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Sunday, 14 May 2017 13:34

Sharing the wealth: ESOPs offer business owners an exit strategy, if they plan ahead

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Ever since Mark Lindquist acquired Rapid-Line Inc. in 1989, he envisioned turning over the business to his workers via an Employee Stock Ownership Plan, or ESOP. He realized that goal in June of last year, but only after years of planning and education. Ever since Mark Lindquist acquired Rapid-Line Inc. in 1989, he envisioned turning over the business to his workers via an Employee Stock Ownership Plan, or ESOP. He realized that goal in June of last year, but only after years of planning and education. Photo by Katy Batdorff

When Mark Lindquist purchased Rapid-Line Inc. in 1989, he completed the transaction with a strategy for exiting the business already in mind. 

Shortly after signing the paperwork to acquire the Wyoming-based contract manufacturer, Lindquist established an employee stock ownership plan (ESOP) to cement a clear path for his eventual retirement.

“The challenge in all small business is it’s easy to get in and not so easy to get out,” Lindquist said of his decision to implement an ESOP early in his ownership of Rapid-Line. “If you don’t have an exit plan, you’re always having that hanging over your head.” 

Lindquist also established the plan as a long-term strategy to reward the employees who stuck by him through the early years of the business, when the company had to rebuild after its parent company, Behler-Young, was sold in 1989. 

When Rapid-Line finalized the ESOP process in June 2016, some of its long-term employees received more than $200,000 in their retirement accounts, an amount Lindquist said would have been challenging for them to earn through traditional retirement plans. 

Lindquist’s decision to enter an ESOP transaction echoes similar sentiments from other business owners in West Michigan who have chosen it as an exit strategy for their businesses. 

Under an ESOP transaction, an owner sells the business to a trust, which in turn manages employees’ stocks in the company until workers retire. Owners can either sell their business to the ESOP outright or the ESOP can take on some debt and pay off the owner over time. 

Proponents say ESOPs offer business owners myriad benefits, including the ability to remain involved in the business, reward their employees and in some instances avoid paying capital gains tax. For companies, ESOPs often are better managed, more productive and experience significantly less employee turnover compared to other organizations.

However, ESOPs do not present a risk-free strategy, especially for employees, as their retirement accounts are directly tied to the performance of the company.

“This is not strategy for every business, for sure,” said Alex Brill, CEO of Washington, D.C.-based Matrix Global Advisors, who studies ESOPs. “Businesses need to be stable, they need to be cash flow positive. They need to be solid operating firms with some relatively stable workforce for the workers ... to have continuity.”

CONSIDERATIONS 

While ESOPs offer an additional pathway for business owners looking to transition out of the business, there are a number of elements that set them apart from other transactions. 

For one, business owners should be aware that unlike a transaction with a private equity firm or strategic buyer where they receive the purchase price up front, owners using some ESOP structures may be paid out for their business over a period of time. 

“Unlike a third-party sale where you may (be) getting most of your proceeds at closing, (with) an ESOP, you may end up getting some at closing, some over a period of time,” said Justin Stemple, a partner at Grand Rapids-based Warner Norcross & Judd LLP, who specializes in ESOP transactions. “You may phase it out over several transactions over a longer period of time, rather than getting all of your cash and you’re off into the sunset.”

One of the most common elements of an ESOP Stemple works through with his clients has to do with the different tax structures that can affect the transaction. Entering an ESOP can offer significant tax benefits, both for the seller and the long-term health of the company. 

For example, if a company is a C corporation, sellers can elect to defer their capital gains tax on the proceeds of the sale if they reinvest those proceeds into a security of a U.S. company. 

With an S corporation, ESOP-owned companies and their shareholders — in this case, the ESOP itself —  avoid paying income taxes.

“When the income of the corporation flows through to the shareholders, the ESOP doesn’t pay taxes so the corporation is able to avoid that tax liability,” Stemple said. “It’s a tremendous cash flow benefit to a profitable corporation that is an S corp owned 100 percent by an ESOP.” 

Stemple noted that some companies can transition from an S corporation into a C corporation to defer the capital gains tax, and then change back to an S corporation at a later date to avoid a tax liability. 

While the transition to an ESOP can be complex, Stemple suggests that owners put together an advisory team experienced in these transactions.

“You need a qualified team of advisers that understand ESOPs so that they can work through each of these issues,” he said.

EMPLOYEE EDUCATION 

Most advisers and business owners who have transitioned their companies through an ESOP point to employee education as a key step in completing a successful transition. 

For his part, Lindquist hosted numerous updates and classes over the course of the ESOP transition, mostly focused on giving employees a better indication of the membership benefits they gained in the ESOP. 

“It’s continuous education (for employees) on your stock, the value of your stock, when you can get your stock,” Lindquist said. “Initial new employees go, ‘Well, I have stock, can I trade it in for a 12-pack?’ And you go, ‘No, not right now. You have to hold it until your retirement.’” 

It’s also important to teach employees what being part of an ESOP does not mean. For example, employees do not have voting rights on key company issues, nor can they make hiring or firing decisions. 

Brent Brinks, vice president of Byron Center-based Buist Electric Inc., also advises employers to educate their employees during a transition to an ESOP. The company completed its ESOP in 2015 after its previous owner chose the strategy as a way to reward his employees over the years. 

Brinks also believes companies should be transparent with members of the management team, in case they believe they should have an opportunity to purchase the business. 

“You may have leadership in place that feels they’re owed an opportunity to purchase the company,” Brinks said. “If you have that, you’re going to have a little more of a problem than we had, where we did not have leadership at the time that felt like they were owed an opportunity to purchase the company.” 

GAINING POPULARITY?

Despite what many see as the numerous benefits of ESOPs, the transactions haven’t gained widespread acceptance nationwide. 

Dave Drews, a consultant who runs Orchard Lake-based Justus Equity and specializes in ESOPs, believes many business owners have avoided ESOPs simply because of a lack of education. While the transaction strategy has been around for several decades, the actual process can be quite complex.

“There’s a real lack of education on ESOPs, a real lack of understanding,’ Drews said. “There’s a niche of experts, but they’re growing. The language is hard to follow because it’s based on tax code, rather than making it understandable for people.”

Drews also serves as an executive in residence for the Center for Positive Organizations at the University of Michigan

Total ESOP transactions have hovered between 80 and 150 conversions per year from 2002 to 2015, according to a report by Matrix Global Advisors authored by Brill. The number of ESOPs per year is roughly equal to the number of new initial public offerings (IPOs), according to the report. 

The report notes that ESOPs could gain steam in the coming years as waves of baby boomers transition out of their businesses. 

While ESOPs may not be popular nationwide, the companies deploying the strategy tend to cluster together. Of the 68 Michigan-based ESOPs registered with The ESOP Association, a national association based in Washington, D.C., roughly half are based in West Michigan. 

For industry advisers, the strong cadre of successful ESOPs in West Michigan can help communicate the process to other businesses contemplating such a transition. 

“What I appreciate about West Michigan is that we have a lot of ESOP-owned companies,” Stemple said. “There’s a good culture for sharing wealth with employees who helped build the company. In many cases, I like to connect a potential ESOP company with another ESOP company … to hear firsthand about how it worked.”  

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