Advantage ESOP: Supporters say employee ownerships bring benefits to owners and workers

Last month, Phacil announced a big step in its development—the company’s founders sold their stake in the company to an employee stock ownership plan, or ESOP.

The transition allowed the founders to exit the company while it carries on with employee-owners.

“It is a long-term plan, which rewards Phacilians for remaining with the company and growing it over time,” executive chairman and CEO Tom Shoemaker wrote in a blog to employees. “The longer employees remain with Phacil, the longer they will be able to create value for themselves and their families.”

“Phacil was our third ESOP transaction in the last 18 months, and we’re starting to see a lot more of them,” said Greg Nossaman, managing director at the McLean Group, who served as an advisor to Phacil.

TechFlow, an IT consulting based in San Diego, Calif., also recently went through a transition into an ESOP company when its founder Robert Baum returned to lead the company in 2016. The company sits at about $80 million in revenue and its customers include the Air Force, Navy, Marine Corps, Defense Threat Reduction Agency, General Services Administration, and others.

“I got back in February (2016), and in June, I pushed us to become an ESOP,” Baum told Washington Technology. “I needed the passion. I needed people to be driven to grow the company.”

The benefits are already beginning to be felt, Baum said, something which is uncommon, as it usually takes a year or two before that happens, he said.

One of the reasons Baum likes the ESOP structure is because, in a way, his position is equalized among all of his employees’ positions. “I can be fired by the board just like anyone else, so my communication with employees is: ‘We’re all in this together.’”

The ESOP structure is appealing for a great number of reasons.

“The major appeal is that it is a very effective exit strategy for the owner or owners of private companies. If you own stock in a private company, and it is time for you to exit, you have very few options to cash out your chips,” said J. Michael Keeling, president of the ESOP Association, an advocacy and education group that represents ESOP companies.

Those options include divesting the business to an heir, making the company public, selling the company, or liquidating the company; however, by “selling to an ESOP,” as Keeling put it, an owner is able to preserve their legacy and pass along the stakes to the people who actually helped make the company.

“What I find is that the men and woman owners that exit their business selling to the ESOP really do have in their psyche, their makeup, their DNA, a view that the company was built by everyone in the company,” Keeling said.

But there are a number of other benefits to being an ESOP other than “giving the power back to the people,” so to speak. For one, ESOP companies enjoy some serious tax breaks.

“Under current law, when you do an ESOP, you usually borrow the money to buy out the exiting shareholder,” Keeling said. “The company gets to deduct the principal and the interest amount repaying the loan because the principal is equal to the so-called contribution to the ESOP, and the interest is deductible under tax law,” said Keeling. “If it’s an ESOP transaction, the entire cost of paying off the loan is tax deductible.”

“If you pay dividends on the ESOP stock, that, too, is tax deductible,” Keeling added.

Additionally, S-Corporation ESOP companies are not required to pay taxes because all of that money gets fed back into the economy through the employees, TechFlow’s Baum said. “You can take that money [that would have been taxed] and reinvest it,” tacking on another reason the ESOP structure is attractive.

And the idea of becoming an ESOP company is becoming an increasingly attractive idea in the defense, technology, and government services space, Greg Nossaman said, for reasons other than the tax advantages.

“One, ESOPs provide ‘fair market value’ for selling shareholders,” he said. ESOPs can also be structured so that the sellers actually can participate in the upside if the company grows. Not to mention the enormous, cultural benefits for the employees, Nossaman said.

The actual process differs from the mergers and acquisitions process, he added.  In ESOP transactions, “you avoid the uncertainty and the potential disclosing of the sales process to the market, so it is a much more quiet process that you go through.”

The McLean Group said companies wanting to become an ESOP generally go through four phases:

Phase one is preparation and organization, during which the company is thinking that an ESOP may be a viable alternative. During this phase, Nossaman said, the company is engaging their internal team and evaluating multiple transaction structures.

“The thing about ESOPs is that they are very customized,” Nossaman said. “We spend a lot of time brainstorming it first, then taking the two or three structures that might be of interest, then doing extensive modeling to make sure that it is supportable.”

Phase two is when the company begins engaging with the outside world, including the trustee, who, once engaged, is in essence negotiating the deal in the interest of the employees—the future shareholders, Nossaman said. “You have to be very thoughtful about who you trust for that role.”

Once the trustee is on board, they begin doing due diligence of the business, much like they would during a mergers and acquisitions process. Meanwhile, Nossaman said, the company is talking to lenders and making sure its financing is in place. At the end of the phase, a seller presents to the trustee a term sheet that gets negotiated.

Phase three is the closing phase. The company will negotiate the terms, prepare the plan documents and features, and finalize the financing from the lenders. At the end of that process, the trustee will have a committee meeting where they approve the transaction structure. After that, the company can close on the deal.

The final phase is communication with the employees. “You have to be very careful in how you articulate the plan to the employees. That’s where we step back,” Nossaman said.

He added that about 10 percent of the transactions that The McLean Group deals with are ESOP transactions at this point.

However, there are negatives to being an ESOP. First and foremost, it is not a structure that is right for every company, Nossaman said. “You have to meet certain size and employee count thresholds. You are not getting all of the liquidity on day one.”

Lastly, ESOP transactions are heavily scrutinized and regulated by the Internal Revenue Service and Labor Department, Nossaman said.

“When you are going down that path, you want to make sure that everything is documented clearly and that everything is thoroughly thought through because they are actively on the lookout for people who are taking advantage of the ESOP tax benefits,” he said.