By the late 1980s, Mike McCarthy had reached a crossroads. After more than a century, his great-grandfather’s lumber business had blossomed into one of America’s largest construction firms, generating $1 billion in annual revenues by building bridges, airports, schools, factories, office buildings and prisons. But McCarthy, the chief executive, wanted to begin planning for retirement (he’s now 63), and there was no obvious candidate to succeed him. His five children were too young or unwilling to take on the responsibilities of leading St. Louis-based McCarthy Building Companies. Of the more than 20 McCarthy relatives who owned stock in the company, none volunteered for the top post. Mike considered selling the business to a competitor, but the prospect of burying one of America’s oldest privately held building companies left him uneasy.
For years Mike had worked with dedicated employees, building an exciting business with a tight-knit corporate culture. Who could predict how a new owner would treat that carefully nurtured organization?
“My lifelong goal has been to develop the best builder in America, and I did not want to see all the work undone,” McCarthy says.
Most family companies confront this issue sooner or later, usually with one of two results: The company is sold (as occurred with the sale of Seagram to Vivendi in 2000, to the Bronfman family’s subsequent chagrin) or the company goes public (as Knight Newspapers did in 1969, to the Knight family’s subsequent chagrin). Either way, the company usually loses its identity or its culture, if not both.
Mike McCarthy’s story is different because he pursued another alternative. To preserve the company’s culture—and reward loyal workers—McCarthy gradually sold the business to its employees, using an employee stock ownership plan (ESOP). Selling the concept to McCarthy employees wasn’t easy, and it has taken more than a decade so far. But today the family members and the new employee-owners consider the program an enormous success. The company’s earnings have climbed, and the price of the privately traded stock has soared. Many longtime employees who never dreamed of being owners now find themselves holding stakes valued in the hundreds of thousands of dollars.
“It took a while to persuade employees that the ESOP could work,” says Michael D. Bolen, the first non-family member to serve as McCarthy’s chief executive. But, he adds, “once employees understood the process, there was a groundswell of support for the idea.”
More than 11,000 ESOPs exist in the U.S. today, many of them in family businesses, like Matthews & McCoy, a distributor of medical books in St. Louis; Sundt Construction of Tucson, Ariz.; Cianbro Corp. of Pittsfield, Mass., a construction company; and Acadian Ambulance & Air Med Services, a large private ambulance service in Lafayette, La. Congress launched the idea in the 1970s as a way to encourage employee ownership. Since then ESOPs have largely thrived, achieving better sales and earnings growth than conventional businesses, according to studies by Joseph R. Blasi of Rutgers University and others.
Boosters contend that ESOPs work so well because employee-owners are more motivated than mere salaried workers and managers. But it also helps that Congress has stacked the deck, giving ESOPs significant tax advantages in order to encourage employee ownership. For example, Congress exempted many ESOPs from income taxes on their earnings, a competitive advantage that most entrepreneurs can only dream about.
A family can sell all or some of its business to an ESOP. In a typical deal, employees form an ESOP as part of their retirement plan. The ESOP borrows from a bank and uses the cash to buy shares from the owner. Tax laws encourage such loans, enabling ESOPs to deduct interest as well as principal payments. Conventional borrowers, by contrast, can deduct only their interest.
Business owners often start the process with a partial sale of stock, as the McCarthys first did in 1996. “Often they see that earnings go up under the ESOP, and the value of the stock rises,” says J. Michael Keeling, president of the ESOP Association in Washington, D.C. “So they will gradually sell more stock and eventually transfer the entire company to the ESOP.”
Selling to an ESOP can provide big tax incentives. If the family sells to a private buyer, it may face huge capital gains taxes. But in deals with ESOPs, the family can defer paying capital gains taxes, provided the proceeds of the stock sale are invested in other securities, such as publicly traded shares.
Here’s how it works: Say the president of a family business acquired his company for $10 a share. After years of success, he sells the business to an ESOP for $90 a share and invests the proceeds in General Motors stock. He dies and wills the GM shares to his son. The heir need not pay any capital gains taxes on the appreciation of the family business stock. The huge capital gains achieved by the late president of the company will go totally untaxed. McCarthy is one family company that has used this technique; so have the four companies mentioned above, not to mention 65% of the ESOP Association’s 1,250 members, according to association president Keeling.
For some businesses, the tax advantages alone provide sufficient reason to go the ESOP route, says Keeling. Others, like McCarthy, choose ESOPs rather than private buyers because they think it’s the right thing to do. But in most cases, “ People don’t do this because of one simple factor,” Keeling says. “People like the tax advantages, but they’re also reluctant to put a new person in charge of workforces that have become like family members.”
For Mike McCarthy, the importance of preserving the family tradition played a major role in his decision. The original McCarthy Lumber and Construction Company traces its roots to Timothy McCarthy, an Irish immigrant who started a lumber business in Michigan in 1864. His sons moved the business to Missouri and evolved into building barns and farmhouses in St. Louis. By 1907 the company was putting up post offices and commercial buildings. While most work remained in the St. Louis area, the company occasionally ventured farther afield, building a post office and courthouse for Anchorage, Alaska, in 1939. During World War II, Mike McCarthy spent part of his childhood in the Panama Canal Zone, where his father worked on government construction projects.
When Mike McCarthy became chief executive in 1976, he inherited a $30 million-a-year operation focused mainly in the Midwest. Convinced that the company’s growth was limited in its home market, McCarthy targeted fast-growing areas in Arizona and California and specialized in health care. Eventually the company became a leading U.S. builder of hospitals and other medical facilities. From there, McCarthy segued into another specialty: laboratories and scientific facilities. After mastering each new and difficult form of construction, McCarthy found it could move into new cities and win contracts, bidding against local competitors who lacked expertise in these areas. Today McCarthy operates in most states, with more than 2,000 employees and $1.2 billion in annual sales.
While Mike McCarthy says he always sought to treat employees like family members, he was a demanding boss. To expand the business, employees often had to uproot their families and move from city to city. “It is difficult to move a family with children, and we did not force people to do it,” he says. “But we made clear that the people who did make the sacrifices and moved would be higher paid, and they would win more promotions.”
When McCarthy decided to begin implementing the ESOP, his first step was to set about training a group of dedicated executives who could succeed him at the helm. All were company veterans with experience working in various regional offices. Although all were skilled in engineering and construction work, none had experience with an ESOP, not to mention marketing the idea to employees. Working with investment bankers and consultants, they developed a plan for implementing employee ownership and set about holding “road shows”—meetings where they discussed the idea with employees. Chief executive Bolen says morale at the company had been fairly high before the ESOP, and it was essential to persuade employees that the company would remain successful after the ownership structure changed.
With employees fully informed, Mike McCarthy acquired nearly all the stock from family members. Then, in 1996, he sold 38% to the ESOP for $12 million—which suggests that the company was valued at only about $32 million. The valuation was developed by an outside consultant, based on prices of comparable public companies as well as textbook methods for estimating future cash flows and the value of those cash flows. (If $32 million sounds low, remember that housing construction companies were extremely undervalued in the 1990s. Many public stocks sold for price-earnings ratios of five or less.)
Instead of taking a loan to finance the purchase, the ESOP bought the stock with money taken from the employees’ profit-sharing plan. This transaction was approved by the company’s board. (Employees had no say in this matter because the funds came from profit-sharing contributions originally made entirely by the company.)
Under the ESOP, the company awarded stock to each employee. Stock awards were based on holdings in the profit-sharing plan, so employees with bigger stakes in the plan received more McCarthy shares. Under the terms, employees must hold their McCarthy shares until they retire or leave the company.
Some employees were at first dubious about a plan that took cash out of the profit-sharing plan and invested the money in company stock. But the doubts soon vanished as McCarthy stock soared, climbing 38% annually during the ESOP’s first six years.
The price of McCarthy stock, which remains a private security, is set each year by an outside valuation firm. To determine a fair price, the valuation consultant reviews McCarthy’s earnings, share prices of publicly held construction companies and other factors. Under law, the consultant must determine a fair market price—not a premium price. This requirement deters some family businesses from using an ESOP. Instead, the owners sell to competitors who badly want the assets and are willing to pay a significant premium. “If acquiring the business gives someone access to a specific marketplace, then they may be willing to pay a very high price,” says George Scherer, McCarthy’s chief financial officer. But in McCarthy’s case, the run-up in the stock price since the ESOP—at least so far—has made believers of the employees. “People have been thrilled to see that they can become significant stakeholders,” says Scherer.
After the annual price of McCarthy stock has been announced each year, employees have had reason to cheer as their account values have regularly climbed. Though they are free to quit the company and cash in their stakes, most have elected to stay. The company says annual employee turnover is now 7%, down from pre-ESOP days and well below industry averages. (The average employee has been at McCarthy for 19.1 years, compared with 9.1 years in the construction industry.)
Scherer says that under the ESOP, employees have become more excited about their jobs, seeking ways to cut costs and improve profits. “We’re seeing a lot more cooperation between the six divisions of the company,” he says. “When one division discovers a technological improvement, they pass it on to other people around the country. And if a division needs to recruit an employee with a certain skill, other people help with leads. In the past, we didn’t see as much of that kind of cooperation.”
Consultants caution that ESOPs aren’t suitable for every business. “It’s easiest for an ESOP to get bank financing if the company has a lot of assets that can be used as collateral, such as buildings and equipment,” says James E. Barrett, managing director of Cresheim Inc.’s family business group in Philadelphia. “Restaurants and professional service businesses often have trouble getting loans.” McCarthy, as a construction firm, faced no such problem.
Barrett says that banks often require the seller to guarantee the loan with personal assets. So the family owners must trust the employees and believe that they can succeed. “The owners have an incentive to make sure that the transaction is structured properly and that the business is likely to do well,” says Barrett. “You can’t just milk the deal and run away to Florida. If the business fails, you can find yourself back running the company.” At Foster & Gallagher, a large catalog company that sells seeds, bulbs and garden supplies in Peoria, Ill., the new employee/owners are currently suing the former owners, claiming the stock was not properly valued.
McCarthy seems to be a happier example. This past April the McCarthy ESOP borrowed from a bank and increased its holdings to 60% of the company. Mike McCarthy still owns about 10% of the stock but says he hopes to transfer all his holdings to the ESOP during the next several years. The remaining 30% of the shares are now held outside the ESOP by the company’s 60 top executives. To acquire the shares, each executive had to borrow from a bank. In similar transactions, some companies give executives bonuses to help cover the costs of acquiring shares, but McCarthy rejected this approach because the executives would have had to pay income taxes on the bonuses and then apply for bank loans. Instead, the executives have obtained conventional bank loans and can deduct interest expenses.
McCarthy’s plan is proceeding at a time when the idea of employee ownership is being questioned. Congressional critics, pointing to stock-abuse scandals like the debacle at Enron, have noted that employees can suffer when their retirements depend on the performance of a single stock. Defenders of ESOPs counter that the law gives employees some flexibility to diversify their holdings. At age 55, for example, participants are permitted to sell 50% of their company stock back to the company and shift those holdings to diversified investments, if they choose. By law, the company must pay cash for this stock. Some companies put the cash into the employee’s 401(k) or IRA. Others simply pay the employee the cash outright; the employee is then free to spend it or roll into an IRA.
To give employees some protection, McCarthy continues to offer a 401(k) plan that invests in conventional stock and bond mutual funds. Keeling of the ESOP Association praises this effort to run a diverse retirement plan in tandem with the ESOP program. He concedes that employee ownership comes with some risks. But he notes that most employee-owners have received decent returns from their holdings of company stock. And at a time when social critics worry that ownership of America’s wealth has become too concentrated, ESOPs enable broad groups to benefit from holding shares.
“ESOP companies can strike a balance, offering diversified retirement programs, while permitting employees to enjoy the benefits of company ownership,” Keeling argues.
With demand for health facilities remaining as strong as ever, McCarthy Building has avoided problems other businesses have faced during the current recession. The company expects to continue expanding its construction business while consolidating the gains achieved under Mike McCarthy. Consultants caution that the good times won’t last indefinitely, and the real test of an ESOP occurs when business inevitably faces a downturn. Then employee-owners must pull together, supporting a management that may be forced to impose layoffs or make other painful cuts. For now, McCarthy’s managers believe that the entire staff is energized, working like a family that can succeed in good times and bad.
“We felt like we were employees of a family business ten years ago,” says Mike Bolen, the chief executive. “Now there is a strong sense that we are owners.”
Stan Luxenberg is a financial writer who lives in New York.