ESOPs on the Rise Among Small Businesses

Bob Moore gathered three employee shifts together last month for pizza parties to celebrate his 81st birthday. But Moore, the founder and president of Bob's Red Mill Natural Foods in Portland, Ore., also had a surprise announcement: He was giving his 200 employees the company he founded in 1978.

"I thought some of them were going to kiss me," Moore recalls. "It went over very, very, very well."

Moore and his partners researched their retirement options for more than a decade before settling last year on an Employee Stock Ownership Plan (ESOP). An ESOP is a tax-advantaged, qualified employee retirement plan similar to a stock bonus plan except that it can borrow money. ESOPs are typically created to buy out all or part of an owner's interest in an established, profitable company. The stock is held in a trust fund, and employees can cash in their shares when they retire or leave the company.

While ESOPs are costly to establish and operate, they have gained in popularity during the recession, says Jude Anne Carluccio, a partner in the Minneapolis law office of Barnes & Thornburg and chairwoman of the firm's ESOP Practice Group. "I've been running this ESOP practice for 14 years, and I have never been as busy as recently," she says.

There were 11,400 ESOPs in the U.S. in early 2009, up about 400 over 2008 and 800 over 2007, according to statistics compiled by the National Center for Employee Ownership, a nonprofit group in Oakland, Calif. As of 2006, the most recent year for which statistics were available, more than 13 million U.S. employees had ESOPs.

Lower Values in the Downturn

ESOPs have become a more appealing way for owners to cash out their equity because the downturn has lowered what most companies would fetch in a merger or acquisition, Carluccio says. "Traditionally, ESOP valuations [done by an independent appraiser] couldn't compete with marketplace enterprise values. But because everyone is being extremely conservative with valuations now, ESOPs seem to be able to compete a little better," she says.

The economy was definitely a factor in Moore's decision to turn Bob's Red Mill, whose annual revenue is around $75 million, over to his employees. "The downturn made this a better opportunity for us," he says, though he acknowledges that he and his partners may have gotten 30% to 50% more for the firm if they had sold out in boom times.

Business owners don't use ESOPs just to get the best possible price, however, as Moore and his partner John Wagner, who serves as the company's chief financial officer, are the first to recognize. The ESOP meshes well with the transparent culture at Bob's Red Mill. Moore and Wagner set up a profit-sharing plan 15 years ago, and Wagner shares weekly sales information with all employees so they can estimate their share of the profits. As Moore got older, longtime employees—some of whom have been with him since he and his wife, Charlee, started the company—would occasionally sidle up to him and ask, "What's going to happen to me?" Says Wagner: "Bob had the belief that there were 200 people who helped us get to where we're at. If we sold to a larger business, we'd have to watch them dismantle what Bob had taken 30 years to build up."

The Nutritionist Wave

In recent years, Bob's has cashed in as nutritionists and foodies have caught Charlee Moore's original enthusiasm for stone-ground whole-grain products. During the early years, after Moore rescued an abandoned, 125-year-old flour mill from demolition, he and a handful of employees weathered a mill fire, invested in new designs to replace antiquated technology, and managed to sell in just a handful of Western states. The turning point came when he brought Wagner on in 1993 to shore up the company's books and manage its finances professionally. Wagner helped take the company, which at the time had 28 employees and $3.2 million in revenue, to a new level. Bob's Red Mill began showing products at trade shows, where its whole-grain flours and mixes attracted attention from health food stores, food distributors, and eventually grocery stores. "Now you can find our products in every province and state in North America and lots of places overseas," Moore says.

ESOPs are not for every small or midsize business. They are best for long-established companies in which the owner is ready to retire—although these days, Carluccio says, she is doing ESOPs for some middle-aged entrepreneurs who simply want to diversify their holdings or pull cash out for things like vacation homes. "More often than not, the best ESOP candidates don't have too many family members waiting to inherit the company," Carluccio says. None of Moore's three sons, who live in California, is interested in taking over the business.

ESOPs are highly regulated under ERISA (the Employee Retirement Income Security Act) and operate through a plan trust. Generally, all full-time employees (those working 1,000 hours or more annually) become participants in the plan. They receive allocations of stock in their accounts from contributions made by the company.

Boost to Productivity

It takes about six months and a minimum of $75,000 to establish an ESOP, which is operated by a third-party administrator, Carluccio says. Moore says the cost surprised him, as did the complexity involved in hiring multiple attorneys, advisers, and trustees: "It's not for the timid, that's for sure," he says. But selling a valuable company can be just as costly, considering that most brokers and others involved in the process work for a percentage of the sale, Carluccio says. "Everyone involved in an ESOP bills hourly—none of them get a cut of the deal."

ESOPs come with significant tax benefits. When an ESOP borrows money to buy stock, both interest and principal payments are tax-deductible. In a C-corporation, stock dividends held by the ESOP can be deducted from corporate taxable income. In S-corporations, which Carluccio says now make up the bulk of her clients, the ESOP becomes a tax-exempt shareholder.

Studies also show that annual sales, employment, and productivity grow 2% to 3% faster after employees are transformed into owners, according to the NCEO. Employees in ESOP companies typically earn more and have greater retirement assets when they retire than do employees of non-ESOP businesses, the organization says. That's important to Moore, who plans to stay involved in the company while easing back from day-to-day operations. "A company of our size, as well as the product coverage we have in the nation and the world, is a very valuable company," Moore says. "I wanted to give the company to my employees years ago, but I couldn't, due to the taxes. This program is cut out for us. I truly feel we're doing the right thing."

Before it's here, it's on the Bloomberg Terminal.