🔒Here’s how one CT business used an ESOP as a buyout strategy

In 2019, Rich Harper was anticipating retirement, and seriously contemplating the future of his successful HVAC sales and distribution company, Flow Tech.

“We were looking for a vehicle to transfer the company,” he said in a recent interview.

Harper had owned Flow Tech since 1998. Over the next two decades he grew it from three employees to about 25, moved its headquarters to South Windsor, opened a warehouse, and expanded its sales territory across New England.

Also during that time — unlike most companies his size — he kept a close eye on a potential succession plan, identifying and training his successor, Michael Davis, who first joined Flow Tech as an intern in 2009.

As he got ready to exit, continuity of the company culture was important to Harper, he said, as was retaining as many employees as possible to allow Flow Tech to build on past successes.

They discussed a straight sale of the company to Davis, but decided that wasn’t the best fit. Then, a rival company in Boston approached him, offering a buyout through an employee stock ownership plan — or an ESOP.

That marriage didn’t work out either.

“But that sort of put the bug in my ear to say, well, let’s further investigate ESOPs,” Harper said.

Eventually, in 2021, Flow Tech became a 100% employee-owned company, without an outside acquirer involved. Harper had his buyout strategy in place, while Davis became the company’s new leader, as president.

Planning for the future

Employee stock ownership plans have been around a long time. First launched in federal law in 1974, as part of the Employee Retirement Income Securities Act (ERISA), they offer tax advantages to owners looking for an exit plan.

Essentially, an ESOP sets up a retirement plan for company employees; that retirement plan buys out part or all of the existing ownership.

The deal can be financed by the owner, who would then receive regular debt repayments from the company, a bank loan, or a combination of both.

Each employee is awarded company shares, which they can cash out when they retire.

“I think it makes sense all the way around,” said Harper. “The employees get ownership of it, it’s a retirement plan and they don’t have to put any money into it – all they have to do is just work hard. It’s a tax-free entity just because it’s a retirement plan. And it allowed me to get a fair price for the company.”

A recent survey shows that nearly two-thirds of small businesses don’t have a documented and communicated succession plan, and only 30% successfully sell, leaving the majority without a buyer, or a concrete plan for the future.

“There’s this hole when it comes to succession planning,” said Corey Veneziano, tax principal in professional services firm CliftonLarsonAllen’s West Hartford office. “It’s something that you really need to be thinking about five years out, or longer term, not three months from now.”

He said an ESOP isn’t for every business, but it can be a useful tool to consider, particularly when the owner is concerned about legacy and culture, and where he or she has long-standing employee relationships.

“It helps you exit the business, but it helps engage those employees even more,” he said. “The work that they’re doing and what they’re contributing to the business directly impacts their retirement.”

Fair market value

The downsides? Complexity and cost.

ESOPs can be structured in a number of different ways depending on if the business is a C corp or S corp, and on whether the sale is financed by the seller or through a bank loan.

Because they are retirement plans under the federal ERISA law, ESOPs are highly regulated. They require an independent company valuation, and the business must hire a trustee and board of directors to help leadership ensure the business is being run in the best interests of the plan.

And that professional advice doesn’t come cheap.

“There’s definitely a pretty high entrance cost,” Veneziano said.

Flow Tech’s Davis said the company’s initial transaction costs for the plan — including valuation consultants, attorneys and the trustee fee for both sides of the deal — amounted to $120,000.

Other experts confirmed that figure is on the low side: most ESOPs require $150,000 or more to close.

Many advisors don’t recommend the model for a business with fewer than about 25 employees.

In addition, there are ongoing annual costs — for a third-party administrator, valuation consultant, board of directors and the trustees — that, for Flow Tech, amount to north of $55,000 per year.

Meanwhile, because the company’s fair market value is established by an outside consultant for the benefit of the ESOP, it can also mean the seller missing out on a possibly inflated price on the open market.

“Some owners that are really out for every last nickel, they’re going to say, ‘I can sell it to my competitor. I can sell it to a private equity, or I can sell it to a strategic buyer that will buy it for more than fair market value,’” said Chuck Coyne, of Empire Valuation Consultants.

In that case, he said, “ESOPs (are) not for you.”

Trend lines

Coyne was the initial adviser to Flow Tech for its ESOP transaction, and carried out the valuation and feasibility study ahead of the deal. He’s been in the ESOP business for several decades and seen their popularity ebb and flow.

According to the National Center for Employee Ownership, ESOPs are actually on a slight downtrend in recent years. The latest available figures, from 2020, show there were 6,467 ESOPs in the U.S.; 46 of those were in Connecticut.

Nationally, that’s around a 4% decrease in the total number since 2014.

Most are in professional services, manufacturing, construction, or finance, insurance and real estate.

Coyne, though, believes that trend may be changing. The last two years, he said, are the busiest his business has ever been.

“I probably talk to at least two or three new owners every week,” he said.

Some of that additional interest is due to the so-called silver tsunami, the generation of Baby Boomer business owners who are all approaching retirement age and looking for an exit.

But some of it may also be due to advocacy and a new awareness. For many years, Ohio was the only state to have established an Employee Ownership Center, promoting the concept and helping businesses navigate the complex ESOP landscape.

Vermont followed in 2001, and now 13 states have similar outreach efforts. Coyne is involved with a group that hopes to establish a similar center in Connecticut.

“I think more and more people have started to understand that this concept of employee ownership is great for everybody,” he said.

And Coyne is also walking the walk. His company in 2021 established its own ESOP, as he and his partners at Empire Valuation approach retirement age in their 60s.

Legislative changes

There’s generally been bipartisan support for the concept of employee ownership at the federal level over the decades since the original ERISA law.

“We often say that ESOPs are the best kept secret in the tax code,” said Rob Schatz, partner at ESOPPlus, Schatz, Brown and Glassman in West Hartford.

He’s an attorney who’s specialized in ESOP transactions since the 1980s. He said when company owners are contemplating an exit, “an ESOP is one arrow in a quiver of options. It’s the least understood arrow, unfortunately.”

But successive rule changes have created renewed interest from the business community, as in 1986, when IRS section 1042 was introduced, allowing C corp owners to defer capital gains tax via an ESOP transaction.

Then in 1998, the rules changed again to allow S corps, for the first time, to transition ownership into an ESOP.

“You saw a huge wave of new transactions,” said Schatz.

He said the 1042 rule means that high interest rate environments, like the one we are in now, tend to spark more interest in ESOPs as an exit strategy. Combined with the silver tsunami, current market conditions could increase ESOP transaction activity.

Schatz warns that owners considering this structure should remember that because ESOPs are required to concentrate only in company stock, they do not provide any protection for an employee’s retirement through diversification.

“Don’t do just an ESOP,” he urges. “If you’re really, truly looking to benefit your employees, give them the opportunity to contribute to a 401(k) plan as well.”

Business continuity

ESOPs can also take some time to mature and add real value, cautions Harper, the former Flow Tech owner.

“The benefit’s not going to happen tomorrow,” he said. “Employees need to be patient because they really won’t see the value of it until five, 10-plus years down the road where some equity in the company has been built, and their stock value has been able to increase.”

That means communicating about this complex financial vehicle is key. That’s been the job of Flow Tech’s marketing director, Nichole Peterson, who has fostered an employee committee around the ESOP, and holds regular events and updates to promote the concept.

She emphasizes the continuity that the transaction has provided.

“When Rich was looking to sell, if he were to sell to a larger corporation, we could have had a mass exodus,” she said.

But with the ESOP structure, “essentially when Rich retired, nothing changed. It wasn’t like we had a new manager to report to, or a new set of rules.”

Another benefit that Davis points to: becoming an ESOP has solved one aspect of the succession problem for Flow Tech in perpetuity.

When it comes time for Davis himself to retire, the company will have to identify a new president, but the structure will remain in place.

And how about Harper? He stayed on at Flow Tech for a year after the ESOP closed to ensure continuity, but he stepped down completely in October 2022.

“So far, so good,” he said of his new life in retirement.