How to Make an ESOP Work

For some time, J. Walter Kisling’s relatives had been getting on hiscase. Kisling is chairman and CEO of the Multiplex Co., in Ballwin, Missouri, which makesrefrigerated-beverage dispensing equipment for the fast-food industry. He and his three sisters owned80 percent of the family company founded by their father. Their 14 children and more than a dozengrandchildren also held some shares.

J.W., as everyone calls him, had worked hard to transform a manufacturing company that was on theverge of bankruptcy 20 years ago into a successful $25 million enterprise, and he believed that tokeep the company on its upward growth path for the benefit of all family shareholders, profits shouldbe plowed back into the business. His problem was that he did not control the company: He and hissisters, none of whom worked in the business, each owned 20 percent of the stock. That meant about 77percent of the company was owned by family members who were not involved.

Only Kisling, his son, Wally Jr., and his nephew, Daniel Scott, were in the business. Thisselectivity bothered some family shareholders. “They don’t understand why their son can’t just walk inhere and take a job starting at $50,000”, says Kisling. “We have a lot of family in remotelocations with little knowledge of the business and little interest.”

Since Multiplex is privately held, discontented shareholders could not easily find buyers forstock. What’s more, Multiplex had paid only one $1 dividend in its history. At annual shareholdermeetings they badgered him about liquidity, about lack of income from their holdings, about the sizeof executive salaries.

- Advertisement -

A potentially bigger problem was also looming. At 53 years of age, J.W. was the baby of the family.Two of his sisters were widows in their 60s, and the third was past 70. Kisling knew it was only amatter of time before their children faced an enormous estate-tax problem. To protect the wealth ofhis own and his sisters’ families — and avoid further trouble within the shareholder group — Kisling hadto do something with the business.

The answer to these diverse problems proved to be remarkably simple. Three years ago Multiplexstarted an employee stock ownership plan, under which a trust purchased 30 percent of the company’sstock from the family for $3.2 million and distributed the shares to the company’s 60 salariedemployees.

The way the Multiplex plan is structured shows how an ESOP can satisfy the interests of differentfamily business constituencies. By means of the ESOP, Kisling was able to soothe his relatives, helpthem avoid onerous estate taxes, and give loyal employees a stake in the business, all whileconsolidating control with those who work in the business and are responsible for its success.

To appreciate how it was done, and the neat symmetry of the result,it’s helpful to know a little about the company’s history.

The original manufacturing enterprise, founded in 1936 by J.W. Kisling Sr., was called Kisco Co.and made hassock fans. Those round floor fans were popular until the 1950s, when the spread ofair-conditioning cooled the fan business considerably. As a result, Kisco Co. began to shift intodefense work. During the Vietnam War the company employed 1,000 people on three shifts makingammunition casings.

Profits remained high throughout the 1960s. But because defense work is cyclical, the Kislingsdecided in the 1970s to diversify. They bought Multiplex Co. at a fire-sale price of $70,000 (“It waslosing lots of money,” recalls J.W.), and ran it as a separate company with the same ownershipstructure.

During the 1980s, as Kisco Co.’s business slowed down, family members started getting restless withthe company’s management of their investment. They would complain about not receiving any dividendincome and ask why executives continued to get paid the same salaries whether or not the company madea profit.

These pressures, combined with Kisco’s sinking fortunes, took their toll on Kisling, who was thenrunning the business with his brother-in-law, J.T. Holden. “I kind of got beaten up a little bit,”J.W. recalls. When the brother-in-law announced he was ready to retire in 1985, the pair faced a toughdecision about the future. The near term prospects of Kisco were dim. Multiplex, on the other hand,was growing steadily. Further, Kisling realized that down the road his children and his sisters’children faced massive estate taxes from the stock they would eventually inherit. With family membersclamoring for cash, J.W. and his brother-in-law decided to sell Kisco.

The sale didn’t solve Multiplex’s basic ownership problem, which was that nobody had a majoritycontrol of the company. And family members were appeased only for as long as the money from the saleof Kisco lasted.” It was like giving them an aspirin,” Kisling says about the disbursement of profitsfrom the Kisco sale. “Their headache — the problem — just went away until the money ran out.”

When J. T. Holden died soon alter his retirement, Kisling realized that the estate tax problem hadnot been solved either. Much of what Holden’s wife (Kisling’s sister) inherited was stock inMultiplex. When the widow died, their children would need cash to pay taxes on that stock, which hadappreciated in value. Likewise, when he and his two other sisters died, their children would face thesame problem. The company had grown in value to the point that, in the event of the death of a majorshareholder, after estate taxes there would be very little left in the estate except Multiplex stock,”Kisling says. “I don’t want everything I leave them to be Multiplex stock. It only perpetuates theproblems my brother-in-law had in our generation, except that the numbers get bigger.”

Members of J.W.’s generation had gifted stock to their children in order to reduce the eventualestate-tax burden. But the parents were apparently too late in deciding to look into the idea, commonin estate planning, of buying life insurance that the children could use to pay estate taxes aftertheir deaths. (“The people are too old,” Kisling explains. “It was too expensive.”) Kisling’s son,Wally, 32, who is Multiplex’s director of international operations, echoes his father when recallingthe concerns of his own generation: ‘The Multiplex stock could have been a burden. I could imagine theheirs of the deceased relative having to sell all of their parent’s liquid assets just to pay theinheritance tax on a stock that returned them nothing.”

A development in 1986 made Kisling realize that an ESOP was the best way togo. When the business moved from its longtime St. Louis headquarters to a suburb, he created a limitedpartnership to buy the new facility and lease it back to the company — a common arrangement that reducescapital borrowing for the firm and gives investors a fairly safe return. He offered the investment toall family shareholders. Only two shareholders, besides his own immediate family members and DanScott, took him up on it. “I realized then that they had about as much interest in the company as[they would] if it were General Motors.”

The ESOP trust was funded on March 17,1989. To purchase the stock for it, the company took out aloan of $3.2 million, which under federal law can be paid back in pre-tax dollars — a major incentivefor an ESOP-type plan. Kisling and his three sisters each sold 7 percent of the company to the trust,and another 2 percent was acquired from stock held in the company treasury. Each employee received apercentage of ownership, depending on salary and length of employment. Technically, what the employeeowns are shares in a beneficial trust that holds Multiplex stock — not the stock itself. An ESOPcommittee appointed by the board of directors instructs the trustee on how to vote the stock. (Mostoften, the committee and the trustee are the same person or persons.)

J.W. and his three sisters received roughly three-quarters of a million dollars, on which they didnot have to pay any taxes. Under federal tax law, if a company sells at least 30 percent of its sharesto an ESOP, shareholders can avoid capital gains taxes if they reinvest the money in the stock ofanother U.S. company within 12 months.

Kisling’s sisters were able to make new investments that provide them with dividends and a modestextra income, which means that their children will have liquid assets when their parents die. In fact,if those investments are not cashed before the parent’s death the children get another big advantage.The tax basis for those investments gets stepped up to the value at the time of the last parent’sdeath. In other words, the heirs effectively avoid taxes on their parent’s original stake in thefamily business and on the gains from new investments made after they sold stock to the ESOP

Besides giving family members liquidity and easing the estate-tax concerns, the ESOP consolidatedcontrol of Multiplex under one roof. Kisling’s immediate family, his nephew, and the employees now ownjust over 50 percent of the stock.

Multiplex employees seem pleased with the ESOP, which replaced a modest profit-sharing program. The average salaried employee is getting nearly $8,000 worth of stock a year,and, if the company keeps growing at its present rate, will continue to do so until 1996. CharlesSeibert, manager of financial services, says that, based on a recent appraisal of the stock’s value,each employee has received about two-and-a-half times as much as he or she would have gotten indistributions under the profit-sharing plan.

Randy R. Castle, senior director of manufacturing, says Multiplex’s profit-sharing plan “wasn’t areal big nest egg, but the ESOP is more of an opportunity. If we can grow the company and have thetotal value appreciate, it means more value for us. Everybody feels it’s a better deal.”

The downside, of course, is that employees can’t cash in their holdings whenever they want.Although some ESOPs permit them to take out funds under limited conditions — for example, to pay heavymedical costs — generally an ESOP is viewed as a form of retirement fund from which shareholders do notreceive cash until they retire or otherwise leave the company. These funds are not as liquid asprofit-sharing plans, which usually have diversified portfolios with publicly traded securities.

Multiplex’s motivation for starting an ESOP had as much to do with control of the business as withliquidity. Richard B. Rose of Menke & Associates, the San Francisco consultant that designed theESOP for Multiplex, says liquidity is the goal for some 75 percent of the firms that set up the plans.ESOPs have been viewed as a device to fend off takeovers, catch an easy tax break, raise capital torepay debt, or rescue a dying business. While ESOPs may be helpful for some of these aims, they have abetter chance of success when the company adopts them from a position of strength.

Rose says the scenario that typically leads a family business to an ESOP goes something likethis: “The owners of a company want to put some cash in their pocket, and the choices are selling out,merging with a bigger company, going public, or selling stock back to the corporate treasury. The ESOPis a fifth alternative.”

Selling stock to the corporate treasury does not offer the same tax advantages as an ESOP. Sellingthe business is a drastic step, especially when there are family members who still want to work in it.And going public imposes an entirely different management style on the company, requiring, among otherthings, full disclosure, and subjects the price of the stock to market volatility.

Donald M. Israel, a partner specializing in ESOP design at Benefit Concepts New York Inc., alsopoints out that selling or going public are probably not the best ways to go in the current economicclimate. Banks are reluctant to finance risky expansion plans during a downturn in the economy, Israelpoints out, but lending for a stock purchase poses fewer risks. “As a result, ESOP transactions areprobably a little easier to do than other deals,” Israel says.

For all the advantages of ESOPs, the idea of giving employees part of thecompany doesn’t sit well with all family business owners. The thought of sharing control meetsresistance in many firms, especially those that have been run in a patriarchal manner. Not everyfamily chief executive is willing to listen to employees, to respond, and especially to sharefinancial information.

Experts acknowledge that the family which is unwilling to offer a greater level of participation toemployees may not be suitable for an ESOP. But they argue that the family does not have to give upthat much control. Rick Rose, whose firm has helped create more than 800 ESOPs, says that control ofthe company need not change at all, since ESOP stock is voted by a trustee who receives instructionsfrom an ESOP committee appointed by the board of directors; presumably, the board will remain in thefamily’s hands.

As for disclosure, the business is not required by law to hold an annual meeting or share financialinformation with employee-shareholders. It is only obligated to provide employees with annualstatements of account showing how many shares of that beneficial ownership they have and what eachshare is worth. “You don’t even have to tell them how much you made,” Rose notes.

Still, Rose and others point out, that isn’t the best spirit with which to enter an ESOP. J.W.Kisling was accustomed to meeting with all employees at quarterly breakfasts to brief them on thecompany’s outlook and strategy. Now he has started monthly roundtables with just a dozen people at atime to discuss where the company is headed and whatever else is on everyone’s mind.

Kisling has also instituted an annual meeting at which he reveals financial information. “We gothrough the balance sheet and the profit-and-loss statement,” he says. But nothing is given toemployees in writing about the firm’s financial condition. “We still are a private company, and ourresults are confidential.”

Recently, Kisling invited every employee to submit three ideas that could save the company at least$1,000 each. Although a number of good ideas were received, Multiplex managers feel that the newemployee-owners still haven’t taken as much initiative as had been hoped. “Maybe we haven’t done asgood a job of communicating and selling the program as we should,” admits William K Jenkins,Multiplex’s president.

Kisling doesn’t deny that communication with employees has not been entirely effective. “I will bethe first to confess that we’re not doing as good a job as we should be,” he says, “but we juststarted.”

Corey Rosen, director of the National Center for Employee Ownership in Oakland, California, notesthat the biggest problem companies with new ESOPs have is “getting employees involved.” Most companiesfind that just having meetings between employees and management isn’t enough, he says. As forMultiplex’s effort to get employees to come up with money-saving ideas, he comments, “What they’ve gotis a suggestion box. It’s a start, but they need the next step.”

The next step, according to Rosen, may be to set up permanent committees ofemployees and management to address key issues, or to appoint ad hoc committees with both groupsrepresented as needed. These groups cannot only come up with good ideas but can follow up and sellthem to the rest of the company.

The payoff could be improved productivity. Corey Rosen says his center’s studies show thatcompanies with ESOPs that have encouraged greater employee participation have grown an average ofbetween 8 percent and 11 percent faster a year than those that do not have such participation. AtMultiplex, one measure of productivity — sales per employee — rose by 18 percent in the first year of theESOP, but Kisling hesitates to attribute the gain solely to the incidence of ownership. “It was a goodyear, volume was up,” he recalls. Kisling does think the ESOP has spurred productivity, but since thatwas not his main aim in setting it up, the company does not have a method of measuring the gains.

“If you want to do an ESOP, do it for the right reason,” Kisling says. “Don’t do it because it’s anopportunity for the owners to get money out. Do it because you don’t want to sell to outsiders. Do itbecause you want to see people who work at the company get something for their work. Do it to helpshareholders.

“If all parties involved — the employees, the shareholders, and the company — come out well, then doit. If one party is going to benefit at the expense of another, then don’t do it.”

Stephen J. Simurda, a journalist in Northampton, Massachusetts, writes often about smallbusiness.

 

FINANCING AN ESOP: HOW BIG DO YOU HAVE TO BE?

ESOPs have proliferated since Congress passed the Employees Retirement and Income Security Actin 1974, which created incentives for companies to establish such plans. In all, there are now some10,500 ESOPs in the United States, covering close to 12 million employees, according to Corey Rosen ofthe National Center for Employee Ownership. At least 700 new ESOPs a year were being created until therecession, Rosen says. While some are huge and well-known, like the one at Avis, the vast majority arein smaller, family businesses.

In fact, size is less important than profitability in whether a company opts for an ESOP If acompany generates at least $75,000 a year in pre-tax profits, an ESOP might make sense, says Rick Roseof Menke & Associates. Another ESOP advisor, Don Israel of Benefit Concepts New York Inc., saysthat as a general rule of thumb, a company that wants to set up an ESOP should have at least 15employees and more than $1 million in annual revenue. Rick Rose says Multiplex is a little larger thanthe average family business that implements an ESOP. Typically, a company’s sales range from $5million to $10 million. The business is often run primarily by one family member who owns a big chunkof stock and is thinking of slowing down a little.

There are dozens of different ways to design an ESOP, depending primarily on how much of the stockis to be sold and the source of financing. But the vast majority of ESOPs started at family businessesare quite similar to the type created at Multiplex. The cost of designing and implementing such aplan, according to Rose, ranges from $17,000 to $30,000.

Before going ahead, however, consider a few caveats. First, if you borrow money to buy stock forthe trust you will, of course, have to pay a monthly debt service. Multiplex, for example, pays some$48,000 a month on its $3.2 million loan. One reason that steady profitability is so important to theESOP equation is that you want to be able to pay off such a loan easily over seven years.

Second, when employees leave or retire, the company will have to cash them out. “Paying the piper,”is what Rick Rose calls this emerging liability within the ESOP. The legislation creating ESOPs helpsthis process, however, by allowing a five-year payoff period for a retiring employee, and 10 years forone who leaves the company for other reasons. And as employees age, the company is required to putpart of its stake in non-company investments. By age 60, half of an employee’s vested stake must be inthese liquid stocks. — S.J.S.

About the Author(s)

This is your 1st of 5 free articles this month.

Introductory offer: Unlimited digital access for $5/month
4
Articles Remaining
Already a subscriber? Please sign in here.

Related Articles

KEEP IT IN THE FAMILY

The Family Business newsletter. Weekly insight for family business leaders and owners to improve their family dynamics and their businesses.