Tales from ESPO Fables

Barbara Smith arrives at work most days with a smile across her face. Does she enjoy her job? Of course. But it’s more than that—one the agency’s key benefits keeps her motivated and dedicated.

Smith, an assistant vice president and director of marketing at Rose & Kiernan, Inc., in East Greenbush, N.Y., has amassed 19 years of service at this growing agency, 17 of them as a member of the agency’s employee stock ownership plan. “If you work for other agencies, they usually give you a turkey at Christmas,” Smith says. “They don’t give you something that ends up being hundreds of thousands of dollars.”

An agency with an ESOP sports a huge advantage over competitors. Agencies lacking these ownership programs can rarely come close to providing the total compensation that an ESOP agency’s employees build up over the years.

“If you get mad about something and start looking at other agencies, you put down your salary plus your ESOP and other benefits, and you tell another agency what you want, they kind of look at you and laugh,” Smith says.

Perpetuation Solution
An ESOP is a perpetuation plan that motivates current workers, attracts new talent and provides a healthy tax deduction. Made popular in 1974 thanks to the Employee Retirement Income Security Act (ERISA), ESOPs can be used for three purposes:
• To buy out departing owners;
• To borrow money for the agency at low cost; and/or
• To create an additional employee benefit.

Through its ESOP, the Rose & Kiernan agency has achieved all three. In early 1974, second-generation owner Peter Kiernan left the insurance industry to become president of the State Bank of Albany (now part of Bank of America). At that time, the law required Kiernan to divest himself of his interest in the agency and, finding no suitors, he sold it to his employees.

But by 1987, many of these employees were nearing retirement. To extract their money from the firm and at the same time help perpetuate it, the employees formed an ESOP. “At that time, it was purely a financial tool,” says Joe Vitale, Rose & Kiernan’s CFO. But since another agency was in hot pursuit, the ESOP functioned as a defense mechanism as well as a perpetuation plan.

Rose & Kiernan also has used its ESOP to help acquire other agencies. Most recently, the ESOP borrowed money to merge with The Daniels Agency in downstate New York. Dividends paid to the plan are used to pay principle on the loan. Once the principle is paid off, these dividends will be paid to agency employees.

But the most important benefit of an ESOP, according to Vitale, is its influence on agency culture. In the mid-’90s, agency managers sat down with non-managers and asked them to begin performing as the business owners they were. “There is no Mr. Rose or Mr. Kiernan today, so [we explained that] any success we have with clients is shared with everyone in the organization.” And this, Vitale says, has made all the difference. Employees who understand the ramifications of an ESOP realize that their performance contributes directly to the growth of the agency, its value and, in turn, their individual prosperity.

The proof: Back in 1987, a third-party agency evaluation determined Rose & Kiernan stock to be worth just above $38 a share. Today, each share is worth more than $200 as annual revenues climb above $44 million. For Barbara Smith and all employees, these numbers translate into a secure retirement, fully paid for by a business in which they have a stake and have helped make a success.

“If you look at it on the surface, it appears that so many of my friends (who retired from state government at age 55 with 100% pensions) have done better,” Smith says. But she’s an aggressive investor who plans to invest the cash from the sale of her ESOP shares when she retires two years from now. “And I know that after years of investing, I may have much more than they will,” she adds.

ESOP Misconceptions
But if regular employees are walking away with hundreds of thousands, what’s left for the managers? The question and its answer form the crux of the philosophy behind the ESOP.

According to the National Center for Employee Ownership (NCEO), banker and lawyer Louis Kelso developed the ESOP concept in the 1950s because he believed the capitalist system would be stronger if all workers—not just a few stockholders—could share ownership of a company’s capital-producing assets. But it wasn’t until 1973 that Kelso convinced Sen. Russell Long, then chairman of the tax-writing Senate Finance Committee, that employee benefit law should permit and encourage tax benefits for ESOPs. Once these tax benefits were enacted into law, more companies began to create ESOPs, “now that sharing ownership was in the economic self-interest of company owners,” according to a NCEO background document.

ESOPs eschew the pocketing of a company’s wealth by a few owners in favor of spreading that wealth among rank-and-file employees and managers alike. And as Hamlet once said, “Ay, there lies the rub.”

“I think the biggest problem some agents have [with ESOPs] is that they hate dilution,” says Dave Evans, a Certified Financial Planner and Big “I” senior vice president. Agency founders and owners “still want to call the shots,” he explains, and a misconception among them is that employee ownership programs are all-or-nothing propositions that can rob top brass of all control.

But leadership’s role is to guide the agency toward growth and profitability. That means managers still have the authority to hire and fire, set strategies and goals and evaluate employees. Instead of focusing on control issues, Evans suggests that current agency owners examine tax laws that could change in 2011, and structure their perpetuation plans accordingly.

For example, although estate taxes are scheduled to dwindle to zero by 2010, the prospect that Congress will extend this provision to continue in 2011 and beyond, especially in the face of the federal government’s unpaid liabilities to Medicare and Social Security, seems unrealistic.

What’s more, any attempt by Congress to rectify the current injustices of the Alternative Minimum Tax (AMT) will likely involve raising the capital gains tax, Evans believes. “To get deferred recognition of the gain of an agency principal’s stock, they need to sell at least 30% of their ownership to the ESOP, because this is the trigger point,” he says.

“When 2011 comes along and you realize that you may owe 50% to 55% of the agency’s value to estate taxes if it remains in your estate when you die, that’ll get your attention,” Evans continues. But by selling to an ESOP and taking other steps, you can ensure the perpetuation of the agency while minimizing income and estate taxes.

Weighing Options
To establish an ESOP, an agency must set up a trust fund and contribute into it new shares of its own stock or cash to buy existing shares. If this money isn’t available, the ESOP can borrow it to buy new or existing shares, with the agency making cash contributions to the plan to allow it to repay the loan.

No matter how an ESOP acquires its stock, however, agency contributions to the trust are tax-deductible. But first the agency must pay to set up the ESOP and have a third party perform a valuation. These costs can run from $10,000 to more than $30,000 for even the simplest plan. And while setup is a one time expense, valuations must be performed annually to determine changes, if any, in the value of the agency’s stock. Then a payment into the ESOP is required.

“It becomes a fixed obligation to the agency,” which must make the ESOP payment “first and then pay everything else,” says Angie Bemiss, partner and vice president at Reagan Consulting in Atlanta. In other words, the agency is required to make a contribution no matter what, whereas with profit-sharing, this amount could be less, potentially, or nothing at all, depending on that year’s profits.

“ESOPs should be used when they are the best vehicle for redeeming agency stock,” Bemiss says. “They shouldn’t be used if there’s a different structure that can be used for repurchase.”

Tim Cunningham, partner at Optis Partners LLC in Chicago, agrees that repurchase liability is the most negative aspect of ESOPs in general. “In most cases, the ESOP has an unequivocal call position: It has the right to require that departing employees sell their shares back to the plan at the then-current value,” he explains.

At this point, the ESOP must have the money to repurchase those shares. In the event that several employees retire during the same year, this financial obligation can become significant. “This is the monster in the box in the basement,” Cunningham says. “Your ESOP may not be growing, but you have to keep feeding it due to the need to fund the repurchase liability.”

One could argue that an agency would have the same issue in any perpetuation plan. But Cunningham says that conventional succession plans allow for greater funding flexibility if structured properly. “[With an ESOP], if you have a 10% turnover each year, you have to fund 10% of the buy-back each year,” he says. This compares to the payout required under other plans wherein individual owners frequently hold their equity for 20 years or longer.

“If your ESOP is structured properly, the agency can project and account for the repurchase liability,” Cunningham adds. “But I believe a number of firms that set up ESOPs don’t fully understand the full ramifications of this.”

If an agency is large enough (at least 20 employees, NCEO says) to warrant serious consideration of an ESOP, Cunningham recommends the agency “manage down” its repurchase liability whenever possible, allowing other employees to buy extra shares. Such purchases are considered capital transactions; thus employees buy the shares with after-tax dollars and must earn more to pay for them.

Another caveat: ESOPs cannot be used in partnerships or professional corporations. They can be used in S corporations, but in this case, they will not qualify for a rollover provision that allows the shareholders of C corporations (whose ESOPs own 30% or more of the company) to defer taxable gain on the sale of their stock, as long as they invest the proceeds in almost any type of stock, bond or partnership. In other words, an older principal in a C corporation could sell all or a portion of his stock to the ESOP and, because of the tax benefit, be willing to sell at a discount.

Although well-run agencies may increase in value, say, from 5% to 7% annually, the U.S. stock market average return is close to 12% per year, making retirement plans that invest in stocks or similar securities a viable alternative.

Deciding Factors
The case for an ESOP should be made at several levels. Does the agency have enough employees to merit the set-up and maintenance of an ESOP? Do current owners subscribe to the philosophy that independent agencies should perpetuate in this manner, or is it more important to keep most of the money flowing into management’s pockets? Does the agency have the discipline to make ESOP contributions a major priority?

Your answers to these questions can help you decide whether or not to further investigate ESOPs. And while it may be a stretch to say that ESOPs are one tool for ensuring the future of the independent agency system, few would argue that employees earning a share of the profits they help create work harder—and, most likely, happier.

Susan Hodges (hodgeswrites@aol.com) is an IA senior writer.

ESOP Case Study

Haylor, Freyer & Coon, Inc., in Syracuse, N.Y., established its ESOP 11 years ago to perpetuate the business and ensure its continued independence. “We’ve always been committed to remaining independently owned,” says CFO Mark McAnaney. “The retiring owners felt they’d had a great opportunity to run a business, and they wanted to pass that legacy on.” An ESOP is not the only answer to agency perpetuation, of course, but McAnaney agrees that it is an effective way for owners to transition into perpetuation while both they and their employees benefit.

Key to making ESOP maintenance a pleasure instead of a problem, McAnaney suggests, are the proper evaluation of the agency each year by a disinterested party, and a commitment from agency leaders to make ESOP payments a priority. When these conditions are in place, the plan grows consistently. And if its members work hard and smart, the agency grows along with it.

This has been the case at Haylor, Freyer & Coon. When McAnaney began work at the firm in 1986, he joined about 120 other employees. Today the agency employs close to 250 people and operates in 12 offices throughout New York. “We’ve had a lot of success and a little bit of luck, and we feel very fortunate,” McAnaney says.

Resources

The Web sites below provide detailed information on the feasibility, formation, tax benefits and rules of ESOPs. Although each site offers a different perspective, together they create a comprehensive source of knowledge about these retirement and perpetuation tools.

The National Center for Employee Ownership
www.nceo.org/ESOPs

U.S. Securities and Exchange Commission
www.sec.gov/answers/esops.htm

About: Retirement Planning
http://retireplan.about.com/cs/ retirement/a/aa_plan_a6.htm

The ESOP Association
www.esopassociation.org