The bugbear of ESOP critics is the fact that employees are also shareholders. Can they be fired? What if the CEO needs to do a layoff or reorganize a department out of existence? The short answer--that he or she has the right to do any such thing, and must redeem only the stock held by departing employees--is true, but it doesn't quite tell the whole story. Successful ESOP companies do treat employees differently, and may indeed find it harder than conventional companies to make "tough employment decisions," as Harvard's William Sahlman puts it. When one ESOP company laid off about 15% of its 150-person work force a few years ago, a worker described it as being like a death in the family.
But there's another dimension that critics overlook, which is that employee-owners can be counted on to go the extra mile to avoid layoffs. Gardener's Supply, a $60 million company based in Burlington, Vt., and partially owned by an ESOP, faced a slow time in 2003. Cindy Turcot, chief operating officer, challenged line employees to reduce expenses. Workers came up with a host of initiatives adding up to $500,000 in savings, a boost to the bottom line that also helped the company avoid layoffs.
Researchers Joseph Blasi and Douglas Kruse of Rutgers University have compared ESOP companies with non-ESOP counterparts in several studies of their own and have reviewed other researchers' work in detail. Their conclusions: ESOPs are indeed associated with greater stability of employment, as the critics might suggest. However, ESOPs are also typically associated with higher productivity, faster job growth, and higher survival rates among companies.
Ultimately, if the outgoing owner is serious about wanting to leave a strong, independent business, he or she has to prepare managers and workers to take over, and then gradually let go of the reins. To do this, CPES's Schramski introduced open-book management prior to leaving the company. He taught line employees, many of whom were social workers, to read financial statements and track their units' spending. He also started asking employees to participate in setting goals, by having them rank their top priorities for improving the workplace every year. He then made a point of delivering on the top vote-getters, such as buying new vehicles and absorbing continuing increases in health insurance premiums.
So CPES was in good hands when Schramski left two years ago. Then, earlier this fall, something unexpected happened: The board of trustees of the ESOP, which was made up of employee representatives, went to the management team with a plan to "freeze" the ESOP. All current staffers would still hold on to the shares they had already, and they would remain on the same vesting schedule as before. But new employees would not be granted shares, and existing employees would receive additional shares only as retirees cashed out of the ESOP and their shares were redistributed.
Why did the board opt for a freeze? "It was a rather sad situation for me," says Sally Lee, one of the trustees, and a seven-year employee of CPES. "But we provide social services on contract to state agencies, and we don't see our profit margins increasing very much. As the liability of the ESOP grew, we were concerned about how to meet that."
CPES's dilemma gets to one of the starker realities. Companies must be pretty sure that cash flow will remain high enough to cover both the front end and the back end of ESOP leverage (see "Facing the Debt Dilemma," at left). Those cash drains are one reason an ESOP company might suffer from lack of flexibility--Sahlman's fear--and why the CFO of a cash-starved company might curse the day it went ESOP.
As for CPES, Davis says that most if not all of the workers understand the decision to freeze the ESOP. And, as she points out, there were two reasons for freezing the ESOP, rather than simply terminating it. First, the company didn't have to come up with a lump sum of money to pay out every shareholder. And second, "anything can happen," Davis says. If margins improve, "we can unfreeze the ESOP at any time."
Zach Zachowski and Barbara Gabel are today roughly where Schramski was in 1996. The husband and wife team are founders of Zachary's Chicago Pizza, a two-restaurant, 110-employee purveyor of gourmet pizza in the San Francisco Bay area. They have run the business for 22 years and intend to maintain control for a while--but they recently sold 35% of the shares to an ESOP and plan to sell another big chunk in the near future. Their goal: "exiting this thing gracefully in a way that we could leave a legacy behind us," says Zachowski.
So far, they seem to be doing things right. They meet regularly with employees to explain the concept and have begun to see signs of understanding. They're working hard on succession plans, even going so far as to begin the groundwork for opening a third restaurant while they're still around. Opening up a new restaurant will be like "training wheels," says Gabel, to give the company's managers and employees experience with starting a new operation from scratch.
The couple themselves never wanted to grow beyond two restaurants, partly for fear that the demands of the business would overwhelm their relaxed lifestyle. But some of their key managers had been urging expansion for a long time, and now they'll get their chance. Like Schramski, Zachowski and Gabel were less concerned with getting top dollar for their business than with giving their managers and employees this shot at an equity stake. "They're smart and energetic and they want to see the company grow," says Zachowski.
Gabel likens an entrepreneurial exit strategy to a dismount after a horseback ride. You want to do it right, she says--otherwise "you've ruined the whole ride." For her and for her husband, giving managers and employees the opportunity to own the business is a way of thanking them, as well as a perfect fit with the couple's aspirations. "It's a reward for them," says Gabel. "But it's also very much a sign of success for us."
