Branching Out An employee stock ownership plan is more than just a great way to boost morale-it's also a cheap source of growth capital.
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When direct marketing agency Creative Direct Response Inc. decided to expandits nonprofit fund-raising business, the Crofton, Maryland, firmbegan looking for a company to acquire. It found Jeremy Squire& Associates, an Oakton, Virginia, fund-raising company. JeremySquire, the firm's owner, wanted to sell but was concernedabout his employees. So Creative Direct Response offered a buyoutproposal that was not only financially attractive, but also a meansto reward loyal employees.
The $5.5 million firm urged Squire to sell his company stock tohis employees through an Employee Stock Ownership Plan, or ESOP.Creative Direct Response would pay Squire for the $3 million stockpurchase, acquiring the company as a wholly owned subsidiary.Because Squire provided financing, he could collect interest thatwould normally go to a bank. And since his company was a Ccorporation, he could defer capital gains taxes by using proceedsfrom the sale to buy securities of U.S. companies, a permissiblepractice when a business sells at least 30 percent of its stock toits employees.
Squire reaped big tax savings. His employees became shareholdersin the expanded operation, and the acquirer, Creative DirectResponse, was able to negotiate a lower purchase price. "If hehad sold to some third party that wasn't involved in an ESOP,he would have ended up paying between $400,000 and $600,000 incapital gains taxes," says Geoffrey Peters, 57, president ofCreative Direct Response. "By deferring those capital gainstaxes by reinvesting in U.S. securities, we were able to purchasethe company at a lower price."
Cheaper Capital
By educating the seller about the tax advantages of an ESOP,Creative Direct Response gained access to a cheaper source ofexpansion funds and secured the $3 million in financing more easilythan it would have with a conventional lender. Fortunately, the taxbenefits aren't limited to sellers of ESOP companies.
Here's how it works: A company issues new shares and sellsthem to an ESOP, which borrows funds to buy the stock. The companycan use proceeds from the stock sale to its own benefit-say, byacquiring a company. The company repays the loan by makingtax-deductible contributions to the ESOP. The interest andprincipal on ESOP loans are tax-deductible, which can reduce thenumber of pretax dollars needed to repay the principal by as muchas 34 percent, depending on the company's tax bracket. That taxshield didn't apply to Creative Direct Response-as a subchapterS corporation, it doesn't pay corporate income taxes. But thecapital gains deferral made an ESOP transaction appealing to itsacquisition target.
Despite the significant tax benefits, the ESOP is anunderutilized business financing strategy. Experts blame it on alack of awareness and misconceptions about employee ownership."The tax shield alone that the ESOP provides enables an ESOPto give a small business more debt, more senior credit, than theycould get with other access to capital," explains MaryJosephs, senior vice president of the Leveraged Finance Departmentat Chicago's LaSalle Bank Corp., an ESOP lender. Lenders like ESOPloans because tax savings boost cash flow, making repayment morelikely. Also, the lender's enhanced comfort level oftentranslates into a larger loan than with regular financing. Thefund-raising strategy, however, is not for the fiscally challenged;since business owners guarantee ESOP loans, their financial cloutand access to collateral are key lender considerations.
While ESOP lending hasn't hit the mainstream, lenders aregetting more familiar with it. Because underwriting hinges on theentrepreneur's credit quality, even untrained lenders can getup to speed quickly. "You're better off educating [your]bank on ESOPs because these loans are underwriting theindividual," Josephs says. And besides banks,investment-banking firms, mutual funds and insurance companies mayqualify as lenders as well.
Finding a lender is just one step in the ESOP planning process.First, the firm has to determine whether the tax perks outweigh thecost of setting up and administering a plan. "The businessneeds to be generating substantial amounts of taxable incomebecause that's the benefit," says Spencer Coates, a CPA inBowling Green, Kentucky. While costs vary depending on the numberof employees-a minimum of 20 is recommended-installing a plan cancost up to $100,000 and run $10,000 to $15,000 annually, saysCoates. But those expenses are often a fraction of the tax gains anESOP can generate. "Usually, first-year tax savings offset thecosts. That's what makes it palatable to smallbusinesses," he says.
But if your goal is quick access to capital, an ESOP loanisn't advisable. You can spend up to a year working with legaland financial advisors to meet requirements, such as obtaining anindependent appraisal to value the company's stock. Even with aspecialized attorney, it still took months for Creative DirectResponse to complete its ESOP merger. "Find a lawyer who isexperienced," urges Peters, stressing that the complicatednature of the transactions results in heftier legal fees than for astraight asset or stock purchase.
Even if you've got time on your side, the financial straincreated by buying back stock from departing employees is anotherlimiting factor. "The company involved with an ESOP has torealize they have a repurchase obligation that can be a demand oncash flow as the company matures," says J. Michael Keeling,president of The ESOP Association in Washington, DC.
Broader Appeal
Though ESOPs are complicated to install and administer, about10,000 companies now have the plans, up from just 200 in 1974.Insiders attribute much of the growth to a 1998 rule change thatallowed S corporations to sponsor the plans. At the same time,companies recognize they can boost profits by giving employees anownership stake, which studies have shown enhances morale andperformance. "Statistics show if you have a meaningfulpercentage of ownership and some communication that theemployee's job impacts the value of the shares they have intheir accounts, these companies outperform their peers by a factorof 10 percent on a compounded annual revenue and [EBITDA] growthbasis," says Josephs. "Although they give something up,what they have is going to be worth more."
But companies with an "open, friendly style ofmanagement" tend to make the ESOP conversion with greaterease, says J. Michael Keeling, president of The ESOP Association inWashington, DC. "If that company had an open environmentbefore they did the ESOP, it will be easier for them to make thetransition. But there is no law that mandates how you manage anESOP company."
Another misstep companies make is skimping on setup fees."You might save a few bucks dealing with local providers whosay they understand ESOPs, but in the long run, you'll pay ifyour plan isn't done correctly," Josephs warns. "Doyour homework, and get recommendations from The ESOP Associationand the National Association for Employee Ownership."
Crystal Detamore-Rodman is a Charlottesville, Virginia,writer who covers the small-business finance market.
