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By Karen Kroll
After stagnating for several years, interest in ESOPs, or employee stock ownership plans, is heating up. One reason: some baby boomers are hitting retirement age and finding ESOPs an effective way to sell their businesses, say experts.
"ESOPs are particularly used by small- to mid-sized companies to accommodate exiting shareholders," says J. Michael Keeling, president of the ESOP Association. Other options, such as selling to just the senior management team or to outside investors, can be hard to swing.
The regulatory and tax environments also come into play. In the late 1990s, ESOPs first were allowed to own stock in S-Corporations, a common form of ownership among private companies, says Jude Anne Carluccio, a Minneapolis-based partner and ESOP expert with the law firm of Barnes & Thornburg LLP. While the ESOP holds stock in the company, it is tax-exempt, just like other qualified retirement plan assets. Moreover, if an ESOP funds its purchase of company stock with a loan, both the principal and interest are tax deductible, says Carluccio.
In addition, many tax experts are forecasting a return to higher capital gains tax rates after this year, she adds. That's prompting at least a few business owners to transfer ownership in their firms now.
According to the ESOP Association, about 11,500 ESOPs are in place across the U.S. They cover about 10 million employees, or one-tenth the private sector workforce.
Although most often associated with company ownership, an ESOP actually is a tax-qualified retirement plan similar in design and function to a 401(k), Carluccio says. However, some distinct differences come into play.
Employees typically don't contribute their own money, and the ESOP invests in the stock of the company that put the plan in place. What's more, an ESOP can borrow money to acquire the stock. "It's a retirement plan created to become a shareholder of the company," she says.
While ESOPs can work for a range of company types and sizes, it helps if they are reasonably profitable, says Corey Rosen, executive director with the National Center for Employee Ownership. That's because the company's profits are used to help fund the ESOP, he notes.
In addition, the ESOP can purchase the shares of employees who leave or retire from the company. Assuming the company grows and its shares increase in value, this demand on cash will grow as well.
To start an ESOP, management first needs to obtain an independent valuation of the company, which is used by the ESOP trustee to set the value of the stock, Carluccio says. Each year, the employer may make a contribution to the ESOP trust; this enables it to invest in employer stock on behalf of employees. Every employee in the plan receives a share of the investment.
While ESOPs can take advantage of several tax breaks, implementing and operating an ESOP isn't inexpensive. For one thing, private company ESOPs must obtain independent valuations of the company's stock each year.
Moreover, because ESOPs are retirement plans, they're subject to rules set by both the IRS and Department of Labor, Keeling notes. "You can set up a 401(k) for a lot less money," he says. "This is primarily an employee benefit."
For many business owners, establishing an ESOP is a way to boost performance and share the rewards with employees. In a 2010 study, Brent Kramer, adjunct professor at City University of New York, compared the average sales per employee between ESOP and non-ESOP owned firms. He found that they were 8.8 percent higher in employee-owned firms.
At the same time, Kramer says that he has no indication that creating an ESOP, in and of itself, boosts performance. "The performance improvements have more to do with corporate culture versus ownership," he says. That is, companies that already treat their employees well and look to them for insight may be more likely to become ESOPs in the first place.
Gardener's Supply Company in Burlington, Vt. is a 100-percent ESOP owned firm, says Cindy Turcot, chief operating officer. Of its 275 employees, 200 have passed the one-year waiting period and are in the plan.
The employee-owners review the financial statements at monthly staff meetings, in which they're routinely asked to provide input to the challenges the company faces. "You have to have systems in place so that when you need your best ideas, you have the culture to help solve the problems," Turcot says.
So, when sales declined in the early 2000s, management and employees scrutinized the 25 expenses that made up 95 percent of spending. One employee suggested trimming the catalog size by one-quarter inch. That slashed paper and postage costs, but didn't impact customer service. "The difference (in costs) was huge, but it was a really small change," Turcot says.
What's more, potential employees who are looking for a workplace in which they can participate seek out the company, Turcot notes. While hard to measure, this likely has a positive impact on performance.
Of course, even with dedicated, motivated employees who share in the success of the company, ESOPs still are subject to the vagaries of the broader economy and marketplace. Keeling says : "Not every ESOP company hits a home run."
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