An employee stock ownership plan is an option that more pet business owners should consider as an employee benefit, or as an alternative to selling to outsiders.
photo courtesy of Mud Bay
Mud Bay, a 33-unit pet food retailer based in Tumwater, Wash., is a company that has always seen its employees as partners. So it made sense that last year it made that formal by making them owners through an employee stock ownership plan (ESOP), a company-funded benefit plan that will, over time, transfer an increasing share of the company to the employees who are helping build it.
ESOPs are common in a number of retail sectors. There are dozens of supermarkets and convenience store chains that offer such plans, some small and some with thousands of employees. ESOPs are much less common in the pet industry, though. While a comprehensive list is not available, the only companies we could identify as having ESOPs are pet food manufacturer Life’s Abundance and retailers Mud Bay, Chuck & Don’s and Mounds Pet Food Warehouse. All are relatively recent transactions. Given the success of ESOPs in other industries, the pet industry should be taking a look at well.
There are about 7,000 ESOPs in the U.S., with over 13 million participants. Research on these companies show that they grow about 2.5 percent per year faster than would have been expected absent an ESOP. They also provide about 2.5 times the retirement assets to employees, default on their loans to buy stock at just two per thousand per year, and lay people off at one-third to one-fifth the rate of other companies. They do this mostly because they combine the motivation of ownership with organizational systems, like those at Mud Bay, that find ways to engage employee owners in generating ideas about how to make the company better.
So is an ESOP right for your business?
How ESOPs Work
Most ESOPs are set up to provide a transition for owners of closely held companies, although some, like at Mud Bay, are used more as an employee benefit meant to share rewards and engage employees.
One of the most difficult problems for owners of closely held businesses is finding a way to turn their equity in a business into cash for retirement or other purposes. The decision is often as much about legacy as money. For some owners, the answer will be to find another buyer (if an acceptable one can be found), but others would much prefer to see the company continue on its own and the people who helped build it own it. ESOPs provide a tax-effective way to make that transition possible.
An ESOP is a kind of employee benefit plan, similar in many ways to qualified retirement plans and governed by the same law (the Employee Retirement Income Security Act) with many of the same rules as 401(k) and profit sharing plans. ESOPs are funded by the employer, not the employees. Stock is held in a trust for employees with at least 1,000 hours of work in a year and allocated to employees based on relative pay or a more level formula. It is then distributed after the employee terminates. ESOPs cannot be used to share ownership just with select employees, nor can allocations be made on a discretionary basis.
The simplest way to use an ESOP to transfer ownership is to have the company make tax-deductible cash contributions to an ESOP trust. The trust then uses these contributions to gradually purchase the owner’s shares. Alternatively, the owner can have the ESOP borrow funds—from a bank, through a seller note or both—to buy the shares. In this way, larger amounts of stock can be purchased all at once, up to 100 percent of the equity. Normally, the bank will loan to the company, which then re-loans to the ESOP. Many ESOP sales are done in two or three transactions over time, but more and more are for 100 percent up front.
If the company is a C corporation and the owner has held the shares for at least three years, once the ESOP owns 30 percent of the company’s shares, the owner can reinvest the gains in the securities of other U.S. companies and pay no tax until the replacement securities are sold. Any investments held to death would not be subject to any capital gains. If some of the securities are sold, tax is due only on a prorated basis.
The price the ESOP pays is based on an independent, third-party appraisal. The trustee of the ESOP, appointed by the board, hires the appraiser. The trustee is considered the shareholder and votes the shares (including for board elections), unless the company passes through votes to employees (there are a few required pass through issues, but they rarely come up). About 45 percent of ESOP companies hire outside trustees to manage the plan; the rest use insiders—usually an officer or officers not selling their shares. Some business owners have been told that an ESOP will mean a big change in corporate governance. In practice, ESOPs virtually never result in changes unless the company’s management and board want it to.
If a company is an S corporation, the tax deferral is not available, but to the extent the ESOP is an owner, that percentage of profits is not taxable. A 30 percent ESOP pays no tax on 30 percent of its income; a 100 percent ESOP pays none (which explains why so many ESOPs now are 100 percent ESOP owned).
Selling to an ESOP vs. Selling to an Outsider
Compare the ESOP buyout to two other common methods of selling an owner’s shares—redemption or sale to another firm. Under a redemption, the company gradually repurchases the shares of an owner. Corporate funds used to do this are not deductible. A $3-million purchase in a redemption might require over $5 million in profits to fund once taxes are paid. Moreover, the owner must pay capital gains or dividend tax on the gain. In a sale to a C corporation ESOP, the money made is considered a capital gain, not ordinary income, and taxes can be deferred. Even more important, the company only needs $3 million to fund the $3 million purchase—something that also applies to sales to ESOPs in S corporations.
Alternatively, a company might be sold to an outsider. In a cash sale, taxes would be due immediately. If the sale is for an exchange of stock in the acquiring company, taxes can be deferred until the new stock is sold, but the owner ends up with an undiversified investment for retirement. The buyer may want part of the price to be an earn-out, or may want to move the company and/or reduce staff, and usually will not see any continuing role for the owner.
Making the Decision
All of this may sound appealing, but it is not feasible for every company. Several factors must, at a minimum, be present:
1. The company is making enough money to buy out an owner. The company must be generating enough cash to buy the shares, conduct its normal business and make necessary reinvestments.
2. The company is big enough. To cover the significant initial costs of setting up a plan, a company generally needs at least 20 employees.
3. If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan. Similarly, the company must not have bonding covenants or other agreements that prohibit it from taking on additional debt.
4. If the seller wants to take the tax-deferred rollover, the company must be a regular C corporation or convert from S to C status. S corporations can establish ESOPs, but their owners cannot take advantage of the tax-deferred rollover described above.
5. The seller(s) must be willing to sell their shares at fair market value, even if the ESOP pays less than an outside buyer would. An ESOP will pay the appraised fair market value based on a variety of factors, but sometimes an outside buyer can pay more for a company if it has a particular fit that creates synergies that go beyond what the company is worth on its own.
6. Management continuity must be provided. Banks, suppliers and customers will all want to be persuaded that the company can continue to operate successfully. It is essential that people be trained to take the place of departing owners to assure a smooth transition.
7. The culture must fit. Top-down cultures rarely work well with ESOPs. For an ESOP to work well, it needs not just to reward employees but engage them. At Mud Bay, employees get a lot of information about how the company and the stores are performing, and they are actively involved in business planning and idea generation. Companies with this kind of culture see profits and employment grow far faster than those without them. It’s a lot of work, but the results are powerful.
For many owners of closely held companies, an ESOP is an ideal solution. For others, it simply will not work. To make a decision, create an initial business plan, factoring in legal costs, the costs to buy the shares, and the company’s cash flow. If that looks encouraging, talk to an accountant about your figures. If things still look promising, have a preliminary valuation done to see if the price is acceptable and feasible for the company to finance. If things still look good, hire a qualified ESOP attorney to draft your plan. As you consider an ESOP, find some other ESOP company executives to talk to, attend an ESOP meeting or two, and finalize your plans with all the key players.
Corey Rosen is the founder of the National Center for Employee Ownership (NCEO), a nonprofit membership, research, and information organization. More information can be found on its web site at www.nceo.org.