Ownership Planning: Many Options, But No Magic Bullet
By Michael S. O’Brien, ASA, with Ian Rusk and Stephen Gido, Principals of Rusk, O’Brien, Gido + Partners, LLC.
Have you ever wondered why some companies succeed at ownership transition while others struggle? The truth is no single ownership transition plan works for all firms, nor is there any guarantee that a plan that has worked well for a firm in the past will continue to work well in the future. Every company has its unique attributes, and those attributes may change over time with new generations of owners. The workplace culture, the employees, the communities in which the firm operates, the services offered, and the financial performance of the company all influence the type of ownership plan that will work best.
In this article we outline the ownership transition challenges firms are currently facing, the myriad of transition options available, and the key tenets for a successful transition plan.
If ownership transition wasn’t challenging enough under the best of circumstances, in the U.S. shifting demographics are creating pressures on the current and future work force unlike any other time in history. According to the U.S. Census Bureau, on average 10,000 people per day reach the retirement age of 65, and this trend is projected to continue. From 2010 through 2050, the percent of the population consisting of those aged 65 years and older (“Retirees”) is projected to increase from 13% to 21%. During the same period, the demographic of the population aged 44 to 64, those most likely to be owners or successors (“Successors”), will shrink from 26% to 22% of the total population.
Although the decline as a percentage of the population is marginal for the Successors, the ratio between the Successors and the Retirees will move from a 2:1 ratio to 1:1 ratio. This presents significant challenges for transitioning ownership and an even greater challenge for leadership transition.
The Changing Industry
Over the last generation, the architecture, engineering, and environmental consulting industry has become more complex and challenging in terms of project execution, project delivery, project design, and business management. In “the old days,” companies could often rely on a small number of key individuals, or even a single person to lead the firm to a successful and prosperous future. In today’s business environment, it takes a team of leaders with a variety of skill sets. In response to this, more companies have begun to focus on leadership development. In fact, large multinational firms have developed systems for identifying potential future leaders and getting them into “leadership tracks” by the time they reach age 30. Such firms might identify 800 or more potential leaders out of a workforce of 20,000 employees, and out of those, 15 to 30 may eventually prove capable of taking on an executive role, with just one rising to the CEO position.
So what does this mean for the average architecture, engineering, or environmental consulting firm, which might have a total workforce of just 20 employees? Simply put, the odds are not in your favor. With a smaller pool to draw from, you will have to work that much harder than larger firms to identify and develop your future leaders. In some cases, firms will be unable to identify and develop internal leadership successors, and will have to consider an external transaction (a merger or acquisition).
Ownership Transition Options
Regardless of your preferred plan for transitioning ownership, it’s helpful to understand the many options available and how they may be utilized, either individually or in combination, within your company. They include:
Direct Stock Purchase
This is the most common method of transitioning ownership. It usually includes company-assisted financing. Buyers of shares are matched with sellers of shares to mitigate the company’s cash flow obligation for redeeming shares.
Many firms choose this option because it is very easy to understand from both a buyer’s and seller’s perspective. However, sometimes the simpler the ownership plan, the more challenging it is to attract buyers. Firms that have experienced poor financial performance in recent years (leading to declining stock values and little or no profit distributions to assist buyers in their acquisition of such shares) have had a hard time attracting buyers. In today’s current economic climate investors have been shying away from equity investments due to their uncertainty. So, why would that be any different at your company?
Employee Stock Purchase Plan (ESPP)
This is a simple savings plan whereby employees set aside part of their paycheck into a “savings account” managed by the company. At the end of the year the employee may elect, at their discretion, to purchase shares of the company at the prevailing stock price.
This type of plan is most effectively used when the current owners have a very long horizon to transition their shares. As an example, we once worked with a firm that had a unique and successful ESPP-based plan. The plan included a provision that required that as employees bought shares from the company treasury through the ESPP, the majority shareholder would sell the same amount of his shares back to the company. This enabled the redemption of shares from the majority shareholder to be limited based on shares purchased by the employees. This promise from the seller is essential to limiting the company’s redemption obligation (of the seller’s shares) to the amount of proceeds from the sale of shares to the other employees.
Employee Stock Ownership Plan (ESOP)
This is a qualified retirement savings plan that offers tax benefits to the company and plan participants. ESOPs are far more common than ESPPs in the A/E and environmental consulting industry. An ESOP is most often used to redeem large blocks of stock—often 30% or more of the total shares outstanding—from a retiring shareholder. More than any other form of ownership, ESOPs work best in firms that have inclusive and participative management.
In 1998, Congress enacted legislation allowing S corporations (the preferred corporate structure of most professional service firms) to sponsor ESOPs. This change in the law, together with shifting demographics, has caused more companies to consider implementing ESOPs. Additionally, ESOPs tend to work best in professional service firms, where the primary assets are the employees. This is because the contribution limitations applied to ESOP benefits are based on overall employee compensation. Unlike other industries, employee compensation is the single largest cost in professional service firms, making them well suited for sponsoring an ESOP.
ESOPs can have their drawbacks. Most ESOPs are implemented in order to allow for redemption of a large shareholder while also providing the company with a favorable tax treatment. We frequently see two missteps when ESOPs are implemented and in the years following. First, management will often make claims to its employees that the ESOP will allow them to become owners without having to pay for the shares. The latter is true enough. Employees of an ESOP company receive their ownership interests much like they might receive an employer match or contribution to their 401(k) plan. However, in an ESOP scenario, the employees do not become direct shareholders. Instead, they become beneficial interest holders in a trust, which in turn owns shares of the company. This sort of miscommunication often leads employees to believe that they will have a more meaningful role in management when the ESOP is instituted. But they usually won’t.
The second misstep we see is ESOPs becoming “dormant” and losing their value as an employee benefit. This happens after the ESOP has repaid all of its debt obligations and the shares associated with the initial buyout have all been allocated. At this stage, any new employees can become participants in the ESOP, but they will not receive any substantial ownership benefits. This situation actually happened to a client that had approximately two thousand employees. Long after the ESOP had allocated all of the shares from its initial purchase, employees that joined the company within the past five years had little to no shares in their account. In fact, 20% of the employees held 80% of the shares in the trust. Because of this, the majority of employees saw little or no value in the ESOP plan, and it ceased to be an effective employee benefit. The failure of this ESOP was not the implementation, but rather not ensuring newer employees were seeing the benefits the ESOP.
Stock Bonus Plan
Under this plan, instead of using just cash, companies will opt to pay bonuses in the form of stock, or a combination of cash and stock. The company enjoys a tax deduction for using stock, while at the same time conserving cash. This method works with firms whose employees truly value (and understand) the benefits of stock bonuses and recognize that they have actually “paid” for these shares by forgoing cash bonuses.
In the present economy, more firms are considering this approach to reward key employees as it allows them to conserve their limited cash. However, there are downsides to this approach. When an employee receives a stock bonus they are obligated to pay ordinary income tax on the value of the shares received. If they receive no cash bonus in addition to the stock bonus, then the tax payment must come from their savings. This scenario can make the recipient feel like they’ve been penalized instead of rewarded. Additionally, if the valuation of the shares is not easily understood, or if the valuation does not appear to have been conducted fairly and independently, then you may get resistance from your employees in receiving paper versus cash.
To illustrate this issue, take the case of a real company that used stock bonuses as a form of compensation to its key employees (along with cash). Since the bonuses were mostly stock, the key employees were concerned about how these shares were valued and whether they would ever realize any real value from these bonuses. Furthermore, the recipients were subjected to non-compete restrictions in return for receiving the stock bonuses (i.e. the non-compete agreement was effectively forced on them), and while they were contributing to the success of their firm, their management rights and privileges were very limited. This led to a revolt by the key employees that threatened to split the company. Eventually, this issue was resolved amicably. The lesson learned was that you never want to force such a program on your key employees. Be sure to get their buy-in first.
This term is used to describe both Stock Appreciation Rights and Phantom Stock. Synthetic equity is often used to grant the economic value of ownership to employees who would otherwise be restricted from owning stock due to state licensing requirements or other restrictions. One question to ask before considering synthetic equity is how such instruments will be received by the recipients.
Most firms that implement synthetic equity do so because they want to reward their employees for the value they create for the company. This benefit is often tied to employee bonuses, but unlike cash bonuses, it encourages long-term view. Employees are therefore encouraged to make decisions that will benefit them and the company in long run.
This is an equity incentive compensation plan that gives the recipient a right to purchase stock at a pre-determined price at some point in the future. This allows the employee to acquire shares at less than the prevailing stock price at the time they exercise the option.
Stock options are most often used to attract key prospective employees. As a recruiting tool, companies can offer the promise of ownership at the current stock price without giving up ownership until that person delivers the expected value. Generally, there are vesting periods attached to the options that must be reached before the recipient may exercise the shares. Vesting schedules can take many forms. We once worked with a client whereby we developed a unique vesting program based on sales performance (the recipient was in a business development role). Under this program options would only vest upon reaching certain sales milestones. This vesting program was unique and particularly effective because it was performance-based rather than time-based.
Mergers and Acquisitions
While most would not consider a merger or acquisition an ownership transition plan per se, many firms end up electing this route for a variety of reasons. M&A is being considered more often by smaller firms than in the past because of the aforementioned challenges of finding internal employees to take the reins of the company. Recently, we have either advised or witnessed companies entering transactions which are characterized as mergers of equals. This is typically a situation where companies are forming new entities and exchanging shares based on a mutually agreed-upon exchange ratio.
This allows the combined company to broaden its employee base, which increases the chance for successful leadership and ownership transition because the firm now has a larger pool of employees to choose from. Let’s say for example you own 50% of your company with your partner. If you were to merge with another company of the same size and value you would end up holding a 25% stake in a firm of twice the size. When you eventually look to retire, the firm should have an easier time managing your stock redemption, as it represents a much smaller piece of the overall firm’s value.
Three Key Tenets
Whatever ownership transition option you choose, it’s important also to remember these three key tenets as you develop your company’s plan:
The issues surrounding the transition of ownership in your company may be complex, but the solutions don’t have to be. Simplicity enhances transparency, which in turn fosters trust and confidence—a key to successful transition. Simplicity and transparency should flow through all aspects of your firm’s ownership plan, including how new shareholders are selected, what it means to be a shareholder (i.e., what rights, benefits and responsibilities accrue to shareholders), how shares are valued, when and how shares are redeemed, etc.
Even the best of plans may need to be adapted to reflect changing conditions. All companies evolve over time, increasing or decreasing in size, adding or closing offices, expanding operations into new states or even new countries, making acquisitions, adding new service lines, and more. Such changes sometimes require changes to the firm’s ownership plan.
A simple example we often encounter is firms that establish minimum ownership percentage requirements (e.g., 10%) for “principals.” The problem with this approach is that as the firm grows the minimum ownership stake becomes more and more expensive relative to the principals’ compensation. In such cases we suggest adapting the plan to establish investment ranges expressed in dollars rather than percentages.
Another example is stock redemption terms. Stock redemption terms that may have been feasible when the firm was small and the stock less valuable (e.g., a retiring shareholder’s stock is to be repurchased by the company in full with a 20% cash down payment and the remainder in a 3-year note) may be difficult if not impossible to honor based on the firm’s current value. A good plan will allow more discretion and flexibility so that a firm can responsibly manage its obligations.
Your ownership plan needs to be consistent with your company’s culture. For example, a firm with an open-book culture and participative management might lend itself well to broadly distributed ownership, and could even be a candidate for an ESOP. A firm with a history of family ownership, or one with a strict management hierarchy and a “need to know” culture with respect to financial performance data will not lend itself well to broadly distributed ownership.
The concept of internal consistency also applies to a firm’s ownership distribution policy. For example, a firm with aggressive growth goals will need to reinvest its profits to support that growth. Its ownership plan should acknowledge this and shareholders should expect to receive less of their return on investment in the form of current returns (dividends, bonuses and s-distributions) and more in the form of long-term capital appreciation.
Developing the right plan for your firm can be a daunting task. The options highlighted above all have their strengths and limitations. The first step for any firm is to assess their current situation. This assessment should include: 1.) A thorough analysis of the firm’s financial performance and future outlook; 2.) An examination of the current ownership group, their individual holdings and their retirement goals; 3.) An assessment of the prospective owners and leaders; and 4.) An assessment of the company’s culture, organization structure, and corporate governance systems. Once you have a complete understanding of this contextual background, you may begin to assess the options available, decide which ones make the most sense for your firm, and begin to design and implement a plan.
About the Authors
The author, Michael O’Brien, and fellow contributors Ian Rusk and Steven Gido are principals at Rusk O’Brien Gido + Partners, LLC. Together they have more than four decades of combined experience working with companies in the A/E and environmental consulting industries to develop comprehensive ownership plans and facilitate mergers and acquisition. The Company operates from offices in the Boston, Massachusetts and Washington, D.C. metropolitan areas and serves clients across the U.S. and abroad. For more information on the authors, please visit their website at www.rog-partners.com.
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