The advantages of employee stock ownership.

Although employee stock ownership plans (ESOPs) have been around since 1974, they are still not widely understood. In addition to their tax benefits, ESOPs can sharpen a company's competitive edge by making employees more concerned with its success and more active in its day-to-day operation.

One of the most attractive uses of an ESOP is to provide for business continuity in private companies. Selling owners can sell all or part of their company and receive substantial tax benefits. ESOPs are also often used to create an employee benefit, especially in companies that wish to reward employees for more active participation in the company. Contrary to popular perception, only a small percentage of ESOPs are used to fend off hostile takeovers or save failing corporations. They are usually set up in smaller, privately held firms like Panel Processing, a manufacturer of flat panel components based in Alpena, Mich.

Panel Processing set up its ESOP in 1982 when the original investors wanted to diversify their investment. The possibility of selling to just any outside buyer, however, was not an attractive one. An ESOP not only guaranteed that the company would remain in the hands of people committed to its long-term success, but it also provided significant tax benefits.

Structure and uses of an ESOP

An ESOP is a trust fund set up by a company as a deferred benefit plan for its employees. A company can fund an ESOP in two ways: by contributing either its own stock or cash to purchase stock (a "non-leveraged" plan), or by borrowing money that the trust uses to purchase the company's stock (a "leveraged" plan). The most attractive feature of an ESOP is that corporate contributions to the plan can be deducted from the company's taxable income. In private companies, the price of the stock is set by an independent valuation consultant who determines the company's worth to a willing buyer.

Each participating employee in the ESOP has an account that receives a portion of the shares, which are subject to gradual vesting. Employees do not cash in their stock until they retire or leave the company. Voting control of the stock rests with the plan's trustee, who can make decisions at the direction of management or employees. Although a company can give participants in the plan full voting rights, it is only required to let participants vote their shares on major decisions like mergers, acquisitions, or the sale of corporate assets. Owners can maintain operating control of the company no matter how much stock an ESOP owns.

Although most media coverage of ESOPs focuses on employee buyouts of large corporations, such as United Airlines or Avis, ESOPs are most commonly used by private companies to buy out the shares of a departing owner or one who wants to sell a partial interest and remain in the firm. This can often be a difficult situation for owners who have built a company up from scratch. The prospect of selling it off to investors that are not concerned about the long-term success of the company, its employees, or its larger community can be a depressing one.

An ESOP assures that the company will remain owned by those who care about its success and can also be the most tax-effective way for an owner to sell shares. Not only can the company deduct the contribution it makes to the ESOP to buy the owner's shares, but if the ESOP owns 30 percent or more of the stock and the owner uses the money to reinvest in stocks or bonds of U.S. companies, he or she can defer any tax on this gain until these stocks are sold. Furthermore, an ESOP gives owners the flexibility to sell their shares as quickly or as slowly as they want.

ESOPs are also commonly used as an employee benefit. The most powerful use of an ESOP is to borrow money through the plan, usually to buy out an owner or for capital investment. Here's how it works:

1. The ESOP takes out a loan, backed by a corporate guarantee;

2. The ESOP borrows money to buy shares either from an existing owner or, if the loan is for expansion, new shares issued by the company;

3. When a loan payment is due, the company makes a tax deductible contribution to the ESOP, which uses this contribution to make the payment.

The interest on a loan can always be deducted from a company's taxable income. If money is borrowed through an ESOP, however, both the interest and the principle can be deducted because both are considered contributions to an employee benefit plan. A percentage of stock equal to the percentage of the loan that is paid off is released to the accounts of the employees in the plan.

Feasibility of an ESOP

Who is a good candidate for an ESOP? First, the company should be large and profitable enough to make the costs of the plan worthwhile. When all of the legal, accounting, and consulting fees are added up, an ESOP can cost up to $15,000-$25,000, or more, to set up. Second, the company should be making a profit, as tax deductions are useless if there is no taxable income. Third, since the company is required to buy back the stock from employees when they leave the company, it must plan ahead for this repurchase obligation. Last, management must be committed to treating employees like owners.

The immediate financial concerns are crucial in determining an ESOP's feasibility. A company must figure out if the costs of an ESOP will be less than the yearly savings on taxes and if an ESOP will actually be cheaper than other ways of either setting up a benefits plan, buying out an owner, or motivating employees.

Participation: The key to success

Research consistently shows that ESOPs can increase performance in companies that combine stock ownership with the increased participation of workers in daily decisions about their jobs. These "highly participative" employee ownership companies grow 8-11 percent a year faster than they would have without an ESOP. Panel Processing is a good example of just such a company. As the ESOP obtained a majority interest in the company in 1982, upper management began to implement structured forms of employee participation, giving workers a larger role in problem-solving and decision-making.

Panel Processing developed an Employer/Owner Participation Policy in 1989 that identified all employees-owners as valued "members" of the company and outlined the basic structure of participation. Standing committees are selected by ESOP participants at each plant and meet monthly to exchange information, discuss any problems, and generate solutions that are submitted to management. Anyone can participate in these meetings, even if they are not elected. Each plant also elects a Corporate Advisory Council, which meets semiannually to discuss corporate-wide issues and report back to individual plants.

The results of employee ownership and participation have been steady profits, an increase in sales from $11 million in 1982 to an expected $37 million this year, a low turnover rate, a huge decrease in loss-time accidents in all plants and a significant reduction in the number of quality complaints from customers.

There seem to be many reasons why the combination of ownership and participation produces these kinds of results. When workers feel they have not only a stake in the equity growth of a company, but also a say in its actual operations, they will be much more interested in making it successful. It also makes sense to give them more input into how their jobs can be best performed, since they are closest to their work.

This common-sense approach is more important than ever as markets change and diversify and new technologies allow access to information at the touch of a keyboard. The ability to process and use this information has become essential to staying competitive, and a small group of managers can no longer do this effectively. Companies need more people trained to make decisions quickly, and they need people to have a reason to do this right.

By giving employees both a long-term financial interest in the company and a say in its operation, Panel Processing has been able to generate more ideas from more people about how it can operate most efficiently. This combination of ownership and participation has been, and will continue to be, essential to the long-term success of Panel Processing.

If an ESOP seems worth investigating, the first step is to become more educated. Owners need to understand their options with ESOPs in order to use them effectively. If the initial research seems promising, talk to colleagues who have set up plans. Next, you need to hire an experienced ESOP attorney and valuation advisor. The process of setting up a plan can take several months and considerable time, but the results can be well worth it.

Ed Carberry is a staff member at the National Center for Employee Ownership, a nonprofit membership and information organization located at 1201 Martin Luther King Way, Oakland, Calif. 94612, [phone].