March 2017

As Baby Boomers Retire, ESOPs Help Employees Take Over the Businesses

Building a successful business, whether it’s a factory, a service company or a retail outlet, is a lifetime accomplishment. But there comes a time when even a successful business owner wants to step down and retire. Creating an Employee Stock Ownership Plan (ESOP) can protect a business’s legacy and its longtime employees. This is how it’s done.



Kim Abello,  National ESOP Director, Wells Fargo ESOP Advisory

Kim Abello,
National ESOP Director
, Wells Fargo ESOP Advisory

Dan Machetti, CFO, Urschel Laboratories

Dan Machetti, CFO, Urschel Laboratories

 

 

 

 

 

 

 

 

 

 

 

 

In 1910, William Urschel invented the Gooseberry Snipper, a piece of machinery that snipped off the stems and blossoms from the popular fruit that was then sold to Michigan canneries. The Snipper could do the work of 100 men in one day and revolutionized the food processing industry. Gooseberry pie is no longer a staple at the dinner table, but chances are the frozen French fries, green beans or carrots sitting in your freezer have been sliced and diced by one of Urschel Laboratory’s machines.

For 106 years, Urschel family members ran the Indiana-based company, which employs more than 400 and prides itself on having never laid off an employee. Today, the founder’s grandsons, Bob Urschel and Rick Urschel, lead the company as chair of the board and CEO, respectively. But, according to Urschel CFO Don Marchetti, Rick Urschel was concerned with the company succession and future leadership, even though he still sees himself and his family in the business for the long run.

“I’m not sure how many years my dad has left to work, but everyone appreciates having him around,” Rick Urschel says. “He’s a great source for institutional knowledge, and I rely on his council. As for me, I love living here and couldn’t think of anywhere else I’d rather work. I’ve grown up with a lot of these guys, and the friendships I’ve had over the years make coming to work and doing the best job I can an easy task.”

Still, they had to consider the possibility that the fifth generation might not be interested in running Urschel. How could they protect the company the family had built? How could it protect its employees?

“Over the 100 year history, it’s always been about the employees. The family feels that they are successful due to the people who work for them,” Marchetti says. The question for the family, he says, was “how do we give the business to the employees, who are really the ones who made it what it was?”

Creating an ESOP

In the end, the solution for the Urschels was one that is gaining popularity throughout the country as baby boomers approach retirement – the family created an Employee Stock Ownership Plan and sold the company to its employees. On February 29, 2016, Marchetti and his co-workers became owners of Urschel through a plan created with the assistance of Wells Fargo’s ESOP division.

Kim Abello, national ESOP director at Wells, has been helping companies create ESOPs for 25 years, and she moved to Wells in 2014 to spearhead the division. While creating an ESOP has many benefits for a privately held company like Urschel, she notes that public companies are also transitioning to ESOP, although in smaller numbers, and handing over a smaller percentage of the stock.

“ESOP tends to be more Main Street U.S.A, for smaller, privately held companies,” she says. “And the employees in these privately held companies typically own a majority of the stock. Unlike public companies where the ESOP may only own 5%, and the rest of it [the stock] is publically traded. In many cases, in privately held companies, employees own the entire company.”

Works Like a 401K

The ESOP trust purchases the stock, explains Abello. “So it is much like a 401K plan that has a trust. And the trust is set up to provide for the retirement of employees. But in a 401K plan, the assets are liquid investments in the public marketplace. In an ESOP, the assets in the marketplace are the employer’s stock.”

Marchetti sees it breaking down across a handful of parties.

“The way I evaluate it, there are three pieces. You’ve got shareholders, stakeholders, employees and the company itself. The company benefits because it becomes this tax-free entity and has excess cash that can now be used to invest back in the business. The employees benefit because now they become owners, and they have a retirement system in place that allows them to work 20 to 30 years and retire with a significant retirement benefit. The owners are also involved in the transaction. As the shareholders, they sell their stock to the trust and, in specific structures like ours, the gains that they earn on the stock can be tax-free if they take advantage of what is called IRS Code 1042. So there are three winners,” he says. “People ask the question, how does the government get money out of this? The government finally gets their money when the employee retires, and they put that money in a retirement account and they start to draw down that money to take care of their retirement needs. It’s like an IRA or 401K. So eventually the government gets its share.”

Shares Based on Profits

At Urschel shares are allocated to employee accounts on an annual basis, and upon retirement from the company, the employee sells their shares back to the ESOP for cash. It also gives the employees control over future transfer of the company, making it difficult to sell or merge with another company. Marchetti says the company uses the ESOP as a recruiting tool. New employees realize they will be company owners. It also provides an incentive to work harder — the more the company earns, the more the employees’ shares are worth. At the end of the year, shares are redistributed back on the company’s profits. Employees who leave or retire are required to sell their shares back to the trust.

One difference at Urschel is the family is not walking into the sunset, although many business owners do take that opportunity after an ESOP.
Tax Advantages for Company

There are advantages for the company, too, Marchetti points out. To qualify for the ESOP, Urschel had to change from being a C-Corporation to become a S-Corporation. For an S-Corp, the taxability of the company falls to the ESOP trust, which, like a 401K, is not taxable by the government.
“So literally what you’ve done is taken a company that was a C-Corp at a 35% tax rate, and now it’s taxed at 0% through the trust,” Marchetti says.
Economist Louis Kelso is credited with developing the first ESOP in 1956 when he helped a privately held newspaper become employee-owned upon the retirement of its owners. In 1974, Congress passed legislation that provided tax and Social Security Advantages to support ESOP transactions, but the concept gained traction slowly. The recent transfer of wealth from retiring baby boomers has brought it into the forefront of modern business planning.

ESOP Can Be Complex

Abello says that she “just kind of fell into it. I was looking to get into corporate finance after being in the tax department at Arthur Young, and the firm that gave me an opportunity to get involved was heavy into ESOP and doing valuation work. I had the tax background that they needed to understand these ESOPs and they had the corporate finance background that I needed.” Abello went on to spend half her career in ESOP divisions, including a stint at JPMorgan Chase.

At Wells, she says, “Our ESOP practice is probably a little different than some of my prior positions in that we team up with our local bankers to bring the ESOP expertise to each of our commercial banking offices nationally. So, we are part of the banking team when we’re looking to bank with ESOP companies. It is a little bit of a different role, and it is definitely a dedicated ESOP practice. There are four dedicated ESOP professionals that cover the U.S., and we also partner across many other business lines. So we work with Wells Fargo wealth management, equipment finance, we even work with the investment bank capital finance…anybody inside of Wells Fargo. We have a very collaborative culture.”

Marchetti worked with Abello and some other banks that assisted with the financing and setup of the ESOP for Urschel. It is, he explains, a complex transaction.

“I would say that the primary role that we [the banks] play of course is to provide the financing for the transactions, because most of the ESOPs are leveraged,” Abello says. “The employees don’t typically pay for the stock out of their own pockets. The stock is paid for by leveraging the company’s balance sheet. So we work with the company to determine their debt capacity in order to lend to the company. That is our primary role.”

Leveraging the Stock Purchase

Marchetti explains the process this way: “There is an initial loan between ESOP and the company. The company doesn’t have that amount of cash on their balance sheet to lend the trust so we go out and enter a credit agreement or borrow from the banks to finance the whole transaction. So there are two loans and three parties.

“The trust and the bank never really work together or work within each other, but the middle person is the company who borrows from the bank and lends to the trust and then it gets paid back. From a lending structure perspective, the loans we have with the bank were basically five-year terms, and our expectation is that we’ll pay it off in five years.”

He adds the trust sets up a longer term loan because the repayment of that loan works through distributions that the company gives to the trust. “At the end of the year we put together financial results, and we distribute cash to the trust, which is equal to the shares of stock value. Then they take the cash that we distribute to them, and they pay us back. That loan with the trust lasts 50 years, which allows us to continue to have shares that get released. So it’s not like tomorrow the employees are 100% owners of those shares. The shares get distributed to them on an annual basis based on their compensation.”

Abello agrees that while creating an ESOP sounds like a simple solution, the transactions are complex. “One of the other roles that we like to play is helping our customers understand the ESOP,” Abello says. “We actually have an ESOP 101 presentation for customers and prospects that are considering an ESOP that helps them learn the basics.

“The underwriting is different for an ESOP because of the tax benefits. So what we’re able to do is partner with the credit chain at Wells Fargo which really helps and enhances the client’s understanding of all aspects of ESOP. We’re able to consolidate the knowledge so that the customers and prospective customers can transition to an ESOP in a way that protects their balance sheet.”

If forming an ESOP is so positive for the business owner and the employee, why doesn’t every company transition that way?

Paying Attention to the Details

“They’re not the easiest transactions to complete,” Abello responds. “They involve a lot of disciplines and if a business owner isn’t paying attention to even one of those disciplines you could have issues that would affect a company. There is also an anti-abuse provision in the tax law that you need to be careful of. This is a transaction in which you’re putting increased leverage on a company. The lender has to make sure the company isn’t over leveraging so we can balance the amount of debt that will be taken on for the transaction which they need to grow.

“The third kind of financial issue is this ESOP repurchase obligation. A 401K plan contains liquid investments that can be sold when someone retires by whoever is running the trust. In an ESOP, the shares inside the trust are privately held. And therefore they need to be monetized. They need to be sold at the time that someone retires. And it’s the company that has to buy back those shares. And that’s a pretty significant obligation. That’s why we feel that we need an ESOP group to really handle the full life cycle of the ESOP that really needs to be analyzed at the time you put in the original transaction. You need to be able to look at the full spectrum of being able to manage and afford the ESOP. And that’s not easy.”

She added that an ESOP is also not an option for a high growth company. “A high-growth company needs a lot of capital to grow. That’s probably the most significant situation we see where people may draw away from us. But in those cases they’re not looking to sell anyway.”

A company like Urschel is a perfect candidate, Abello says, because of the nature of the business and the close-knit relationship between the owners and the employees.

“Business owners have different agendas,” she says. “And those that choose ESOPs and bring employees into the fold, they have lower turnover. I do think they’re very good companies to work with. Their interests are aligned with the shareholder’s interests. It’s a team environment.”

As Marchetti puts it, “I am the CFO at Urschel. And since February 2016, I am also an owner.” For a worker who loves where he or she works, that’s a great place to be.