Editor’s Note: Mary Beth H. Gray is a managing partner of Kleinbard LLC in Philadelphia. She practices in the areas of mergers and acquisitions, representing both buyers and sellers, as well as corporate finance, governance, restructuring, and executive compensation. Her practice places a special focus on business succession, including the sale of businesses to employee stock ownership plans (ESOPs) and other transactions involving ESOPs.
“Treat employees like they make a difference and they will.” Jim Goodnight, CEO SAS
Why consider employee ownership?
Think about the first time you applied for a job or interviewed someone for a job. The conversation probably did not include a discussion of who owned the company. For public companies, this is not surprising, because employees may know what it means for the company’s stock to be owned by the public. At privately-held companies, though, the question of who owns the company may be more important. Ownership could affect whether the company is going to be sold, and to whom, and with what consequences. It could affect whether operations are going to be moved to a different facility or country. It could also affect employee culture and benefits. In a company owned by a few investors, or family members or founders, there will almost always be an ownership transition, and that transition can create anxiety, disruption and cultural changes.
Craft brewers who care about providing innovative benefits, competitive compensation, and tools for employee engagement might consider employee ownership as a part of a strategy to achieve these goals. Employee ownership provides a way for the current owners to sell their shares and also to create a unique employee benefit whose value is tied directly to the success of the business.
There is a growing number of examples of craft breweries currently using employee ownership for both ownership transition and employee benefits. Deschutes, Harpoon, Left Hand and Odell – to name just a few – have all become wholly or partially employee-owned. New Belgium was 100% employee-owned when it was sold to Kirin-owned Lion Little World Beverages last year.
Employee ownership of companies enjoys unusual bipartisan support. This may be because most of us work at companies, and we care about whether those companies are successful. We want to be part of that success, and we want to have enough money saved so that we can retire comfortably from those companies. Employee ownership gives employees both the responsibility and the potential reward that business owners have always had. Ownership can lead to financial benefits, but with it comes an obligation to work hard, make good decisions, and stay focused on how the business can run at its best.
Because companies have to be owned by someone, most owners think carefully about who would own their companies if they could not. There is compelling evidence that broader-based employee ownership, including through ESOPs, is correlated to higher sales growth, higher sales per worker than in companies without employee ownership, and longer survival rates.
What is an ESOP?
An ESOP is a qualified employee benefit plan, but it is also a buyer. It exists to purchase stock from a company or from a shareholder. A sale to an ESOP is not as familiar as more traditional sales (e.g., direct internal sales or a sale to a strategic buyer) but, fundamentally, it has the same result. The person or people who own the stock sell it and receive the purchase price. The shares are then owned by an employee benefit trust. Employees don’t own the stock directly but have a beneficial interest in the trust and the right to receive the vested value of their accounts (in cash) when they leave. A company owned by an ESOP could, like a public company, be owned by the ESOP indefinitely, and never have to do another transition of ownership. The shares in the ESOP are bought and sold many times over, with shares moving from today’s employees (when they leave) to the employees of the future.
Why an ESOP?
Companies adopt ESOPs for two main reasons. The first is that the owner or owners want to sell their stock and the available buyers (other principals, private equity, strategics, etc.) aren’t perfect candidates. Other principals might not have the funds or the desire to take on the risk of direct ownership. Private equity funds or other financial buyers might plan to take on too much debt or might create the risk of a negative culture change. Strategic buyers might be hard to find or might threaten a founder’s legacy. Moreover, no other sale offers the significant tax advantages that an ESOP does.
Second, many companies adopt ESOPs to provide a tax-favored employee benefit plan that does not require employees to contribute their own funds. Company contributions to an ESOP are tax-deductible, and employee accounts are typically not accessible by the employee until the employee leaves the company. The company stock in the plan is valued at least once a year and the company buys back the stock at its then value when an employee leaves, but only after a fairly long waiting period (up to 10 years). Most importantly, a pass-through corporation (an S corporation) that is owned by an ESOP pays no income taxes.
As a simple example of the impact that tax-free S corporation ownership has, consider a brewery owned in equal shares by three individuals. If the brewery has $2.1 million of taxable net income each year, each owner is responsible for the taxes on $700,000 of net income. In a state where the federal and state tax burden for individuals is 40%, each owner would owe $280,000. If the company pays distributions to the owners to permit them to pay their taxes, the company uses $840,000 of cash to pay the tax distributions. By contrast, if an ESOP (which is a tax-exempt employee benefit trust) owns the company, it has no tax liability and the company can use the $840,000 for other corporate purposes – buying equipment, expanding operations or hiring people.
Valuation
In any corporate transaction, sellers may have to be prepared to receive less than top price for their shares, and buyers may have to be prepared to pay more than planned. Few deals begin and end with both parties getting or paying exactly what they expected. ESOP deals, like most deals, involve arms-length negotiations between a willing buyer and a willing seller, where the fair market value determination is made after due diligence, a comparison of similar deals, and evaluation of the projections of the brewery being sold. Valuation depends on numerous factors, including company-specific circumstances and market dynamics as a whole. The recent economic challenges created by the COVID-19 pandemic provide an example for breweries. Sales have declined sharply at breweries with taprooms and mostly on-site services. Some breweries, though, have been able to innovate to increase off-site sales and find other distribution channels. Many more people are home and drinking beer as a happy distraction from bad news, and maybe this will improve the industry in the long run. Timing is everything, and the pandemic may delay transactions or make a current valuation inappropriately dismal. But downturns and pandemics do end eventually, and a business in need of a buyer will be able to ready itself for a sale in a more promising economic environment.
Complexity
ESOPs can be trickier buyers than others. All transactions require advisors with legal and financial expertise, but ESOPs specifically require advisors who also know something about ESOPs. Because ESOPs are employee benefit plans, companies with ESOPs will also need to hire third party administrators who understand how ESOP benefits work. Also, many ESOP purchases are done as leveraged buy-outs. The ESOP provides a relatively tax-efficient way to take on the leverage (with both principal and interest being effectively tax-deductible), but sellers who are looking for a complete, immediate, debt-free exit might not be able to meet that goal with an ESOP.
A successful ESOP transaction requires patience and flexibility. Unlike other transactions where the buyer might bring all of the money or all of the operational expertise to the deal, in an ESOP transaction, the seller brings both. Strong corporate governance and a plan for internal management succession will significantly improve both the performance and the sustainability of an ESOP-owned company.
Employee Ownership Culture
Many breweries are, in a sense, employee-owned, but possibly not by all of the employees and most not with the tax savings provided by an ESOP. To the outside world, a company owned by an ESOP is largely unchanged from the pre-sale company. The management team and employees stay in place, the strategic plan does not have to change, and the ESOP ownership neither prevents nor requires a subsequent transaction in the future. (As the New Belgium example shows, an ESOP-owned company can be sold, and many of the employees receive a share of the purchase price.) But adopting an ESOP does something critical for the business: It gives employees a stake in the growth and profitability. There is strong evidence that this stake leads to lower turnover, lower rates of layoffs in an economic downturn, and higher profitability. There is also evidence that employee ownership improves employee satisfaction and reduces wage inequality.
Employee ownership is not a perfect fit for every company. Ownership transition requires planning, balance, and attention to numerous — sometimes competing — objectives. But an ownership transition plan that does not include discussion of an ESOP is missing an important opportunity, and one that could make a significant difference to your company and its employees.