STORY PROPOSAL

I've been reading negative stories on employee stock ownership plans for years. That scarcely prepared me for what i found at last year's Nation Center for Employee Ownership conference. It was attended by hundreds of small-business people, and most were pleased with their ESOPs. Later I began visiting ESOP companies and learning about their experiences. My conclusion: smaller companies have been figuring out how to use ESOPs to their advantage. Let's sort through what they've done and tell our readers what works -- and what to watch for.

J.C.

EMPLOYEE STOCK OWNERSHIP PLANS -- ESOPS -- have been around for a while now, and plenty of companies have tried them. Having spent a year or so studying up on the experience, I've come to a couple of conclusions.

One: It would be very easy to argue that no company owner should even consider installing an ESOP.

Just think of all the companies with employee ownership that got themselves into trouble. Frank Borman, chief executive officer of Eastern Air Lines Inc., agrees to give workers about 20% of the stock in return for wage concessions. And what happens? Losses mount, unions and management keep on bickering. Employee owners vote to sell U.S. News & World Report to would-be media mogul Mortimer B. Zuckerman. Immediately the deal gets tied up in lawsuits -- ex-employees feel they've gotten the shaft.

The cautionary tales aren't limited to large companies. "If I had it to do all over again, I wouldn't have an ESOP," says Phil Grogan, who led an ESOP-financed buyout of Keyser Garment Inc., a small clothing manufacturer. Elliot Schrier, president of a San Francisco consulting firm called Manalytics Inc., set up an ESOP but terminated it this year. At least Grogan and Schrier talked to INC.; another CEO wouldn't let us get past his secretary. "He doesn't wish to discuss the ESOP," she informed us icily. Too bad; we'd heard he'd had some serious problems.

All this was beginning to add up to yet another negative article on ESOPs. But wait! There seemed to be a few other experiences -- no, a lot of other experiences -- that didn't fit this sour view.

For one thing, the number of ESOPs is continuing to grow. "About 700 to 800 new ESOPs are established every year," says Corey Rosen, executive director of the National Center for Employee Ownership, a research organization. Most of them, Rosen adds, are in small, private companies. All told, there are maybe 9,000 U.S. companies with ESOPs.

Then too, there are just too many CEOs who like their ESOPs. Henri Berrtuch, for example. Until recently Bertuch was sole owner of D.V.C. Industries Inc., a Bay Shore, N.Y., manufacturer of looseleaf binders and packaging materials. Then he established an ESOP and sold it 30% of his stock. Now, he says, he's "in a dreamworld." Not only does he have a hefty jingle in his jeans, but his company has a new team spirit. For years, D.V.C.'s sales had been flat, hovering around $15 million. In 1987, the first full year after the ESOP was installed, revenues were up 8%, pretax profits up 64%. This year looks even better, with sales running ahead of last year's by 28%.

As it happens, Bertuch isn't the exception, he's the rule. Over the past 12 months I met with dozens of executives who had installed ESOPs. I attended conferences at which dozens more lauded the plans. I talked with employees and experts -- and came to another conclusion.

Yes, ESOPs can cause problems. And yes, the problems can sometimes overwhelm the benefits. But the difference between ESOPs that work and those that don't isn't blind luck. Rather, it's knowing when an ESOP is appropriate and when it's not -- and how to use it when it is. An ESOP can accomplish everything it was designed to accomplish. For some companies it can work wonders.

With that in mind, here's INC.'s question-and-answer guide to ESOPs -- the promises and possibilities, the problems and pitfalls. There are plenty of each.

OK, given all the sad stories about ESOPs, why should I even consider installing one at my company?

In a word, liquidity.

Owners of small, private companies usually engineer an ESOP to create a market for their stock. It's a way of cashing in -- or out -- without going public or selling the company. The tax breaks are huge. The psychic rewards -- well, let Bertuch tell it.

In December 1985, at age 54, Bertuch was beginning to think about getting some of his money out of the business his family had owned for three generations. An IPO was out of the question. D.V.C. Industries was in too unglamorous an industry, its sales and earnings too lackluster. Granted, some would-be buyers were sniffing around. But Bertuch couldn't see selling. An acquirer would probably move the business, costing a generation of loyal employees their jobs. Family members who might want to come into the company -- Bertuch was thinking mainly of his sons Michael and Mark -- wouldn't get the chance.

And oh, those tax breaks. Bertuch sold his new ESOP 30% of his stock. That made him eligible for so-called rollover treatment: all he had to do was reinvest the proceeds in other U.S. corporate securities, and the tax on his gains was completely deferred. If he dies before selling the new assets, his heirs can avoid income tax on the gains entirely. To buy Berrtuch's stock, the ESOP borrowed $1.8 million. Because banks get a tax break on ESOP loans, the interest rate was 82% of prime, not the point or so over prime that D.V.C. normally pays. And because both principal and interest payments are tax-deductible, D.V.C.'s ESOP is buying the stock with pretax dollars as it pays down the seven-year loan. Had it simply retired Berrtuch's stock, the company would have been using aftertax dollars. And it wouldn't have gotten a break on the loan rate.

The story of Henri Bertuch is the reason why the number of ESOPs continues to grow: a lot of people are, or will be, in his situation. Are you among them?

If you're looking for liquidity; if you want to continue running the company or at least see it remain independent; and if you want to avoid the whopping taxes you'd owe on a cash sale -- well, then, some day, you'll at least consider an ESOP. If your accountants don't insist on it, your children will.

The cash and the tax benefits sound great -- for me. But what happens to the business?

Rest easy: despite the occasional horror story, thousands of thriving small and midsize companies now have ESOPs. The plans themselves are both a powerful financial tool and a potentially generous benefit.

Consider BCM Engineers Inc., in Plymouth Meeting, Pa. Eleven years ago, BCM employees bought their $6.5-million company from Betz Laboratories Inc. Officers put up about $1.4 million for convertible debentures; the rest, $3.8 million, was paid by a newly organized employee stock ownership plan, which borrowed the money.

Today, BCM racks up about $50 million a year in revenues from consulting engineering, mostly in water, asbestos, and waste treatment. A share of stock worth $2.40 in 1977 hit $21.25 at the end of 1987 -- and last year alone paid its owner a cash dividend of 12.5 cents. The ESOP owns more than 85% of the shares.

How much the ESOP contributed to BCM's stellar performance is a question company president James Jablonski doesn't answer directly; engineer-like, he prefers facts to theories. But the facts he cites are compelling. In 1984 the company paid off the last of the purchase loan. Two years later it borrowed $1.5 million for an acquisition, and last year it financed a $1.1-million renovation of its laboratory and equipment. Since both loans were channeled through the ESOP, the bank offered fixed rates of about 80% prime -- and BCM can repay the money with pretax dollars. Put the two factors together, says Jablonski, and you have borrowing costs that are roughly half what they would be without the ESOP.

Cheap money; attractive benefit. BCM -- which also has a 40(k) retirement plan -- typically contributes 4% to 6% of compensation per year to employee ESOP accounts. With share appreciation, an engineer who started in 1977 and earns $40,000 annually would already have an ESOP account worth roughly $60,000. Employees also get annual dividend checks on their shares, vested or not; and they can vote in shareholder elections after as little as six months of service.

Two years ago the company employed 400 people. Since then it has added 300, a difficult task in a field as competitive as BCM's. Jablonski credits the ESOP. First-rate candidates, he avers, are so much more likely to take a job with stock ownership that the company puts "employee owned" in every advertisement. "It's particularly attractive to engineers coming from closely held firms, in which the prospect of owning stock was so remote," he says.

Brass tacks, please: does stock ownership breed cooperation? Does it make employees more productive?

When ESOPs were new, many observers thought they would solve labor-management problems. Events, alas, quickly overtook hope. In New Jersey, for instance, workers bought out a General Motors roller-bearing plant and set up a new company, Hyatt Clark Industries. But employee ownership never came close to overcoming a legacy of labor-management mistrust, and the company had to file for Chapter 11. Much the same legacy of mistrust undermined Eastern's short-lived experiment in employee ownership. In 1986 CEO Borman demands another 20% wage cut. The machinists union refuses. Borman sells Eastern to union-hater Frank Lorenzo's Texas Air Corp. End of experiment.

In a privately held ESOP company, employees' ownership rights are limited. The stock, typically, is held in a trust controlled by management. Employees don't vote their shares except -- as the law requires -- on such life-and-death matters as sale of the business. (Even then, their vote doesn't mean much unless they control a majority.) Nor do Securities and Exchange Commission rules about disclosure apply. ESOP shareholders don't have to be kept informed about the plans, prospects, and financial situation of their company.

Such provisions are reassuring to entrepreneurs who fear losing control. But they don't exactly make workers feel like owners. "The emmployees couldn't care less about the stock," says David L. Stone, a partner with Touche Ross & Co., describing a contentious company that sold its workers a third of the shares. "They know that 65% of the stock still belongs to guys who treat them like garbage and will continue to treat them like garbage."

The fact is, however, that the hopes for ESOPs weren't entirely misguided. The plans can foster a spirit of cooperation and can have a positive impact of performance. They just don't do it automatically. That's a conclusion bolstered by interviews with CEOs who not only established ESOPs but have gone out tf their way to treat employees like owners. Three methods stand out:

* Information and communication. "If you're not willing to have a committee," says Berrtuch, "you shouldn't have an ESOP." His committee, composed of two people from each department, is the way he disseminates information about the business, including financial figures. The first year after the ESOP was installed, the valuation of the company dropped a little, and Berrtuch knew the committee would hold him accountable. It did. "They called me in and asked me about our strategy and long-range plans," he says. "I talked about what equipment we were buying, how we were addressing the problem." Last year the valuation of D.V.C. Industries rose 18%.

Employees have to be able to understand the information they're given. Another ESOP company, Reflexite Corp., distributes an unusual kind of financial statement to employees: every entry is annotated to explain exactly what it means. Bertuch provides the committee with only the ordinary financial statements. But he has invited the new York State Center for Employee Ownership and Participation into his company to teach employees about business. "The more knowledge people have about how a company works -- how prices are determined, how we make money -- the better off they're going to feel about the company," says Bertuch.

* Money. Bertuch doesn't pay cash dividends; instead he contributes 15% of salary to ESOP accounts plus 4% interest per year in addition to stock appreciation. Other ESOP companies, such as Reflexite and BCM Engineers, boost the ownership message with regular cash dividends. "We pay them in the summertime, right around the Fourth of July," says BCM's Jablonski. "It really makes the ESOP mean something more than just a stock certificate."

* Participation in management. At BCM -- and at other ESOP companies that pass voting rights through to employees -- workers elect the board of directors, just as shareholders do in a public company. But participation need not be limited to elections, nor to the kind of consultation Bertuch has established with his committee. At Clay Equipment Corp., an Iowa manufacturer of farm equipment that installed an ESOP a few years ago, employees meet in groups to discuss ways of increasing sales, cutting costs, and improving products. At Phillips Paper Corp., a San Antonio distributor of packaging to the fast-food industry, employee committees make nearly all decisions relating to working conditions, benefits, equipment purchases, and sales policies.

The CEOs who treat employees as owners swear by their methods -- which is not to say that those methods are appropriate for all. But at least some evidence points to an effect on company performance. A National Center for Employee Ownership study, for example, found that a sample of 45 companies grew faster after establishing an ESOP than they had been growing before, with sales rising fastest in high-participation companies. And a recent report by the U.S. General Accounting Office found a positive relationship between employee participation and corporate productivity, though no relationship between economic performance and ESOPs in general.

Information sharing, generous compensation schemes, participation in management -- is it all a bit much? It was for Phil Grogran of Keyser Garment, who resented the fact that, as he put it, "There are certain individuals who think they own the plant and think they should run it." If you're in Grogan's camp -- if you'd just as soon not rock the managerial boat -- you may not want an ESOP.

But if you believe that a culture of cooperation is exactly what your business needs, you may well want to start with sharing ownership -- and then learn to involve your employees in the operation of the company. The one without the other may give you some tax breaks, but it won't have any positive effect on the way your business works.

So far, so good -- but aren't ESOPs expensive and complicated? And can't they backfire?

Yes, and yes.

First come the consultants, then the lawyers and accountants. A feasibility study alone can cost several thousand dollars. If you decide to proceed with the plan, you'll spend at least $15,000 to set it up. Once it is in operation, moreover, the law requires a complete annual valuation of the company, and someone on your staff will have to spend large amounts of time administering the plan. ESOPs are even more complex than other tax-qualified retirement plans -- themselves no models of simplicity -- because the relevant rules and regulations are still being written.

These administrative costs alone can blunt the attraction of an ESOP. "For small companies, the costs are really just too high," says Elliot Schrier of Manalytics, the San Francisco consulting firm. An ESOP isn't cost effective, experts agree, until the payroll is larger than 15 or 20. Similarly, if all you want is an employee benefit -- and you don't particularly care about the tax and financial advantages -- an ESOP may be overkill. "I could design a stock-option or some other kind of stock plan that would have all the motivational benefits of an ESOP and cost the company less," says Touche Ross's David Stone.

Administrative costs are at least predictable. But there's also a hidden -- and unpredictable -- cost to an ESOP. Consider: in an ESOP transaction like Bertuch's, the cash borrowed from the bank goes to buy out the owner. Employees get stock, not money. Yet the company or the ESOP must offer to buy back every departing employee's stock at current appraised value. So D.V.C. Industries will eventually be liable for cash outlays beyond what it pays the bank.

This repurchase liability, as it's known, operates by a kind of perverse logic. The faster D.V.C. grows, the more the stock will be worth and the more costly the buyouts. If the company runs into trouble the stock will be cheaper -- but there may not be enough money to redeem it. Exactly when the bill will come due, moreover, isn't clear. In a small company, employee departures can't be predicted with precision.

The problem arises whether or not the plan is buying the original owner's shares. A company can contribute new shares to an ESOP, for example, and deduct their full value from its taxable earnings. That's a cash-generating benefit plan -- but the company will need all these tax savings and a good bit more when employees leave. The situation is the same when a company borrows through its ESOP, as BCM Engineers has done. For every loan dollar that's repaid, the company must credit employee accounts with a dollar's worth of stock. That dilutes existing shareholdings and creates new repurchase liabilities. So the transaction makes financial sense only if the loan "buys" enough growth and profitability to cover its eventual costs.

It's possible to make more of the repurchase liability than it merits. The ESOP is, after all, a benefit plan, and benefit plans do cost money. Even so, some of the companies we talked with had gotten themselves into trouble on this score. A Honolulu entrepreneur, whose company has hit hard times, said he'd have to sell assets to buy out his key employees if they chose to leave. The bottom line? "You have this big uncertainty hanging out there," says Corey Rosen, of the National Center for Employee Ownership. "You're trading a present cash-flow benefit for a future liability of uncertain size."

How else can these plans get me in trouble? Seems to me a lot of ESOPs have wound up in court.

The administrative complexities of ESOPs -- and the strict rules governing repurchase -- reflect a fundamental tension in the conception of the plans. ESOPs provide all kinds of tax advantages. But they are benefit plans, not just tax shelters, and they're governed by many of the same restrictive laws that govern other tax-qualified deferred-compensation plans. In legal terms, they're expressly required to operate for the "exclusive benefit" of the participants.

That opens the door to plenty of disputes -- over valuation, for example. Companies have always been required to assess ESOP stock at fair market value. But the objectivity (or competence) of the appraisers has sometimes been in question. The U.S. News case dramatized the potential for, let's say, different interpretations. In 1983, the magazine was appraised at $425 a share; when it was sold the following year, the price was $3,000 a share. Hard times can also cause disputes. When a company goes belly-up, as employees of several defunct airlines and trucking companies have discovered, ESOP assets can vanish into thin air.

Since 1986, the government has required annual valuations by qualified independent appraisers. It also requires that companies with ESOPs offer diversification options (in certain circumstances) to employees 55 and over. The one area it hasn't yet addressed is repurchase liability. The law says you must buy the stock back, but it leaves the planning up to you. And there's no easy way around it. A company can eliminate the liability by going public -- but it may have established the ESOP precisely to keep the business private. Short of an IPO, it can either begin putting aside cash or it can take its chances.

With all these complexities, what's the chance that a company with an ESOP will wind up in court? Many troubles originate in the motivation for establishing the plan. If you're interested primarily in the financial advantages -- and if the benefits to employees are distinctly secondary -- realize you're playing with fire. The law gives disgruntled employees plenty of grounds on which to sue, and it's getting stricter every year. If employees think you're playing fast and loose with them, sue they will.

So what should I do? How should I think about all of this?

The world of ESOPs is filled with irony. An idea born of spread-the-wealth fervor is propagated by lucrative tax shelters. A device that can help relations between labor and management is also one more tool in the Wall Street M&A specialist's kit bag. These facts alone guarantee that ESOPs will keep cropping up in the news.

But don't be misled by what you read. For smaller companies, ESOPs are simply a way of restructuring ownership to provide certain benefits -- analogous, in a sense, to going public. As with going public, there are situations in which an ESOP makes sense, others in which it doesn't. And there are certain constraints to be kept in mind as you figure out which camp you fall into. Three rules of thumb:

* ESOPs are for well-established, profitable companies. Not tiny businesses; not start-ups; not companies in decline. A company has to be able to afford the costs, and it should be able to take full advantage of the tax breaks. Once in a while an ESOP saves a failing company. Often it only postpones the inevitable.

* An ESOP, like a marriage, isn't to be entered into lightly. Yes, you can get liquidity for yourself and financial benefits for your company. But the plans are expensive and cumbersome, and if you don't pay attention to them they can backfire. If you're thinking about establishing an ESOP, talk to a lot of experts and a lot of CEOs who have done it before. There are plenty around.

* An ESOP raises expectations among employees. Like former Senator Long, most people take the notion of ownership seriously. If they're treated like owners, they'll respond accordingly, and your company's performance should benefit. If they aren't, they won't, and you'll end up with employee relations no better than before.

Contrary to some of their partisans' hopes, ESOPs aren't likely to dominate the business landscape anytime soon. But neither are they likely to disappear. In the right circumstances -- as Henri Bertuch and many other CEOs will testify -- they offer benefits that companies and entrepreneurs can't get anywhere else.