Is an ESOP right for your firm?

If your firm has the following characteristics, the more likely an ESOP is a good and viable option for your firm.

During economic expansion, owners of well-managed firms see their company’s value grow significantly. The jump in firm value, however, can make the prospects of a fair-market-value internal ownership transition difficult.

Next-generation owners may be unprepared financially for a significant ownership stake. That hurdle often results in an outside sale to fully capture a firm’s value.

Over the past few decades, an increasing number of companies including AEC firms, have addressed the financial challenges of ownership transition with an employee stock ownership plan. ESOPs are federally regulated trusts, similar to a 401(k) trust. At Fleis & VandenBrink Engineering, and other AEC firms, ESOPs have proven effective in maintaining ownership “in-house.”

We created our ESOP in 2004. It was designed at the time to accumulate assets as our firm grew for the eventual buyout of significant owners. In our case, the ESOP assets come in the form of the match the company makes to the 401(k) plan. The match goes into the ESOP account for each employee and is held in cash, bond, and other investments until stock is available to purchase. As our growth increased the value of our firm, an internal transition would have been very difficult without an ESOP.

ESOPs are generally designed to fit the culture and long-term goals of a specific company. Generally, ESOPs purchase stock from selling owners. The value of the ESOP is then distributed as “ESOP shares” to a large number of employees, who are often referred to as “employee-owners.”

Profits of the firm are shared with the ESOP’s employee-owners in the form of distributions to all shareholders including the ESOP. The value of the ESOP grows tax-deferred both from on-going profit distributions and increases in the value of the company. ESOPs, however, lose value if the company share value falls.

Is an ESOP right for your company? It depends on your situation. In my experience, the more a firm holds true the following characteristics, the more likely an ESOP is a good and viable option.

• Your firm has a track record of profitability. Nothing increases the likelihood of a successful ownership transition like solid profits. They are essential for a company to provide enough working capital to reward staff, maintain quality work environments, and keep up to date with training and equipment. However, when a transition of ownership is added into the equation, enough profits must also be generated to accumulate cash for a future transaction, or to service debt to fund a current transaction. While profitability is key for most transactions, it is magnified when an ESOP is involved because employees have a direct ownership stake.
• Your firm commits to ESOP education. It is important that participants in an ESOP understand their role in creating a successful employee-owned firm. Ali Jamshidi, CFO of CTL Engineering, Inc. based in Columbus, Ohio, reports that employee-owner ESOP education at his firm has been ongoing for nearly two decades. This includes annual ESOP education and discussions at the 12 CTL offices located in five states. Annual ESOP education details the rights and responsibilities of CTL’s nearly 300 employee-owners. The firm finds this education helps employees identify methods to cut costs and increase revenue while keeping client satisfaction high.
• Your firm shares key financial information. While most employees at an ESOP company are not involved in the day-to-day management, all are directly impacted by company’s financial performance. Minimally, this performance is shared annually with the announcement of changes in ESOP value. However, employee-owners can better impact the bottom line if there is a culture of openly sharing key financial information. This includes understanding what financial metrics they directly influence and how those metrics are currently doing. At F&V, core financial information is shared with all employees at least quarterly and a more in-depth analysis is shared annually at an all-staff breakfast.
• Your firm organizes as a subchapter S-corporation. The power of an ESOP shines in S-corporation firms. “S-corps” do not pay federal income taxes. Instead, the individual owners of an S-corp pay the companies federal income tax with each owner paying tax on their percentage of ownership. However, federal income tax is not paid on company stock held in an S-corp ESOP. This is significant when an ESOP owns 100 percent of the S-corp.
• Your firm is sized to properly administer the ESOP. Attorney Justin Stemple, who specializes in ESOPs at Warner Norcross + Judd, LLP (Grand Rapids, Michigan), says successful ESOP ownership typically happens with at least 25 employees. It is possible to have an ESOP with fewer than 25 employees, but smaller companies may struggle with certain IRS compliance tests, particularly those seeking to be 100 percent ESOP owned S-corporations. According to Stemple, if you are below this number, you may find the administrative costs of the ESOP (e.g., annual valuation, administrative, and legal fees) are too burdensome to generate enough profit to cover day-to-day company needs and fund growth opportunities.

For firms that have the right culture, staff, and motivations, the time and resources needed to design and sustain an ESOP are dwarfed by increased engagement and creation of wealth for employee-owners. If you think an ESOP is right for your firm, do your research and work with experienced professionals to design one to fit the culture and vision of your firm.

Brian Rice is a principal and manager of the Environmental Services Group at Fleis & VandenBrink. He can be reached at brice@fveng.com.