Kloke and his wife and co-owner, Beth, had to decide who would take over. Kloke was in his mid-60s and knew he would soon retire, so he sought a way to extract his capital from the company. He also wanted to help his employees, and offer them a retirement plan that, he hoped, would provide his company with a higher employee retention rate than its peers in this turnover-plagued industry.

The Klokes realized that they could not saddle their children with an unwanted company. Irene Firmat, CEO and founder of Full Sail Brewery in Hood River, Ore., had a similar dilemma. “It took us a while to decide what we wanted to be when we grew up,” she says, “and I can’t think of anything worse to do to my kids than to say, ‘Hey, we made this decision so it’s made for you!’ I want them to be anything they want to be. Right now one of them wants to be a restaurant critic and the other one wants to design roller coasters; they don’t want to be brewers.”

Both families came up with a solution: an employee stock ownership plan, or ESOP. For Kloke, who devised the plan with his accountant, an ESOP would turn his company’s 80 qualified employees into owners, solving his succession problem It would also allow the Klokes to step back from the company, liquidate their holdings and set off on the travels they had long craved.

TOP VIEW For business owners seeking an exit strategy, an employee stock ownership plan, or ESOP, has several advantages. ESOPs enable the owner to sell all or part of a company to its employees, garnering liquidity—and tax breaks—for the owner and a new source of motivation for the staff. ESOPs work best in larger companies that can generate enough cash to finance the buyouts.

Land of ESOPportunity
Today there are some 11,500 companies with ESOPs in the United States, including giants such as Procter & Gamble. While these tools are effective defenses against hostile takeovers, this is the motivation for ESOPs in only a handful of cases. The vast majority are set up as exit strategies for owners of privately held businesses.

These transactions involve a company’s owners selling their stakes to the ESOP plan. The plan then parcels out shares to qualified employees in much the same way as profit-sharing plans do; employees do not have to buy the stock. An ESOP offers a number of advantages for an owner, particularly when compared to other liquidation strategies, such as selling to a strategic or financial buyer. But perhaps the most compelling aspect of an ESOP is its tax benefits. ESOP legislation provides tax incentives for owners, shareholders, the lending institution that provides financing for the ESOP, the employees and the company itself.

“The goal was to make ESOPs the most tax-favored way to transfer ownership to employees,” says Corey Rosen, executive director of the National Center for Employee Ownership (NCEO) in Oakland, Calif. “So whatever you’re comparing it to, the tax treatment won’t be as good.” Indeed, if the company buys more than 30 percent of the shares and the owner rolls his proceeds into securities of U.S.-based operating companies, he can defer taxes on the gain indefinitely.

Keeping it in the Family
In addition to tax benefits, an ESOP holds more certainty for owners attempting to liquidate their holdings than does selling the business on the open market. Such a sale can be gut-wrenching for the owner. Peter A. Rohr, senior vice president of Merrill Lynch’s Private Banking and Investment Group in Philadelphia, has witnessed much gnashing of teeth. “They felt some sort of loss by thinking of selling the company,” he says. “They even feel a bit traitorous when employees begin to ask, ‘Who are these people in suits coming in to see the owners?’ ”

Selling to an outsider can also be detrimental to the business itself, according to Firmat, who established an ESOP in 1999. “People don’t take into account the costs of putting a business up for sale and what impact that has on productivity and market presence and just a whole slew of issues,” she explains. “What the ESOP provides for smaller companies that are not public is an avenue of liquidity for the ownership to say, ‘I see how I can sell my shares in a way that is not going to hurt people I work with or the company I’ve built.’ ”

Selling to another party is typically an all-or-nothing proposition, but ESOPs enable an owner to sell a part. Full Sail established an ESOP after four of the company’s six original founders decided that they did not want their money bottled up in the microbrewery. Firmat and her husband, Jamie Emmerson, did not want to sell. The other investors gained liquidity via the ESOP, while Firmat and Emmerson maintained their 42 percent stake. Not only have Firmat and Emmerson remained active in Full Sail, they have laid the groundwork for someday selling the company in its entirety.

Firmat admits that the biggest challenge of the ESOP experience has been teaching employees what it means to be owners. This can be a challenge in blue-collar businesses where employees rarely have any experience with entrepreneurship and little understanding of compensation beyond hourly rates. Firmat had to address the misconception that those on the floor could arbitrarily award themselves new raises. In private ESOP companies, employees can vote on critical issues, such as plant closings or relocations. In public ESOP companies such as Proctor & Gamble, employees can vote according to their shares on all matters.

Kloke concedes that getting the employees to understand that they benefit from the company’s future success has been a “long, long-term process.” Even so, after employees get over their initial misperceptions, Rosen claims that they embrace the ownership ideal, and the benefits of this are significant. Research by professors Douglas Kruse and Joseph Blasi of Rutgers University has shown that ESOP companies perform 2.3 percent better per year, on average, than their non-ESOP counterparts. Full Sail has lowered its break-even point and increased its value each year since instituting the ESOP.

Finally, an ESOP allows an owner to part with his business gradually. Still trucking at 74, Kloke no longer owns any stock; the full ownership transfer took over 10 years. He still reports to work—often six days a week—and he is the company’s lowest-paid employee, earning $5,000 per annum. For some owners, however, Rohr says the unhurried disassociation with the company is too difficult. One client calls it “slow bleeding.” In cases in which an owner desires an expeditious exit—particularly if his health is a concern or the business causes family strife—the far horizon of an ESOP is ill advised.

Successive Successes
Management succession becomes a central issue for ESOP companies. Kloke has paid ever-greater attention to his managers and new hires since establishing the ESOP, targeting those who can take on more responsibility as he, in turn, surrenders it.

Before becoming willing participants in management succession, however, employees must be in favor of the ESOP. Although an owner does not need to seek permission to hand over control, the employees wield de facto veto power. If they are not on board—perhaps because they fail to see the value in ownership or believe the company’s prospects are poor—the venture is destined for trouble. Bridging this gap may require restructuring the entire company to appeal to its new employee-owners.

The ESOP itself is a complex matter. An owner or ownership group must prepare an ESOP team consisting of the owners, the company’s CFO and corporate counsel, a lending institution, an outside ESOP specialist and often the owner’s attorney, accountant and/or financial advisor. At a minimum, expenses will run approximately $40,000, but are more likely to go beyond $100,000. Expect to pay between $25,000 and $50,000 for feasibility studies before an ESOP even gets off the ground. Companies must undertake a thorough valuation and pay fees to lawyers and an ESOP administrator. The ESOP entity cannot pay more than fair market value for the equity.

If the company cannot finance its own buyout, as is usually the case, it must borrow from a commercial lender. During the repayment process, much of what the company repays to the lender (both principle and interest) is tax deductible. The monies paid to the owner are tax deductible if his company is a C corporation with at least 30 percent of its stock owned by the ESOP.

ESOPs work best at companies that are profitable, because they can more easily generate the cash to pay the owners or the lenders. They should also be of an established size; companies with fewer than 20 people find it challenging to pay the six-figure fees involved in administering one of these programs.

Generally, all full-time employees over 21 can participate in the ESOP, with shares apportioned based on some formula. Often this scheme is relatively straightforward. For example, an employee making $80,000 will receive twice as many shares as an employee making $40,000. An ESOP is not an appropriate mechanism for transferring control to only certain employees or family members.

Employees’ shares vest over time, usually in five to seven years. When an employee leaves, the company is obligated to buy back his shares at fair market value. ESOP companies must set aside significant funds for this purpose. If a company’s value rises significantly, buying back shares from departing or retiring employees can become prohibitively expensive.

Rosen adds that owners are often initially most impressed with the ESOP’s tax benefits, but years later admit that they are happiest knowing that, through employee ownership, their life’s work will endure. Kloke fits this mold precisely. “It’s still there. It’s still an institution,” he beams. “That was part of our motivation. Our name is on the business. We’d like to see it perpetuate and prosper.”

Lee Gimpel is a business and technology writer based in Richmond, Va. lee@gimpelwriting.com