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Retaining skilled workers with an employee ownership plan

How an ESOP incentive benefits employees, owners, and the bottom line

Retaining skilled workers with an employee ownership plan

Research shows that companies with ESOPs grow about 2.5 percent more per year than they would have without an ESOP, and employees end up with about 2.2 times the retirement assets.

Jeff Heck had a problem.

His company, ATEC Steel, a steel fabricator of storage tanks and other structures, had grown exponentially since he opened the doors in 2006. Maintaining this growth required that his major customers would come back anytime when they needed a steel fabrication, such as an above-ground storage facility.

To find and retain these customers, however, Heck had to have highly trained employees—and keep them happy. Losing a key employee brought the possibility of losing key customers, so replacing a highly skilled employee, like a project manager, in a tight labor market took on even greater urgency for Heck and ATEC Steel.

A successful and growing company in a niche market—was this the proverbial “embarrassment of riches”? Not to Heck. He knew long-term success hinged on finding the best talent available and developing that talent for ATEC Steel to maintain its position in the marketplace. But how could he keep them around? A new benefit package and a bigger 401(k) match were viable options, but they weren’t going to be enough to make Heck’s top talent stay put.

The Right Incentive

On April 24, ATEC Steel announced that it would become a 100 percent employee-owned company through the adoption of an employee stock ownership plan (ESOP). This, Heck recalls, was a no-brainer for his unique set of challenges. The ESOP could solve the retention problem (and attract good new people), and tax-wise it was a very beneficial way to accomplish business transition as Heck got older.

Heck’s intuition about ESOPs is well-supported by research. ESOP companies grow faster than they would have without an ESOP, have lower turnover rates, and are much less likely to lay people off or go bankrupt. In the largest and most significant study to date of the performance of ESOPs in closely held companies, completed in 2000, Douglas Kruse and Joseph Blasi of Rutgers University found that ESOPs increase sales, employment, and sales per employee by 2.3 to 2.4 percent per year over what would have been expected without an ESOP.

ESOPs are good for business, but they also are good for owners selling to an ESOP. Fabricating business owners looking to retire could sell to another company or a private investment group, but either approach could leave the future of their employees and their company in doubt. Selling to an ESOP, by contrast, keeps the company in place, rewards the people who helped build it, provides the owner flexibility in how much to sell when and what role to play going forward, and nets substantial tax benefits. It’s all done with future, tax-deductible profits, not employee purchases.

How It Works

An ESOP is a kind of retirement plan, similar in some ways to a 401(k) plan. The company sets up an employee stock ownership trust. The trust can borrow money to buy shares, with the company repaying the loan by making annual tax-deductible contributions to the trust to repay the loan. The company can borrow money from a bank, and the seller can take a note, repaid with a reasonable rate of interest. The trust puts the shares in a suspense account and releases them to employee accounts as the loan is repaid.

Alternatively, the company can make discretionary annual cash contributions to buy shares gradually over time. This is, in effect, a stock redemption, but normal redemptions are not tax-deductible; contributions to ESOPs to buy shares are. So if a company is sold for $5 million, it does not need about $7 million in profits to redeem the shares, it just needs $5 million.

For an owner of a C corporation at which the ESOP ends up with at least 30 percent of the stock, proceeds on the gain from the sale to the ESOP can be tax-deferred by reinvesting in the securities of other domestic companies. Tax is due when these securities are sold. If the company is an S corporation, limited liability company, or partnership, it can convert to a C corporation before the sale to take advantage of this tax deferral. If the company stays S, the owner does pay capital gains tax on the sale but reaps all the other benefits of selling to an ESOP. S corporation ESOPs, however, pay no tax on the profits attributable to the ESOP, so a 100 percent ESOP pays no income tax. Many companies are C corporations at the time of sale, then convert to S status immediately afterward to cut their tax bill.

The sale can be all at once or gradual, for as little or as much of the stock as desired. For the employees, no contributions are required to purchase the owner's shares. The owner can stay with the business in whatever capacity is desired. The plan is governed by a trustee who votes the shares, but the board appoints the trustee, so changes in corporate control are usually nominal unless the plan is set up by the company to give employees more input at this level.

Stock is held in the trust for employees until they leave. At the least, all employees with 1,000 hours or more in a plan year must be included. Their accounts vest over up to six years. Contributions allocated to employees are based on relative pay or a more level formula, then distributed after the employee terminates. ESOPs cannot be used to share ownership just with select employees, nor can allocations be made on a discretionary basis.

The price the ESOP will pay for the shares, as well as any other purchases by the plan, must be determined annually by an outside, independent appraiser, based on what a hypothetical willing buyer would pay. This occasionally is less than what a company might be able to get from selling to a third party, although those sales do not generate tax benefits.

Is an ESOP Right for My Company?

ESOPs have a stellar track record. Research shows that companies with ESOPs grow about 2.5 percent more per year than they would have without an ESOP, and employees end up with about 2.2 times the retirement assets.

All of this may sound appealing, but it is not feasible for every company. Several factors must, at a minimum, be present:

  1. The company is making enough money to buy out an owner and keep up with its other business costs.
  2. If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan.
  3. If the seller wants to take the tax-deferred rollover, the company must be a regular C corporation or convert from S to C status.
  4. Management continuity must be provided.
  5. The company must be willing to put up with the added costs and complexity of an ESOP. ESOPs cost about $100,000 to $150,000 to set up (sometimes more), although any sale involves substantial fees and often a brokerage percentage that ESOPs do not. ESOP sales also do not require contingencies, such as earnouts, that are common in other sales.

If all this seems to fit, find someone who has experience in the ESOPs world (and not just someone who claims it) to see if this makes sense for you.

About the Author

Jon Adams

Jon Adams is a freelance writer doing research on employee ownership. He got his start in employee ownership in 1988 while working with the National Center For Employee Ownership on a graduate research project on ESOP.