ESOPs Strong Exit Alternative

January 29, 2007
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Despite many incentives and advantages, it seems few business owners seriously consider an Employee Stock Ownership Plan as an exit strategy or corporate culture.

According to the National Center for Employee Ownership, barely 10,000 companies nationwide are incorporated as ESOPs, representing only 7.7 percent of private-sector employees. Yet, ESOP companies have not only proven to be better performing, longer-living and more valuable, federal incentives can allow them to operate virtually tax-free.

“It does surprise me that more companies don’t take advantage of it,” said Rick Adamy, founder of Grand Rapids accounting firm Adamy + Co., one of the largest ESOP valuation practices in the Midwest. “A lot of companies that would be a great fit for an ESOP dismiss it without looking at the pros and cons.”

An ESOP is an ownership structure that places a company’s shares into a trust intended as an employee retirement fund. The employees become owners of a sort, but with no direct oversight of the company. Earnings are used to purchase shares or make institutional investments. The stock is valued annually by independent auditors, and then distributed on the basis of compensation and/or seniority.

A consensus of NCEO studies found ESOP firms to be 6.2 percent more productive, with an average annual growth in productivity of 4.4 percent immediately following adoption. Firms with substantial employee ownership stakes proved 20 percent more likely to survive than their non-ESOP counterparts over the course of a 12-year Rutgers University study.

More impressive than the operational gains, the ownership plan created by the original and updated Employment Retirement and Income Security Act included substantial tax incentives. The original owner is able to defer all capital gains taxes on the sale of its shares, sometimes permanently. For the employee trust, the entire financing package for the purchase and other qualified expenses is tax deductible on an annual basis — both the interest and principal.

Plus, the earnings of most ESOP companies are exempt from federal taxes.

“A company we recently worked with saw their tax bill go from a million dollars to zero,” said Adamy. “Think of what a company could do with an extra million dollars.”

Grand Rapids architecture and design firm Progressive AE formed its ESOP as a tax consideration. Since forming the ESOP with 5 percent of the company’s shares in 1994, the plan has slowly grown to nearly 50 percent of the company.

“We had a tax rate of 35 percent and our line of credit required a certain amount of profits be left over to increase the net worth of the company each year,” said Ray Fix, Progressive AE’s chairman and CFO. “If we earned $335,000, we’d have to pay the federal government $135,000 and then leave the rest to increase the net worth.”

Through the ESOP, the firm was able to satisfy the bank requirements with the money distributed to the trust, while eliminating a sizable portion of its tax liabilities. When Holland-based furniture manufacturer Trendway Corp. transferred 25 percent of its shares into an ESOP program last year, a fourth of its earnings were immediately tax abated. Companies with 100 percent ESOPs such as National Nail and Alexander Marketing in Grand Rapids and Fleetwood Group in Holland (The ESOP Association’s National ESOP Company of the Year) pay no federal income taxes.

Prior to its ESOP formation, Progressive AE had long been wholly owned by its employees, with the stock split between senior employees and the company’s 401(k) retirement plan. The additional class of ownership was not a distinct cultural change for the company, as it would be for many others.

“Companies shy away because they believe their employees don’t have the business acumen to run a corporation like theirs, and that’s probably true,” said Vern Saper, a partner at Warner Norcross & Judd in Grand Rapids and one of the nation’s leading ESOP attorneys. He is currently leading an ESOP formation for Muskegon-based grocery chain Plumb’s Valu-Rite Foods.

“It needs to be understood that employees don’t necessarily take control of the company,” Saper said.

“That they have a say in compensation for officers or other decisions is really a fallacy. The board continues to run the company.”

A trustee votes on behalf of the ESOP stock, and while that individual is by law required to act on behalf of employees, there is no requirement to be independent of management. At most ESOP firms, the trustee is a senior executive.

Saper urges his peers at Warner Norcross & Judd to educate corporate clients to ESOPs as an alternative exit strategy. “People simply are not aware of ESOPs and what the advantages are.”

Not every company is meant for employee ownership, Adamy cautioned. If a company has shrinking or inconsistent profitability or a large amount of debt, the ESOP will struggle to gain value. Many times, the corporate culture is just not compatible.

“Management has to want to share ownership with their employees and not just put some tax advantage dollars into their pockets,” he said.

When longtime Trendway owner Don Heeringa began considering retirement, he decided an ESOP was the exit strategy that best fit the culture he had instilled in the company.

“We’ve always been an employee culture,” said Trendway CFO Richard Martinus, noting the company’s multiple layers of employee participation, benefits and communication. “Don is the fairest guy in the world, and he decided, ‘Who better to transfer ownership to than people who work here?’”

Companies with a strong employee ownership culture see decreased turnover and greatly increased productivity and satisfaction, according to an NCEO report suggesting that forming an ESOP alone does not guarantee improvements in employee behavior and attitude.

“You really have to promote the value of this,” said Scott Baker, National Nail president and ESOP trustee. He was previously a consulting partner at now defunct accounting firm Arthur Andersen in Grand Rapids, where he helped several companies form ESOPs. “You need to show them how you can create more value as a team.”

The first ESOP in West Michigan was also its most notorious: Eberhard Foods Inc. Some of Adamy’s clients have seen blue-collar employees retire with nest eggs of $100,000 or more; Eberhard employees received no more than $5,000 when the company folded in 1992 after founder L.V. Eberhard’s death.

“If you’re doing it for the right reasons, it can really have an impact on culture,” said Baker. “If you’re just doing it to get cash and get out, those tend not to work. L.V. Eberhard did an ESOP because he wanted money. The company tanked and employees didn’t get any benefit from it.”

Adamy, whose firm is required to be independent of its valuation clients, has seen several companies abandon ESOPs after employees reject the concept because of the Eberhard fiasco, a high-profile example of an ESOP trustee, Eberhard, not acting in the interests of employees. The 2001 bankruptcy of Michigan Bulb Co. was another.

With all the scrutiny being placed on corporations today, Adamy believes more ESOP firms will employ independent trustees. Most firms continue to avoid that expense.

J. Michael Keeling, president of industry advocate The ESOP Association, cited other issues: Many entrepreneurs dislike the thought of having an independent auditor determine the sale price of their company. Others are concerned about equity issues that can arise as each generation of employees retire and cash out shares.

There is also the issue of diversification.

Decades ago, Alexander Marketing founder Jim Alexander sold the last of his shares into his company’s ESOP. Shortly after the Eberhard collapse, the company began investigating how to diversify its investment.

“We were fortunate enough to have a separate pension plan, but that was still a lot of eggs in one basket,” said Bob Milroy, Alexander Marketing president.

Although it is one of the few decisions that must be voted on by all shareholders, ESOPs can, and often are, acquired by other companies. They are prime private equity targets, and some firms, such as Alexander Marketing, are attractive acquisitions for larger conglomerates.

The firm was offered an acquisition package from a national agency that would have cashed out the ESOP shares at a significant premium, but likely eliminated much of its work force. Instead, the company sold itself to an ESOP holding company, Alliance Holdings in Philadelphia, preserving the company’s employee ownership while diversifying its investment throughout several other ESOP firms across the country.    

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