The Ultimate Employee Buy-in
Sell the company to your employees? It's a great idea--both for you and for the business you're leaving behind.
One of the great ironies of entrepreneurship is that many people spend years building their companies, only to undo all of that work at the very end by deciding to sell the business to the wrong person. Decisions like that don't have to be made, especially today. Employee stock ownership plans, or ESOPs, have become a mainstream alternative for business owners who wish to sell their business but want it to remain largely intact.
As recently as 10 years ago, employee ownership was considered a maverick strategy; it isn't anymore. ESOPs have now been around for more than three decades, and the legislation affecting them has remained largely unchanged. About 10,000 U.S. companies, most of them closely held, have ESOPs. A number of banks, lawyers, accountants, and consultants specialize in ESOP transactions. Today, when you say the words "exit strategy" to one of these advisers, you're almost guaranteed to hear "ESOP" among the choices he or she ticks off in response.
But if you're like a lot of entrepreneurs, your first reaction may be, "Huh?" Maybe that's your second and third reaction, too. For despite the fact that ESOPs offer some compelling benefits, only a couple thousand company owners a year sell to an ESOP. If you're not among them when the time comes, it should be for a better reason than ignorance or prejudice.
So let's begin by considering the advantages. You can start selling shares in your company to the ESOP whenever you want. You can sell any percentage of shares you choose (including 100%), thereby taking out as much cash as you like. If you sell at least 30%, you can defer capital gains taxes, in some cases indefinitely (for details, see "The Tax Advantage").
Regardless of how much you sell, moreover--even if you sell a majority interest--you can run the business pretty much the way you think it should be run for as long as you want. Or else you can decide to leave right away. When you do retire, the company continues its existence--prospering, one hopes--as an independent entity. Your loyal employees keep their jobs. The name you gave your baby is still on the door.
Yes, there are drawbacks and uncertainties. An ESOP is like a leveraged buyout. An employee trust borrows against the company's future earnings to buy the business. As the debt is repaid, shares are distributed. Thus, very small companies and unprofitable companies aren't good candidates (see "Is an ESOP Right for You?").
And even if your company fits the bill on other grounds, you still may wonder how a company owned by its employees can run smoothly in today's cutthroat marketplace. Some knowledgeable folks share these concerns. "I worry about the inflexibility of ESOPs," says William Sahlman, a professor at Harvard Business School. "Very few businesses run smoothly and in a positive direction. ESOPs make it hard to make tough employment and financing decisions."
Point taken. Yet plenty of experts argue just the opposite--that an ESOP actually helps a business succeed--and that company owners would be crazy not to consider one. So it's really a matter of sorting out the upsides and the downsides, then making a judgment about what's important to you.
That, more or less, is what Tom Schramski did. A dark-haired, round-faced 53-year-old, Schramski is a psychologist turned businessman who lives in Tucson. The son of a Minnesota gas station owner, he fled as a young man to the sunny Southwest after "one too many subzero mornings" manning his father's pumps. There, he earned his college degree and a doctorate in psychology, figuring he would set up a practice.
But the entrepreneurial itch was strong, and in 1980 he learned that the state of Arizona was beginning to contract out the care of people with developmental disabilities and mental illness, a clientele Schramski knew something about. So he and a partner started a company to provide services to these folks. The partner stayed for only four years, but the company carried on after he left. Over the next 15 years, Community Psychology & Education Services, as the business was then known, grew into a healthy operation with $5.5 million in annual revenue.
By the mid-1990s, though, Schramski was in his early 40s; he was ready to begin thinking about liquidity and an eventual exit strategy. He talked to a couple of potential strategic buyers of CPES. They were interested, even eager. He realized he could walk away with a multimillion-dollar check.
But something didn't sit right, and he found himself lying awake at night. Those buyers, he knew, would consolidate facilities. They would slap their own company's name on the office door, if they even kept the office open. Undoubtedly, they would lay off many of CPES's employees. "My perspective on it was, how would I feel about it when I was 80 years old and looking back?" he says now. "I had employees who had been with me 10 years or more. I couldn't have looked them in the face."
So Schramski began casting about for an alternative, and in the process discovered ESOPs. After considerable research, he decided an ESOP was for him, and in 1995 he began selling the business to his employees in stages. By 1998 he had sold all his shares. In 2004 he gave up CEO duties completely.
Was it the right choice? On the one hand, Schramski paid a considerable price for his decision. As required by law, CPES's valuation for the ESOP sale was determined by an independent appraiser, who put it at $2.5 million. Schramski believes he could have sold the company to a strategic buyer for $3.5 million--though, of course, he wouldn't have received those aforementioned tax breaks, which were worth between $200,000 and $300,000.
On the other hand, his employees kept their jobs, and CPES--now known as Community Provider of Enrichment Services--has done better than ever. The company grew from $5 million in revenue in 1995 to $25 million in 2004; the payroll has swelled from 250 to 775. Families of clients, often mistrustful of for-profit companies in the field, liked the idea of employee ownership. Line employees learned to control key budget items such as vehicle expenses and maintenance costs, thereby boosting the bottom line. Managers who might have left the company, including one who got an offer doubling her salary, stayed with CPES to realize the rewards of equity. "We couldn't have grown like that without the ESOP," says Schramski. Employees help explain why. "The ESOP was really huge for me in terms of my investment in the company--my loyalty and longevity," says Cindy Gallon, an associate director at CPES. "Huge."
