Why an ESOP?
Several years ago, Employee Stock Ownership Plans (ESOPs) were the underused gems of the Employee Retirement Income Security Act of 1974 (ERISA). Today there are more than 6,500 vibrant companies with ESOPs in place, benefiting over 14 million employees and representing $1.3 trillion in assets. Why did these companies do it? The reasons are varied, but these four advantages weave through each of their stories:
- Incentivize the Employees. Study after study shows that workers belonging to ESOPs tend to identify more strongly with their employers and work harder as a result. Individual performance-related pay-plans do not show the same positive effect. While some individual pay-plans will motivate a few individuals, the positive relationship engendered through an ESOP simply cannot be replicated through individual rewards. Just ask the folks at WinCo Foods.
- Remain in the Community. When a third-party buyer purchases an enterprise, it may be part of an effort to purchase customers and take advantage of those revenues while cutting costs by cutting labor or moving away from a community; however, a sale to an ESOP ensures community continuity. Former owners of ESOP-owned companies are often bedrocks of their communities. When Edwin L. “Dubbs” Roush sold his businesses to separate ESOPs, he was ensuring that Westerville, Ohio, would retain these excellent enterprises – and it still does. Dubbs went on to donate a generous amount of the proceeds to his alma mater – Otterbein University in Westerville. You can visit Roush Hall on Otterbein’s main campus or Roush Hardware and Roush Honda on the corner of State Street and Schrock Road to see the value Dubbs Roush bestowed on his community.
- Retain Independence and Continued Role for Seller. Selling to a third party can mean that you are giving complete control to a buyer with its own ideas on how the company should be run and that will believe it knows better than the prior owners and management. While an ESOP does require management to consider another constituency other than the selling owners and itself, the ESOP-owned company retains its independence as an enterprise, and the former owners often play a key role in the continued success of the enterprise. Absent complete successor management in place at the time of the ESOP transaction, which is rare, the selling owners continue to play a key role in ensuring that the ESOP receives the benefit of the bargain. The selling owner has built a business worth selling and has key institutional knowledge, and, for the benefit of the participants and beneficiaries, any Trustee would want to ensure that it remains with the business it just bought. Professional trustees do not run ESOP-owned businesses; rather, they play an important role in ensuring that proper corporate governance is in place so that those who know how to run the business continue to do so in the best interests of its new shareholder, the ESOP.
- Take Advantage of Tax Breaks. When ERISA was implemented with tax breaks for those who set up ESOPs, Senator Russell Long wasn’t above “using a lump of sugar to get a horse into the barn.” Senator Long wanted every employee to own a piece of the company for which they work, but he didn’t want to force it. So, he made sure that the tax breaks were significant enough to entice owners to sell to an ESOP. For example, a seller of a C corporation can take advantage of a 1042 exchange and defer capital gains tax on the sale of his stock to an ESOP. An S corporation with an ESOP as an owner does not pay tax to the extent of the ESOP’s ownership. If the ESOP owns 100% of the S corporation’s stock, it pays no federal income tax and, in most instances, no state income tax either.
While one of the foregoing reasons to sell to an ESOP may be primary in any particular instance, all of these reasons show the advantage an ESOP sale can have over a third-party transaction. Naturally, if you are the owner of a business and you can get strategic value (highest dollar) – and that is your primary driver – an ESOP is not for you. But fair market value determined by an independent appraiser, coupled with the tax advantages available when you sell to an ESOP, could get you pretty close on an after-tax basis. That being said, the other reasons to sell to an ESOP may just be what guide you to embrace employee ownership.