A piece of the pie: Employee Stock Ownership Plans provide unique advantages

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Ruekert & Mielke Inc. owner Bill Mielke started thinking about his eventual exit from the Waukesha-based civil and municipal engineering firm about 20 years ago. He wanted to see the firm his father co-founded in 1946 continue in his absence and remain successful for years to come, but an outright sale wasn’t an option.

“A lot of people will sell their firm to the next generation management or another firm. Well, there was no way we could sell this firm to the people inside this firm because there just wasn’t enough funding available for them,” Mielke said. “I wanted the firm to continue and I wanted to reward the people that had helped to make the firm successful.”

Mielke, the firm’s majority shareholder, decided to form an Employee Stock Ownership Plan and transferred 40 percent of the company’s stock to employees in 1995. As of March 1, the firm has transitioned to a 100-percent ESOP.

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ESOPs are a non-traditional setup. They involve extensive annual valuations, in-depth employee education and thoughtful management succession planning.

However, their benefits can be immense – including affording the company lower or zero taxes, generating economic growth, engaging employees in the big picture performance of the firm and setting them up for retirement.

“To set up an ESOP is probably not as complicated as some people think,” said Timothy Stewart, an employee benefits and ESOP attorney at DeWitt Ross & Stevens in Brookfield. “It is not much different than setting up any other type of retirement plan.”

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The company must have more than 10 people, be an S or C corporation, should be profitable, and the owner must want to sell part or all of his or her shares, said Sue Michalski, manager for retirement plan services at Sikich LLP in Brookfield.

An attorney or another professional assembles and executes a plan document. The employer lays out eligibility criteria, vesting provisions and how and when distributions are made from the plan. A plan sponsor also can customize a variety of other facets of the plan, including how compensation is defined and whether certain groups of employees are excluded from the ESOP.

One of the biggest decisions the employer makes is how much stock to contribute to the plan. Sometimes, a company chooses a 100 percent ESOP, while other times an owner may choose to contribute 49 percent of the company stock to the plan, so he or she retains majority ownership and control, Stewart said.

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A valuation firm analyzes the company’s cash, profits, assets and other economic factors and then puts a fair price on its stock. That process takes about six to eight weeks, said Craig Olinger, principal at Enterprise Services Inc. in Delafield. ESI has 14 employees who complete about 200 ESOP valuations nationwide each year.

Based on that valuation, a trustee offers the owner a price to buy the company and an ESOP trust purchases the company’s stock. The trust then awards a certain number of shares of the stock to qualifying employees, Olinger said.

“The ESOP, as a retirement vehicle, is entirely funded by the company, with no participant money going into it,” he said.

The trustee also selects a board of directors, manages the trust’s assets, hires the appraisal company and makes sure assumptions made by the appraiser are accurate, Michalski said.

Going forward, the ESOP is guided by a plan document, an ESOP administrative committee, the board of directors and the trustee. The board of directors is responsible for appointing the administrative committee, which assures the plan documents are kept up to date and are being followed. The administrative committee also directs the trustee on how to vote for the board of directors. It’s a “triangle of accountability” that looks out for the best interests of employees, the business and the board, according to Lisa Reardon, chief executive officer of Brookfield-based OwnersEdge Inc., a 100-percent ESOP firm.

Each year, the company undergoes another third-party valuation to value its stock. Employees receive a statement each year with information about how many shares are in their accounts and what the value of those shares is. The company distributes stock to the employees annually based on how it performs, and the performance of the company determines how the value of the stock changes.
Best kept secret
In 1999, the U.S. tax code changed to allow S corporations to form ESOPs. Until then, only C corporations could form the plans.

S corporations’ taxes flow through to the end owner of the company. If the end owner is an ESOP, which is a qualified retirement plan and therefore tax exempt, the corporation does not pay taxes.

When tax season rolls around, the ESOP business reaps big rewards. A 100-percent ESOP S corporation is not liable for either federal or state taxes in Wisconsin, an intentional tax consequence created by lawmakers to encourage employee ownership models, Stewart said

The reason: ESOPs are a long-term net positive for the state. Studies have shown that employee-owned companies are more successful, more sustainable, have fewer layoffs and terminations, and build more wealth in employees to set them up for retirement. The companies can use the tax savings to create more jobs, expand and create other economic growth in the state.

According to The ESOP Association, from 2008 to 2011, during the height of the Great Recession, the average layoff rate for traditional companies was about 12 percent. Among ESOP companies, it was just 3 percent.

“(The government loses) tax revenue in the short run but they gain it in the long run, because of all the sustained employment and employment taxes,” Stewart said.

So if a corporation can use an ESOP to function as a for-profit, tax exempt entity, why aren’t more companies set up this way?

The Wisconsin chapter of The ESOP Association is trying to tackle that question head on. It offers education, networking and resources for ESOP companies, as well as the providers that administer their ESOP plans. One of the association’s main functions is lobbying state legislators to keep the favorable tax code to encourage more companies to take the leap.

The ESOP Association has about 45 company members and about 10 professional services members in Wisconsin, Olinger said. There are a total of about 150 ESOP companies in Wisconsin, a number that has remained relatively stable over the past several years, he said. However, the organization has noticed a recent trend toward more companies moving to 100-percent ESOP versus a smaller percentage of ESOP ownership.

The recently renewed interest in ESOPs may be driven by business owners’ plans to sell or pass on their companies in the near future, Stewart said.

“I think a lot of that has to do with pent-up demand, because many owners were not inclined to sell in 2009 and ’10 and ’11 because their business values fell, just like everybody else in the recession,” Stewart said. “They wanted to wait until their businesses recovered before they thought about succession.”

An ESOP can be useful when an employer wants to give back to employees and provide them an opportunity to participate in the upside of an organization, said Kevin Hanson of Milwaukee-based corporate financial advisory firm Ashton Group.

It can also provide tax savings to a business owner in the sale of the company, and allow the parties to transfer ownership tax-free, he said.

While an S corporation ESOP does not pay federal or state corporate taxes in Wisconsin, the employees do pay a tax on the contributions when they withdraw from their accounts upon exiting the company or retiring, similar to other retirement plans.

There are also added administrative costs for the corporation, which include an annual valuation, the repurchase of shares when employees leave the company, maintaining a board of directors and retaining an attorney to handle the plan documents.

“You do have some additional fees associated with the fact that you’re an ESOP and certainly more due diligence in the details…but it still is a net positive in comparison with paying taxes,” Reardon said. “(And) the functionality of the board for both ESOP oversight as well as strategic value is just fantastic.”

There have been some valuation troubles that have resulted in federal enforcement action and impacted ESOPs’ reputation in the past, Hanson said. Some companies, for example, were valued just prior to the Great Recession and then ended up with overinflated values and couldn’t pay back their debt.

The key to making a good valuation, Hanson said, is looking at both historical performance and a company’s forecasted performance.

Worries about the enforcement actions seem to have subsided in today’s improved economic climate, he said.

“We’re seeing ESOPs be positioned in a much different light now as a strategic alternative to an outright sale,” Hanson said. “It’s another tool in regards to a business owner having the ability to monetize their investment. We’re seeing people become more and more receptive to the option than what it was historically. I know this year we’re going to do more ESOP plans than we did last year and the dollar value of those transactions is going to go up.”

Employee Owners: Dave Klemm and Mike Michalski, engineering technicians and Bronson Jastrow, GIS analyst.

Going all in
Ruekert & Mielke has 76 employees, about 70 of whom are based in Waukesha. It also has offices in Kenosha, Madison and Itasca, Ill.

On Jan. 1, it changed from a C corporation to an S corporation. As a result, the company will operate tax free. While there are added costs to administer the plan, the tax advantages and other benefits far outweigh them, Mielke said.

“When I set this all up years back, I recognized that if we were successful, it was because of the people that were here, and so we tried to set up plans to reward people for gaining the success for the firm,” he said.

And those rewards seem to have made an impact on retention. “We’re below the 25th percentile for national standards for turnover,” Mielke said.

The decision to transition to 100-percent employee ownership also was part of the management team’s transition strategy, said Stan Sugden, who became president of the company at the same time as the March 1 transaction.

“We had to make a decision about where the company was going to go in the future,” Sugden said. “We wanted it to be an internal transfer of ownership and what better way to do it than with all of our employees instead of a few of them.”

While Mielke has transitioned out of the president role and sold his ownership stake, he continues to serve as chief executive officer and chairman of the board.

“We’ve got a young leadership team that we’ve been working on mentoring for many years,” he said. “I wanted to get rid of the day-to-day things of running the company and work more on strategic planning and some of our major clients and those types of projects.”

The ESOP is one of the benefits offered to any full-time R/M employee, in addition to a 401(k) with employer matching. At the end of each year, an outside firm completes a valuation and then the stock is allocated to employees based on that year’s performance.

“How they perform their jobs can directly affect the stock value,” Sugden said. “To me, it’s a motivating factor. People are here to do a good job. If they help their co-workers, that’s going to help us be more successful.”

Since the transition, the company has ramped up its employee education and now provides monthly financial information to staff to help them track performance and make any necessary adjustments, Sugden said.

“In my mind, having a 100-percent ESOP is going to be a way to attract top talent to the firm,” he said.

Sugden was named president when Mielke transitioned the company to 100 percent ESOP.

Model ESOPs
A number of other local companies operate under an ESOP model, each with its own unique twist.

Brookfield-based OwnersEdge Companies Inc. is a 100-percent employee-owned S corporation. Employees of its portfolio companies, CC&N and NEXT Electric Inc., all participate in the ownership of the company.

The firm, which has the motto “owning it,” won the Wisconsin ESOP of the Year Award in both 2010 and 2014.

CC&N was founded in 1986 by Dick Hettwer, Tom Greuel and Jim Wegner. The three launched both a technology and a cabling and low-voltage side of the business.

In 1995, the owners sold 30 percent of the company’s stock to employees through an ESOP. The three remained with the organization to assure that it was able to pay down some of the debt and thrive in the new model. In 1998, they sold another 17 percent of the company to the ESOP, and in 1999 they sold the remaining 53 percent to the ESOP trust.

Lisa Reardon took over as president in 2008 and in 2012 launched the NEXT Electric subsidiary. In 2014, she created the OwnersEdge holding company to assume the corporate and ESOP fiduciary responsibilities.

“That allows us – we’re in an acquisition search now – to bring in another organization under this umbrella to continue to provide 100 percent ESOP ownership to a whole other organization that would be under our umbrella but also to continue…to grow and protect share value for all of our employees,” Reardon said.

OwnersEdge, since becoming a full ESOP, has included its 250 employees in high level strategic conversations about the organization. It also has an elected ESOP committee that is tasked with culture, wellness and employee education.

“An ESOP is a very positive attribute to employees, driving a culture of ownership and responsibility and accountability,” Reardon said.

Reardon sees the ESOP as a form of diversifying employees’ retirement portfolios. OwnersEdge also offers a 401(k) plan, without an employer match. The company’s ESOP has a six-year vesting period.

“After employees become vested, our retention rate is exceptionally high because they really understand at that time the retirement benefit that they’re getting from the ESOP,” she said.

ESOPs aren’t limited to private companies. Menomonee Falls-based Kohl’s Corp., one of the nation’s largest retailers, facilitates an ESOP. The company declined to address the subject, but the ESOP is listed among its benefit offerings for non-management associates. Shares of Kohl’s stock held by the ESOP are included as shares outstanding in the public company’s earnings reports.

Kohl’s spent a total of $43 million on its ESOP, defined contribution savings plan and non-qualified deferred compensation plan in 2014, according to an SEC filing.

Wauwatosa-based WaterStone Bank last year became a fully public company and diverted 8 percent of the proceeds of that public stock sale to an ESOP for employees. The ESOP was established as part of the company’s initial public offering in November 2005, which brought 30 percent of the institution public. In that initial offering, WaterStone raised $100 million, so $8 million in stock was put into the ESOP.

In its second offering, WaterStone raised $250 million and about $20 million went into the ESOP.

The ESOP stock is distributed to employees annually as part of their salaries, said Doug Gordon, president and chief executive officer of WaterStone. Employees must work for the company for at least a year to be eligible, and then are fully vested after five years. Last year’s ESOP distribution amounted to about 18 percent of employees’ pay.

“It’s a real tremendous benefit,” Gordon said. “It’s capped, too, so higher income employees get capped. It’s a great retirement account then for employees because it’s tax free, just like an IRA, and hopefully it grows.”

WaterStone benefits by offering the ESOP plan because employees act like owners and their interests become more aligned with shareholders and management, he said.

“Part of the benefit to the employer is the employees are cognizant that their performance can help drive the stock price and at the same time create wealth for themselves, because now they’re stockholders,” Gordon said.

WaterStone also offers a 401(k) with employer matching and cash bonuses to employees.

“Obviously, as a bank, we’re cognizant of savings and we’re trying to encourage savings even for our employees,” he said. “It’s nice to have those accounts that are retirement accounts that grow and hopefully will support you when you retire.”

The bank tracks retention of its 170 employees and has noticed a decrease in turnover since establishing the ESOP and since becoming public, Gordon said.

“I can’t tie it directly to the ESOP but I’ve got to believe it’s a benefit when people see basically an 18-percent payout to their retirement plan,” he said.

Lonnie Cody, executive administrative assistant

Advantages of ESOPs

  • During the Great Recession, ESOPs laid off employees at a rate of less than 3 percent, while conventionally owned companies laid off employees at a rate of more than 12 percent.
  • Among 1,400 ESOP companies surveyed in 2010, the average account balance for employees was almost $200,000, much higher than data reported for average 401(k) account balances.
  • According to the 2012 General Social Survey, 13 percent of employees of ESOP companies were thinking of seeking employment elsewhere, whereas 24 percent of employees of conventionally-owned companies were considering leaving their current job.
  • More than half of ESOP companies have two retirement savings plans.
  • The average ESOP company (less than 200 employees) has sales of $9 million more per year than its non-employee owned comparable competition.

Source: The ESOP Association

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