Ready to Move On? Consider Selling to Employees

Employee Stock Ownership Plans offer advantages for company owners, workers, and managers.

AGM Container Controls is a small, Tucson designer and manufacturer of a range of components and finished products. Roger and Joyce Stewart founded the company in 1970, and it became 40% employee-owned in 1988, as part of the founders’ long-term exit strategy. They were both in their late 50s when they set up an “Employee Stock Ownership Plan” (ESOP) to begin transition of ownership to employees. They wanted to plan for their own retirement security, and they wanted to ensure the continued viability of the business after they retired.

Howard Stewart, the youngest of the couple’s three children and their only son, rejoined the business in 1989, after finishing some other entrepreneurial ventures, and was named the company’s president in 2000, having gained the experience of various positions throughout the company.

“Having an ESOP has provided AGM with a flexible vehicle for my parents to pass on the business to our employees, while simultaneously providing a platform upon which we could stage the business’ future growth,” explained Howard, who was a recipient of the Tucson Chamber of Commerce’s Small Business Leader of the Year Award (2002), and was at the company’s president in 2009 when it was recognized by the U.S. Chamber of Commerce as “America’s Small Business of the Year.”

AGM manufactures a number of different products, including environmental control hardware for containers, as well as Ascension wheelchair lifts. It has done very well in recent years, despite the difficult economic times. An important factor in the family-run manufacturer’s success seems to be conscientious investment in employee development and engagement, which has resulted in higher-than-average retention rates, and a cross-trained management team that has grown along with the company.

Despite the lagging economy, and Arizona’s stagnant unemployment rate, AGM has quadrupled its sales over the past 16 years. Notably, the company has not laid-off a single employee for the past 20 years. In addition, its order backlog soared to record highs as late as the fourth quarter of this year.

AGM is not unique, nor even unusual, in its owners’ choice of an exit strategy or its success with an ESOP. The National Center for Employee Ownership estimates that there are over 11,000 companies with Employee Stock Ownership Plans. Although almost unknown until 1974, the ESOP arrangement now covers over 13 million U.S. workers.

As baby boomers reach retirement age, there will be at least two to three times as many closely held companies for sale in the next decade as there have been in the past one. What are the prospects for owners successfully transitioning out of their businesses and enjoying retirement? Current trends are not encouraging; with studies showing that just 30% of business owners have a business succession plan. Without an exit strategy, experience shows that many businesses will be liquidated or shut down, needlessly.

While some business can be sold to other companies, passed on to family members, or sold to managers, few owners realize that ESOP —a type of qualified employee benefit plan, and by far the most tax-favored method of ownership transition — is an option for them.

ESOPs are funded by a company’s profits, not by their employees’ own money. To start one, the business sets up a trust to hold company stock. The company funds the stock purchase out of tax-deductible pretax earnings, either by putting in cash year after year to buy shares; or, more commonly, by the trust borrowing money to buy a larger chunk of the company all at once, and then, the company making tax-deductible contributions to the plan to pay off the loan. No other company loan allows the deductibility of both principal and interest.

Benefits to owners/sellers
A chief attraction of ESOPs is their flexibility. ESOPs can be used to buy all or part of a business. An ESOP allows owners to sell their business all at once, or gradually in installments. In addition, owners have the option to define their role in the company moving forward, either by continuing in an executive role or by relinquishing all managerial duties. Also, if there is more than one owner, an ESOP allows just one owner to sell while allowing others to stay on for the time being. The ESOP pays owners a price established by an independent appraiser. If purchases are made over time, that price is determined at least annually.

Moreover, many owners can defer the gain they make on the sale by reinvesting in other companies. Ongoing ESOPs have additional tax benefits, and Sub-S, 100% employee-owned ESOP companies do not have to pay any federal or state income tax at all. Because employees become beneficial owners of the company, not surprisingly, ESOP companies tend to outperform other companies, and this extra profit helps pay for the sale.

Benefits to employees
Employees become the company owners and, the research shows, as owners they help their companies to generate 2.5% more jobs per year than would have been generated without an ESOP. Employees in ESOP-owned companies have two to three times more retirement assets than employees in non-ESOP companies. In addition, for employees, selling the company to an ESOP often protects jobs and may create a better work environment.

Benefits to the company
As noted, only ESOPs can use pre-tax dollars to buy out an owner. An ESOP is the only way a company can use pretax earnings to buy its own shares. Once a company has an ESOP, it can also make tax-deductible contributions to the plan to facilitate acquisitions of new capital or other companies. Even better, if the company is (or becomes) an S corporation, the percentage of profits attributable to the ESOP is non-taxable. S corporations do not pay taxes—they pass the obligation on to the owners pro rata to their share of ownership. But, ESOPs do not have to pay these taxes, so if a company is 30% ESOP-owned, 30% of its profits are not taxable. If it is 100% ESOP-owned (and now about 40% of ESOPs are or will be fully owned), it is not taxable at all at the federal level. That means these companies can spend more to finance growth.

Companies that are employee-owned often use this as a marketing feature, pointing out that their employee-owners will be especially customer-focused.

Research on ESOP companies shows that employee ownership can improve business performance. A 1998 study by Rutgers University that looked at corporate performance, pre- and post-ESOP, found that after the ESOP was in place, companies had on average 2.4% higher annual sales, a 2.3% higher annual growth rate, and a 4.5% increase in productivity.

Is an ESOP right for your company?
As effective as the ESOP approach may be for many business owners, most of them don’t know what an ESOP is, or they misunderstand the idea. Business brokers do not generally talk to owners about ESOPs (even if they know how ESOPs work) because brokers do not earn commissions on sales to an ESOP. Accountants and other financial advisors may have heard about ESOPs, but few of them are well informed about the plans, and they often mistakenly believe that only large companies can be owned by ESOPs.

Despite all the benefits, ESOPs are not for every business. The costs, and some of the rules, make them impractical for companies with fewer than 10-15 employees, and ESOPs are difficult to fund if a business is not profitable.

Before creating a plan, owners need to be informed about their options and find advisors with substantial, specific expertise in the field. The National Center for Employee Ownership, a private, nonprofit membership-based information organization, can help companies and their owners understand the options for starting a succession plan.

June Sekera is the project director at the National Center for Employee Ownership, and Corey Rosen is the he founder of that group — a non-profit organization that provides information on employee ownership for the benefit of business owners and employees. For more information on succession planning, selling to employees, and ESOPs, visit www.nceo.org/succession, or contact Rosen at 510-208-1314, or [email protected].

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