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Within the last month, three Central Pennsylvania companies announced that they had or would be buying back part or all of their stock to give to their employees as part of new Employee Stock Ownership Plans, known as ESOPs.
The announcement that your company is adopting an ESOP can be an exciting one. It means the potential of retiring with a drastic boost to your retirement fund after selling your stock back to the company.
For an employer, it means securing a business succession plan, giving employees a sense of ownership and more. However, while a company can have a long list of reasons for adopting an ESOP, maintaining the plan and educating employees about ownership brings its own challenges.
The initial decision
Providence Engineering, a Lancaster-based engineering firm with 75 employees, announced in November that it would be going to employee ownership. For Providence leadership, an ESOP plan was one of three options on the table when discussing what the next phase of transition would look like for the firm. Providence could look for potential buyers outside of the company, look internally to be purchased by someone within the company, or it could take out a loan and give its stock to its employees.
“At a point after really digging into the options, it became clear that for Providence, the best option was to ESOP the company,” said David Bernhardt, president of Providence Engineering. “It allows Providence to remain Providence. We didn’t get bought or sold, the brand remains and the culture remains.”
As a professional services firm without many saleable, tangible assets, going ESOP spoke to Providence because it supplied an avenue to transition the company without having to bet on finding an interested buyer, said Bernhardt.
“We don’t have a warehouse full of goods, a yard full of equipment or contracts that annually renew to help establish a sales price,” he said. “A professional service firm is built on good will– The good will of our team to help provide our service and the good will of our clients to provide us with opportunities to provide that service. The value of that good will is only worth what someone is willing to pay.”
ESOPs have been around since the 1950’s but began to see more use after the Employee Retirement Security Act of 1974 (ERISA). The law introduced an incentive for ESOP creation in the form of tax exemptions, which help a company with the funds needed to make contributions back into the company stock.
“The federal government, Pennsylvania and most states stood up and said that if you adopt an ESOP, you don’t have to pay taxes on the part owned by employees,” said Kevin McPhillips, executive director and CEO of the Pennsylvania Center for Employee Ownership. “You get all of this extra cash to build the business.”
In forming an ESOP, a company must have the capital on hand to buy whatever percentage of the company it is looking to give to its employees. Generally, a loan is needed to tackle that upfront cost, which affects the initial value of the stock now owned by the employees.
The stock becomes a retirement benefit in line with something like 401-k. Employee owners can then watch their stock mature over the years and sell it back to the company when they leave. The stock maturates as the company increases in value, which can be found through an external ESOP trustee who works with a valuation firm to value the stock annually.
Educating new employee owners
The champaign has been poured and the company has celebrated the adoption of their new ESOP.
That initial announcement may not convince every employee of the latent benefit they would receive upon retirement. If they check the worth of their stock in those early days, they may be surprised to see that their stock is worth hundreds- not thousands of dollars.
“It’s not uncommon for an ESOP that the company took on all of this debt and that debt drives down the value of the stock,” said Trevor Bare, a partner and consulting actuary with employee benefit and investment advisory firm, Conrad Siegel. “There is this disconnect where we have this valuable, big company but they don’t see that reflected in the stock because most of the shares are held because of the outstanding debt.”
Bob Whalen, CEO of Harrisburg-based HB McClure, helped lead the charge for the company’s transition into an ESOP in 2010. Since transitioning into an ESOP, the commercial, residential plumbing and HVAC services company has also transitioned the employees of the companies it has acquired, which Whalen said has made the company a more attractive buyer.
Despite HB McClure’s 23 transactions, educating employees on the benefits of an ESOP has not gotten any easier, said Whalen.
According to McPhillips, one third of employees understand the function of an ESOP and are excited by the concept, another third has a wait and see attitude and the final third believe the entire thing is a scam.
“Educating the employees is a challenge. We would like to think that we can tell them that they are an owner of the firm, you snap your fingers, and their behavior aligns with how you want it to,” said Whalen. “The reality is, just like any other adoption curve, that happens over time. People want to see results before they are willing to buy into it.”
In the new year, Providence will be introducing an ESOP committee, comprised of both Providence leadership and staff to allow the firm’s employees to learn about the ESOP process and explain it to their peers, rather than allow communication to come just from leadership.
“It’s important. The message is received better from your coworkers and friends,” said Bernhardt.
A national outlook for ESOPs
The most recent data available from the National Center for Employee Ownership states that there were 6,501 ESOPs operating across the country in 2018 with total assets over $1.4 trillion. In Pennsylvania, that number was 252 ESOPs with assets over $8.3 billion.
McPhillips anticipates that Pennsylvania may have become the state with the most ESOPs in 2020, but that data won’t be available for some time. “We are hearing from the business community that activity is brisk in Pennsylvania,” he said.
The data also shows that the number of ESOPs nationally have continued to decline, dropping from a recent high of 6,717 in 2014. That is due to the double-edged sword that is an ESOP, said McPhillips.
“Many times, these businesses are extremely valuable,” he said. “The company does very well, and you get offers for the business. Once the business is more than 50% employee owned, the trust has the authority to assign the Board of Directors. I’ve never seen them change the board, but they have the authority, and the trustee must make a decision of what is best for the employees.”
Cashing out
Even when forming an employee ownership plan, a company should take into consideration what it will look like when employees are ready to sell stock back to the company and receive payments from the company, which can take time to completely pay out.
Conrad Siegel does not work with new companies looking to adopt an ESOP, but it does bring on ESOP clients and help with the ongoing administration of the plan.
Securing a loan, planning out the initial ESOP strategy, and announcing the plan to employees is a months-long process but maintaining an ESOP lasts decades.
“We help companies communicate this to employees, we manage it so its sustainable for the long term, we make sure everything is in balance so that the cash paid to former employees is matched by active employees,” said Bare. “We are not there are the start line, but we are there for the rest of the race.”
McPhillips seconded Bare, noting that companies should look to other companies when deciding on going ESOP and work with organizations specialized in employee ownership.
“If you are a real estate lawyer and you are trying to help with an ESOP, you are going to be costly and it’s going to be flabbergasting to you,” he said. “You need to work with experienced people.”
