When Employees Acquire the Company
ESOPs offer an attractive alternative in Alaska
A few years ago, Alaska Mining and Diving Supply underwent a major conversion: It became a 100 percent employee-owned business. The company established an employee stock ownership plan (ESOP) that enables its eligible thirty-five employees to earn a stake in the business. The more hours they work, the more shares they earn. And in six years, they get fully vested.
“It’s a tremendous opportunity for those involved to be a part of an ESOP,” says President and General Manager Nick Olzenak, who’s been with Alaska Mining and Diving for eleven years. “From the employee side of things, it’s being able to control our own destiny. The sky is the limit. It’s an exciting time for the company.”
Employee ownership of closely-held companies is increasingly becoming more popular in Alaska. Often, employees gain an ownership interest through an ESOP like the one created by Alaska Mining and Diving, stock awards, and stock purchases.
In Alaska S corporations, limited liability companies, and smaller businesses are more likely to become employee-owned entities. So are companies that are well established and successful in the marketplace. These businesses often have been around for years and are well entrenched in their industries.
According to the U.S. Securities and Exchange Commission, an ESOP is a federally-qualified retirement plan in which the company contributes its stock (or money to buy its stock) to the plan for the benefit of the company’s employees. Essentially, an ESOP is a broad-based instrument that gives eligible employees a chance to gain ownership in a company without having to invest their own money.
Technically, the ESOP is a trust which purchases the company’s stock and holds it for the benefit of eligible employees. The ESOP maintains an account for each employee participating in the plan. Typically, employees must be full-time workers with the company for at least a year before they can participate. Shares of stock vest over time before an employee is entitled to them.
With an ESOP, workers never buy or hold the stock directly while they’re still employed with the company. Instead, their shares are held in the ESOP trust as part of their compensation for work performed. If an employee is disabled, terminates, retires, or dies, the plan can distribute the shares of stock to them from their account. “The longer you’re with the company after the ESOP is in place, the more stock you get,” says Kim Blaugher, CPA, vice president of consulting with Iowa-based Principal Financial Group. Blaugher—who is based out of the company’s Boise, Idaho office—has been working with ESOPs for twenty-five years. He has facilitated ten ESOPs in Alaska over the past five years, including the ones for Alaska Mining and Diving and Alaskan Brewing Company.
Although an ESOP is commonly considered to be an employee benefit plan, it’s also a tool to strategically finance corporate mergers and acquisitions. An ESOP can leverage the tax advantages available to qualified employee benefit plans to allow for purchases with pre-tax dollars.
A Popular Option in Alaska
When an ESOP is established, the owner can choose to sell his equity stake and remain active in the company. In fact, the leadership team and other aspects of the business typically remain the same after conversion to an ESOP, according to Blaugher.
He says ESOPs are a popular alternative for well established companies in Alaska. It’s no wonder why, considering they allow companies to continue operating with local ownership after becoming an ESOP. “Nothing changes necessarily in the company after the ESOP,” Blaugher says. “That’s very appealing to a lot of companies, especially in Alaska. The owner can sell the stock and still participate in the company, and there’s no loss of control to an outside third party.”
An ESOP can be an outstanding alternative for a seller wanting to transition ownership for succession planning or other reasons. However, an ESOP isn’t appropriate for everyone, Blaugher says. He adds: “If you want to sell your business today and leave, you don’t need an ESOP. If you have three to five years, an ESOP might work.”
Jesse Janssen, vice president of lending at Alaska Growth Capital, has also noticed an increase in ESOPs in Alaska recently. From his experience, most owners choose not to step out of the picture when they sell their stock to an ESOP. Many of them have spent their entire lives building their business, and they prefer to maintain an ownership interest in the ESOP-owned trust. Selling to an outside company could scare away existing and prospective clients—and, ultimately, ruin the brand.
However, Janssen maintains, there has to be a long-term succession plan. “At some point in the game, the owner will have to completely step away and sell the rest of the shares,” he says.
Benefits of ESOPs
An ESOP offers tremendous benefits for the owner, company, and employees. For the owners, Janssen says, it’s an excellent way to capitalize on their work in the company. “It allows the owner the flexibility to liquidate whatever portion of the company they choose and defer taxation on the (capital) gain,” he says.
There are also significant income tax benefits for the company—and the employees that own it. For example, an ESOP is a tax-exempt entity for federal and state corporate income tax purposes, which means the ESOP can make pre-tax dollars available to finance company growth. That can translate into a major benefit for companies like Alaska Mining and Diving.
“As a business, we have a huge competitive advantage,” Olzenak says. “We don’t have the same (tax) obligations as a non-ESOP company. We can bring out a product line quickly. We can make an acquisition if we need to.”
The tax-exempt status of an ESOP also allows employees to acquire an ownership interest in the company (through the trust) without paying a current income tax on the stock. That’s because they’re not responsible for paying the income tax liability until the shares are distributed.
As an intangible benefit, the employees of ESOPs have a vested interest in the company’s success. They also get to experience the pride of ownership. Those benefits are making a noticeable difference at the Nerland Agency, which became an ESOP in 2005. The Anchorage-based ad agency has thirty-six employees, which have stock in 100 percent of the ESOP.
“The ESOP says ‘independence’ and ‘accountability’ in new ways, and our employee owners step up even more to the challenge of being the best they can be,” says Owner/President Karen King. “In new-business recruitment, our ability to talk about our employee ownership and the individual ownership it brings to ‘the work’ is a sellable advantage.”
Becoming an ESOP has proven to be a great recruiting and retention tool, although the agency was already fairly successful in these areas. “People mention it during recruitment, and it both intrigues them and appeals to their self-interest (as it should), as a company reward/benefit they don’t often see on their job search.”
Being employee-owned has also had a positive effect on the company’s value. Its stock price has risen significantly since the initial price evaluation, according to King.
Ownership through Stock Awards and Purchases
Employee ownership often results when a private company awards stock to a few managers or other key employees. The stock is typically granted as part of the employee’s compensation package, serving as an incentive or reward for performance. The employee normally receives a minority share—such as 5 or 10 percent—of the company’s stock, leaving the owner with a majority ownership interest. “It’s more typical in Alaska where you see key employees end up with minority stock,” said Richard Rosston, a partner with Dorsey & Whitney LLP.
Sometimes select employees gain ownership of a business by buying out the stock of the majority owners. Here’s one possible scenario: The original owners might decide to sell to an outside buyer and ask top management if they want to buy the company first.
An acquisition involving employees is very similar to a sale to an outside buyer in that a fair market value must be established to determine the purchase price and for taxation purposes. Sometimes, however, allowances are made when employees are the buyer. For example, buyers usually want certain warranties and representations with a purchase and sale agreement. These warranties and representations could involve how many shares are issued/authorized and who owns them; whether the shares are owned free and clear of all liens and encumbrances; copies of audited financial statements and absence of liabilities not disclosed in the financial statements; and the location, completeness, and accuracy of the books and records. Statements relating to accounts receivable, inventory, tax returns, assets, litigation, insurance, environmental matters, employee benefits, and number of employees are also commonly made under warranties and representations.
However, the owner will often make fewer warranties and representations when selling to company managers. That’s because they’re already familiar with the business. “These (warranties and representations) are in a typical merger and acquisition agreement, but the seller may say you don’t need all of these because you already have access to that information.”
The motivation for company owners to award or sell stock varies. For some owners, the underlying objective is succession planning. They might want to retire, but don’t have family members to assume control of the company. So they opt to transfer some or all of their ownership interest to key employees who have been instrumental in the company’s development. This not only enables the owners to leave the business in good hands, but it lets well-deserving employees share in future profits, giving them further incentive to continue in their position. “If the company is successful that person makes more money,” Rosston says.
When employees gain ownership of a company, many factors remain the same. The company generally maintains the established legal structure, management, and brand identity. “People build up goodwill in a name, so they’ll usually keep the same name,” Rosston says.
Janssen agrees. When companies become employee-owned, they typically don’t make any major changes that could potentially disrupt the company’s success. He explains: “If a company’s going to convert to employee owned, it’s happening because the company worked. You don’t want to step into a company and make broad changes and possibly lose market share.”
Employees who purchase company stock are responsible for finding their own money to fund the deal. An entity such as Alaska Growth Capital can finance the acquisition—as long as the loan makes sense. Janssen takes a number of factors into consideration: “We look at whether there are employees there who can manage the company. Do the valuations of the company make sense? The biggest issue is who’s buying the company and are they going to run the company the same way.”
Former Alaskan Tracy Barbour writes from Tennessee.
Posted: July 1, 2013