ESOPs: The Answer for Retaining Jobs?

The state of North Carolina could be facing massive job losses in the near future. And encouraging retiring business owners to sell to an ESOP—rather than closing up shop—might be an especially effective way to stop that potential job hemorrhage, according to a new report from the North Carolina Justice Center, an anti-poverty group.

According to the report (Down Home Capital: How Converting Businesses into Employee-Owned Enterprises Can Save Jobs and Empower Communities), the potential for business-closure job loss is particularly dire in North Carolina, and the possible benefits of encouraging ESOPs may be especially well suited to that state.

But the coming storm of retiring business owners—referred to by some as the Silver Tsunami—is something all states will face. So, encouraging the transition to ESOPs might help other states retain more jobs as well.

Job Losses Caused By Business Closures

Since 2000, 2.2 million jobs in North Carolina were lost due to business closures. In any given year, more than 25 percent of job losses occur because businesses decide to close their doors.

These types of job losses “have seriously hampered North Carolina’s economic recovery,” the Justice Center report states. Since 2010, the number of jobs lost in the state due to business closures is larger than the net job gains made in the state during the same period. Conditions in the state are ripe for those losses to continue.

“A huge share of the jobs lost to business closure happen in relatively mature enterprises. North Carolina is particularly reliant on older businesses,” the report found, noting that the percentage of the state’s businesses that are 15 years or older is twice the national average.

These mature, viable companies are a tremendous source of value—and jobs—to the communities in which they are located. And if these businesses close, it can be a tremendous hardship—especially for communities that are economically challenged, or have few available employment options to replace the shuttered companies.

The Perfect, Rural Storm

Patrick McHugh, the author of the study, says many of the states’ most economically challenged areas sit right in the cross hairs of this coming trend.

Many of these areas are rural, have a high density of individuals approaching retirement age, and are particularly dependent on mature companies as sources of employment.

And because these regions are less populated and less affluent, they may struggle to provide an adequate pool of local buyers for retiring business owners. And local buyers—including employees—are key to boosting the financial health of these areas, the report finds.

Buyers from outside the local area are more far likely to move the business—even to reap only modest, short term gains—the report states. By contrast: “When firms are locally owned, the profits are more likely to be spent or reinvested locally, keeping that capital flowing and creating opportunities within a community.”

The report states that: “All other things being equal, communities with more local business ownership tend to achieve faster economic growth than areas where comparatively few of the firms are locally owned.”

Some of the regions poised to suffer most from the coming Silver Tsunami also are ones that have been economically depressed for multiple generations, says McHugh.

Better Than No Option

Some argue that owners who sell to an ESOP may be leaving money on the table. But in some of the less affluent regions of North Carolina, ESOPs can provide an opportunity to find a buyer where few, or even none, might otherwise exist.

What’s more, a business sold to the current employees will have an easier time transitioning than one sold to an outsider, who must take the time to understand the customer base, employees, suppliers, and more, McHugh says.

Perhaps most importantly, programs that help keep existing jobs—rather than investing valuable resources in luring outside businesses to create new ones—are inherently more efficient. “It is often more cost-effective to save what already exists than to bring in something new,” the report states.

The report found that North Carolina’s traditional job creation efforts are far more costly than comparable efforts of the Ohio Employee Ownership Center. The result, the report states: “Compared to the traditional economic development incentive programs, expanding employee ownership is an incredible bargain.”

A Penny Saved

The report makes note of the potential benefit to sellers of using the 1042 rollover, which allows owners of C Corporations who sell stock to an ESOP to defer capital gains from the sale, in certain conditions.

The 1042 rollover became a source of controversy last fall, when the Joint Committee on Taxation determined that applying it to S Corporations would cost the United States treasury more than $7 billion in lost revenue over a 10-year span.

Does the potential for ESOPs to cost-effectively save jobs in places where they are needed most—like the areas in North Carolina identified by the report—provide an argument for expanding the 1042 roll over? For the moment, McHugh steers clear of conversations about tax deductions. He is more interested today in programs that might help business owners pay the cost of initial inquiries that help them see if an ESOP is right for them.

But, he adds, if a tax incentive were the reason that business owners were prompted to sell to an ESOP—and retain to jobs in areas where they are needed most—that would be a positive outcome he would welcome.

The Ownership Infection

What if the spirit of employee ownership was like a virus, something that could be caught and transmitted to the next person you talk to?

What if it already is?

Amy Kirby is an employee owner at DCS Corporation. Last year she wrote an impressive letter nominating one of the people on her staff, Karla Langhus, to be The ESOP Association’s Employee Owner of the Year. Langhus, the chair of the DCS ESOP Communications Committee, won the award.

Ask Langhus about the remarkable list of accomplishments detailed in Kirby’s letter, and she credits Kirby for supporting her work as committee chair. “If it weren’t for her, it would never have gotten done,” says Langhus.

Langus also points out how well she and Kirby work together in their daily roles. Kirby, says Langhus, often acts like a partner, someone with whom she can bounce around ideas and work with to solve problems.

Langhus’ accomplishments clearly are the result of energy and hard work. Why does she put so much into the job of helping co-workers understand the ESOP? What does she get out of it?

“I get to do what I want to do,” says Langhus.

Taking ownership is important to Langhus. And she recognizes that it is important to others as well, so she makes sure committee members have autonomy and can make the projects they tackle their own. “I leave it to each committee member to figure out what will work best in their area,” she says.

Committee member Alan Johnson agrees.

“We come to her with ideas and she says, “Yes, that sounds good,’ and gives us feedback. And then we run with it.” Says Johnson: “We do feel like we are responsible for making an impact.”

Like a virus, ownership seems to have been passed from one person to another. Each one ends up with the space to claim ownership of his or her own efforts.

The results are more than just a good feeling. They are a focus on the long term benefit of the employee owners and the company.

Johnson says that while some investors in public companies may care only about the short term—and might be willing to tolerate cutting staff or shuttering branches to achieve that goal—he feels ESOP companies are more focused on the long term and are more loyal to their employees. In turn, that helps him focus long term.

“Having the long term in mind means you can plant these little seeds. And if you stay with the company you can see those seeds grow and grow,” says Johnson. “You actually are empowered to make a difference, and you can see that difference unfold.”

He adds: “I know the reward for helping out the company as a whole is eventually going to come back to me.”

Clearly, Johnson has the employee ownership spirit bug—one he caught from Langhus and Kirby.

Newsflash: Employee Owned Firms Are Good for Employees

While ESOPs can provide softer benefits to employee owners—such as greater involvement in decision making—at their core, they are a means for putting money into employees’ pockets. Typically, that money is intended for use in retirement. But ESOPs also tend to provide financial benefits that employee owners may realize much sooner.

For example, an ESOP requires no out-of-pocket contribution by employees—so they still have the same funds available to invest elsewhere, such as a 401(k). And many ESOPs provide that option: The 2015 ESOP Survey of members of The ESOP Association found that 93.6 percent of respondents offer a 401(k) in addition to their ESOP.

In general, research has found, ESOPs are more likely to provide two retirement benefits than most firms are to provide only one.

And it doesn’t stop there: The ESOP Survey found that 2.6 percent of respondents also offer employees a defined benefit pension. That means employee owners in these companies get two retirement plans, and neither plan requires them to invest a single dime from their own pockets.

Some critics assume that all this generosity must come at a price—namely that companies pay for their ESOPs by cutting back in other areas. But that doesn’t match up with the research. In a brief slated for publication in the November IZA World of Labor, Rutgers Professor Douglas Kruse writes that in almost all studies “employee ownership tends to come on top of market levels of pay.”

He adds that in comparisons of conventional and employee-owned firms, “employee owners in general reported higher levels of annual earnings, and were more likely to say they are ‘paid what they deserve’ and that their fringe benefits are good.”

Perhaps most importantly, employees at ESOP companies are less likely to be laid off. And that is true whether the economy is in recession or going great guns.

So employee owners at ESOP companies get a great retirement benefit that costs them nothing, often still have access to other retirement options such as pensions and 401(k)s, typically earn salaries at or above market level, and are more likely to keep their great pay and benefits because they are more likely to stay employed.

This last point is the most important, because the best pay and benefits in the world won’t amount to much if you can’t keep your job.

ESOPs Excel at Making AND Sharing the Wealth

Employee ownership is a fantastic concept, one that immediately brings to mind thoughts of equity, fairness, and sharing the wealth with those who have helped create it. But that concept sometimes gets a sideways glance from pragmatic business executives who know that sharing the wealth isn’t possible unless there is wealth to be shared.

Put another way, you won’t have much to share if you are broke.

Those executives can rest assured: ESOPs are generally very good at making money—and often are even better at it than conventionally-owned companies.

But talk is cheap, so let’s look at some facts:

Sales per employee at ESOP firms are 8.8 percent higher, on average, than at non-ESOP businesses. For the group studied, ESOP companies averaged $44,500 more in sales per employees. This means a 200-person ESOP firm would generate an additional $9 million in sales, compared to a traditional business.

Companies that were 100 percent ESOP-owned, and those with higher ESOP account balances, performed above the average.

(Source: 2008 study by Brent Kramer, a doctoral candidate at the City University of New York. Kramer is now a lecturer and holds his Ph.D. in economics. The study was funded by the Employee Ownership Foundation and included 328 firms that are at least 50 percent ESOP owned, and over 2,000 matching non-ESOP firms.)

On average, companies perform 4 percent better after adopting an ESOP, or compared to non-ESOP companies. (Source: Effects of ESOP Adoption and Employee Ownership, page 11, Steven F. Freeman, University of Pennsylvania.)

ESOPs appear to increase sales, and sales per employee by about 2.4 percent over what would have been anticipated, absent an ESOP. (Source: A study comparing 1,100 ESOP companies to 1,100 comparable non-ESOP companies for more than a decade. The study was conducted by Professors Joseph Blasi and Douglas Kruse of the School of Management and Labor Relations at Rutgers University, and was funded in part by the Employee Ownership Foundation.)

So the record is clear: ESOPs are not only good at sharing the wealth, they are also very good at creating it.

Nearly 10,000 Years of ESOPs

About 40 years ago, a smattering of critics said ESOPs were nothing more than a way for wealthy owners to cash out of their businesses. The typical ESOP, these critics said, wouldn’t last more than a few years. After that, it would be sold to the highest bidder.

Those critics were right about one thing—ESOPs are a great way for owners to cash out of a business. But the critics misunderstood a vital factor that motivates owners to sell to employees, instead of someone else.

It is longevity.

When you start or own a business, you invest a great deal of yourself into it. You bear a responsibility to your customers, and to the people you employ. And the way you meet that responsibility reflects who you are as a person; it reflects your values and ideals.

If you value what you have built, you want to see it live on. And you want the people who helped build it to shepherd it into the future, and to be rewarded for doing so.

In short, you want your company to carry on.

If your business is solely a way to make the greatest amount of money possible, why go to the trouble of setting up an ESOP—which might sell to the highest bidder a few years later? Why not cut out the middle man and sell to the highest bidder today?

For proof that ESOPs are an enduring form of ownership, just look at the list of Silver ESOPs—companies that have maintained an ESOP for at least 25 years. The ESOP Association has been honoring members that reach this milestone since 2008. In that time, 386 member companies have achieved Silver ESOP status.

Take those 386 companies and multiply them by the 25 years they’ve each had an ESOP, and you come up with 9,650 years of ESOP management.

Any many of those firms are still going strong—which probably makes their founders and former owners very happy indeed.

(Additional materials: a video about this year’s Silver ESOP companies and the press release announcing this year’s winners.)

The 2016 Silver ESOP Award companies are:

American Systems Corporation, Chantilly, VA

Black, Gould & Associates, Inc., Phoenix, AZ

BRPH Companies, Melbourne, FL

Bryant Air Conditioning & Heating, Lincoln, NE

Cannon Cochran Management Services, Inc., Danville, IL

CTL Engineering, Inc., Columbus, OH

EBO Group, Inc., Sharon Center, OH

Edmund A. Allen Lumber Company, Momence, IL

First State Bancorp, Inc., Caruthersville, MO

Goettle Construction, Cincinnati, OH

Granco Clark, Inc., Belding, MI

Great Lakes Orthodontics Ltd., Tonawanda, NY

Jackson’s Hardware, Inc., San Rafael, CA

KCI Technologies, Inc., Sparks Glencoe, MD

Kemner-Iott Group Agency, Adrian, MI

Kendall Electric, Inc., Portage, MI

Messer Construction Co., Cincinnati, OH

Morton Buildings, Inc., Morton, IL

New England Controls, Mansfield, MA

Pavement Recycling Systems, Inc., Mira Loma, CA

Prime-Line Products Company, Redlands, CA

Rable Machine, Mansfield, OH

Slakey Brothers, Sacramento, CA

Telephone Electronics Corporation, Jackson, MS

Trans-Overseas Corp, Romulus, MI

Veterinary Service, Inc., Modesto, CA

How to Plan for the Baby Boomer Bubble’s Upcoming Cash Requirements

By Trevor S. Bare

Nearly 10,000 baby boomers—individuals who were born between 1946 and 1964—retire every day, according to the Social Security Administration.

With this large group of retirees, ESOP plan sponsors need to be prepared for repurchase obligations they may face in the near future. A repurchase obligation is an ESOP’s requirement to buy back employer stock from participants who are eligible to receive distributions from the plan.

There are various ways to fund these obligations. Typically the cash used to purchase employer stock comes from an annual employer contribution to the ESOP allocated to employees in proportion to their compensation. Below are factors to consider when funding repurchase obligations with employer contributions.

Every ESOP is Unique
The timing of each company’s retirement bubble varies. A company that is growing quickly now may be decades away from its retirement bubble. For a small employer, the bubble may be one key employee with a large account.

An ESOP plan sponsor needs to plan ahead for its own bubble. If an ESOP isn’t prepared for distributions, the plan sponsor may face fluctuating contribution levels, or even an inability to make contributions. Furthermore, a company may find itself exceeding the IRS’s limit of 25 percent of eligible payroll that is imposed on annual retirement plan contributions.

Find Your Bubble
To determine if you have a bubble approaching for your ESOP, you can conduct a distribution projection or repurchase obligation study, which projects the distributions and associated cash requirements that an ESOP will face in future years.

The timing and scale of a company’s repurchase obligation study depends on a number of factors, including the available budget and number of employees. Simple distribution projection studies with limited assumptions may suffice for smaller ESOPs. Regardless of a study’s complexity, the projected results are based on assumptions. Actual distributions will deviate from projected distributions, so projections will need to be updated periodically.

Planning For Your Bubble
Companies concerned with future repurchase obligations should review the ESOP’s distribution policies. ESOPs may delay starting payments for five years for employees who terminate employment prior to retirement, disability, or death, as defined by the plan. Distributions also may be payable as installments over five years, rather than as a lump sum distribution.

A plan sponsor that identifies a retirement bubble coming up in 5 to 10 years in its ESOP will need to determine if the current employer contribution levels will be sustainable through the bubble. If not, the organization should consider increasing its contributions now to build up a reserve and maintain a consistent benefit.

Consider a company that currently has to contribute three percent of payroll to pay out distributions, but does a projection that reveals it will have to contribute 15 percent of payroll during an upcoming retirement bubble. If the annual contribution is increased now, a cushion will be created that can reduce the potential 15 percent bubble-level contribution to a more affordable level.

Finally, as the non-employer stock assets accumulate, companies should review how these assets should be invested.

 

Trevor S. Bare, FSA, is a consulting actuary for Conrad Siegel Actuaries. He specializes in retirement plan consulting and administrative services for defined contribution and defined benefit plans, such as 401(k), Profit Sharing, Cash Balance, and Employee Stock Ownership Plans. He also specializes in nondiscrimination testing and tax shelter plan designs.

September Success

Something impressive happens in the month of September: Members of the House of Representatives flock to add their names to the latest pro-ESOP bill.

It happened last year, when 20 House members opted to sponsor HR 2096. And it is happening again this year: In the first 12 days of September this year (an election year, when representatives are most keenly attuned to constituents) already eight House members have decided to sponsor the bill.

What makes September so special?

You do.

Congress typically adjourns in the late summer, and its members head home—where many ESOP companies are waiting to host them on pre-arranged visits. In those visits, members of Congress get to see for themselves what makes ESOP companies unique. They get to see how involved and engaged employee owners are. They get to see the spirit of employee ownership for themselves.

When you host your members of Congress, they remember. For the past four decades, they have been telling us how profoundly those visits affect them.

And then they come back to Congress and sign on to the latest pro-ESOP bill.

They don’t do it because they have been flooded with e-mails, all generated by the same online program. And they don’t do it because a high-powered lobbyist in a finely tailored suit treated them to a fancy steak dinner in a dimly lit power-broker restaurant.

They do it because they have seen that special quality present in you, your employee owners, and your businesses. And—like us—they want to see more of it in America.