Esops;

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.