Employees with equity

Schu Marketing Associates Inc. has been entirely employee owned since 2020 when founder Steve Schumacher decided to retire. He’d previously sold 30 percent of his shares to his workers in 2016.

But the independent manufacturer’s representative that sells for the plumbing and building materials industries began its transition to employee ownership more than a decade earlier.

“The succession of Schu Marketing was important,” says Sarah Levens, current president and the founder’s daughter. “Originally, he was a sole proprietorship. He was the guy. So, over time, he had to transition a lot of his responsibilities to others.”

That’s when Levens, who started as an operations manager, and several other executives joined Schu Marketing as it began the process of becoming an employee stock ownership program (ESOP)-owned company.

Education important to successful transition

ESOPs, for employees, are a retirement plan, just like a standard 401(k) that gets invested in the stock market, except the plan involves accumulating shares of stock in your employer’s company instead, says Kyla Hansen, a partner at John A. Knutson & Co. (JAK).

Incidentally, she adds, ESOP-owned companies often still offer a 401(k) program alongside the ESOP, though they may no longer contribute. 

The move to employee ownership has paid off significantly for Schu Marketing. The company has nearly doubled its employee count. Employee recruitment and retention are tremendous, Levens says. Workers are engaged.

“Because we’re a sales agency, the engagement and motivation of our employees is key to our success,” she says. “We felt that an ESOP would be a good way to get some engagement or increased engagement from our employees. It really has proven to work very, very well.”

But initially there were challenges. Levens says the company lost a few employees early on and buy-in wasn’t immediate because management didn’t realize the importance of educating the team. 

“I think it was a lack of understanding,” she says. “But those folks who did stay, and the folks that we’ve added to our team since then, we’ve done a better job of educating them on what an ESOP is and how it’s going to benefit them.”

And that’s the idea of an ESOP and other employee ownership plans. The employees have a stake in what happens, so they are engaged and work harder. They see how their efforts benefit the bottom line of the company and, thus, their own retirements.

Schu has 39 employees now, up from around 20 during the transition. The company has introduced an ESOP Communications Committee, to which employees are elected, that puts on events, researches and publishes newsletters for staff and generally provides information about the ESOP. Recently, several employees participated in the National Center for Employee Ownership conference.

“We’re always learning,” Levens says. “It didn’t start out that way. Frankly, ESOPs were confusing to me at the very beginning. I remember our attorney saying ‘It’s going to take repetition. You’re going to need to hear it more than one time.’ And he was absolutely right.”

Early steps

Hansen suggests doing some research upfront. A good place to start, she says, is at the website for the Minnesota Center for Employee Ownership (MNCEO). 

ESOPs, for example, can be a great option for small business owners, but might not make sense for companies with fewer than 20 employees, five years of profits and at least $250,000 in earnings before interest, taxes, depreciation and amortization (EBITDA), she says. 

That is both because of the need to fulfill Internal Revenue Service limits and spread value across the wage base and because there are significant upfront and ongoing costs that would eliminate any “bang for the buck,” she says.

Typically, a company would hire a third-party trustee to help negotiate the transaction and that person would hire a valuation firm. “The trustee can’t pay more than fair market value, otherwise they are harming the participants,” she says. “So, you have to be okay with not getting the highest price if you’re becoming an ESOP. If you really want to give back to your employees, it’s a great way to do that.”

Process

Making sure you’ve got good advisers upfront is vital, says Bob Kovell, who owns Kovell Advisory Service and has worked with ESOPs in several roles for decades, including as a transaction adviser and board director.

He recommends getting an attorney, a financial adviser and a reputable company to help provide a valuation. Once the valuation is in place — say it’s worth $5 million — the company would take out a loan for that amount and then lend that money to the ESOP.

Each year, the company, through its profits, would contribute to the ESOP, much like it would for a 401(k). Then the ESOP turns around and uses that to pay the company back for part of the loan. As that loan is paid off, the employees of the company — the beneficiaries of the ESOP — gain equity because now the stock is worth $5 million and the loan is less than $5 million.

Equity can go up further each year, Kovell says, as part of an annual valuation. If the company has grown and is worth more, even better for the ESOP beneficiaries.

“There are complications,” he says. “Every year there needs to be an appraisal. That’s a cost and there are legal costs to set this thing up. You need to have a plan and you need to have a trustee of the ESOP who will look out for the benefit of the employees.”

Trustees can be internal from company management or external. Kovell and others suggest an outside trustee to avoid any potential conflicts of interest.

“There are a number outside trustee organizations that do this,” he says. “Some of the banks do it, some organizations have trust companies that do it.”

Kovell echoes other experts who say good ESOP candidates have 20 to 25 employees, stable revenue patterns, good cash flow and a succession plan to ensure strong management.

“Some cyclical industries may not be good candidates,” he says.

For business owners whose companies meet those standards, Kovell says, ESOPs can be a great way to reward loyal employees and “give the rank-and-file employees a chance to participate in ownership,” he says. “That’s a very powerful thing.”

Things to think about

One of Levens’ advisers at Schu Marketing is Dan Markowitz, a partner at Boulay Group who works with hundreds of ESOPs. 

He likes companies considering transitioning to employee ownership to have even higher employee counts — a minimum of 25 employees — and EBITDA at either $1 million or more or $750,000 in EBITDA with a plan for how to get to $1 million before he’d recommend moving forward.

Same reasons. The 25 employees, he says, helps satisfy a requirement for disaggregated ownership, he says, and you have to have enough payroll to be able to make contributions to the plan. The $1 million will ensure the ability to cover the transaction fee and ongoing costs.

For companies within or beyond those ranges, ESOPs can be a great option for owners in their 40s or 50s who want to stay involved but are looking for some liquidity.

“That’s a perfect scenario,” he says. “They want to give back to their employees, they understand what it means from a recruiting and retention perspective. There are a lot of positives too. You can control your exit from a business versus a third-party sale because you are still running it.”

ESOPs can also help companies expand, as there are tax breaks involved.

“You’re really creating a growth engine for these clients because they’re basically operating on tax-free cash flow,” Markowitz says. 

Potential stumbling blocks

But it’s not easy. There are challenges, both upfront and ongoing. ESOPs are regulated by the Department of Labor and, while it may be rare, the agency does occasionally audit such transactions and that can lead to bad press about the ESOP format, Markowitz says. 

Much like with other transition strategies, owners looking to exit through ESOPs also need to focus on succession planning. “Smaller companies that haven’t figured out who’s going to run the business if the shareholder is going to exit, that can be a stumbling block,” he says.

Succession is even more important for ESOPs, however, because they always need to consider growing to ensure they can maintain sufficient cash flow. “One of the things that allows it to cash flow is that good management team,” Markowitz says.

Companies also must keep in mind repurchase obligations. Markowitz says a good guideline is keeping those obligations at less than 40 percent of EBITDA because at that level “you are still in a good position because you are still able to invest in your business.”

Robust ecosystem

ESOPs — and other forms of employee ownership — are becoming more popular. “We have a very robust ecosystem around ESOPs,” says Kirsten Kennedy, executive director of MNCEO.

She acknowledged the tax benefits — whatever portion of the company the ESOP owns pays no federal or state corporate income tax — that come along with the employee ownership format but adds that smaller companies can also explore worker-owned cooperatives, which have lower barriers and can start with as few as four individuals, or employee ownership trusts.

There is only one employee ownership trust in Minnesota, she says, adding there may be a couple more in the next few years.

Kennedy is in the process of creating a working group aimed at spreading the word on employee ownership. She’s received support from the McKnight Foundation to do so. “Less than 5 percent of people in Minnesota have even heard of employee ownership,” she says.

While ESOPs and other employee ownership strategies may not be for everybody, the transition has been helpful at Schu Marketing. 

One recent job posting produced 60 responses. The company interviewed 20 and hired three. Levens attributes part of that demand to being able to say the company is employee owned.

But even now, there are still challenges. As Markowitz mentioned, Levens has been meeting recently with her advisers working on strategies to ensure there are enough funds available to pay out the shares of employees nearing retirement. 

“That’s not necessarily a challenge, but more of a consideration and something more mature ESOPs need to think about,” she says, adding that despite those ongoing issues, the ESOP has been a winning proposition at Schu Marketing all along. “It has helped us grow significantly.”