Employee Ownership: A Capital Idea

Employee Stock Ownership Plans offer you access to a new group of investors -- your workers.

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One day in 1975, Jack Lamp, president of Arrow Metal Products Co., an East Palo Alto, Calif., sheet metal fabricating shop, was complaining to his lawyer about the company's employee profit-sharing plan. Lamp had installed the plan five years earlier in order to share with its employees the firm's success. But as in so many small companies, though Arrow was profitable, cash was tight. Lamp usually found himself taking out a loan to make the annual profit-sharing contribution.

He would have preferred not to borrow. Lamp had to guarantee all the company's loans personally. And besides, he says, "It wasn't like borrowing to invest in new equipment. It wasn't making any money." But suspending the contributions was out of the question: That would shake his workers' morale.

His lawyer made a suggestion: Why not look into a new kind of employee trust plan allowed under a recently enacted federal law? He was referring to Employee Stock Ownership Plans (ESOPs), sanctioned by the Employee Retirement Income Security Act (ERISA) of 1974. An ESOP allows a company to make trust fund contributions in its own stock as well as in cash. That way, the money stays right in the company itself, instead of being handed over to a bank's trust department, never to be seen again.

It looked complicated, so Lamp contacted John D. Menke, a San Francisco lawyer who had recently opened a firm to specialize in ESOPs. For $5,000 -- today it would cost more -- Menke made Arrow Metal one of the first companies to take advantage of the law.

As it turned out, Arrow's ESOP accomplished much more for the company -- and for Jack Lamp -- than just relieving the profit-sharing cash pinch. It helped meet the capital needs of the growing, privately owned company.

"Since we founded our ESOP, we haven't had to borrow any money at all," says Lamp. "Our capital expenditures since then have totaled about $1 million, and the ESOP has funded most of that." The company's sales now stand at about $1.8 million a year, up from $150,000 when Lamp bought the firm and rescued it from failure in 1968.

Arrow now has 25 employees, all of whom have benefited from the ESOP, too. Under the former profit-sharing plan, coming up with a cash contribution of about 8% of payroll annually was a strain for the company. Now Arrow contributes stock worth up to 15% of its $620,000 payroll each year. (Contribution amounts are, as in profit sharing, discretionary.) The value of a share, as determined by an independent appraiser, has risen from $4.22 in 1975 to $10 today.

As they would in a pension plan, Arrow employees usually leave their allotment in the trust until they retire (though early withdrawals are possible under some circumstances). Then they "put" the stock to the company or to the trust -- that is, sell their shares back at fair market value. Thus the company ultimately does hand them cash -- and perhaps much more than the shares were worth in the first place, if the company has prospered and the shares have appreciated in value.

Arrow gets use of their cash in the meantime. The company also takes a standard tax deduction on the value of every share given to the trust, up to 15% of payroll. Thus by raising contributions from 8% of payroll (all it could afford when it was putting in cash) to about 15% now, Arrow gained a tidy sum through deductions. Since the company pays tax at the full 46% corporate rate, each dollar's worth of stock contributed earns 46? in cash for the business.

There's a catch for Jack Lamp, as readers undoubtedly have noticed. In order to give the ESOP stock, the company issues new shares. That dilutes Lamp's ownership. Arrow's employees now own about 38% of the company. The typical ESOP firm is 20% to 30% employee-owned after five years, notes Menke.

But dilution doesn't deprive Lamp of his control of the corporation. Through a trustee he appoints, he directs the way the ESOP votes its shares. "Having the ESOP eventually become majority stockholder doesn't bother me as long as voting rights aren't involved," he says.

And dilution can carry a shiny silver lining: It creates a convenient "in-house" market for Arrow's shares. This permits Lamp occasionally to cash out some of his equity in the company -- on terms vastly more favorable than the Internal Revenue Service otherwise allows. Last year, for example, Lamp sold 9,000 of his 80,000 shares to the ESOP for $10 a share. Where did the trust get the money? From the company -- in the form of an ESOP contribution (for this purpose it gives cash, rather than the usual stock, to the trust). Arrow took a corporate tax deduction on the transaction, and Lamp paid personal taxes at the capital gains rate.

Compare that to what would occur, under IRS rules, if Lamp had tried to cash in those shares by selling them back to the company directly. The company would have had to redeem them with after-tax dollars, and the IRS would have called it a "constructive dividend," making Lamp liable for taxes at the regular income rate. Thus the company would forgo a deduction worth 46%, and Lamp would have to pay up to 50% in income tax rather than 20% in capital gains tax. That adds up to an additional 76% penalty on the same transaction, at maximum rates.

Owners of small, closely held companies usually find no other reasonable means of redeeming shares of stock, unless they want to sell the whole company (the IRS offers very favorable tax treatment for that).

"It helped me diversify my own portfolio," says Lamp. "Who else could I sell shares to, except perhaps a friend? This isn't a high-technology glamour industry." According to several ESOP consultants, in fact, this ability to get cash out of the business is the most common reason for installing ESOPs among privately held companies. Publicly held companies can install ESOPs, too, though if there's an active market in a firm's stock, an "in-house" market is unnecessary.

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