Making the case for employee ownership

Retirement planning usually focuses on setting expectations about a retiree’s future lifestyle and working backward to determine how much money should be invested in various asset categories now to provide for that retirement lifestyle.

Business owners face an additional challenge. To achieve their goals, they need to maintain the financial health of their enterprise in the interim between planning for and executing their retirement. This added wrinkle makes an employee stock ownership plan, or “ESOP,” a very attractive alternative for government contracting owners who want to plan their eventual exit from the business but who remain focused on maximizing performance in a constantly changing political, economic and social environment.

What is an ESOP?

An ESOP is a qualified defined contribution retirement plan designed to invest primarily in the stock of the sponsoring employer. ESOPs are unique. Unlike other qualified retirement plans, an ESOP can borrow money from its corporate sponsor and purchase shares of the corporate sponsor from its shareholders.

Most ESOPs are created when the company takes out a loan and in turn lends the proceeds to the ESOP to finance an initial purchase of company stock from a selling shareholder or shareholders. Each subsequent year, the company makes tax-deductible employee benefit contributions to the plan that are used to repay the loan (and sometimes buy additional shares). Shares held in the plan are allocated to employees based on a formula that may include compensation and/or years of service.

An independent appraiser performs a valuation on the company every year. Individuals who leave the company and are vested in the plan can sell their shares back to the employer or the plan at appraised value.

3 Ways an ESOP Strengthens a Business

• Studies show improved performance at companies that institute ESOPs, and that ESOP companies typically outperform similarly situated non-ESOP companies.
• The availability of equity-based compensation helps to attract and retain talent—perhaps the most critical resource in the highly competitive government contracting sector.
• The favorable tax treatment of ESOPs provides some savings opportunities to the business and its owners that are not available with other plans.

Let’s take a look at these competitive advantages:

Improved Performance

According to several studies, companies that implement ESOPs improve their performance and outperform similar companies that do not offer employee ownership plans. In the introduction to a collection of papers titled “Shared Capitalism at Work: Employee Ownership, Profit and Gain Sharing, and Broad-based Stock Options,” (Shared Capitalism at Work: Employee Ownership, Profit and Gain Sharing, Kruse, Freeman and Blasi, ed., University of Chicago Press, 2010, pg 11-12 the authors described how ESOPs and other employee equity programs improve performance through:

• Greater attachment, loyalty and willingness to work hard
• Lower chances of turnover
• Worker suggestions for innovations

These factors combined to deliver an average sales growth rate that was 2.4 percent higher for ESOP businesses than their non-ESOP competitors, according to a comprehensive study that set the benchmark for ESOP performance research over a decade ago (“National ESOP Comparison Study (2000)” Kruse and Blasi,  Projected out over 10 years, according to the National Center for Employee Ownership (NCEO), that growth differential would make the ESOP company significantly larger than a similarly situated company without an ESOP.

An ESOP needs the right culture to succeed, though. The NCEO describes six essential rules for companies looking to improve performance through an ESOP:

• Provide a financially meaningful ownership stake.
• Provide ownership education that helps people understand how the company makes money and their role in making that happen.
• Share performance data about how the company is doing overall and how each work group contributes to the bottom line.
• Train people in business literacy so they understand the information that the company shares with them.
• Share profits through bonuses, profit sharing or other tools.
• Build employee involvement by creating structures that support employee contributions of ideas and information.

Attracting and Retaining Talent

Many of the most talented professionals in the government contracting arena seek pay packages that include some form of equity compensation. An ESOP serves several purposes when it comes to recruiting.

First, it meets a candidate’s expectation of equity compensation. But an ESOP also goes beyond that initial criterion to show recruits that the company has a plan for succession after the current generation of leadership.

Experienced recruits in this sector have usually gone through ownership changes in previous jobs with various levels of success. An ESOP offers some clarity around what the future might look like if the candidate comes to work for your firm.

Another recruiting argument in favor of ESOP companies is their significantly lower rate of layoffs during the last recession. According to a recent NCEO analysis of the 2010 General Social Survey, employee-stock-owned companies laid off employees at a rate of less than 3 percent, while conventionally owned companies laid off at a rate greater than 12 percent. (“Research Indicates ESOPs Save Federal Government Billions Due to Fewer Layoffs,” Employee Ownership Foundation, January 14, 2013)

Tax Benefits

ESOPs can generate significant tax benefits for companies that implement them and shareholders that sell to them. The structure of a shareholder’s stock sale to an ESOP may result in tax deferral or a tax-free transaction, and the company should be able to deduct the price of the stock acquired.

In certain circumstances, some or even all of a company’s income could be made exempt from federal and state taxes if the ESOP and the company are structured properly. The benefits can vary depending on whether the business is organized under Subchapter S or C, but the bottom line is that Congress has shown a willingness to support employee ownership of businesses by offering incentives in the tax code.

Like many targeted tax breaks, ESOP incentives are occasionally reconsidered whenever Congress looks for ways to increase government revenue. However, the NCEO analysis of 2010 layoff data went on to point out that the higher rate of employee retention at ESOP companies helped the federal government save over $14 billion.

The lower rate of layoffs at America’s employee-stock-owned companies resulted in continuing employment for individuals who contributed billions in tax payments to the U.S. Treasury. When measured against the annual cost to the Treasury of the tax incentives that support ESOPs, retained employees at these companies contributed $13 in tax for every $1 in support that the government provided their employers via tax deductions.

Each exit strategy is as unique as the business and the individuals that it covers. The most important step is to start planning early and work with a talented team of advisors that you trust. If you’re evaluating business succession plans or methods for enhancing the profitability of your government contracting firm, an ESOP is definitely an important option to consider.