The Fabled ESOP
April 1 1998 by Robert R.Falconi
Sometimes, the government does something right. And the establishment of Employee Stock Ownership Plans (ESOPs) in 1974 is a good example. There are now approximately 10,000 ESOPs in the U.S. Hallmark, Anheuser-Busch, Procter & Gamble, and J.C. Penney are just a few. Of those 10,000, 1,000 are in publicly traded companies.
Avis, for one, made the fact that the company was employee-owned part of it employees tried harder. From 1985 until recently, a significant portion of the company had been owned by an ESOP. In the latter part of ’96, the company was purchased for a price double the last valuation of the ESOP stock prior to the sale. Proponents of ESOPs point to that favorable price as proof that the tool helps companies grow profitably.
While the government’s primary objective when establishing ESOPs was to spread the wealth by providing equity opportunities to employees, there are a number of ancillary benefits favorable to employers and shareholders. ESOPs can be used to buy out a major stockholder, improve cash flow, help finance acquisitions, and thwart hostile takeovers. They can also increase productivity and improve employee morale.
First Line of Defense. During the ’80s, ESOPs were adopted by many public companies as a takeover defense. By placing sufficient stock in the hands of friendly employees, management made it more difficult for corporate raiders to acquire their companies.
Take DynCorp, a large professional services firm based in
Financial Restructuring. United Airlines struck a deal with its employees, who accepted a 15 percent pay cut in exchange for 55 percent of the company and three of the 12 seats on the board. Since the buyout, United’s stock has gone up 120 percent; the company has hired 7,000 new people; revenues are up 7 percent, as are pre-tax profits. With the improved profitability came increased cash flow. United prepaid $750 million in debt.
Financing Vehicle. With a leveraged ESOP, the company or the ESOP borrows money from the bank or other lenders. The loan proceeds are used to buy stock from either the company or existing shareholders, and the stock’s value is established by an outside appraiser. The feature that makes the ESOP leveraged loan unique: all the money used to repay the loan is tax-deductible, both the principal and the interest.
With this piece of tax magic, the periodic contributions the company makes to the ESOP are deductible, just like contributions to a 401 K plan. Depending on the company’s tax bracket, it can repay a $1 million dollar loan with less than $650,000.
It is also worth noting that the heavy debt load assumed in a leveraged buyout does not portend financial problems. A recent study by the
For owners of privately held companies, the ESOP provides a market for their stock and an orderly way to transition ownership. Even better, an individual can defer the gain on the sale of the stock if the ESOP owns at least 30 percent of the company after the sale.
Employee Satisfaction. In addition to those old Avis commercials, there are several empirical studies supporting the hypothesis that employees are more productive when they have “a piece of the action.” Indeed, 30 of the corporations described in The 100 Best Companies to Work for in
One CEO who believes firmly in employee stakeholding is Robert Beyster, CEO of San Diego-based Science Applications International Corp. (SAIC), a $3 billion high-tech research and engineering firm. Beyster did his own study a few years ago and found that, of the SAIC employees who had been with the company at least three years, those who bought stock had a turnover rate of 5 percent compared with 12 percent for those who didn’t. The company is currently 90 percent employee-owned.
As a financing tool, ESOPs offer unique advantages, and 10 million employee owners participating in ESOPs speak volumes about their popularity with the rank and file.
Robert R. Falconi is CFO of Planning Systems, Inc., a defense contractor based in McLean, VA, and has written articles for Financial Executive and Employee Benefit News.