Just as the handoff from a quarterback to a running back requires a smooth transition, so too does the passing of the ownership of a security business. One answer to making the handoff from a closely held firm to employee ownership is via Employee Stock Ownership Plans (ESOPs).
ESOPs are becoming increasingly viable in the security services industry; in fact, three major firms have already successfully enacted one — Pro-Tech Design and Low Voltage Contractors, both of Minneapolis, and Tech Systems Inc., of Duluth, Ga. — each creating a company that is 100-percent employee-owned.
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The Path to Employee Ownership
Eva M. Mach’s business title at Pro-Tec Design is President, CEO & Employee Owner — and the “employee owner” part is the key to the success of any ESOP program. As of Feb. 1, 2016, Pro-Tec became a 100-percent employee-owned company, and it is paying big dividends.
Pro-Tec had considered various forms of employee ownership as an incentive plan and a way to reward high-performing members of its management team. At the same time, company owner Tom Hagen was thinking about his own exit strategy. “ESOP emerged as the option that would accomplish both and be broadly based,” Mach says.
The ultimate goal of the buy-out from Pro-Tec’s long-term owner was to reward the people who helped him build the company with an ownership stake, preserve the company independence and build on his legacy. “From the company point of view, the transaction provided stability, continuity and empowered the employee owners to excel,” Mach says.
The situation was similar in 2014 at Tech Systems. Company owner Darryl Keeler wanted to find a way that he could eventually retire and transfer ownership to the employees while leaving the company, its clients and employees intact after the transfer of ownership. “Tech Systems already fostered an ownership culture in that all employees were empowered to do whatever was required to exceed our client’s expectation,” says Jerry Clark, Senior Vice President of Tech Systems. “Adding true ownership was a natural fit.”
Any ESOP program is fairly complicated, Clark says, so helping the employee-owners understand how an ESOP actually works has been challenging. Tech Systems is an unusual ESOP because they included union employees in the plan. “Our effort now is to communicate effectively while keeping the information simple and straightforward,” Clark adds.
“We are seeing enthusiasm on the part of our employees and more of an ownership approach to how people do their jobs,” Mach says. “We are able to leverage the employee ownership in attracting high-caliber candidates. The reception from our customers and vendor partners has been overwhelmingly positive.”
Clark found the same response. “There was no carrot required,” he says. Since the program does not require a monetary contribution — just a continued effort to be committed to the success of Tech Systems — employees embraced it.
“ESOPs can be an effective and tax-efficient succession alternative,” says SD&I’s legal expert Eric J. Pritchard, Esq., of Kleinbard Bell and Brecker in Philadelphia.
Pritchard explains that an ESOP is a qualified benefit plan similar to a profit-sharing plan. ESOPs invest in the stock of the employer company. The security integrator sets up a trust. It then may contribute cash to buy existing or new shares of stock. “Regardless of how the ESOP acquires the stock, company contributions to the trust are tax-deductible, within certain legal limits,” Pritchard explains.
The purpose of an ESOP is to enable employees to acquire beneficial ownership in their company without having to invest their own money.
Robert Hoertsch, President and CEO of Low Voltage Contractors (LVC), finds the employee ownership culture encourages and incentivizes company efficiency and growth. “Since 2008, LVC has grown at an accelerated rate both in revenue and profit,” Hoertsch says, noting that ESOP companies typically outperform non-ESOP companies because the employees are empowered. “This is their company,” he says. “I have no doubt that LVC will continue to grow over the next five years.”
LVC’s ESOP offered the owner a calculated exit strategy and has provided LVC a disciplined and profitable retirement plan for the employees.
It is not a cheap path to follow. ESOPs are complicated and highly regulated. Legal advice is mandatory and not cheap. “We used outside parties to handle the evaluation, legal documentation and the Trustee function, and we still do,” Clark says.
While acknowledging that it is expensive, Clark says ESOPs are well worth the initial cost. “A small company considering an ESOP should budget a minimum of $100,000,” Clark says, noting that larger companies can expect that number to be two or three times that.
Getting the ESOP off the Ground
“The cost to set up an ESOP can be daunting, but the cost can be reduced substantially if the company looking at doing an ESOP takes advantage of the information and organizations that offer good advice and knowledge on how to approach them,” Hoertsch says.
When Pro-Tec first communicated its intention of setting up an ESOP during an all-employee meeting, the idea was well received, Mach says, adding there had been concerns up and down the line as to what would happen to the company and the workers once owner Tom Hagen retired.
“This provided us with a path forward, ended worries among employees and potential new hires and also provided a compelling story for our customers,” Mach says. “The employee-owners of Pro-Tec Design have been given a unique opportunity to continue improving the Pro-Tec experience for all our stakeholders and contributing to their own success.”
Employees of an ESOP company are known as “beneficiary stockholders.” As such the stock is held by a trust which is governed by the fiduciary and is not held, traded, bought or voted by the employees. Each ESOP participant gets a yearly statement detailing how much stock is in their name and the current value of that stock. “The ultimate goal of any ESOP is eventually full ownership of the company by the (employees),” Hoertsch says.
Management of the company still follows a traditional management scenario with the exception that an ESOP must have a fiduciary, which can be an individual or group of individuals, which appoints the board of directors. In addition, an annual appraisal of the company’s worth is required for stock valuation.
Clark recommends management explore the difference between a C Corp and S Corp ESOP. Tech Systems, for example, is an S Corp.
Hoertsch says it was not difficult to get buy-in from the employees. “Once the deal is done and the employees are educated on what an ESOP is, the buy-in is immediate,” he says. “A key that ensures employee enthusiasm is the fact that employees are able to acquire company stock without paying a current income tax on the stock,” he adds.
Employees are not taxed when the stock is acquired. Tax is levied upon stock redemption which occurs in a timed sequence after the employee leaves the company through retirement, death or other manners of exit, similar to a traditional 401(K) plan.
“One thing that is often missed is that the ESOP really is a retirement program that can create tremendous wealth, and the employee owner makes no contribution,” Clark says. “Stock ownership is not the important part — the stock value as a vehicle to establish a contribution to a retirement account is the important part.”
“While ESOPs can be effective succession vehicles, they are not one-size-fits-all solutions,” Pritchard warns. “One misstep could be costly and diminish the effect of its benefits.”
As a brand new ESOP, Pro-Tec wanted to be 100-percent employee-owned from the start. “Our challenge for the next two years is to keep the employee engagement visible during the period immediately following the announcement and channel it to continuously improve our service delivery and overall profitability,” Mach says.
She expects it will take a couple of years of shareholder reports to establish the economic value of being an individual employee owner. “In the meantime, we need to build the culture of employee ownership throughout our company,” Mach knows.
Meanwhile, look for more ESOPs in the small business arena – many, many more. In fact, baby boomer-owned businesses may become a glut on the market. Pritchard says ESOPs are worth considering in the face of an increased supply of closely held businesses which may flood the market, outpacing demand and potentially causing depressed purchase prices and longer timelines for sales.
That is similar to what happened at LVC. In 2008, the majority stockholder of LVC decided that he wanted an exit strategy. “An open market sale of the company was disregarded because the owner felt that this type of sale would have an adverse effect on the employees — specifically the fear that some employees would lose their jobs due to redundant positions with the purchasing company,” Hoertsch says. “An ESOP allowed an orderly exit strategy and also rewarded the employees for their years of service.”
As an added benefit, it also allows an owner to retain control until that person is actually ready to retire — at which time the control of the company is turned over to the key employees.
Pitfalls and Advice
The move to an ESOP can create serious cash flow issues and have an adverse effect on the business’s debt-to-equity ratio, Hoertsch warns. “Do your homework,” Hoertsch advises. “An ESOP is not right for everyone. An ESOP does not provide an immediate total cash payout that a standard sale may. The ESOP payout is regulated by law and typically takes a number of years.”
Clark figures that, in five years, Tech Systems’s ESOP will have reduced its debt considerably, thereby increasing the company’s stock value. “Increased stock values will mean that individual employee accounts will begin to show some attractive contributions,” he says.
If an ESOP sounds enticing, Pritchard strongly recommends finding professional firms with ESOP experience since the plans require in-depth understanding of tax laws.
Pro-Tec budgeted what some of their professional advisors thought was more than adequate amount for the legal, financial, trustee and valuation expenses. “At the end we spent double the amount budgeted,” Mach says, agreeing that an ESOP can be an expensive process. “I would strongly advise anyone entering this process to make certain that there is a clear path to the goal and all the parties and their attorneys and advisors are continually engaged.”
Clark agrees. “We were very fortunate because we found the right people to walk us through the setup,” he says.
Mach advises making certain that all parties understand as much of the details of setting up an ESOP as possible. Their program trustee described the process as non-adversarial negotiation; however, Mach reminds that it is a negotiation process nonetheless, and there are built-in protections to ensure that the ESOP does not pay more than fair price.
Mach lists four questions that must be answered when transitioning to an ESOP:
- What is the company valuation based on?
- What is the relationship of various parties involved? This list can be quite extensive: the outgoing owners, their legal and financial representatives, their families, personal advisors, the company’s attorneys and financial advisors, the outside trustee, if applicable.
- What are the terms that need to be negotiated?
- Who will provide the oversight affecting the negotiation?
“Take your time and do your homework,” Clark says. “Find an ESOP company that is in a similar business and talk to them,” he advises. “ESOP companies love to help each other and people considering an ESOP.”
Adds Hoertsch: “It is very important that a company deciding to be an ESOP hires a law firm with ESOP experience. It is also important that the company hires a trustee and an appraiser that understands ESOPs.”
The ESOP is federally regulated and as such comes under scrutiny by the Department of Labor, which performs frequent and periodic audits of ESOPs to make sure they follow the rules and guidelines as defined by the Employee Retirement Income Security Act of 1974 (ERISA).
As Pro-Tec pays down the loan used to finance the buy-out, the company’s cash flow will allow taking on new initiatives and expanding reach. In five years, the employee-owners will have a suite of financial results behind them, deep understanding of what it means to be an employee-owner, and knowledge of how they can individually contribute to the share price.
Reaping the Benefits
“ESOP has allowed LVC to remain an independent, entrepreneurial company rather than being swallowed by a large corporation,” Hoertsch says. “Morale is high and LVC is well respected across the country as a professional integrator.”
On top of that, LVC’s employees remain proud of what they do and their approach to the work they do. Hoertsch notes that customers would often ask “How long have you owned the company?” The previous answer was “I don’t own it.” Now he can say, “since 2008.”
Mach says Pro-Tec would travel the ESOP road again in a heartbeat. “The creation of an ESOP aligned with company culture and values,” she says.
Hagen achieved his objective to establish an exit plan that would be good for the employees, clients, suppliers and his family. “The strategy enables the Pro-Tec team to continue building on its successes without disruption,” Mach concludes.
Curt Harler is a freelance technology writer and regular contributor to SD&I magazine. Contact him at [email protected].