November 21, 2017

You’re the Boss Blog: The Questions to Ask Before Adopting an ESOP

Creating Value

Are you getting the most out of your business?

When I talk with a business owner about succession planning, the idea of an employee stock ownership plan, or ESOP, always comes up.

It’s a method of leaving a business that many business owners are fascinated with, and one that could potentially leave a business in the hands of those who have a deep-seeded interest in maintaining its prosperity: its hard-working employees. Gar Alperovitz, a professor at the University of Maryland, recently extolled the virtues of ESOP’s in an Op-Ed in The New York Times. As he describes, companies in which employees have a direct ownership stake typically have higher productivity, profits and other benefits.

The bottom line, however, is that the structures of such programs are complicated. The Web site of the National Center for Employee Ownership, which endorses ESOPs, can give an overview of just how complicated they are. That’s not to say that business owners should shy away from such plans. But before settling on starting an ESOP, there are several factors to first consider:

Is you company big enough? An ESOP is expensive to put in place. It will likely cost at least $150,000 and can easily cost $250,000 to establish. For an ESOP to be a cost-effective transaction, you need to have a company that has at least 40 employees and has over $5 million in annual sales.

To establish an ESOP, a company is going to need at least two lawyers, a valuation expert and a trustee for the program. Then, there are continuing compliance and costs for extra tax returns and annual valuations. This is not a strategy for an owner who just wants a simple exit.

Are you ready to share your financials? At the very least, you will have to allow your employees access to the annual valuation of the company. And companies that use best practices go much further than the minimal requirement.

For example, King Arthur Flour, which converted to an ESOP in 1996, spend lots of time and money teaching employees to be financially literate. Steve Voigt, chief executive, says he believes that effort is one of the drivers of the company’s success. He believes that when you combine employee ownership with financial understanding employees take steps to make a better and more sustainable company.

Does your company have growth prospects? Mr. Voigt feels strongly about this point. Employees are beneficiaries of the stock value of the company. If your company isn’t growing and doesn’t increase in value, the ESOP could become a negative in the eyes of your employees.

Do you have a good nonfinancial reason to form an ESOP?
ESOPs are strong financial tools, and they have great tax benefits. But companies that undertake them for financial reasons only will often run into trouble.

Will Raap, the former owner of Gardener’s Supply Company, a gardening company that sells products through mail order and the Web, wanted to keep the jobs he had created in Burlington, Vt. He knew that if he sold the company to the suitors that were knocking on this door, there was a good chance the jobs would leave the state.

Mr. Raap started out having the program owning a minority of the shares. He hoped the ESOP would work well enough that he would feel comfortable having the ESOP take control of the company and keep the jobs he created in Vermont. As of December 2009, the company became 100 percent employee-owned.

I believe one of the reasons Gardener’s ESOP is successful is because Mr. Raap had more than a financial reason to start an ESOP at his company.

Do you have good management in place to take over? A successful ESOP should last for more than one generation of managers. The owner needs to establish a method for identifying and training the next generation before starting an ESOP.

Chris Mercer from Mercer Capital had a good reason to find a new shareholder for his company. He had a partner who had reached retirement age and needed to be bought out. Mr. Mercer, an expert in business transition issues, chose an ESOP as a good way to buy out his partner and start moving management of his valuation and advisory firm to the next generation of managers.

Like Gardener’s Supply, the ESOP at Mercer Capital became a minority shareholder. This allowed him to test his new managers to see whether they could run the company. It turns out Mr. Mercer is happy with the next generation of mangers, and he’s now thinking about having the ESOP buy more of his stock so he can start his own transition out of the company he founded.

Do you have managerial training in place? An ESOP is intended to last for several generations. This will only happen if there is an active training program to help create future managers.

Mr. Voigt of King Arthur Flour has instituted several programs to address this. Cross-training across various job functions is the norm. Management seminars are offered to employees who want to advance.

Mr. Voigt points out that a good reason to grow the company is to provide opportunities for younger employees who want to grow into more responsible positions, and thus creating a deep bench for leadership.

Are you in a rush? King Arthur Flour, Gardener’s Supply and Mercer Capital – three very different businesses – all started out by having their ESOP’s take minority positions. This allowed them the opportunity to unwind the structure if the ESOP’s weren’t working out.

An ESOP is not a quick succession strategy for selling shareholders. In all three cases, the owners took years, sometimes more than 20 years, to complete the sale of the company to the ESOP. You must have patience and time to make such a plan work. Many owners I’ve spoken with have decided against ESOP’s simply because of the time necessary for them to separate from their business. If you want a fast exit, an ESOP is probably not for you.

Many business owners who start a business make all of the decisions by themselves and don’t want to share information with anyone. These owners are not going to try an ESOP. But those who like the idea of including employees in the success of the company and are willing to get more people involved in decision-making should explore the strategy.

Do you think an ESOP would work for your company? Have I missed any questions that should be asked?

Josh Patrick is a founder and principal at Stage 2 Planning Partners, where he works with private business owners on creating personal and business value.

Article source: http://boss.blogs.nytimes.com/2013/07/11/the-questions-to-ask-before-adopting-an-esop/?partner=rss&emc=rss

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