BUYING A SMALL BUSINESS

ESOP Facts

Answers to the questions that business owners frequently ask.
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Is this some kind of weird or untested idea?

Is this some kind of weird or untested idea? Nope. After decades of skepticism, there are enough successful ESOP companies (and 10,000 ESOPs in total) that the idea has been refined. Many professional service firms specialize in working with ESOPs. There's ample proof of concept.

What's with the tax breaks and the capital gains deferral?

The tax provisions of an ESOP can be a source of tremendous benefits to a retiring owner. The so-called Section 1042 rollover, for instance, allows C corps to defer all capital gains taxes so long as they sell at least 30% of the company's shares to an ESOP. To qualify for tax deferral, you must buy other U.S. operating companies' securities with the proceeds. But if you then leave those securities to your heirs, their cost basis for tax purposes will be "stepped up" as of the date of your death, and your capital gains liability simply evaporates.

How can employees afford to buy the business?

Quick answer: Just as in a leveraged buyout, they borrow against future earnings. A new legal entity called an employee stock ownership trust usually borrows the money, and the company provides the trust with the funds to pay back the loan. As the loan is paid off, shares of stock are allocated (often in proportion to salary) to each employee's account.

Will I have to give up control--and will I have to disclose salaries?

From a management point of view, an ESOP company runs just like any other: The CEO is in charge and can share or not share any financial information he or she chooses. Typically the board appoints the ESOP trustee, which means that directors effectively control the votes represented by ESOP shares. "An ESOP is great for the entrepreneur who finds it psychologically difficult to disinvest in the company," says Mary Josephs, a senior vice president with LaSalle Bank's ESOP Financial Services Group in Chicago.

How is the price set?

An independent valuation expert sets the price at which the ESOP will buy out an owner. This is the moment of truth: Tom Schramski of CPES, for example, figured he was probably leaving $1 million on the table by selling to an ESOP rather than a strategic buyer (see main story). But other companies find that the "going concern" valuation prepared for an ESOP buyout is more than any other buyer is willing to pay. Of course, the price can change over time with each block of stock the owner sells.

What's in it for the employees?

A company with an ESOP is a little like a 1990s tech business with stock options: If it succeeds, everybody prospers. The dollar figures may not match those racked up by Microsoft millionaires, but they aren't chump change either. "Normal employees that've been with us 20 years, they're probably going to have three-quarters of a million dollars" in their ESOP accounts, says CFO Tim Jonas of McKay Nursery Co. Unlike with a typical 401(k), he adds, "they didn't put a nickel into it." Numbers like these--not uncommon at established ESOP companies--do wonders for recruitment and retention, and mitigate conventional labor-management tension.

The tax advantage

Federal tax law says that S corps can have an ESOP, and that no income tax is due on the portion of stock owned by the ESOP. So if the ESOP owns all the stock, then the company pays zero federal income tax. Talk about a great deal: "We're in a position where we can use that tax savings to start taking bigger risks," says Cheryl Volkman, co-founder of AbleNet, based in Roseville, Minn., a 100% S corp ESOP with $8 million in sales. "We can even consider an acquisition."

Facing the debt dilemma

Typically, an ESOP borrows money from a bank to buy the owner's shares, then allocates the shares to individual employees' retirement accounts as the loan is paid off. The ESOP has to pay principal and interest on the loan--both tax-deductible--out of the company's cash flow. The effect? Suddenly a business that has been cruising along with a nice conservative debt-to-equity ratio may have a couple million dollars or more in nonproductive debt, just as it would if it had been purchased in a leveraged buyout. Leaders of ESOP companies must "guide a company with lots of leverage in a highly regulated environment," says Tony Mathews, an ESOP specialist with Principal Financial Group based in Glendale, Calif.

That's the front end; there's a back end as well. Employees own their stock, but they can't cash it in until they leave the company (and even then they must be vested). When they do leave, the company must buy the shares at the current valuation. This repurchase obligation "is the Achilles' heel of the ESOP world," says J. Michael Keeling, of the ESOP Association, a trade group based in Washington, D.C. The more successful the company, the more each employee's shares increase in value--and the more cash the business must cough up to buy them back. One common device: rules mandating that workers with more than a few bucks' worth of stock be paid off over five years or more.

Is an ESOP right for you?

ESOPs are cumbersome beasts. Because they're technically tax-qualified retirement plans, they are governed by a thick stack of regulations. Just to set one up can run you $40,000 to $80,000 on consulting, accounting, legal advice, and an independent stock valuation (which is required). What's more, the ESOP probably has to borrow money to buy your shares, and it will be relying on profits to pay off the loan. So if your business is tiny (less than $1 million in revenue), unprofitable, or just barely scraping by, it is not (yet) a candidate for sale to an ESOP. Another matter to consider carefully: Are you willing to treat employees like owners?

What about United Airlines?

Companies with ESOPs sometimes fail, and United Airlines' parent UAL--majority-owned by an ESOP until it entered bankruptcy--was certainly the biggest and most visible collapse in recent years. No real surprise: "Changing the ownership isn't going to solve a company's fundamental problems," says Tony Mathews, of the Principal Financial Group. But blaming employee ownership for the failure makes about as much sense as blaming investor ownership for the bankruptcy of US Airways and other insolvent airlines. Says Mathews: "The failure lay in the implementation, not the idea."

Last updated: Dec 1, 2005




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