Peck's role on the board came about through his participation in Crane's employee stock ownership plan (ESOP). Company founder Harvey Crane began transferring his ownership stake to the company's employees almost 20 years ago, and since then Crane workers have been building equity. One byproduct of the ESOP has been a closer bond between management and workers. Of management, Peck says, "They listen to us."
Perhaps more important, Crane's ESOP, one of about 150 in Florida, has been a good deal financially for Peck and the firm's other 280 Daytona employees. Employees like Peck - finish grinders make about $13.50 an hour - have been able to accumulate retirement nest eggs of stock worth up to $30,000.
Other Florida companies report similar success stories with ESOPs, including high-profile firms such as Publix, U.S. Sugar and Jacksonville's Physician Sales & Service. At publicly held Sawtek, a fast-growing Orlando maker of components for digital cell phones, the value of the company's ESOP has grown from $4 million when the ESOP was formed in 1991 to $160 million. With just 400 participants in Sawtek's ESOP, the average value of employees' holdings is $400,000, and more than 100 Sawtek workers are millionaires, despite a decline in the company's share price from $50 in September to the mid-$20 range lately.
While the number of ESOPs has plateaued in recent years, 1998 may see an uptick because of the strong economy and a recently passed federal law that makes it practical for Subchapter S corporations to form ESOPs. "I'm getting more inquiries about ESOPs right now," says Roberta Casper Watson, a partner who specializes in ESOPs with Trenam, Kemker, Scharf, Barkin, Frye, O'Neill & Mullis law firm in Tampa.
But there's no guarantee of duplicating the success of ESOPs at firms like Crane and Sawtek. And however well things may turn out for employees, the main benefit driving the formation of an ESOP remains the tax advantages that go to the owners of the company. "ESOPs are absolutely perfect for the right companies and absolutely horrible for everyone else," Watson says.
Most often, ESOPs are set up when owners of closely held businesses want to sell their stakes. The owners are usually motivated by a desire to do well by their workers - what John W. McFadden, senior vice president in the Tampa office of Aon Consulting, a human resources consulting firm, calls "almost a paternalistic attitude toward their employees." But an IRS provision known as the "1042 Rollover" provides the owner with a big financial incentive as well.
The 1042 Rollover allows owners who sell their company stock to an ESOP to defer the capital gains tax if they invest the proceeds in other U.S. stocks and bonds within 12 months. The tax-deferred rollover only is allowed if the ESOP owns 30% or more of the company's stock. The law permits employee ownership through an ESOP to range from less than 10% to up to 100%.
Luhrs Marine Group in St. Augustine aimed for that 30% benchmark in 1996 when co-owners Warren and John Luhrs wanted to do some estate planning and also benefit their 1,000 employees. "The goal is to continue to acquire a greater percentage of the company," says Luhrs Operations Director Dick Ash.
To set up an ESOP, a company establishes a trust fund and deposits cash that's then used to buy the owner's share of the business - either outright or over time. The trust fund becomes the ESOP, with its value divided among existing employees, who receive shares usually according to their salaries. Typically, the company adds new stock to the ESOP each year, either by buying additional shares or issuing new ones. The ESOP then distributes those shares among employees, meaning that an employee's stake in the company increases along with his or her tenure.
A trustee from a bank, consulting firm or within the company's management administers the plan. Once a year, privately held companies must have their shares "valued" by an ESOP appraiser. Public companies are valued according to the stock market price. Over five to seven years, employees become "vested," giving them rights to 100% of the shares in their account.
If a company doesn't have the cash to fund an ESOP, it can set up a "leveraged ESOP" in which the plan borrows money and uses that money to buy out the owner. The company generally deposits money into the ESOP, which then repays the lender. It can be an efficient way of borrowing because both the loan interest and principal are tax deductible.
Not for every company
With tax advantages for both the company and its owner, why haven't ESOPs become more popular? One reason is that most owners who are ready to sell want a clean break; ESOPs frequently purchase the owner's stake over the course of several years. In addition, ESOPs "take a lot of work'' to set up, according to Watson. "And little ESOPs take as much work as big ESOPs."
Then there's the cost. According to estimates from the National Center for Employee Ownership, a small company with 20 employees would pay $5,000 to $10,000 for a lawyer to prepare plan documents and file government papers to set up a non-leveraged ESOP. The initial valuation of the company's stock by an appraiser costs an additional $5,000 to $10,000, with annual valuations running somewhat less.
A leveraged ESOP is much more expensive. Initial and ongoing legal costs often are 50% to 100% higher than for a non-leveraged plan. Perhaps more important is the issue of loan payments. "A company with a small payroll can't amortize a big loan," says Watson, who explains that a company's loan payments generally cannot exceed 25% of eligible payroll.
Another factor affecting ESOP formations is that company management must give up some control. When an ESOP is formed, employees must get voting rights on major company decisions such as merging, selling or closing the company.
Some companies also give employees a voice in day-to-day operations as a way to empower workers. When Ewing & Thomas, a New Port Richey physical therapy business, put in an ESOP in 1987, it re-evaluated its entire structure. "For years, we'd been a pyramid," says Delores "Dee" L. Thomas, co-founder of the company and a founder of the 55-member Florida Chapter of the Washington, D.C.-based ESOP Association.
Ewing & Thomas, which employs 48 and is 100% employee owned, added a non-management member to its six-member board of directors. The company also set up a five-member ESOP Committee that evaluates employee benefits and channels information about the plan to workers. To emphasize that employee owners have a real stake in the company, Ewing & Thomas hands out actual stock certificates. Says Thomas, "We make a big deal of our once-a-year stockholder meeting."
For Ewing & Thomas, the expense and effort of forming an ESOP have paid off in increased worker loyalty and reduced turnover, a crucial issue in the physical therapy field, where there's a chronic shortage of skilled professionals.
Which companies should steer clear of ESOPs? Very small companies with fewer than 20 employees probably can't afford an ESOP. Partners Bank of Florida, with one office and 15 employees, formed a leveraged ESOP in 1991. "It was designed to be an employee incentive," says Ash Fisher, president of the Tampa institution. But it didn't work out that way, and the value of Partners stock has fallen, not risen. Now Fisher is in the process of converting the savings bank's ESOP into a 401(k).
Risk or reward
On the surface, ESOPs look like a good deal for employees. But while they get a stake in their firms, if the company falters, the employees' retirement nest eggs can be shattered. "I've just seen a company where the stock went to zero," says McFadden, who declines to name the company.
Employees who rely on ESOPs for most of their retirement funds will be happy as long as the company and its stock are doing well. But lack of diversification can lead to disaster. If the stock plummets, employees don't have the option of switching to another investment. "The downside to an ESOP is you are putting all your eggs in one basket," says McFadden.
There are some safeguards that allow diversification. ESOP employees who are 55 years old with 10 years of service can put up to 25% of the value of their ESOP shares into non-company stock.
Some companies help all employees, regardless of age, diversify their ESOP holdings. Sawtek combines its ESOP with a 401(k) plan (a combination known as a "KSOP"). Last July, participants had a one-time option to sell half their stock and deposit it into a separate account, still within the ESOP, that offered the option of investing in any of nine mutual funds. Also, last year Sawtek began offering "in-service distributions" that let employees transfer up to 5% of their holdings into an individual IRA.
That money can be cashed in at any time, but as with any IRA cashed prior to retirement, there are taxes and penalties. However, an employee with a modest income but a six-figure retirement fund may not be able to resist raiding the piggy bank. One female Sawtek employee, who earns less than $30,000, last year withdrew 5% of her fund, which total almost $1 million. "I'm debt free," she explains.
Another risk: ESOPs allow employers to wait five years before turning over ESOP accounts to former employees, unless they retire, become disabled or die. In the worst case scenario, an employee could leave a company and then, if the company ran into financial trouble, slowly watch his retirement savings dwindle, with no power to move the holdings.
Once the five-year period ends, the company must pay the employee the fair market value for his stock. But the company can take another five years to pay for the stock, a complication when the former employee rolls the money into an IRA.
Both Congress and the U.S. Labor Department are concerned about the issue of retirement plans that invest heavily in their own company's securities. Although it didn't affect ESOPs, last year Congress restricted the ability of companies to require employees to invest their 401(k) money only in company stock. And the Labor Department's ERISA (Employment Retirement Income Security Act) Advisory Council is calling for a 10% limit of employer stock in some pension plans. What gives ESOPs more protection than other plans, according to the ERISA Council, is employees' right to vote, the annual stock valuations and diversification opportunities as the employee nears retirement.
Yet despite the financial risks, an ESOP clearly can energize both a company's management and its workers when there is an emphasis on employee participation. Thomas, co-founder of Ewing & Thomas, attributes her company's growth to the creative ideas that have come from her employees. Says Thomas, "A big part of that is they own the company that they work in." Adds Raymond A. Link, Sawtek's vice president for finance: "It clearly has made it one for all, all for one."