Companies Enjoy Benefits of Employee Ownership

Central State’s Manufacturing Inc. keeps no secrets.

Each month the Lowell-based metal building component manufacturer opens its financial records for inspection by each and every employee. All questions are answered and all expenditures are explained, said Ladena Lambert, human resources director for CSM.

“We’re so open-book, we tell them everything,” Lambert said of her company’s policy. “A lot of stuff we talk about, in most companies it would be considered confidential. We want everyone to feel like the owner.”

CSM’s full-disclosure policy helps its employees feel like owners, but the company’s employee stock option program actually makes them part of the financial ownership structure of the company.

CSM is one of three Northwest Arkansas-based companies and one of eight in the state with an active ESOP.

Through an ESOP, employees earn shares of company stock that accrue value during their tenure at the company. The company stock is owned by a trust, thereby making the trust, and the members of the trust, full or partial owners of the company.

ESOPs are a unique way to transfer ownership of a company from one owner or a group of owners to all company employees. The plans require oversight and capital but the tax benefits help to offset the expense. The program’s joint ownership structure allows employees at all levels to become partial owners and reap the benefits of a company’s financial success.

According to data from The National Center for Employee Ownership, companies with ESOPs nationwide employ more than 11 million people and have assets of $928 billion.

“The soft side of an ESOP is a real attraction for employees or managers that are going to move into the company,” said Michael Keeling of the ESOP Association. “It’s just a feel-good place to work.”

Ownership Oversight

ESOPs are often used to repay a retiring owner’s investment in a closely held company. The programs can also be used as an extra employee benefit or employee incentive plan Keeling said.

When an ESOP is used to transfer ownership, a trust is established and a loan, guaranteed by the business, is extended to the trust to buy out the owners’ investment in the business.

The loan money is used to incrementally pay off the owner. At the same time, the company uses a percentage of its total payroll to buy stock from the trust to infuse it with capital to pay back the bank and, in turn, issue the stock to the employees.

The process continues until the owner is fully compensated for his or her investment in the company.

The trust then becomes the ownership entity of the company and employees, through stock, are partial owners in the business.

Roger Collins, Harps Foods Inc. president and CEO, said Harps started its ESOP in 2001 as a way to transfer ownership from the Harps family to the company’s 1,500 employees.

Collins said Harps, which is now 100 percent employee-owned, assigns stock to its employees annually.

In 2007, each employee received stock equal to 19 percent of his or her pay.

Data from the National Center for Employee Ownership shows that private companies, such as Harps, allocate an average of 8 percent to 10 percent of employee payroll to the ESOP trust annually. Public companies with ESOPs allocate slightly less, averaging 4 percent to 6 percent each year.

Many ESOP companies’ stock is not exchanged on the open market, Keeling said, and many companies do not allow their employees to buy additional amounts of stock beyond what is issued to them each year.

An external auditor is hired by the company annually to assess the value of its stock. In turn, each employee’s stock holdings are assigned a value.

Collins said Harps’ stock quadrupled in value from 2001 to 2007.

When an employee leaves the company, his or her stock is purchased back by the trust. The employee is paid the value of the stock holdings and the repurchased stock is put back into the trust to be given to another employee.

Glen Carte, corporate secretary and treasurer for Foundation Specialties Inc., said the company uses its ESOP as its retirement program for its employees.

Lambert said CSM makes annual contributions to both the ESOP program and the company’s 401(k) program.

Once the trust has paid off the former owner, Carte said the ESOP will continue to purchase stock from the exiting employees and allocate stock to new and existing employees.

When employees leave, they can choose to receive their money incrementally or in a lump sum.

Carl Grimes, owner of Sunbelt Business Advisors in Fayetteville, said ESOPs are a great choice for some companies but are not appropriate for every business.

The managerial oversight and annual financial investment make them ideal for companies with at least $5 million in revenue, Grimes said.

And because ESOPs are dependent on the businesses’ financial success, companies in more stable industries often have more success with their employee ownership program.

Keeling said several tax incentives created by Congress in the early 1980s helped to spur the popularity of ESOPs.

But many of the incentives are best suited for small or mid-sized companies, leaving many larger companies without incentive to start an ESOP.

Additional laws passed in the late 1990s gave companies more incentives to implement the programs.

Keeling said one of the largest tax benefits of an ESOP is the ability to file state and federal taxes as an “S” corporation. Because the trust is the actual ownership entity, or partial ownership entity, of a company with an ESOP, the trust can file state and federal taxes as a not-for-profit entity, and therefore pay no taxes.

The original owner can also avoid paying capital gains taxes on the sale of the business if the company is purchased by an ESOP.

Keeling said the tax incentives have spurred more interest in ESOPs in the past two decades.

According to data from The National Center for Employee Ownership, the ESOPs operated by U.S. companies have increased 511 percent from 1975 to 2007 and more than 27 percent from 2000 to 2007.

Ups and Downs

Like any business model, ESOP programs are not fail-proof, Grimes said.

Companies can still go bankrupt under an ESOP, leaving the employees without a job and without a retirement fund.

And management teams can simply crumble under the pressure of running an ESOP.

For smaller companies, the stock repurchase amount required when a long-time employee leaves the company can put a strain on the trust.

And success can sometimes spell doom. According to a study conducted by the National Center for Employee Ownership, financial success usually causes a company’s stock to increase in value, causing repurchase obligations to grow.

The Center’s study showed that a third of the companies interviewed cited “importance of repurchase obligation in decision to end ESOP” as an important reason they terminated the ESOP.

Companies can also falter from lack of business or poor management. In that case, the owner is often repaid first, usually with company funds, leaving the company unable to compensate employees for their stock holdings.

“That’s a lose/lose for both sides,” Grimes said.

Collins said education is extremely important for a company the size of Harps because new employees are entering the program each year.

And knowledge often breeds excitement and enthusiasm for the program and the business, Collins said.

“I think people that have been at Harps for a while understand what ESOP means,” Collins said. “As a company I would like to think that means stockers and checkers think about it as their store, which I believe helps creates a competitive advantage.”