ESOP's appeal on the increase: employee stock ownership plans are back - and stimulating productivity

Nation's Business, June, 1997 by Steve Kaufman

Employee stock ownership plans are back--and stimulating productivity.

Don Way didn't realize at the time that he was in the vanguard of an important movement to bolster the success of small businesses. It was nearly 22 years ago, and he was workig for Thoits Insurance Service, a cormmercial-insurance firm in Palo Alto, Calif., when, as the firm's vice president, he spearheaded an effort to set up an employee stock ownership plan (ESOP) at the company

Way now is the firms chairman and CEO, and the ESOP has thrived.

Like most people who start an ESOP, Way initially was attracted by the tax breaks that federal laws accord te such plans. For example, a firm with an ESOP--which buys company steck on behalf of the employees--can borrow money through the ESOP for expansion or other purposes and repay the loan by making fully tax-deductible contributions to the ESOP. (In making loan repayments directly to a lender rather than through an ESOP, of course, only the interest portion of the repayment is tax-deductible.)

After establishing his firm's ESOP, however, Way discovered that it can increase productivity. Way says the fact that the firm has an ESOP has made it easier for him te recruit, retain, and motivate talented people. "Under an ESOP, you treat employees with the same respect you would accord a partner," he says. "Then they start behaving like owners. That's the real magic of an ESOF."

A Renaissance At Small Firms

The number of ESOPs increased steadily during the 1980s, particularly after tax-law changes made them more attractive financially te business owners. Formations declined in the first half of the 1990s, however, largely because of the recession and its aftermath. Now that the economy has revived, the number of ESOPs is on the rise again. According te the National Center for Employee Ownership in Oakland, Calif, about 10,000 companies have ESOPs today, up from 9,000 in 1990. And in just the past year or so, the net increase in ESOPs has reached about 600, or about three times the annual level of recent years.

"A renaissance is under way in the creation of ESOPs at small companies," says Michael Keeling, president of the ESOP Association in Washington, D.C.

Business-finance expert Jim Zakin agrees: "ESOPs have captured a second lease on life." Zukin is senior managing director of Houlihan, Lokey, Howard & Zukin, a Los Angeles investment-banking firm that specializes in ESOPs. The renewed ESOP activity stems not just from the economy's strength, he says, but also from small firms' realization that an ESOP can provide a competitive edge by encouraging productivity.

Profit sharing, of course, is an incentive, too, but a couple of extra checks in a good year can hardly match the effect of giving employees a piece of the company, say those familiar with ESOPs.

"An ESOP creates a vision for every employee and gets everybody pulling in the same direction," says Joe Cabral, president and CEO of Chatsworth Products Inc., a Westlake Village, Calif., maker of support gear for computer networks. Chatsworth created an ESOP in June 1991. "Everybody wants the company to do the best it possibly can," says Cabral.

Says Christopher Mackin, president of Ownership Associates Inc., a Cambridge, Mass., employee-ownership consulting firm: "Increasingly, the success of companies relies on the success of its employees." Mackin, whose firm works with United Airlines and dozens of much smaller ESOP clients, says it's important to develop creative ways "te keep good people interested in the business longer-term."

Tax-Free Growth

For long-term employees, the financial rewards of an ESOP can be considerable. As with other retirement plans, an individual's ESOP account grows tax-free until retirement. At that point, the employee Steve Kaufman is a flee-lance writer in San Jose, Calif. sells his or her shares in the ESOP back to the company. (Federal law requires an independent evaluation of an ESOP's stock every year.) The employee can roll the proceeds of the stock sale into another tax-sheltered investment, such as an individual retirement account.

The company stock that ESOPs purchase and then allocate to individual employees' accounts can be acquired in various ways. Under some plans, the employer contributes securities or cash every year to the ESOP so it can buy company stock. Most ESOPs, however, obtain bank loans to buy the stock, and the employer may use the proceeds of the stock purchase to expand the business or, in the case of a small company, to fund the owner's personal retirement nest egg.

In addition, ESOPs provide the principal business owner some important tax advantages--in addition to the ability to deduct the full payments on loans obtained through the ESOP.

An ESOP itself may also borrow money, typically from a bank, to buy the business owner's stake in the company. If, after buying stock from the owner, the ESOP owns at least 30 percent of the company, the owner may defer capital-gains taxes on the proceeds of the sale--provided the proceeds are invested in other securites such as stocks and bonds. No capital-gains tax is paid until those investments are sold.