As previously published on In Business Wisconsin June 10, 2013 issue

By Edward Weisto, senior vice president, commercial middle market and regional banking for Associated Bank

One of the most difficult problems for owners of closely held businesses is finding a way to partially or completely monetize their equity interest in a business. Most often this complex subject arises during estate, retirement, or management succession planning discussions that, because of potentially significant economic and deeply personal considerations, may be extremely challenging matters to resolve.

Business executives are beginning to see the importance of tackling another seemingly unrelated challenge – deepening employee engagement. Leading research and consulting firms such as The Gallup Organization, McKinsey & Co., and The Hay Group have documented the real and significant impact of employee engagement on customer loyalty, financial profitability, productivity, employee turnover and absenteeism, patient incidents, or production/installation error rates. Given its importance to performance outcomes, business leaders now consider engagement an essential component of their business strategy.

Interestingly, employee stock ownership plans (ESOPs) may address both of these situations. The ESOP is a corporate finance tool that enables business owners to sell all or a portion of their ownership interest to an unrelated trust for the benefit of participating employees.

The value of ESOPs in the estate and retirement planning process

When developing an estate plan, which includes ownership interests in a private or public company, ESOPs can be a very attractive and tax-favored corporate finance alternative. For example, the owner of a C-corporation may be able to defer sale-related capital gains taxes by selling his or her ownership interest to an ESOP and reinvesting in select corporate securities. If these securities are not sold prior to the owner’s death, no capital gains tax is ever due. In the case of limited liability and S-corporations and partnerships, undergoing a legal conversion to a C-corporation before the sale may permit the owner to take advantage of this tax deferral. Alternatively, if the company remains an S-corporation, the owner does pay capital gains tax on the sale but reaps all the other benefits of selling to an ESOP.

Additionally, an ESOP may be appropriately structured to accommodate selling owners interested in remaining active with a business. While ESOPs are governed by independent trustees who vote the shares, the board appoints the trustees, so changes in corporate control are usually nominal unless the plan is set up by the company to give employees more input at this level. An owner may sell his or her ownership interests in a single, one-time transaction or may find value in structuring a gradual sale over a longer period of time.

Lastly, in this situation, an ESOP evaluating estate-planning alternatives may help to address some of the emotional or qualitative considerations of investing time, energy, and personal capital that often arise. After investing years in a business, an owner typically develops a strong feeling of identity with the company. At the same time, the owner often has a sense of loyalty to the employees and would like to see them have a continuing role in the company. For some business owners, the answer to these problems is to transfer ownership of the company to a family member or sell to a competitor, but those options may be unrealistic for others. Thus, those looking for an alternate solution should consider an ESOP, the outcome of which would be, at minimum, on par with what a financial buyer is likely to pay.

Impact of ESOPs on employee engagement and company performance

One of the first in-depth studies to suggest ESOPs can help improve employee engagement was published in 2000 by Douglas Kruse and Joseph Blasi of Rutgers University. The study, which examined a cohort of Department of Labor filings and Dun and Bradstreet statistical data for ESOP and non-ESOP companies formed between 1988 and 1994, found that ESOPs increased sales, employment, and sales per employee by 2.3% to 2.4% per year over what would have been expected absent an ESOP.

In a 2012 paper published through the National Bureau of Economic Research, Kruse and Blasi, along with Richard Freeman of Harvard University, also found compelling correlations between ESOPs and employee engagement. Their research was based in part on data collected by the Great Place to Work Institute, the organization best known for producing Fortune magazine’s list of the 100 Best Companies to Work for in America. They found that employees of ESOP companies had a significantly reduced employee turnover, felt more engaged, and more consistently saw their company as a “great place to work.” They also found ESOPs to most consistently have significant, positive performance improvement effects.

ESOPs can also help improve employee engagement by improving operating performance through increased sales and employment, but keep in mind that performance improvement effects do not automatically appear the moment a plan is adopted. To optimize the engagement and performance effects of an ESOP, research shows business leaders need to focus on three areas:

  • Making significant annual contributions to an ownership plan
  • Providing regular, structured opportunities for employees to participate in decisions affecting their jobs
  • Routinely communicating with employees about company financial performance and strategy

While an ESOP can be a powerful corporate finance tool to facilitate estate planning or enhance company performance through heightened employee engagement, it isn’t feasible for all businesses. When considering if this is the right strategy for your business, be sure to consult with an ESOP expert prior to making any commitments or major decisions. Be sure to have a thorough discussion about whether an ESOP is a good fit for your company, both personally and strategically.