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Making Choices

A model for employee ownership certainly is W.L. Gore & Associates, a company owned by an Employee Stock Ownership Plan (ESOP) and by Gore family members. One of the most innovatively managed companies in the country, it has been on Fortune’s 100 Best Companies to Work list every year since 1984. It generates more than $3 billion in sales, has 45 plants in locations around the world, and employs about 10,000 associates.

Most people will not immediately recognize Gore as a company, but they know its most famous product. Gore-Tex made the outdoors a much more comfortable place, but it was only the start of a long series of innovations in multiple product lines, particularly in biomedical applications. Gore is a market leader in stents for cardiovascular disease and also has major product lines for everything from cell phones to aerospace to guitar strings. Gore’s product innovation is impressive, but its organizational innovation is what makes it truly stand out. 

Developing the Culture

From its founding in 1958, the company was committed to a model of management that deemphasized the notion that authority should flow from position or title but should instead flow from expertise. The central notion was that anyone could have a good idea and should have the authority and resources to pursue it if enough colleagues agreed. 

As is the case in all the best ESOP companies, it practices an active form of open-book management, treating all its employees like businesspeople. Everyone knows the company’s financial and performance metrics and goals, and everyone is involved in teams working on coming up with better ways to do things. 

The result is a highly engaged company of owners, people who care about making the company better and have the information and structure they need to make that happen every day.

As a result, Gore has a remarkable record of growth in employment, sales and productivity. But other measures back up the way it does business, including exceptionally efficient production, very low turnover. Experts have said they cannot understand how a company with so much slack in its control processes can be so efficient, but Gore has very high productivity rates and quality results that match its innovation. 

W.L. Gore & Associates is one of about 7,000 ESOPs. There are also about 2,000 other plans that are much like ESOPs but do not have all the same rules or tax benefits. There are about 15 million employees participating in these plans who control over one trillion in assets. ESOPs and plans like them are a big part of the economy, even if they remain largely a mystery to most business owners. So what is an ESOP and is it right for your company? 

How an ESOP Works

ESOPs are a kind of employee benefit plan, similar in many ways to 401(k) plans and profit sharing plans governed by the Employee Retirement Income Security Act. Any S or C corporation can set up an ESOP. 

In an ESOP, the company sets up a trust to acquire company shares. A company can just contribute unissued shares to the plan and get a tax deduction, but to buy out an owner, it would either contribute cash to purchase shares on a discretionary annual basis or, more commonly, it would have the ESOP take out a loan to buy a block of shares. The company then contributes cash to the ESOP to pay the loan back. All the contributions are tax-deductible.  ESOPs can borrow from a bank or other lender or, as is increasingly common, the seller can take back a note at a reasonable rate of interest.

The ESOP can buy any percentage of stock. The shares in the trust get allocated to employee accounts. Generally, at least all full-time employees who have worked for a year or more can get allocations, which can be based on relative pay or a more level formula. ESOPs cannot allocate shares on merit or other discretionary formulas. Employees vest in their shares over time and get their shares after they leave. 

ESOPs must buy and sell shares at an appraised fair market value. An independent expert will determine what a willing financial buyer would pay for the company as a stand-alone entity. Some companies can attract a synergistic buyer willing to pay more, but the ESOP cannot match that price.

Congress has gone out of its way to favor these plans. Data from the National Center for Employee Ownership shows the key tax benefits:

    • Contributions to fund an ESOP are deductible. That means a company can redeem shares from an owner in pre-tax dollars, whereas normally it must earn the money first, pay taxes, and use what is left to buy the shares.
    • Sellers who sell to an ESOP in a C corporation or a company that converts to one that ends up with at least 30 percent of the stock can defer capital gains taxes by reinvesting in other securities.
    • S corporations do not have the tax deferral option, but any profits attributable to the ESOP are not taxed. A 30 percent ESOP pays no tax on 30 percent of its profits; a 100 percent ESOP pays no taxes.

As appealing as the tax benefits are, a more important driver is often corporate legacy. Selling out often just does not feel right. Moreover, an ESOP allows owners to retain any role they like in the company.

Research shows that companies that set up ESOPs and combine them with the kind of high-involvement management grow about six to 11 percent faster than would have been expected after the ESOP. 

Potential Issues

All of this may sound appealing, but it is not feasible for every company. Several factors must, at a minimum, be present:

    1. The company must be willing to pay the costs and live with the rules: Setting up an ESOP is much cheaper than selling a business in other ways, the initial costs will run anywhere from $60,000 and up. That means very small companies are not usually good candidates. 
    2. The company must be generating enough cash to buy the shares, conduct its normal business, and make necessary reinvestments.
    3. If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan. 
    4. The seller(s) must be willing to sell their shares at fair market value, even if the ESOP pays less than an outside buyer would. 
    5. Management continuity must be provided. 

Even if your company meets these criteria, there can be future pitfalls:

    • If sellers take a note or back up a bank loan, the company may face economic problems in the future and impose costs on the seller.
    • The new company’s board and the trustee of the ESOP may decide they have an offer too good to refuse and later sell the company. If a company has a very strong ownership culture this is extremely unlikely.
    • The rules require that you hire experienced, qualified experts and have someone in management who learns them as well. Errors can be costly.

An ESOP is not the right choice for everyone, but for many companies, it is an ideal solution. It certainly has been for W.L. Gore & Associates.

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