Much is said about the benefits of employee stock ownership plans, known as ESOPs: They're a good option for helping business owners tap into the value of their companies without engaging in the public markets. They have been shown to boost employee morale and to improve profits. But less is said about the potential downsides--and the downright crippling affects an ESOP gone awry can have on a company's bottom line. Perhaps no one knows this better than Chris North, the CEO of Shutterfly.

Shutterfly is itself not an ESOP. It's a sturdy 20-year-old public company based in Redwood City, California. In 2018 the digital photos powerhouse acquired the sprawling school-photos provider Lifetouch Photography, which was at the time 100 percent owned by employees and was starting to crater, in part, under the weight of paying out its many retirees' for their owned stock. So, Lifetouch's trustees, who represent employee shareholders, had a difficult decision to make, and one that would almost certainly end its beloved ESOP. It put the company up for auction.

Shutterfly's growth had long been fueled by acquisitions, and CEO North had already eyed up to 100 other companies when he heard Lifetouch was up for sale. He swooped in.

The pressure of slowing growth.

At the time of the acquisition, about half of all U.S. schoolchildren had their photographs taken by Lifetouch photographers--a massive network of some 12,000 shutterbugs--for class picture day. It had also become the largest American photographer of infants and toddlers with more than $950 million in revenue. Everything looked sunny for the Eden Prairie, Minnesota-based business--from the outside.

On the inside, a different picture had emerged. Not unlike Shutterfly, which had been one of the few success stories to survive the dot-com boom and bust, Lifetouch had fueled most of its company's growth through acquisition. But despite the massive revenues for the fiscal year ending in June 2017, Lifetouch actually had an operating loss of $3.9 million--in part, because of a roughly $100 million ESOP contribution. It had become the state's largest ESOP, and that meant paying out funds to former employees rather than pumping them back into growth. With 16,000 current and former employee owners, the payouts were sapping its ability to invest in the future.

The 82-year-old company, suffering also from waning consumer interest in print photography, had to act or face possible annihilation. "Growth had slowed. We had to make investments. That put pressure on us," Michael Meek, Lifetouch's chief executive, told the Star Tribune in 2018. "To accelerate growth we needed to consider a new structure." That's when Lifetouch's board of trustees approved putting the company up for auction--knowing it would likely mean the dissolution of their ESOP. Shutterfly, the winning bidder for Lifetouch, declined to make Meek, now a Shutterfly employee, available for this article.

To Shutterfly, it was a big opportunity, in no small part because Lifetouch had 10 million customers. There was also potential to take all of those school-photo packages--strangely still paid for by cash or check, and available in print only--and upload them to the cloud, giving parents a wider range of options. Parents could have the ability to reorder, or store the photos for a lifetime, and be introduced to Shutterfly's other products. "[Lifetouch] had the right vision, but they didn't have the resources to execute on that vision," North said. 

Shutterfly paid approximately $825 million, a price determined by an independent business evaluator, Meek told the Star Tribune. Under the deal, Shutterfly bought out the ESOP entirely. The company's many, many owners were bought out of the ESOP, and some were able to convert their ownership to other types of qualified retirement plans, such as an IRA or a 401(k). 

Whether or not employees were ultimately happy about the switch isn't clear. Some, however, did express concern about the state of the company ahead of the acquisition on careers website Glassdoor. A number of anonymous reviews hinted at tumult in staffing and an atmosphere far different from the former "family" feeling of the company during its heyday. "They cut out the heart of the business," one wrote.

Inside an unusual ESOP.

The dissolution of an ESOP is rare. Some 23,000 companies have adopted ESOPs since they became legal in 1974, and currently there are about 6,700, according to Cory Rosen, founder of the National Center for Employee Ownership in Oakland, California. A study of 6,000 ESOP companies conducted by the Institute for the Study of Employee Ownership and Profit Sharing at the Rutgers School of Management and Labor Relations showed that an average U.S. worker from an ESOP company had accumulated $134,000 due to his or her stake in the company. Other studies have shown that employee-owners have better job stability than those at traditional firms, and employee-owners have more confidence in their financial futures. ESOP companies tend to simply grow faster.

But Lifetouch wasn't a typical ESOP. After Eldon Rothgeb and Bruce Reinecker founded the company in 1936 to bring portrait photography to one-room schoolhouses around Minnesota, it grew steadily for decades. Then in the early 1970s, as the only surviving founder, Reinecker began considering his own retirement, the IRS added a new form of retirement to the federal tax code. It was dubbed an "employee stock ownership plan." By 1978, Reinecker reset the company, transferring 100 percent of it to employee ownership, in what would be one of the country's largest ESOPs. He set it up more like a trust, and it gave employees ownership of the company and transferred that ownership to individuals without requiring contributions. It was basically a free retirement account.

These days, most ESOPs involve employee ownership of 10 to 40 percent of a company. Studies showing improved growth under employee-ownership generally look at just the first few years of a company's life as an ESOP; there simply aren't many examples of ESOPs as old and large as Lifetouch's. While roughly half of ESOPs are at least 20 years old, Lifetouch was around for more than 40 years, and the largest in Minnesota.

Rosen says few other ESOPs have survived more than 40 years, and although 30 or 40 employee-owned companies are sold every year, most of those are "at a huge premium." He says: "Some smaller number are sold because their business model was such that they're better off selling. Like Lifetouch. They just see the writing on the wall."

Despite the unusual circumstances of its union, Shutterfly's North is pleased with how it all went down. So much so that this past fall, nine months into the integration of Lifetouch and Shutterfly, North went on something of a victory tour. Armed with the modern technology for digitizing everything Lifetouch does, he had in his mind the millions of new customers the integration will bring Shutterfly.

In November, he flew from Silicon Valley to New York, to ring the bell of the NASDAQ Stock Exchange, in part to celebrate Lifetouch's new future as part of a public company.

Published on: Jan 31, 2019