ESOPs: Profit by Turning Ownership Over to Employees
by Shel Horowitz
Nicholas Filler, from FBC sponsor Bulkley, Richardson and Gelinas, held the Family Business Center spellbound as he explained the ins and outs of ESOPs: Employee Stock Ownership Plans
By and large, ESOPs create a win-win situation for both owners and employees. Among the many benefits:
- ESOPs provide a smooth transition mechanism to buy out a retiring owner's equity, and/or a way to raise capital for expansion, buy-outs, etc.
- Workers have greater morale and productivity because they are vested in the company's success--and this reduces friction between labor and management.
- ESOPs allow a company to effectively deduct 100% of both principal and interest for the borrowing that funds the ESOP. Over time, this becomes a very large difference: annual cash flow to service a debt is reduced by 1/3 of the principal amount through tax savings. In real terms, this might save a company as much as $3 million on a $10 million, 10-year loan.
- Retiring employees may take their choice of a cash payout to buy back their shares or maintain an ownership position in the company--either way, it is a very nice financial benefit, since employees don't pay into the stock purchase.
- A selling shareholder who is bought out by an ESOP can avoid capital gains tax, simply by rolling over the proceeds of the sale of his or her stock into another qualifying investment, such as publicly-traded stocks or bonds, within 12 months.
- An ESOP has the potential to maintain local businesses in the community, because it can be a more attractive option than selling out to a multinational competitor; it creates a level playing field for the company's owners, making it just as attractive to sell to the ESOP on a tax deferred basis as it is to sell to a publicly-traded company.
- * Shareholders no longer depend on the company's continued profitability to fund their retirement--because, with the purchase of their shares by the ESOP, that retirement income has already been provided for. Since they are regulated under the Employee Retirement Income Security Act (ERISA), there are a number of restrictions on the ways ESOPs can be set up and used. To name a few:
- The primary investment of the ESOP must be in the company's stock--and its ability to diversify the portfolio is sharply limited. At the same time, the ESOP is exempt from the normal ERISA requirement for fair returns on a "prudent" investment.
- A retiring employee has only two 60-day opportunities to convert the stock into cash--and if he or she fails to convert, that stock remains outstanding. But the company has the right to spread the buy-back out over a predetermined period of years. Thus the company has a repurchase liability for all ESOP stock and ends up paying for the stock twice, once when it is bought for the ESOP and again when the employee retires.
- Company contributions to an ESOP cannot exceed 25% of payroll.
- ESOP employee-participants have the right to vote, with other stockholders, on major company decisions.
- The ESOP must have a formal written plan.
Still, in many situations, the advantages outweigh the burdens. Filler demonstrated this by drawing on a panel of business executives whose firms already use ESOPs: Michael Bete from Channing L. Bete, Robert Trask from Country Kitchens in Stockbridge, and Don Madison from Marland Mold, Inc. of Pittsfield.
Madison's case is particularly interesting, because his company is owned 100% by the ESOP--which created the company out of a division of a larger firm. When the parent company wanted to close shop and consolidate, the employees bought it through their ESOP and their union. After a few years, the ESOP bought out the union's share, and now owns 100% of the company. The other two ESOPs were set up more traditionally. Bete's and Country Curtains were retirement vehicles to facilitate the sale of a substantial portion of stock by the principal shareholders. The result, says Madison: "It's been a tremendous boon. We had an unusual surge of productivity. We make more money selling a $180,000 mold than we did on a $200,000 mold" before the ownership transfer.
Is an ESOP right for your company? Call Filler * and find out.
*as of 11/98, Attorney Filler is no longer with Bulkley, Richardson and Gelinas. Contact Ron Weiss at BR&G (see Corporate Partner page)