The Better Exit Strategy: ESOPs Satisfy Business Owners And Preserve Their Legacy

Entrepreneurs

By Mary Josephs, Contributor

On Chicago’s North Side, decades after other manufacturing companies went bust, migrated to the South or outsourced everything to China, S&C Electric – a $700 million-a-year maker of equipment for utilities – stood independent, profitable and debt free. Then, its controlling stockholder, John C. Conrad, died at age 89, and like so many family companies before it, S&C’s future was in doubt. Conrad’s daughters had waited patiently for many years and wanted to cash out.

The year was 2005. Would a private equity firm acquire S&C, leverage it, suck out cash, and slash costs? Or would a bigger equipment maker buy it, fold S&C operations into its own and idle many of S&C’s more than 2,000 employees?

I’m here to tell you there’s a third option, and it often delivers a superior price on an after-tax basis to the seller while also preserving jobs and, over time, building a stronger company. It’s an Employee Stock Ownership Plan. I’ve devoted my professional life to convincing company founders that an ESOP is often the best exit strategy for them and for the company that is their legacy.

What’s that? You recall some disastrous ESOPs like United Airlines and Tribune Co., which both ended up in bankruptcy? Let me assure you, those transactions’ structures bore little resemblance to most of the more than 10,000 ESOPs operating in the U.S. — companies that collectively employ more than 10 million workers and generate retirement savings for them at rates far in excess of the private sector generally. Tribune was a takeover by investor Sam Zell, masquerading as an ESOP. At United Airlines, pilots took control and literally ran the airline into the ground. Unfortunate exceptions. Not the rule.

At real ESOPs, things go more like this: a company founder, nearing retirement age, sells to an employees retirement trust. The proceeds to the founder, if properly reinvested, can avoid capital gains taxes indefinitely. Given the founders’ cost basis tends to be close to zero, that’s huge. The company borrows the money and it’s repaid from the future earnings, which, too, become largely sheltered from taxes.

The 1974 ESOP law and later amendments were designed to encourage employee ownership. Company founders (I’ve advised scores on ESOPs) who initially sell just part of their stake and stay on as CEO say the best news comes after the deal: employees start to act more like owners. Ideas formerly kept quiet start to bubble up. Costs, once resistant to reduction, come under control more easily.

The largest ESOPs include highly competitive companies like Publix Supermarkets and Gortex maker W.L. Gore Associates. As Publix CEO Ed Crenshaw recently told Forbes: “I’m always amazed that more companies don’t recognize the power of associate ownership.” Publix’s 159,000 employees, after they’ve worked 1,000 hours and been there a year, begin receiving company stock through the ESOP.

ESOPs aren’t for every company. High-debt already? High worker turnover? ESOPs aren’t ideal. But companies with high-value employees, low debt and solid prospects are often great matches for ESOPs.

S&C Electric, which became my client, was a great ESOP candidate. Employee involvement and lengthy worker tenure had long been features of the company. S&C was founded by John Conrad’s father, Nicholas J. Conrad, and by another man, Edmund O. Schweitzer, who were engineers at Commonwealth Edison. After a 1909 fire at one of the Chicago utility’s generating stations, they came up with a spring-loaded fuse, essentially, sealed inside glass and surrounded by a liquid that suppressed arc. They started S&C to make the innovative devices and sell them widely.

John Conrad paid near the top of the range for skilled workers and then insisted on overtime, so that when slack times came S&C avoided layoffs. “When business gets slow, we find something else for people to do,” John Estey, the engineer who succeeded John Conrad as CEO, told me.

John Conrad worried over ownership succession. In the early 1980s, Stan Slabas, S&C’s CFO, dragged his boss to an ESOP conference, and they heard that management had to seek employee votes on major matters (not the case these days), Slabas recalls. “And he said, ‘That’s the end of that. We’re not going to be an ESOP company.’ ” Conrad wasn’t ready to relinquish control.

When Conrad died, however, Slabas, Estey (both 40-year S&C veterans) and other managers realized that selling would likely be the end of S&C as they’d known it; S&C’s electric power switching, protection and control products form large parts of what’s known as the “smart grid” being installed to make the U.S. electric system more efficient and safer. A buyer could force R&D cuts. Eventual offshoring of manufacturing. A steady talent drain.

The Conrad sisters and other stockholders were bought out in a series of transactions between 2007 and 2012 for more than $250 million. Most of that was borrowed.

CEO Estey says the ESOP brought two big advantages. One involved taxes. Sellers can defer capital gains taxes. And for S&C (by converting to an S Corporation), federal income taxes disappeared. Some state and foreign taxes remain. Overall, the effective tax rate fell to 12% from 33%. Secondly, worker-owners are more engaged. Pre-ESOP, S&C counted 7,000 implemented employee ideas over a 15-year period. In 2013 alone, S&C counted 8,000. That’s engagement