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A succession solution

June 29th, 2016 / By: / Business, Management

How to determine if an employee stock ownership plan is right for your company.

An exit plan is generally not at the forefront of a company owner’s mind, especially at the height of career success, but it’s no less important than any other business strategy.
When the time comes to step down, a comprehensive exit plan is crucial for a smooth transition, whether that means selling the company to an outside buyer or transferring it to a next-generation family member. Another less-understood option has proven successful for both suppliers and end product manufacturers—an employee stock ownership plan (ESOP).

Defining ESOPs

An ESOP is an employee benefit plan set up as an independent trust that buys the company owner’s stock at a price set by an independent evaluator. The stock is held for employees until they leave or retire and can sell it back to the company at market value.

“In reality, it’s a retirement plan,” explains Chris Fredericks, president of Top Value Fabrics, Carmel, Ind., which implemented an ESOP in 2010. “It functions almost like a 401(k) plan as far as the way it’s structured and governed, except instead of the money being invested in publicly traded stocks, it’s in the company.”

A common misconception is that employees are required to contribute money to an ESOP, but “they don’t have to pull any money out of their pockets,” says Dan Niehaus, vice president of the formerly family-owned Miami Corp., Cincinnati, Ohio. “The company issues stocks and dividends each year based on earnings.” Companies that offer an ESOP can continue to provide a 401(k) plan, and Niehaus recommends that they do.

A fourth-generation family member, Niehaus and his cousins Tim, president, and Kevin, secretary, decided in 2014 to set up an ESOP when they realized there were no family members qualified or interested in taking over when their time was up. “We didn’t like the idea of selling to a third party and having no control over employees staying or operations or the culture,” he says. “We still need to make money, and we’re willing to stick around and see it through for a few more years.”

Tax breaks all around

The most significant advantage of an ESOP—monetarily, at least—is the tax break: ESOPs qualify for federal income tax deferral until the employees turn their stock into cash when they leave the company. The flexibility of ESOPs allows owners to sell any percentage of the company, so if, for example, a company sells 30 percent of its company, it pays no tax on 30 percent of its income.

Because employees recognize they have more stake in the company, another benefit is often a more positive, engaged working environment. Fredericks recommended an ESOP to Top Value’s founder when he was considering a succession plan but had no family in the business. “Rather than selling to a competitor, he sold it to the employees who helped him build the business,” Fredericks says, adding that teamwork is at an all-time high, which has improved both innovation and customer service.

“It rewards my long-term employees and retains good employees during a transition because now they have skin in the game,” says Jerry Grimaud, president of Lawrence Fabric & Metal Structures Inc., St. Louis, Mo., who implemented an ESOP in October 2015. “They can now increase the value of the company, and that will increase their retirement funds; there’s more motivation to do well.”

A meticulous method

The process of transitioning to an ESOP involves specific procedures and can take anywhere from two or three months to a year. “You can’t do this on a budget, and you can’t do it wrong,” Niehaus says. “You’re dealing with the federal government—if you do it wrong, you’re in trouble.”

The first thing to do is hire an accountant and a lawyer who have significant experience with ESOPs, Fredericks recommends. “It’s different enough that you definitely want accountants and lawyers who have already dealt with it before,” he says. The accountant can help with feasibility analytics to determine if the company is a good candidate for the ESOP. Once determined to be feasible, an ESOP trustee must be hired to oversee the ESOP on behalf of the employees. Receiving guidance from their respective lawyers and accountants, the trustee and company owner go through a process of negotiation to finalize the terms of the sale and the structure.

An independent firm must also be hired to complete an evaluation to determine the fair market value of the company, which often dictates the selling price. This can be both an advantage and disadvantage, as selling to a third party could result in a higher sale price. “I probably did not get the maximum amount of money for the sale of the company, but I was very satisfied with what I got and with the transition,” Grimaud says. “I was able to get money upfront and some deferred compensation, and the legacy as I established it can continue as the company culture stays the same.”

This means the transaction is done aboveboard, so honest bookkeeping is a must, Niehaus advises. “We have been very adamant about paying taxes and standing by every number we put down on paper,” Niehaus says. “We didn’t try to hide anything and were pleased with the deal.”

Proceed with caution

An ESOP may not be the best option for every company. Because of the legal fees alone, a company’s profits must be high enough to compensate for all of the expenses involved. In addition, a move to an ESOP must come with a shift to greater transparency, Fredericks says. “A collaborative environment is more conducive than a top-down environment.”

A viable ESOP candidate should also have a solid management team in place, Grimaud recommends. “I learned that you cannot sell a company unless you have a good management team in position, so the whole time I owned the company, one of my focuses was to develop managers. I didn’t want to fall in the situation many small company owners do—they wait too long to plan their exit, and all of a sudden their company doesn’t have a value because they don’t have a strong management team.”

Knowledge is power

Several sources are available to help inform companies interested in learning more about ESOPs.

Grimaud found local business seminars put on by banks and universities to be helpful. “I’d say anybody 55 or older should start attending as many seminars as they can because you learn a little bit every time you go,” he says. In addition to attending IFAI Expo business seminars, he belongs to Vistage International, a business mentoring organization. He also sent his company’s president and vice president to a convention hosted by The ESOP Association, an advocacy and education institution focused on ESOPs.

A similar membership and research organization recommended by Fredericks is the National Center for Employee Ownership, which aims to provide the most objective and reliable information possible on employee ownership.

“At a basic level, you can search the Internet or find brochures with high-level explanations, but it’s extremely complicated,” Niehaus says. “Once you decide to do it, you have to commit to big-time lawyers and advisers, but they’re sharp and know all the tricks allowed by the law. You have to come to grips with the fact that it’s going to cost money.”

The detailed nature of an ESOP may also confuse employees, who should be educated as well. Grimaud announced the new plan at a company-wide meeting with an attorney present to answer any technical questions. The company provides continuing education every month or two at similar meetings. “Once you do one full calendar year, they’ll have a much better understanding of what it’s really about,” he says. “It’s an ongoing learning process.”

Holly Eamon is a business writer and former assistant editor of the Review.

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