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ESOPs – Often Lauded, Sometimes Maligned, Usually Misunderstood

“Too often, people have pre-conceived notions about ESOPs that are based on one or two anecdotal experiences, but ESOPs come in all shapes and sizes.”

As business owners in the A/E and environmental consulting industries examine their ownership transition options, we’re finding more and more are considering employee stock ownership plans (“ESOPs”). But too often, people have pre-conceived notions about ESOPs that are based on one or two anecdotal experiences. Perhaps they worked at a firm in the past that had an ESOP. Or maybe they have a professional colleague that instituted an ESOP in his or her firm. The problem is that ESOPs come in all shapes and sizes. An ESOP strategy that might have been successful for one company, may not be appropriate for another. Conversely, because a particular company had a disastrous experience with an ESOP, doesn’t mean that an ESOP couldn’t work for your firm.

General ESOP statistics

Here are some ESOP statistics that many readers may find surprising. The National Center for Employee Ownership (NCEO.org) reports that there are approximately 7,000 ESOP companies in the U.S., with the most common industries being manufacturing, banking, construction and, you guessed it, engineering. In fact, NCEO’s 2016 list of the top 100 ESOP companies include some of the country’s most prominent A/E firms, such as Gensler, HDR, Black & Veatch, Burns & McDonnell, HNTB, Terracon, Kleinfelder, and STV Group, among others.

However, ESOPs are not solely the province of large firms—on the contrary. NCEO’s latest study reports that 41% of ESOP-sponsoring companies have 50 or fewer employee-participants, and 60% have 100 or fewer employee-participants. So if you had dismissed an ESOP as an ownership transition alternative for your firm because you thought you were too small, you may want to reconsider.

Various Shapes and Sizes

One of the most common misconceptions is that all ESOPs must take the form of a leveraged transaction (i.e. the Company takes on debt to fund the ESOP’s purchase of stock from a retiring shareholder), or that the ESOP will end up as the controlling shareholder. In fact, ESOPs may be funded and accumulate stock in a number of ways, and the plan may hold ownership stakes ranging from a small minority interest up to 100%.

Many of the horror stories about failed ESOP companies involved highly leveraged transactions, where companies took on more debt than they could afford, or conducted a leveraged ESOP transaction and then experienced an unexpected downturn in their business. This is a legitimate concern in cyclical industries, or for businesses that have volatile earnings histories, but there are ways to address this.

An increasingly popular ESOP structure in the A/E industry is the non-leveraged or “pre-funded” plan. As an example, let’s say a firm is planning for the retirement of a group of shareholders anticipated to take place three years from now. The firm could establish an ESOP, and begin making cash contributions to the plan, effectively building a fund using pre-tax profits (contributions to an ESOP are a tax-deductible expense) that may be used at a future date to purchase stock from the retirees.

The advantage to the pre-funded plan is its flexibility. If the sponsoring company has a particularly strong year, it could increase its contribution to the plan (within statutory limitations), thereby sheltering more profit from taxation and potentially accelerating the timeline of the transition. And if the company had a weak year, it could reduce or postpone its contribution to the plan.

Controlling the process

The tax benefits that ESOPs provide to the sponsoring company, and in some cases to the sellers, are often what accounting and financial advisors focus on. However, while the tax savings of the ESOP structure can be significant, another advantage is often overlooked. Unlike orchestrating a sale to a select group of employee-managers, or seeking to sell to or merge with another firm, transitioning ownership to an ESOP is a process that can be planned and executed with a much higher degree of predictability.

With a sale to an ESOP, the company’s directors decide when and how to structure the transaction, and the share price is informed by an independent appraiser engaged by the ESOP’s appointed trustee to ensure that the ESOP does not pay more than fair market value for the stock in order to comply with the Employee Retirement Income Security Act (ERISA).

The afterlife

Once an ESOP has been established, its ownership level can be actively managed in accordance with the culture and strategic objectives of the Company. Our own A/E Ownership Transition Study, conducted in partnership with Practice Lab, indicates that the average ESOP ownership interest in the industry is 51%, and ranges from a low of 8% to a high of 100%. Many firms in the A/E industry maintain their ESOPs at a level that provides a meaningful employee account balance, while also allowing direct ownership opportunities for the management team.

The ESOP’s ownership level can be managed by controlling how repurchases of ESOP shares are handled (are the shares redeemed and cancelled, or recirculated to remaining plan participants), what is contributed to the plan, and the ESOP’s purchases of stock from retiring shareholders and the treasury.

The bottom line

When it comes to ownership transition planning, ESOPs are not the panacea. But if such an ownership model is in keeping with the culture and strategic direction of your firm, they may very well be an option worth considering.

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Ian Rusk will be co-presenting an informative session on ESOPs together with Attorney David Solomon of Levenfeld Pearlstein, and Pete Prodoehl of Principal Financial Group on November 4th at the Growth & Ownership Strategies Conference in Naples, Florida. Registration for this popular educational and networking event is still open. Visit http://conference.rog-partners.com/ to register.

ESOPs — is there a plan that will work for your firm?

Employee Stock Ownership Plans, or ESOPs, are increasing in popularity as a vehicle for ownership transition, but in spite of this, they are frequently misunderstood. In this article, we examine the recent trends in ESOP ownership and address some of the misconceptions.

Recent ESOP Trends
According to the National Center for Employee Ownership—a private non-profit research organization, since the recession, both the number of plans, and the number of employee-participants have increased steadily.

ESOP trend chartSource: National Center for Employee Ownership (www.nceo.org)

This trend is even more pronounced within the architecture, engineering and environmental consulting industry.  Firms in these industries already make up a disproportionate percentage of ESOP-sponsoring companies.  Among the 100 largest employee-owned firms in the U.S. as reported by NCEO (defined as a company that is at least 50% owned by an ESOP or other type of qualified plan) approximately 20% are in the design and construction industries.

Our anecdotal experience working with industry firms on ownership transition planning efforts also suggests that more and more firms are implementing or considering implementing ESOPs. Furthermore, in our annual A/E Business Valuation and M&A Transactions Study, 20% of participating firms reported that they sponsored an ESOP.

Why the trend toward ESOPs?

The simplest answer to the question above is “supply and demand.” In the U.S. we are in the midst of a demographic shift, with the “baby-boomer” generation moving into retirement, and the younger generations “X and Y” moving into larger leadership roles.  With the baby-boomers representing sellers (or the supply side of the equation), and generations X and Y representing buyers (or the demand side of the equation), we have the classic Economics 101 supply & demand curve shift.

If the demand (D) for stock is less than the supply (S), all other things being equal, the price (P) and quantity (Q) will fall, as the supply and demand chart below illustrates. In an ownership transition scenario this will result in lower value for the sellers and a longer or delayed transition.

quanityprice

In many cases, an ESOP can help “pick up the slack” by serving as an additional buyer, and helping the sponsoring company maintain supply and demand equilibrium.

“But we don’t want to be an ESOP company”

This is a common refrain, and often originates from a lack of understanding of the many shapes and sizes an ESOP can take. It’s a mistake to characterize a firm that sponsors an ESOP as simply “an ESOP Company.”  An ESOP is simply a qualified plan (like a 401(k) plan) that is designed to invest primarily in its sponsoring company’s stock. The ESOP is considered to be a single owner, and the employees of the firm are its beneficiaries.  Just like any individual owner, the ESOP’s ownership could range from a very small minority interest in the Company, all the way up to a 100% interest. An ESOP may also be leveraged, having borrowed money from a third party to fund its acquisition of stock, or unleveraged / pre-funded, using annual profit contributions from the company to acquire shares over time.

Unfortunately, many peoples’ perceptions of ESOPs are informed by a single personal experience, or that of a friend or colleague.  If that experience involved a leveraged ESOP that owned a majority of the sponsoring company’s stock, their assumption might be that all ESOPs take this form, which of course is incorrect.

In fact, the most common form of ESOP we encounter in the A/E industry is one that holds a minority interest (often between 20% and 40%) and is not leveraged.  This form of ESOP allows the company to be majority owned by its senior management, while providing a stock-based benefit to its entire workforce, and taking advantage of the tax benefits the ESOP affords.

Tax benefits can be substantial

The primary tax benefits that an ESOP provides relate to the tax-deductibility of the company’s contributions to the plan. Because contributions to the plan are a deductible compensation expense, the company can effectively use pre-tax dollars to fund the redemption of shares from a retiring owner. Thus a $1 million block of stock, if purchased by the ESOP using contributions from the company, would result in a tax savings of approximately $350 thousand (assuming a 35% corporate tax rate).

ESOPs bring additional tax benefits to S-corporations. Because S-corporations are pass-through tax entities (the income tax obligation associated with corporate profits flows through on a pro-rata basis to the owners), and because the ESOP is not a taxable entity, the ESOP’s share of the sponsoring company’s taxable income is effectively sheltered from taxation.

Finally, in certain circumstances, an individual who sells his or her shares to an ESOP may be able to defer the capital gain associated with the sale. This benefit applies only to the sale of stock in a C-corporation, and only if the ESOP holds a 30% interest after the transaction.  The seller must also roll over the proceeds into investments that meet the IRS definition of “qualified replacement property” in order to defer the gain.

Other Considerations

There are other considerations as well. Company culture, management structure, and corporate governance structure are all factors to consider. Generally speaking, firms that already have widely distributed ownership, practice open book management, and promote employee participation in management are better suited for ESOP ownership than those that do not.

From a financial point of view, a feasibility analysis prepared by a qualified financial advisor can illustrate how an ESOP might work in your firm, taking into consideration factors such as: 1.) The company’s stock value; 2.) Future stock redemption liabilities; 3.) Projected direct stock investment by individual owners; 4.) The projected growth and earnings of the company; 5.) The ages and compensation of your workforce.

If you’re interested in learning more about how an ESOP might fit with your firm’s ownership strategy, feel free to contact us. And please plan on joining us at the annual A/E Growth & Ownership Strategies Conference taking place from November 12th – 14th in Naples, Florida.  A pre-conference workshop will cover ESOPs in the context of other ownership transition strategies, and a special break-out session will cover the legal and financial mechanics of establishing an ESOP.

For more information and to register, please visit the event website at:

www.rog-partners.com/conference/home.html

New Study Reveals What People REALLY Pay for A/E Firm Stock

If you were interested in buying a house, and the seller told you it was worth $1 million, would you take their word for it and write them a check. I certainly hope not. Ideally, you’d want to see an appraisal. At the very least you’d want to do some research to see what similar homes had actually sold for—what appraisers refer to as “comparable sales.”

Transacting stock in a privately held A/E or environmental consulting firm should be no different. As business appraisers and financial advisers, we make our living helping owners establish the value of their businesses, and transact stock either internally (to other employee-managers) or externally (through a strategic merger or acquisition). But we also realize that not every situation requires a full independent business appraisal. Sometimes all a business owner or a potential investor needs is some independent data on “comparable sales.”

While there are surveys of how firms in the industry value themselves and the formulas they use to do so, there has never been an in-depth study of actual transactions of stock between willing buyers and willing sellers in the A/E industry, UNTIL NOW.

Over the last six months we have been conducting a confidential survey of firms in the architecture, engineering and environmental consulting industry, as well as researching stock transactions in the public realm. The result is the 2014 A/E Business Valuation and M&A Transactions Study.

What makes this study unique is that we have incorporated ONLY data from actual transactions where consideration (cash, notes, earn-outs, etc.) has changed hands between willing buyers and willing sellers. The study examined data from over 200 distinct stock transactions collected via a confidential online survey. We have supplemented this with data collected from publicly available sources. All data was analyzed and compiled by accredited business appraisers with decades of experience valuing privately held A/E firms. The result is the most comprehensive and reliable study on business valuation ever published for the A/E and environmental consulting industries.

Among other information, the study provides statistical data on the following valuation ratios or “multiples.”

  • Enterprise Value / Gross Revenue
  • Enterprise Value / Net Service Revenue
  • Enterprise Value / Pre-bonus EBIT (earnings before interest & taxes)
  • Enterprise Value / Pre-Owners’ Bonus EBIT
  • Enterprise Value / Pre-bonus EBITDA (earnings before interest, taxes, depreciation & amortization)
  • Enterprise Value / Pre-Owners’ Bonus EBITDA
  • Enterprise Value / Number of Employees (full-time equivalent)
  • Equity Value / Pre-Tax, Pre-Bonus Profit
  • Equity Value / Pre-Tax, Pre-Owners’ Bonus Profit
  • Equity Value / Book Value

Unlike any other surveys on the subject, this study examines the differences in valuation multiples between controlling and minority interest transactions, the difference in value between marketable stock (stock of publicly traded firms) and non-marketable stock (stock in privately held firms), and the valuation of stock in ESOP (employee stock ownership plan) transactions. Also provided is a statistical analysis of merger and acquisition deals—including how the transactions were structured, and the forms of consideration paid.

Data from this study begins to quantify concepts like the premium paid for controlling interests in A/E firms. For example, the survey, which includes statistics on 40 controlling interest M&A transactions revealed that earnings multiples in controlling interest transactions were 48% to 80% higher than corresponding earnings multiples in minority interest transactions.

ROGStudy_ControllingInterestimage

As a bonus, the collection of detailed income statement and balance sheet data from survey participants afforded the opportunity to calculate a wide variety of key financial performance metrics—19 in all. These financial metrics are also detailed in the study and include: net service revenue growth rates, various measures of profitability, staff utilization rates, labor multiplier rates, overhead rates, return on assets and return on equity, various balance sheet and leverage ratios, and more.

This study is available for a limited time for only $349. Click here to purchase.