When Employees Own the Shop
Written by Dianne Molvig Thursday, November 11 2010
Sandra Green knew at the outset that she wanted her business startup to be a special kind of company. “From the beginning, I had it in my head that the employees who worked in the company should be the owners,” says Green, CEO of n-Link Corp., a Bend, Ore.-based information technology and engineering services business launched in 1995.
Green wanted employees to own 95 percent of the company, and she’d own the remainder. “I thought that if employees owned the business,” she says, “they’d think like owners, act like owners, and have more at stake in the outcomes. They’d be more creative and feel more committed and loyal to the corporation.”
Thus, Green reasoned, employee ownership would translate into greater success and faster growth for n-Link, which would benefit everyone, including Green. “I figured if I ended up owning 5 percent of, say, a billion-dollar corporation [or $50 million], that’s a lot more than 100 percent of a $5 million corporation,” she says.
To create the type of company she envisioned, Green set up an employee stock ownership plan, or ESOP. An ESOP is a type of employee retirement benefit plan, similar in many respects to a 401(k) plan. The employer makes tax-deductible contributions to the ESOP, and then the ESOP uses those funds to purchase company shares from the employer.
“An ESOP is funded by the employer, not the employees,” explains Corey Rosen, executive director of the National Center for Employee Ownership, Oakland, Calif. “That’s something people have a hard time getting their heads around. I’ll go through a long explanation about how ESOPs work, and at the end people ask, ‘But when do employees actually buy the stock?’ Well, they don’t. The ESOP buys the stock.”
Currently there are about 11,500 ESOP companies in the United States, covering 10 percent of the private-sector work force, according to The ESOP Association, Washington, D.C.
To set up an ESOP, a company must be either a C corporation or an S corporation, or convert to either. In a C ESOP, the owner can defer capital gains on the proceeds from selling stock by reinvesting that money in other securities. This tax advantage kicks in only after the ESOP owns at least 30 percent of the company.
An S corporation offers a unique tax advantage because an S ESOP is considered to be a tax-exempt shareholder of the company. That means cash that otherwise would go to pay taxes can be used instead to fund the ESOP’s stock purchase. Or, if the S corporation is 100 percent ESOP-owned, that cash can stay in the company to fund growth.
Although Green’s original plan for her business was to be 95-percent employee owned, she decided, for various reasons, to become a 100-percent ESOP, effective last December. As an S corporation ESOP that’s totally employee-owned, “We’re now 100 percent tax-exempt,” Green says. “If we make $2 million in profit, that $2 million stays in the company.”
Tax advantages are just one driver behind ESOPs. Emotional issues also enter in, Rosen says. While Green established an ESOP soon after starting her company, it’s more common for business owners to create an ESOP as an exit strategy, especially if they have no family member to take over the business.
“People work hard to build their business, their reputation, and their relationship with the community,” Rosen explains. “So when they’re ready to retire, they don’t want to sell to someone who may not care about any of that. They also have valuable employees who could lose their jobs or see pay cuts under a new owner.”
Green’s primary motive in creating an ESOP wasn’t to devise an exit strategy. Still, she knows that when she does decide to leave some years down the road, the company will be in good hands. “As much as possible,” she says, “the employee/owners will keep the company close to whole with the same corporate culture.”
To be a viable ESOP candidate, Rosen says a business needs to have strong management succession, as well as good profitability and ample cash flow to be able to cover the costs of creating and maintaining an ESOP. “I’d say you need to be at least $1 million to $2 million in annual sales,” Rosen suggests.
He says typically it costs at least $40,000 to set up a plan plus $12,000 or more per year to maintain it, depending on how many employees a company has. But, Rosen notes, business owners must weigh that against the significant cost of someday selling a non-ESOP company to an outside buyer. In the latter scenario, a seller must pay lawyer and accountant fees, plus a broker’s commission of at least 5 percent of the sales price. And some aspects of the deal may not be to one’s liking.
“You have to look under the covers of the bid,” Rosen advises. “Maybe the financing is uncertain or there are contingencies you’re not happy with, such as you have to leave the company, or you have to stay.”
Green won’t have to worry about any of that when she eventually walks away from her company. Even though n-Link is now 100 percent ESOP-owned, Green wants to stay involved for at least another 10 years. The business she started 15 years ago has grown to be a 150-employee company with $17 million in annual sales. “The ESOP has worked out well,” she says.
The biggest challenge has been to make sure employees fully comprehend what an ESOP is and what it does for them. “That takes a while,” Green says, “because at first employees think it’s some feel-good concept.”
The reality sinks in when they see their retirement accounts growing and when they attend conferences to learn more about ESOPs and what other ESOP companies are doing. “Then it starts to dawn on them,” Green says, “that we do have something special here.”
Dianne Molvig is a Madison, Wis.-based freelance writer who writes regularly about business management, financial services, law practice, consumer education, and other topics.
