My Awakening
In the end, our panel did not choose Goel as the 2006 World Entrepreneur of the Year. That honor went to Bill Lynch of South Africa, who had turned a money-losing car dealership into a $6 billion transport and mobility empire after arriving from Ireland in 1971 with a village school education, few prospects, and 2,000 British pounds. Lynch's business has now been around for more than 30 years. Whether Goel's can last that long remains to be seen. You have to question the staying power of any company operating with a pretax margin of less than 1 percent. But sustainability aside, Goel has already demonstrated that it is possible to improve efficiency and cut costs in just about every area of a business by taking advantage of the technological tools of the new world economy and operating on a truly global scale. I suspect other companies will pick up on the techniques eSys has pioneered, and some will no doubt introduce innovations of their own. The effect will be to put increasing pressure on the margins of companies like mine. Based on what I learned in Monte Carlo, I decided that if SRC Holdings was going to remain competitive, we'd have to improve our efficiencies and cut our costs, and we couldn't limit ourselves to the lines of the income statement covering direct labor, materials, and overhead. We also had to look at the expense lines--including the one for taxes.
There was one possibility that I could see right away, but it involved changing the ownership structure of our company, and especially the role of our Employee Stock Ownership Plan, or ESOP. Under a law passed by Congress in 1997, an ESOP in an S corporation is exempt from federal taxes on the portion of the company's profits attributable to its ownership stake. An S corporation doesn't pay any taxes itself because all of its profits pass through to the owners. If the owners are individuals, they pay income tax on the money they receive. But if 100 percent of the S corporation's stock is owned by an ESOP, no federal taxes are due annually. Instead, members of the ESOP pay federal taxes on the money they receive when they cash out. (The ESOP may still have to pay some state taxes; the laws vary.) So the federal government does get its share in the end, while the company gains a significant competitive advantage. It can use the extra cash from the deferred taxes to price more competitively, to make acquisitions, to start new businesses, to do everything businesses do to create jobs and build wealth. What's more, the wealth winds up in the hands of employees, thereby helping to reduce the gap between haves and have-nots.
Aside from being a great deal for employee-owned companies, the law on ESOPs in S corporations is a means for addressing the danger I saw in Goel's business model. If companies can shop the world to find the lowest taxes, competitive pressure may force a lot of them to do it. That could pose huge problems for countries with higher tax rates, unless they create a mechanism that allows businesses to remain competitive. The ESOP law is such a mechanism.
Then again, there are challenges to running a company owned by an ESOP, not the least of which has to do with creating an ownership culture wherein employees not only have stock but also think and act like owners. Fortunately, SRC Holdings has a strong ownership culture. Our ESOP already owns about a third of the company's stock, with the rest in the hands of individual employee-shareholders. While we are presently organized as a C corporation, we could go subchapter S. The ESOP could then borrow enough money (about $50 million) to buy out the other shareholders and use the tax savings (3 percent of sales, or about $6 million a year) to help pay off the debt. It might take five or six years to complete the transfer, but thereafter we would have that extra $6 million in cash flow to reinvest in the business. That would put us in a very solid position.
But there's always a risk in borrowing a lot of money, and it would be a risk our employees would be taking. They would be the ones who'd be doing the work required to pay off the debt. They would also be the ones who stood to gain the most if they succeeded in paying it off--or lose the most if we got in trouble. We would be doing it mainly to make our culture sustainable and to give the next generation a shot at having the kind of run my generation has had. On the other hand, members of the next generation might do better by taking another route--going public, say, or bringing in private equity. The decision about what to do, I felt, had to be theirs.
So I formed a committee of employees who'd received the Top Gun awards we give each year to people singled out for special recognition by the company's managers. The rule is that the managers have to select employees who've made significant contributions beyond their departments, doing things that have had an impact on the company as a whole. I chose seven Top Guns and asked them to return with a recommendation on how we should handle buying out the stock held by employees, as we would eventually have to do in any case. I made it clear that having the ESOP buy the stock was just one option. Another was to continue doing what we've done in the past--borrowing the money to purchase the stock of employees as they leave. Or we could go public, or do a private equity deal, or sell the business, or liquidate other assets we own. The committee members thought it over and recommended that we become an S corporation and have the ESOP acquire everyone else's stock. When I asked them why, they said that they wanted to keep our culture of ownership, and taking the ESOP route seemed like the best way to do it--maybe even the only way to do it over the long term.
For now, at least, that's the path we're taking. In choosing it, there were obviously considerations other than the prospect of having to compete with the likes of Vikas Goel, but I do have to give him some credit for waking me up. It's a brave new world of business that we're heading into. Thanks to Goel and the other entrepreneurs I met in Monte Carlo, my company will be better prepared to meet the challenges that lie ahead.
Jack Stack, contributing editor and CEO of SRC Holdings, and Bo Burlingham, editor-at-large, are co-authors of A Stake in the Outcome.
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