Transition alternative

Executives say moving to ESOP can ensure preservation of company legacy, culture

In 2020, John Martell, the CEO of South Bend’s Martell Services Group, was less than a month away from selling his company to a private equity firm. He was ready to move on from the responsibilities of daily ownership.

However, negotiations dragged on. Martell eventually concluded the two sides were not going to reach a deal. He sensed there was a greater problem with the prospect of selling to outside interests.

“We decided this was a wake-up call with these private equity guys, and we said it was time to look at an alternative,” Martell said.

After discussing the idea with his wife, Martell looked into an Employee Stock Ownership Plan. An ESOP is a benefit plan providing workers ownership in the company through shares of stock.

“This was an alternative that allowed us to really somewhat control the direction of the company and reward the companies that helped get us there.”

By February 2021, Martell Services shifted to ESOP ownership. The transition was fast tracked, because much of the financial work already was done when Martell was discussing his company’s sale to the private equity firm.

“We wanted to control the destiny of our company,” he said. “It was about controlling the legacy and being able to control direction.”

More than a year later, Martell said his company offers ESOP ownership to nonbargaining unit employees. He says other workers have retirement plans through their unions.

“We have a great group of people, and everyone has worked hard at developing the business,” Martell said.

Employee owned

Martell’s story is a process shared by many companies across the country. There are almost 6,500 ESOPs nationwide, with 174 in Indiana, according to the National Center for Employee Ownership.

Greg Facchiano, the vice president of government relations and public affairs for the Washington D.C.- based ESOP Association, said almost 11 million Americans are employee owners, and that ESOPs have $1.37 trillion in value.

He believes the number of ESOPs will grow.

“Our data also shows that employee-owned companies were more resilient in the pandemic, for example, with fewer hour and pay reductions and fewer layoffs,” he said. “We believe employee ownership is certainly experiencing renewed interest, including by Congress, by company founders, by investors and by employees at all levels seeking more input in how their companies are run.”

Gibson, a South Bend-based insurance services firm launched in 1933, implemented an ESOP in 2011.

Tim Leman, chairman and CEO of Gibson, said the catalyst to start transitioning the company to an ESOP was when company partners began retiring. Additionally, company executives sought a way for all employees to participate in ownership while the economy was still recovering from the 2008 Great Recession.

“We were getting our sea legs back beneath us, and we needed some help,” Leman said. “Secondly, we wanted to find a way to include all of our employees when we were having success, and we wanted to share that with everybody.”

He said launching an ESOP achieved that goal.

First steps

For companies exploring ESOPs, experts say there is much to learn about how they work.

“The ESOP’s shares are allocated to individual employee accounts,” said Schuyler Geller, a partner with the law firm of Burke, Costanza and Carberry in Merrillville. “Although there are some exceptions, generally all full-time employees over the age of 21 participate in the plan.”

These shares must vest within three to six years, which means the employee gains rights to the shares in their account over time, he said.

Geller said employees also have a say in the operation of the company.

“In private companies, employees are able to vote their allocated shares on major issues, such as closure or relocating the business; while in public companies, an employee can vote on all issues,” he said.

Geller said, in general, employees are enthusiastic about the formations of ESOPs.

“ESOPs are a great way to develop an ownership mentality and increased employee retention,” he said.

Geller said ESOPs can serve as a long-term benefit or incentive for workers as employers seeking candidates in a competitive labor market.

“ESOPs can also offer the company’s current owners greater flexibility in the timing of the transfer of ownership,” Geller said. “Ownership can be transferred instantly or gradually over time.”

Much to consider

While the proponents of ESOPs speak highly of the potential benefits, they are not a panacea. There are many cautionary tales. Prominent examples of ESOPs not working include those offered by United Airlines and Tribune Co. Both those businesses eventually filed for bankruptcy, ending their ESOPs.

Martell and Leman said there are hurdles to overcome when transitioning to an ESOP.

Martell said there is much scrutiny in the process. The most difficult part is convincing employees to understand the lasting value of the ESOP, he said.

“When they hear about employee ownership, they think they are instantly wealthy,” Martell said. “It is not a get-rich-quick program; it is long-term employment, and this is a retirement benefit.”

He said it can be a significant retirement, but it does not produce results people see immediately.

Martell said finding accountants and lawyers knowledgeable on an ESOP’s intricacies can be difficult.

Leman said ESOPs require frequent communication and education with employees, especially at times when business may be down.

“You have to have those adult conversations with people,” he said.

Leman said many levels of complexities come with an ESOP, along with additional government scrutiny. The Department of Labor wants to ensure the ESOP is benefiting the participants.

There are also many layers of tax complexities.

“ESOPs have to satisfy specific requirements set out in the Employment Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, and require knowledgeable and experienced attorneys, accountants, and possibly advisers and trustees, to create and administer the plan,” said Geller with Burke, Costanza and Carberry. “Additionally, ESOPs require initial and annual valuations of the company to be compliant.”

Geller also cautioned that current owners might not be able to receive the maximum value in the sale of their shares.

“The ESOP can only pay fair market value for the current owners’ stock in the company, whereas a third-party buyer may have reasons to offer a premium to acquire the company,” he said.

Patrick Stoltz, executive vice president and managing director of ESOP finance at Wintrust, said compared to other succession planning alternatives, ESOPs often require patience from the shareholders selling the stock to receive the complete payout of liquidity from the company stock sale.

“Another obstacle can be the repurchase obligation that can arise with successful business models,” he said. “Repurchase obligation is the put-back of stock from the ESOP plan participants (i.e., employees), which the company is required to pay out.”

The ESOP Association announced in September that it is calling on Congress to change the rules about ESOPs to ease what it sees as undue regulation. For now, company executives have much to consider before deciding to take this route.

“An overall assessment of the value of legacy, culture, tax-adjusted sale proceeds, financial reporting and level of board oversight (is needed),” Stoltz said. “More specifically, most ESOP opportunities are led by sell-side advisers (investment banking firms that lead the ESOP formation process).”

He said, in the early stages of understanding the pros and cons of an ESOP as an alternative, the sell-side adviser often prepares an analysis of the possible change.

“The feasibility study provides a solid understanding of the potential value of the transaction, as well as the various scenarios surrounding the C-corporation versus S-corporation tax adjusted analysis,” Stoltz said. “During this process, the selling shareholders typically realize whether ESOP is the appropriate transition alternative.”

Leman said the shift to an ESOP has been successful for all parties at Gibson, adding it can be a great solution for owners preparing to make the transition.

“When I first got here about 17 years ago, we made a lot of decisions that were for the best of one individual, sometimes at the expense of the other 99 families,” Leman said. “Today, we will make decisions on what is best for the 99 families.”

That paradigm shift might mean his company is not a perfect fit for everybody, but decisions will be made for what is best for the whole company, he said.

“I think the ESOP is a big part of that,” Leman said.

Click here to read more from the December-January 2023 issue of Northwest Indiana Business Magazine.