national firm, going head to head with Omnicom Group and other big players for business. Last week, the company announced it had been picked by AstraZeneca Pharmaceuticals to help the drug giant market two new products, one a drug to treat psychiatric conditions, the other an acid reflux disease treatment. "There are so many changes in medicine," Torroella said. "The number of new drugs, new indications, new ways of diagnosing diseases -- the scientific community is learning all the time." And so is Torroella, about the ways an entrepreneurial culture engages employees. She reviews the company's balance sheet and financial goals monthly, and Columbia MedCom Group staffers aren't shy about talking numbers over lunch.
.
"I've gotten a flavor of what the culture of ownership does," she said. "This company is like a community. It's the right thing to do."
© 2005 American City Business Journals Inc.
By Mark R. Smith
Posted on Wed Jul 6 at 10:10:00 by the The Business Monthly is the business-to-business newspaper covering
Howard
County
, BWI Business District and
Northern
Anne
Arundel
County
. www.bizmonthly.com
An employee purchase of Columbia MedCom Group (CMCG) was the furthest thing from Susan Torroella's mind a year ago.
After all, most companies that conducted such transactions, traditionally, came from industries that could offer ample physical collateral, in the form of its own building or equipment, perhaps, to accentuate its financing plan.
However, CMCG and its 70 employees bucked tradition and made the deal happen via the implementation of an Employee Stock Ownership Plan (ESOP), with a loan guarantee from a state program.
Today, CMCG stands alone as, "The first completely employee-owned company in the medical communications industry," said Torroella, the company's CEO.
Above Board
CMCG, founded 17 years ago in
Laurel
as Medicalliance, has been located in
Columbia
Town
Center
for the past decade. The company educates physicians and other health care practitioners on new ways of diagnosing and treating diseases, and new advances in care.
The ESOP plan gained traction when Jill Rathburn and Donald Croce, founders and majority owners of CMCG who had been serving as board members for the past five years, decided to sell.
As luck would have it, the executive team had the same goals as the duo and discussions of an employee purchase evolved, "especially given that the alternative would have been to sell to an outsider," Torroella said.
Despite CMCG's lack of collateral, the state helped make the ESOP possible via DBED's Maryland Industrial Development Financing Authority (MIDFA), which backed part of the loan (terms of which were undisclosed) that was granted by Wachovia Corp. and Allegiance Capital. The MIDFA guarantee is for the Wachovia portion.
Maryland
, as luck would have it, is one the few states to offer such a program.
What's even better for the employees is that not one left the office the day of the purchase with a lighter wallet, as the four members of the executive team were the only investors. Ownership was transferred via stock to the employees, all of whom still have their 401(k)s and profit-sharing bonus plans.
"The brilliant thing," Torroella said, "is that when you leave down the road, that stock gets rolled over into a qualified plan. So it's a retirement plan for our employees."
Keep on Rollin'
The IRS created ESOPs to promote the transition of ownership to all employees, Torroella said, which is "great for entrepreneurs, who don't have to put their company on the block to get the value out of it.
"If you work for a company with an ESOP or a 401(k), if you leave, you can roll that money over into another qualified plan without tax penalties," she said. "You don't have to touch it until after you retire and enter a lower tax bracket."
The deal calls for the stock to go into a trust and for CMCG to pay off the loans to Wachovia and Allegiance during the next five years in pre-tax dollars. As that occurs, the shares will be gradually released into the hands of the employees.
"One thing we have chosen to do that is very unique is that we are vesting prior years' service. So employees who have been with us for six years or more are 100% vested," Torroella said.
"I don't think you see this happen more often for two reasons," she said. "It's because professional services firms such as ours don't typically have collateral or fixed assets; and that it takes founders who have the same interests as the employees."
Also important to the equation is that when a company is put on the block, it may draw a higher purchase price. "An ESOP can happen only for fair market value, so you won't get the premium a strategic buyer might demand," she said. "But what was more important in this case was that the owners and employees had a similar vision for the company, maintaining its independence and culture."
Saving Jobs
The CMCG deal is part of a trend where "ESOPs are being employed in a wider variety of businesses that now include service industries and manufacturing," said Ron Gilbert, president of ESOP Services in
Scottsville
,
Va.
"We are seeing it happen when companies want to remain independent and perpetuate a privately-held company," he said. "It's happening often in family businesses."
There were two very unusual aspects of the CMG transaction, Gilbert said. One was the involvement of MIDFA.
"
Maryland
has a unique program in this regard. Also, the four-person management team at CMG invested its own money in the deal, separate from the ESOP. It needed both of these funding sources in this situation. In most ESOPs, you do not have employee investment of any kind, nor do you have state assistance."
MIDFA, he continued, had never done a guarantee of an ESOP transaction before an early 2004 deal for Hedwin Corp. of
Baltimore
.
"Aris [Melissaratos, DBED secretary] saw that several hundred jobs were likely to leave the state otherwise. He and [Gov. Robert] Ehrlich are supportive of ESOPs. The probability was very strong that the CMCG jobs could have left the state, especially since these are service jobs."
Gilbert would not say exactly how much MIDFA guaranteed the loans for, but did note that the amount was "significant" and that the maximum amount the state guarantees on any single deal is $2.5 million.
Tim Doyle, DBED director of finance programs for the
Baltimore
region, discussed the role of MIDFA, a commercial and industrial insurance program that was founded about 40 years ago "and has been a workhorse for the department since."
Noting that MIDFA "may have been the only such DBED program of its time," Doyle said it "is independent of the full faith and credit of the state," as the guaranteed money is funded by the legislature.
Since 1965, the program has participated in 783 loans totaling more than $1.9 billion. Currently, 72 transactions remain active, with principal balances totaling more than $514 million insured for $48.7 million, as of the end of last fiscal year on June 30, 2004.
Extra Eyes
Doyle gave the example of the legislature adding $5 million to MIDFA, meaning that it can insure at a 5:1 rate. He said the state contemplates adding extra funds that may be necessary annually.
Doyle said, "It is an insurance program to insure financial instruments" with a current fund balance of $37 million. "If a company needs a sizable loan, the state looks at its profile and credit history and determines what amount it will offer, if any."
In short, if a bank cannot cover an entire loan amount that a company needs, MIDFA offers a bridge to insure the remainder of the money and help facilitate the deal, as was the case with CMCG.
"Our eyes and ears are the banking community, because they can gauge the market to the extent that they deal with many, many more customers than the state can," Doyle said.
At the close of fiscal 2005, MIDFA will have approved 13 deals for $106 million for the year. It considers about four deals for each one that is executed. Though the economy of the state is moving toward technology, a high-risk area, MIDFA has not had any losses in that sector in five years. That is unusual for a government guarantee program.
"I don't know why more states don't have such a program," Doyle said. "It is very flexible and we wonder who thought of this in 1965."
On the client side, Laura Seplavy, senior marketing director for Guilford Pharmaceuticals in
Baltimore
, also thinks executing the ESOP with the assistance of MIDFA was "a great move.
"This could potentially impact us," Seplavy said, "because now, anyone who puts their hands on our account not only has more of a vested interest in the day-to day work that they do, but now they know it has a direct impact on [CMCG]."
Simply put, it establishes more of a commitment in what the employees do. "That gets lost with people who work with a mid-sized company, because the bigger the company, the more employees might feel removed from the ownership position," she said. "Every way you look at it, it was a very smart business move for the owners, management and employees."
Selling A Business
January 2005 Hoffman,White & Kaelber Financial Services, LLC Wealth Management Newsletter
Either you built it from the ground up, or maybe you bought it. If your business has been a success, you've probably invested significant time, energy, and money into it for what may have seemed like forever. Now, after assessing your reasons for doing so, you feel it's time to sell and move on.
But before proceeding with what could be the most important financial deal you'll ever make, you should carefully assess your reasons. And, when doing so, it may be helpful to consider the following: What are my objectives as an owner of the business? Am I looking to diversify risk, retire or maybe both? What are my objectives as manager of the business? Do you want to continue managing or retire soon? What are your objectives for the business itself? Are you intent on liquidating the business or do you want to afford it potential for continued growth? And, who else will be affected and what will they want? (I.e., other shareholders, managers, key customers and suppliers.)
While you’re going through this sole searching process, it’s usually wise to keep your plans confidential. If word gets out that you plan to sell, that information can be exploited by competitors and may disrupt relationships with suppliers, customers and employees. The result could adversely affect your ability to continue the business and could certainly have a negative impact on its selling price.
Selling all or part of your business may be the best way to achieve your objectives, but an outright sale may not always be the optimal solution. While most businesses wind up being sold to another business, there’s a range of exit routes that may suit your needs better. If you’re not ready to retire, seeking investors could provide access to capital to develop your business and make it easier to sell all or part of your stake. Alternatively, you could consider an ESOP (Employee Stock Ownership Plan) can help you retire, provide tax benefits and enable you to sell the company in a manner that allows the people who helped build it to run it in the future.
As mentioned in our prior newsletters, we strive to provide articles on various aspects of wealth management to assist your understanding of why planning for the present and for your future has importance. Yes, we also promote our services; yet, you will find that we always seek to present thought provoking topics that are relevant to our wide audience.
This month’s letter will cover some basic information about ESOPs. And, substantial thanks for this month’s topic go to my new friend, Ron Gilbert. Ron is President and Co-founder of ESOP Services, Inc. (www.esopservices.com) and is considered a guru in the ESOP consulting business. And, the significant literature he provided me affords us an informative look into his industry. Lastly, and as always, we will finish with an update on our investment activities.
What Is An ESOP?
An ESOP is an employee benefit plan, which qualifies for some very interesting tax saving advantages under the Internal Revenue Code. But, in order to take advantage of these tax benefits, it must comply with various participation, vesting, distribution, reporting and disclosure requirements set forth therein. ESOPs are also subject to regulations set forth in the Employee Retirement and Income Security Act of 1974 (ERISA) and must meet the employee benefit plan requirements of the Department of Labor.
An ESOP functions like a profit sharing plan. The company creates a trust to which it makes contributions. Then, contributions are allocated to individual employee accounts within the trust. The shares of company stock and other plan assets allocated to employees’ accounts vest over time, and the employees receive vested portions of their accounts at retirement or termination. Moreover, employees incur only long-term capital gain tax treatment on the appreciation in stock value, rather than ordinary income tax on the appreciation. The company makes discretionary contributions on an annual basis of at least 25%, and up to 50%, of covered payroll. These contributions can be made in either stock or cash.
With a leveraged ESOP, the company obtains a loan from a commercial lender and then lends this money to the ESOP. The proceeds are then used it to buy stock from either existing shareholders, or the company itself. Thereafter, the company makes deductible contributions to the ESOP to service the loan. Also, the company can pay tax-deductible dividends to the ESOP to amortize the loan. Consequently, even principal payments on the loan can be tax deductible to the company. As the loan is repaid, the stock held aside as collateral on the loan is released and allocated to participant accounts within the ESOP.
What Are Some Advantages To Setting Up An ESOP?
For private business owners, ESOPs can be used to develop a business succession strategy; implement an estate plan that includes providing for children who are not involved in the business; or, afford an ability to cash out tax-free while continuing to control the company. An ESOP can also allow for retaining an equity interest in a tax-free company; provide a tax advantaged way to sell some or all of a business in order to diversify holdings; deduct principal payments on existing or new loans to finance growth; tie employee compensation to company performance; or, make a tax-free sale of some or all of the business to employees.
As a corporate finance tool, ESOPs can provide businesses a viable means to: deduct the cost of buying out stockholders; increase working capital through significant reduction of tax liability; repay stock acquisition debt with pre-tax dollars; or, provide an ability to outbid competitors on transactions with tax savings from deducting acquisition costs. Even management groups can benefit from an ESOP. This versatile tool can assist a management buy-out for the subsidiary or division that employs them using pre-tax dollars. This list of advantages is not exhaustive.
From my understanding, and I’m expecting Ron Gilbert to correct me if I’m wrong, the best ESOP candidates seem to be C or S corporations that have profitability and pay taxes or, in the case of S corporation owners, create tax liability for owners. It seems that one of the best reasons to set up an ESOP is the remarkable tax benefit that accrues to owners, the company, and employee-owners. The contributions employees make to the plan are tax deferred, and when they eventually tap the plan for their own retirements, they may be eligible for substantial tax savings. Also, if the company donates stock to the plan, the gift is tax deductible, and when owners sell stock to the plan, they may not have to pay current ordinary income or capital gains tax rates. So, it would seem that, the more profitable the business and the more tax liability thereby created, the better the ESOP benefits.
Some Disadvantages And Potential Problem Areas
Valuation, consulting and administration costs. Depending on your purposes, an ESOP’s structure can range from simple to very complex. Yet, in any event, the stock must be valued annually in order to establish its value for purposes of purchasing shares, allocating shares, and/or distributing shares. As such, to ensure tax deductibility compliance with the Internal Revenue Service regulations and to meet the employee benefit plan requirements of the Department of Labor, it would be well advised to retain or employ competent consultants, lawyers, accountants and administrators for help.
Stock valuation and liquidity issues. If the value of the stock appreciates substantially, the ESOP and/or the company may not have sufficient funds to repurchase stock, upon employees’ retirement. And, if the stock appreciates dramatically, it’s certain that your company’s liquidity needs will increase correspondingly. Whereas, if the value of the company does not increase, the employees may feel that the ESOP is less attractive than a traditional profit sharing plan. Also, if the company fails, the employees will lose their benefits to the extent that the ESOP is not diversified in other investments.
Dilution and disclosure issues. If the ESOP is used to finance the company’s growth, the cash flow benefits must be weighed against the rate of dilution to shareholders. During their participation in the ESOP, plan participants are not entitled to receive annual reports or attend annual shareholders’ meetings. However, owners or participants of privately held companies may be less sensitive to these concerns.
Pro-rata offers and fiduciary responsibility. Offers to purchase stock on behalf of an ESOP must be made on a pro rata basis to all shareholders. Therefore, unless remaining shareholders agree, a retiring shareholder, may not be able to sell his or her stock without offering other shareholders the same opportunity to sell stock on a pro rata basis. This same requirement applies to corporate stock redemptions. Additionally, committee members who administer the plan are deemed to be fiduciaries and can be held liable if they knowingly participate in improper transactions.
Some Concluding Thoughts
As you may have already guessed, an ESOP isn't created without some careful consideration. There are so many options that doing it right can take significant analysis and planning. And, even after the ESOP is in place, it will require continual strategy and record keeping. Yet, in the right situation, the benefits are very compelling.
If this sounds like something you’d like to explore further, I recommend you contact Ron Gilbert at ESOP Services, Inc. (www.esopservices.com). Ron’s been at this for more than 25 years and has written and spoken extensively on the subject.
Copyright ©2005 Hoffman, White & Kaelber Financial Services, LLC. All rights reserved. Research us on the web at www.hwkfs.com
Macfadden, Inc.
ESOP Launches Transition
To New Employee-Owned Company
The approximate 75 employees of MacFadden, Inc. recently joined the growing ranks of
U.S.
workers who have a substantial ownership stake in the company where they work. This ESOP's acquisition of 35 percent of the company's stock from founder Jim MacFadden was the culmination of a nearly two-year planning process to launch MacFadden’s conversion to an employee-owned company.
A diversified professional services company providing integrated information technology and program management support services to a variety of federal and state government clients, MacFadden is known for dynamic, innovative systems development and operations management. Specializing in systems development & integration, finance, health and human services, the company works in the areas of aviation safety, food safety, imaging and assistive technologies including the provision of disaster assistance and managing economic development contracts with USAID, the State Department and the Peace Corps. The majority of the MacFadden staff are technical experts who maintain close identification with their clients.
Company founder Jim MacFadden first began investigating the idea of employee ownership in 2002. Based on a feasibility analysis by the Beyster Institute, he determined that an ESOP represented the most effective means of transitioning ownership to the MacFadden employees. The company first started making cash contributions to the ESOP in anticipation of the eventual purchase of the shares. As a result of that pre-funding strategy, only a modest amount of debt was required to finance the ESOP’s acquisition of its 35 percent stake in the company. Furthermore, a majority of the shares acquired by the ESOP were already allocated to the individual accounts of the ESOP participants. The company expects to make substantial contributions to the ESOP over the next few years to repay the remaining debt, which will of course translate into growing ownership stakes for the MacFadden employees.
Having worked in several companies earlier in his career that provided stock incentives for managers, Jim MacFadden felt that broad-based employee ownership offered an effective means of incentivizing his employees. Implementing an ESOP fits well with a company culture focused on “delivering results and exceeding expectations” and offers a tax-effective means of designing an ownership transition strategy to ensure the company’s long-term success.
MacFadden’s transition to employee ownership is the latest chapter in a remarkable story that began in 1986 when Jim MacFadden first established the company as a small disadvantaged minority business. Two years later he became the first deaf person to receive 8(a) status for his company from the U.S. Small Business Administration. MacFadden graduated from the federal 8(a) program in 1998 and has continued to grow, generating annual revenues in excess of $12 million in 2003. Our flexibility and quick response to client needs.
Others use breakfasts, family picnics, team building retreats, and essay or poster contests to call attention to this unique approach to doing business. Some companies emphasize fun by throwing company parties or designating themes on certain days of the month, such as crazy hat day. Companies also use the month to educate employees with round-table discussions, lectures, workshops or financial training with the CEO or CFO.
Need Other Ideas?
The consulting company Ownership Associates publishes “42 E.S.O.P. Ideas for ESOP Month,” a book of creative ready-to-use ideas for Employee Ownership Month activities. In this book, which was recently updated for 2004, ESOP stands for Educational, Smart, & Occasionally Playful Ideas for ESOP Month.
The book provides creative ideas and practical “how to” tips for activities such as educational games, community outreach, special communications, serious training, and just plain fun. It includes chapters on educational games, contests, outreach, and celebrations, among others, as well as lists of questions and facts to use in program design.
Most of the activities are lowcost and fairly easy to organize. Each activity in the book is graded and marked as being low, medium, or high cost and difficulty. To see a sample idea from the book, go to http://www.ownershipassociates. com/online_res_eomidea.shtm.
More Celebration
Instead of creating special attention for just one month or one day out of the year, some companies emphasize continual celebration. This is not an eight hour-a-day party but instead a laser-like focus on recognizing success. One example of this celebratory culture is Obie Media, based in
Eugene
,
Oregon
. Some of its ideas may be worth emulating.
The unique corporate culture at Obie values integrity, respect, growth, ownership, a positive environment and celebration. The company celebrates every month with management and sales meetings, all-staff lunches, or other gatherings. By telling success stories about the results of their hard work, employees have the opportunity to teach, learn and grow.
One way Obie celebrates success is through rewards. They value the intrinsic reward of satisfaction from personal growth. Financial rewards come from stock options and retirement plans. Recognition comes at 90 days and one year of employment through the gift of a pin and a watch. They focus on rewarding the right things: success and integrity.
Perhaps the company’s web site best describes its philosophy: “The corporate culture of Obie Media succeeds in part because it's not just a program to maximize potential. Everyone ‘walks the talk.’ The managers participate in the work; the workers participate in the management. Open communication is a well-worn path. Information gathering and disseminating is non-stop. Everyone is encouraged to brainstorm, to think outside of the box, to challenge our understanding, and to raise the bar on excellence and opportunity. And when we enjoy success we remember our foundation and go back to the basics to strengthen our commitment to the
Obie Way
.”
Author and consultant Ed Rigsbee also embraces the celebration of success as a way to give employees “emotional WORDS OF WISDOM continued from page 1 “... ESOP stands for Educational, Smart, & Occasionally Playful Ideas for ESOP Month.”
ownership” in their companies. He cites recognition as one of the most powerful ways to create employees who operate as if they own the company and always look out for the company's best interests.
In his words, “I believe most executives, owners and managers secretly yearn for employees who have an emotional ownership in their company. Unfortunately, few are willing to do what it takes to cultivate this emotional ownership. Often, I hear managers saying that loyalty is too costly.”
Rigsbee suggests that by asking employees how they want to be recognized, seeing what colleagues have done, and not limiting creativity, companies can find the means to reward success, encourage loyalty, and create emotional ownership.
From a list of 50 low cost recognitions offered by his seminar attendees, we've selected his few choice items:
-
Contact with the company president through a visit, note, email or lunch.
-
A celebratory gesture such as flowers, balloons, or gift certificates.
- Intangibles like encouragement, private verbal praise, choice of work assignments, or being included in decision-making.
-
Visible rewards like a “get off early” card, a special parking space, permission to attend a seminar or being “boss for a day.”
The one thing that all of these ideas have in common is the use of creative celebration to develop and sustain a thriving company. It doesn't have to be costly or require special approval. If it’s meaningful, sincere, and imaginative, it will go a long way toward supporting a culture of success.
This article originally appeared in the Beyster Instititue’s Fall 2004 In Focus Newsletter. The Foundation for
Enterprise
Development is a worldwide organization that, since May 2002, operates within the USA as the Beyster Institute for Entrepreneurial Employee Ownership.
Opinions expressed in this article do not necessarily reflect the views of the
Foundation for Enterprise Development or ESOP Services, Inc.
© Foundation for
Enterprise
Development and the authors and their entities. All rights reserved.
"ESOP" . . . A Four-Letter Word?
Liquidity and Perpetuation Pros and Cons
While the ESOP offers tremendous tax advantages to both selling shareholders and the sponsoring corporation, as well as allowing employees to build significant wealth, it is also very important to understand the potential disadvantages of the ESOP. First outlining the tax benefits and potential advantages, the authors then discuss potential disadvantages, misconceptions, and cite extensive ESOP research. Their goal is to create more ESOPs that are used in the right situations for the right reasons, and reduce the number of situations where the ESOP is a “four-letter word” by cautioning against using the ESOP in the wrong circumstance and/or for the wrong reasons.
Introduction
Owners of privately held companies face difficult choices when they seek to liquidate some or all of their ownership interest. If they also desire to perpetuate the company, the choices become fewer. For certain companies at certain times in certain industries, selling to an outside buyer for a good price may be a viable option. Even when the price is right contingencies, holdbacks, or earn outs may make the transaction less than attractive.
Enter the Employee Stock Ownership Plan (“ESOP”). The vast majority of ESOPs (there are over 10,000) were implemented to address the issues cited above. Specifically, ESOPs can provide partial or full liquidity for selling stockholders, while simultaneously perpetuating the business and providing the employees of the company with a “piece of the action.” Even if the sellers desire to maximize the sale price, and perpetuation is not an issue, the ESOP is frequently the best option due to the very substantial tax benefits offered to both selling shareholders and the sponsoring corporation.
In many respects the decision to implement an ESOP may be the most important decision ever made by a business owner next to founding of the business itself. ESOPs can be, and often are, implemented on a limited basis where a minority block of stock is sold to the ESOP, and the selling shareholders remain active and continue to run the business. However, many other ESOP transactions involve the sale of a large block of stock and the immediate or eventual retirement of one or more major shareholders from active involvement in the business. It is this latter set of circumstances that the ESOP is most frequently used in privately held companies as a liquidity and perpetuation planning vehicle. In selling to an ESOP, owners can maintain partial or complete control of the company, retain equity, and invest the sale proceeds in a diversified portfolio of stocks and bonds without incurring a capital gains tax, all the while rewarding the loyal people who helped build the business. In making the decision whether or not to use the ESOP as a principal (but not necessarily the only) perpetuation vehicle, the impact on (1) the selling shareholders, (2) the company, (3) other existing shareholders, and (4) the employees (especially key management) must all be considered.
Summary of ESOP Uses
An ESOP is a very flexible financial and equity incentive instrument that uses corporate tax deductible or tax-free dollars to achieve a variety of individual and corporate objectives. These objectives include raising working capital, facilitating charitable giving and providing for the acquisition or divestiture of a division or subsidiary. These ESOP applications are beyond the scope of this article, which focuses on providing shareholder liquidity and perpetuation planning.
In this context, the ESOP can provide a market (at fair market value) for the partial or complete sale of stock by existing shareholders, while simultaneously providing a strong equity incentive for employees.
Individual Tax Benefits
Individuals (or partnerships) who own stock in a privately held C Corporation may be eligible for “tax free” rollover treatment provided that the initial ESOP ownership is 30% or greater, and the shareholders otherwise qualify. These requirements include ownership of the C Corporation stock for at least three years, and reinvestment of the proceeds from the sale of the stock to the ESOP in stocks or bonds of
U.S.
operating companies within twelve months after the sale of stock to the ESOP.
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If the sponsoring company is an S Corporation, then it may be able to convert to C Corporation status to provide selling shareholders with the “tax-free” benefit. This benefit is the equivalent of a “tax-free” stock swap with a publicly traded company. The capital gains tax (generally 15% federal plus state capital gains tax) is deferred. Upon death the estate receives a “stepped up” basis, and the capital gains tax is extinguished. (Note – the current estate tax law substantially changes in 2010).
Selling shareholders may not qualify to elect the “tax-free” rollover for a variety of reasons. The sponsoring company may be an S Corporation and not wish to convert to C Corporation status, the shareholders may have received their stock through some form of stock option plan or other method that makes it ineligible, the stock may be owned by a corporation, the company may be publicly held, etc. In these instances, the stock sold to the ESOP would be subject to capital gains tax treatment, provided the normal one-year holding period had been satisfied.
Example. A publicly traded company wishes to use the ESOP to go private. Selling shareholders do not qualify for the “tax-free” rollover treatment because the company is not privately held. The selling shareholders would pay capital gains tax on the difference between their basis in the stock and the sale price.
Shareholders of privately held companies are frequently eligible for “tax-free” rollover treatment when they sell stock to the ESOP. Even when they are not, the tremendous tax benefits available to the corporation can make the ESOP an ideal liquidity and perpetuation planning vehicle.
Corporate Tax Benefits
A corporation receives tax deductions for making contributions to the ESOP (within the limits discussed below) regardless of whether the ESOP is leveraged or unleveraged. However, in the context of perpetuation planning, most ESOPs are leveraged, either initially, or several years after adoption.
In a leveraged ESOP, the ESOP receives a loan and uses the proceeds to purchase a block of stock from current shareholders. (The loan is frequently made to the corporation by a bank, and the bank re-lends the money to the ESOP. The corporation that sponsors the ESOP must guarantee the ESOP debt and selling shareholders are sometimes required to guarantee a portion of the debt if the company has inadequate collateral.) The company or selling shareholder can also provide some or all of the financing. The stock purchased by the ESOP is held in a Trust. As the company makes tax deductible contributions to the ESOP to repay the debt, shares held in an ESOP suspense account are allocated to employee accounts at a rate corresponding to the debt amortization. Plan participants vest in the shares allocated to their account under normal ERISA vesting schedules. See diagram below.
(1) Bank lends to ESOP with company guarantee.
(2)
ESOP buys stock from existing shareholders.
(3)
Company makes annual tax deductible contributions to ESOP, which, in turn, repays lender.
(4)
Employees receive stock or cash (4) when they retire or leave the company.
All contributions used by the company to repay principal on ESOP debt are tax deductible to the corporation.
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Interest is also deductible for C Corporations earning more than $75,000 in pre-tax income. The combined federal and state tax rate is approximately 40%. For every $1,000,000 of debt repaid through the ESOP, there is approximately $400,000 of corporate tax savings.
Contribution Limits
The company may generally contribute up to 25% of covered payroll annually to repay ESOP debt. Interest is normally excluded from this limit in C Corporations. Reasonable dividends on ESOP-owned C Corporation stock when used to repay ESOP debt (or passed through in cash to ESOP participants) are excluded from the 25% limit, and are tax deductible to the corporation.
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As a result, contributions can frequently be substantially above 25% of covered payroll.
Tax-Free Corporate Income
As advantageous as the above corporate tax benefits are, there are even more substantial tax advantages for an S Corporation.
The income attributable to S Corporation stock owned by an ESOP is not subject to federal income tax. Most states mirror this provision.
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Example. If an S Corporation were 40% owned by an ESOP, then 40% of the company’s income would be tax-free. If the company were 100% ESOP owned, then the company would pay no tax. This is not a deferral; the tax liability no longer exists. In most instances companies with at least twenty employees can benefit from tax-free S Corporation income.
The Perfect ESOP
An ideal ESOP candidate is a C Corporation with more than twenty employees, with pre-tax, pre-discretionary bonus income of $1,000,000 or more, whose owners seek liquidity and wish to perpetuate the company. Assuming the sellers qualify, they sell their stock to the ESOP and pay no capital gains tax (tax savings = approximately 20%). Corporate contributions to repay ESOP debt, both principal and interest, are tax deducible to the corporation (tax savings = approximately 40%). If the company converts to S Corporation status, then it receives tax-free income (tax savings = 100%!). In many instances, it is impossible to achieve the liquidity objectives of shareholders in a privately held company, and perpetuate the company, without the use of an ESOP.
The Potential Disadvantages of an Employee Stock Ownership Plan
In privately held companies, the corporation has the obligation to repurchase shares from participants who terminate due to death, disability, retirement or “other” reasons.
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Funding for this so-called repurchase liability or repurchase obligation requires careful planning. Also, if selling individuals elect the “tax-free” rollover, they, as well as certain family members, are excluded from participation in the ESOP.
Furthermore, it may be necessary, or at least strongly recommended, to change the corporate governance structure, especially if the ESOP is a majority owner. More and more ESOP companies have outside board members and the current stockholders may be able to receive a higher price for the sale of the business to an outside buyer if there is a strategic fit. In this instance a number of loyal long-term employees may lose their jobs, but if the highest price is the only consideration to current shareholders, the ESOP may not be able to compete with an outside buyer. Also, the ESOP by itself may not provide enough equity incentive for key management, and ESOPs can be complicated.
It should be emphasized that these are potential disadvantages. However, through proper planning, and corporate and transaction structuring, these disadvantages can frequently be addressed to the satisfaction of all parties involved.
Repurchase Obligation
The repurchase obligation normally begins to emerge approximately six or seven years after the ESOP has been established, about the time that the first ESOP loan is typically repaid. The graphs illustrated below demonstrate a typical trend.
Annual ESOP Repurchase Obligation
Source: Private Capital Corporation
.
Cumulative ESOP Repurchase Obligation
. While retirements and turnover are somewhat predictable, death and disability is virtually impossible to estimate due to the relatively small number of employees in the ESOP.
Funding for the repurchase obligation frequently is done through the corporation. This is particularly true when key person life insurance is used to fund the repurchase obligation. A “split funded” approach is usually best, with the corporation, not the ESOP, being the owner, premium payer, and beneficiary. Typically the individuals with the largest ESOP account balances, representing approximately 20% of all ESOP participants, would be insured for death and disability.
Failure to properly plan for the repurchase obligation can create a ticking “time bomb” that can emerge suddenly and threaten to sink the company.
Note, while GAAP does not currently require that the repurchase obligation be listed as a liability on the company’s balance sheet, it is possible that this could change in the future.
Exclusion from ESOP Participation
When selling shareholders elect the “tax-free” rollover, no portion of those shares may be allocated to the seller, certain family members (including parents, children, brother and sisters), or any person who holds directly or by attribution more than 25% of any class of outstanding stock.
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The company must be a C Corporation at the time of the sale for the sellers to be eligible to elect the “tax-free” rollover. In many situations the excluded individuals can be made whole outside of the ESOP through a non-qualified deferred compensation plan. The larger the payroll of excluded participants as a proportion of the total payroll, the more difficult it is to accomplish the “make whole” objective. If the company is operating, or will operate, as an S Corporation, recent IRS regulations limit the amount of deferred compensation.
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A frequent solution to this problem is for selling shareholders to pay capital gains tax on their sale of stock to the ESOP. Selling shareholders, as well as individuals referred to above, would all be included in the ESOP, provided they are employees of the sponsoring corporation. The stock allocated to their individual ESOP accounts may offset a substantial portion of capital gains tax paid on the sale to the ESOP.
Corporate Governance
ESOP participants in privately held companies generally must be given voting rights on only seven major issues, which do not include voting for the board of directors, or for the sale of stock of the company. The seven “vote pass-through” issues are merger, consolidation, recapitalization, reclassification, liquidation, dissolution, or sale of substantially all of the assets of a trade or business. If one of these vote pass-through issues is triggered, then under state law, participants must be given “full disclosure,” and afforded an opportunity to confidentially vote their shares.
In many ESOP companies, a vote-pass through is never triggered because one of the seven issues cited above never arises. However, in this post-Enron/WorldCom era, there is more focus on proper corporate governance in all corporations, including ESOP companies. More and more experts recommend that there be at least one outside independent member of the board of directors, especially when the ESOP has a majority ownership stake.
A Higher Price
An ESOP can pay no more than fair market value for the stock it acquires, as determined by an independent appraisal.
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Once the ESOP is established, the stock must be appraised at least annually. Outside buyers may offer to pay a higher price for the company due to strategic fits, or “downsizing” that will occur after the acquisition, or a combination of the two.
If the outside price is higher, the ESOP frequently can be a competitive buyer for several reasons. If the sellers are eligible for the “tax-free” rollover, then the outside price will normally need to be more than 20% higher to net the selling shareholders the same amount after they have paid their capital gains tax to the outside buyer. If the buyer is purchasing assets in a C Corporation, then selling shareholders may have to pay substantially more than 20% in tax. In addition, outside offers normally contain some type of contingency, hold back, earn out, etc. In many instances, the ESOP can be a very competitive buyer.
Insufficient Management Equity
A stand-alone ESOP may not provide sufficient equity incentives for key management. The solution is to provide either real (i.e., stock options, stock purchase, or stock bonus plan) or synthetic (phantom stock or stock appreciation rights) equity. Many planners feel it is essential for key management have “skin in the game” in order to focus them intently on the success of the company going forward.
Ownership Culture
Focusing only on the tax benefits of the ESOP, and then expecting employees to jump with joy when told that the company is now “employee owned” may lead to major disappointments. How does the ESOP benefit compare with retirement benefits provided under the old profit sharing, 401(k) or defined benefit plan? How will an ownership culture that enables employees to “think like owners” be developed? Research has demonstrated that the full benefit of the ESOP is realized only when an ownership culture incorporating employee involvement is developed.
Tax Loophole ESOPs
From time to time some misguided planners have attempted to use the ESOP in ways never intended by Congress or the regulatory agencies that oversee ESOPs: the IRS and the Department of Labor. After the passage of the Taxpayer Relief Act of 1997, S Corporations were allowed to sponsor ESOPs, generating tax-free income as explained earlier in this article. Some planners decided they would create “one person” ESOPs that provided benefits to only one or to a very small group of highly compensated individuals. This resulted in a provision in the Economical Growth and Tax Relief and Reconciliation Act (EGTRRA) of 2001, which contained an anti-abuse amendment to stop arrangements that did not create significant employee ownership.
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The industry’s leading trade organization, The ESOP Association, acted in concert with key members of Congress to shut down the abuses.
The passage of this law spawned the so-called “Management Company” abuse scheme. The ESOP was established in an S Corporation with more than ten employees, thus creating tax-free corporate income. Much of the income of the company was “up streamed” to a management company that provided benefits, frequently including non-qualified deferred compensation, for a small number of key employees. The IRS became aware of this abuse, and under the anti-abuse provisions of EGTRRA issued temporary and proposed regulations, which limit the amount of non-qualified deferred compensation that S Corp ESOPs can have.
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As evidenced above, when ESOPs are formed in an attempt to exploit real or perceived loopholes in the law, the loopholes are ultimately closed, and the ESOPs that were formed to exploit the loopholes will usually be terminated. When that occurs, employees may have a lot of questions to ask, and they may not be easily answered.
Lack of Planning
ESOPs are normally formed only after a comprehensive feasibility study has been performed to show the impact of the transaction on the selling shareholders, the corporation, and the employees. Individual and corporate cash flow, stockholder equity, projected repurchase obligation, etc. is all studied under different ESOP scenarios. CEO’s or CFO’s of a company attempting to implement an ESOP without such a study are “flying blind without radar.” In addition to projecting the repurchase obligation, the rate at which the ESOP debt is repaid, the impact of different distribution policies, whether to operate as a C Corporation or an S Corporation in the future, using ESOP stock as a match to a 401(k) plan, and even using a convertible preferred stock in the ESOP instead of common stock, are among the issues addressed in a comprehensive feasibility study. The feasibility study is designed to be a “decision package,” where current shareholders, management, and the board of directors (which may or may not overlap) determine to what extent an ESOP can meet individual and corporate objectives.
Misconception
Sadly, sometimes the ESOP as an option for liquidity and perpetuation planning is never seriously addressed, due to misconceptions held by major shareholders and/or their key advisors.
Once business owners and their advisors carve out several hours to communicate with an experienced ESOP practitioner, they frequently find that an ESOP is not only a viable option, it may be the best option.
ESOP Research
Numerous studies have been done over the past 25 years demonstrating the productivity and performance of ESOP companies. Several examples are listed below.
