A Wealth-Building Tool Often More Coveted Than a 401(k) Plan by Employees
By Susan Caminiti, CNBC
December 4, 2018
- There are nearly 7,000 employee stock-ownership plans in the U.S., holding assets of $1.7 trillion, according to the National Center for Employee Ownership.
- More small to mid-size companies and some start-ups are looking at ESOPs as yet another attractive benefit they can offer job candidates in industries with high turnover rates.
- The Main Street Employee Ownership Act allows the Small Business Administration to make its loan guarantee programs more readily available to companies looking to transition to an ESOP.
In the ongoing battle to find and keep the best workers, here’s another tool more and more companies are considering: ESOPs.
Employee stock ownership plans allow businesses of all sizes — from S corps to C corps — to make employees the owners of the company. They also give business owners a way to sell their company without having to look for an outside buyer, or depend on the next generation of family to take over.
And now increasing numbers of small to mid-sized companies and some start-ups are looking at ESOPs as yet another attractive benefit they can offer job candidates. For industries with high turnover, such as hospitality and trucking, ESOPs can be an effective tool for recruitment and retention. After all, workers are more likely to stay when they know they have the chance to accumulate some significant wealth down the road.
Legislation signed into law this summer now makes converting to an ESOP easier. The Main Street Employee Ownership Act allows the Small Business Administration to make its loan guarantee programs more readily available to companies looking to transition to an employee stock-ownership plan. In the past these companies often had trouble getting loans through regular banks.
New York Sen. Kirsten Gillibrand, an early champion of the idea, came up with a bipartisan plan that had the best chance of passing. She and others recognized that employee ownership is one of the more effective ways for workers, who contribute to a company’s success, to actually share in its value as it grows.
“We talk about income inequality in this country, but ESOPs are a solution to wealth inequality,” said Keith Butcher, co-founder and managing partner of ButcherJoseph, an investment bank that specializes in helping companies transition to ESOPs. Butcher helped draft the recent legislation. “Over the long-term, employees can develop significant equity balances and really participate in the growth of the business,” he said.
And because workers have a financial stake in the success of the company, studies show that ESOPs are a great tool for retaining employees and motivating performance. In fact, nearly 75 percent of ESOP companies surveyed by the ESOP Association said they had better year-over-year performance as a result of their structure, and only 15 percent said they had worse performance.
The plans were formalized by Congress in 1974 when plan details were laid out in the Employee Retirement Income Security Act (ERISA). While some notable companies, like Wawa and Publix Supermarkets, offer them, they remain a modest part of total American stock holdings, at $1.3 trillion.
An easier process
The new legislation makes it easier for companies to get an SBA-guaranteed loan up to $5 million to transition to an ESOP. To qualify, however, companies must have been in business and profitable for at least three years.
Here’s how it works: A bank loans money directly to a business. That company then re-lends it to the ESOP. The ESOP is the entity that actually buys the business from the owner, making this an attractive way for entrepreneurs to exit their companies when they don’t have another generation to take over or don’t want to sell it to an outsider, said Butcher. Each year, the company makes a tax-free contribution to the ESOP, and the ESOP uses these dollars to retire the loan it took from the company. As the ESOP repays the loan, it releases shares to employees.
Like other types of retirement plans, the employer’s contributions to an ESOP on behalf of employees are allowed to grow tax-free until the funds are distributed upon an employee’s retirement. At the time an employee retires or leaves the company, he or she simply sells the stock back to the company. The proceeds of the stock sale can then be rolled over into another qualified retirement plan, e.g., an Individual Retirement Account or a plan sponsored by another employer. Another provision of ESOPs gives participants — upon reaching the age of 55 and putting in at least 10 years of service — the option of diversifying their ESOP investment away from company stock and toward more traditional investments.
The financial rewards associated with ESOPs can be particularly impressive for long-term employees who have participated in the growth of a company. Of course, employees encounter some risks with ESOPs, too: Their retirement funds are invested in the stock of one company. In fact, an ESOP may become worthless if the sponsoring company mismanages the company and goes bankrupt. But history has shown that this scenario is unlikely to occur: Only 1 percent of ESOP firms have gone under financially in the last 20 years.
Typically, workers become vested in an ESOP after three years and pay nothing to participate. As co-owners of the company, employees vote on major events, like mergers and spin-offs, but a management team still handles day-to-day decisions.
The number of shares awarded to an employee each year is based on their salary and how long they’ve been employed by the company. And unlike other qualified retirement plans, like a 401(k), which ESOPs also are free to offer, workers don’t contribute financially to participate. A share’s value is determined once a year by an outside trust company based on the company’s performance and growth. Those shares are then awarded to an employee’s account.
Workers can accumulate some significant assets. The average employee account balance in an ESOP is $134,000, according to research by professors Joseph Blasi and Douglas Kruse at the Rutgers School of Management and Labor Relations. That’s over and above any other retirement plan a company might offer.
The National Center for Employee Ownership says there are nearly 7,000 ESOPs in the United States, holding assets of $1.7 trillion. A few large private companies, such as Publix Supermarkets and WinCo Foods, are ESOPs, but most are small to mid-sized businesses across all industries and geographies, said Butcher. “These aren’t high-flying tech companies,” he added. “They’re service and manufacturing firms growing anywhere from 3 percent to 8 percent a year, providing core things for the economy. An ESOP is a retirement plan for their employees, not a get-rich-quick scheme.”
A motivation tool for employees
Dennis Quaintance is the CEO and co-founder of Quaintance-Weaver Restaurants and Hotels in Greensboro, North Carolina. Two years ago he and his partners made the decision to become an ESOP and turn over ownership of the company to its employees, many of whom wait tables and clean the rooms in his hotels and restaurants. “This is a wonderful way for employees to maintain their mojo,” he said. “Every year they are here is another year that they’re seeing their account balance grow. I can’t think of a better way to align everyone’s interests than with an ESOP.”
The company has about 670 employees, and all (including management) are eligible to participate after they’ve been there for a year and work an average of 19 ¼ hours a week. The shares, or “retirement units,” as Quaintance calls them, vest after three years. Since no one at the company will reach the vesting threshold until next year, he said he’s been careful not to oversell the ESOP to his employees.
“Over time they’ll begin to see money in their accounts, and as it grows, they’re going to realize that this is a great way to accumulate retirement funds without having to contribute through a payroll deduction,” he said, noting that the company will also start to offer a 401(k) plan beginning next year.
The business also gets a significant tax break. When an ESOP purchases the shares of a company, it is no longer required to pay federal or state income taxes. “We pay no income tax, since we became an ESOP,” Quaintance said. “That’s what allows us to fund these retirement accounts for our employees.”
An exit strategy for founders
One of the other big advantages of an ESOP is that it creates an exit strategy for business owners that want to retire or sell their company. Selling to employees eliminates the need to find an outside buyer who may want to reconfigure the business or eliminate jobs. This is especially important now as research from Rutgers University shows that half the nation’s small businesses are expected to change hands in the next decade as more and more baby boomers look to retire.
That was the case with EOC, a heavy-equipment distributor with about 288 employees in 16 locations across Texas. CEO Whit Perryman said the company converted to an ESOP in 1995 when its then 55-year-old founder was contemplating life after the business. With two daughters not interested in taking over the company — and a desire to reward employees — the founder decided an ESOP was the best way, said Perryman, who joined the company in 1992.
Although he admits the company didn’t do a great job of explaining the benefits of the ESOP to employees in the early days, today every employee understands its significance. “When they get their statements and see how their accounts for retirement have grown, it becomes pretty real,” he added.
The structure, Perryman said, also helps EOC attract and keep talent. Offer letters to job candidates include the amount of money they can accumulate in an ESOP over various time frames. They become interested when they hear that the average ESOP account balance for employees at EOC is $208,000.
And once they’re on board, EOC employees tend to stay. Perryman said the company loses fewer than 10 percent of its workers each year. “I can sleep at night knowing I have 288 employee-owners who are always thinking about how to make the business better,” he said.