The Wall Street Journal

By Liz Moyer

Business owners seeking to cash out of their companies don’t necessarily have to merge with a rival or solicit bids from private-equity firms. They can sell to their employees through a so-called employee stock ownership plan.

While there are potential advantages of selling to an ESOP, there also can be pitfalls, experts say. Bosses and workers can come out ahead financially, but the maneuver takes work to execute, and there needs to be considerable trust between ownership and labor for it to succeed.

ESOPs create trusts to hold shares for the benefit of employees. The shares are transferred into the trust either all at once or over a period of years, and the trust allocates shares to employees based on their tenure with the firm. The plans are commonly used to give workers added incentive to help the company prosper.

There are 10,000 ESOPs in the U.S., at firms that have a combined 10.3 million employees, according to the ESOP Association, a trade group in Washington. Most are closely held, and roughly half are owned entirely or mostly by employees.

For a business owner, selling a firm to an ESOP can be an appealing option. An owner who sells at least 30% of the shares in a company to an ESOP can defer paying capital-gains taxes as long as the proceeds are reinvested in the debt or equity securities of another U.S. company.

In addition, an owner can help ensure the company remains intact and employees’ jobs are protected, at least for a time.

Sales to ESOPs are often done in stages, with the owner starting by unloading a small stake. “It’s a gentle transition,” says Jeffrey Kahn, a lawyer at Greenberg Traurig in Boca Raton, Fla.

In January, Hypertherm, a 1,300-employee firm in Hanover, N.H., that produces cutting tools for manufacturers, announced it had become 100% employee-owned after the last of the shares of the company were transferred to the firm’s ESOP in December.

Hypertherm’s owner, Dick Couch, opted to sell to his employees after evaluating bids from large publicly traded competitors and private investors, says Carey Chen, the firm’s former chief financial officer and now a general manager for two of its units. The sale took years to complete.

Mr. Couch is staying as chief executive and his wife, Barbara, also is remaining at the firm. Employee ownership “aligned with Barbara’s and my core values: shared rewards, respect for the individual, fairness, and our effect on our community,” Mr. Couch said in an email, and added “maximizing financial return to the Couch family was not the most important factor.”

But the move doesn’t work for every company. For example, partnerships and limited liability companies, such as many law firms and medical practices, can’t sell shares to an ESOP.

Companies that carry heavy debt are often poor candidates for ESOPs. The trusts generally borrow to purchase the owner’s shares and companies give the plans the funds to pay back the loans, so companies need to be able to manage those payments.

Setting up an ESOP can trigger extra scrutiny from the Internal Revenue Service, because of the change in ownership, as well as the U.S. Labor Department, because ESOPs are treated as retirement plans, which the department regulates.

In addition, owners have to be able to convince workers that the deal is worthwhile and shares are likely to increase in value over time. Otherwise, the firm risks losing vital employees and undermining morale.

If the company is healthy, employees can benefit. ESOP holdings can be converted into cash and rolled over into other retirement plans, such as individual retirement accounts, if an employee leaves the company. As with other retirement plans, employees generally can’t withdraw the funds without penalty until they reach the age of 59½.

Critics say ESOPs can leave employees too exposed to the fate of the same company that pays their salary. Many plans aim to mitigate that risk by allowing workers 55 and over who have been in their plans for at least 10 years to sell 25% of their holdings and invest them in something else. At age 60, another 25% often can be sold.

Roger Ryberg, former chairman and CEO of Windings, a manufacturer of parts for motors and generators in New Ulm, Minn., started selling his shares to employees in 1998. The firm, which has about $30 million in annual sales and 95 employees, reached 100% employee ownership in 2008.

“I’m strongly opposed to private-equity deals that consolidate companies and then move them and disrupt so many lives,” says Mr. Ryberg, who is 73.

Mr. Ryberg says he sold his shares at prices ranging from about $8 to $25, and they are currently valued around $55 each. “I’m happy to see the employees are retiring with significant savings,” he says.