Distributing an ownership stake to employees

By Dave Donelson

D&H Distributing's ESOP plan and the Schwab family's conservative approach to cash management helped the business to continue growing during the recession.

Many owners of family businesses treat employees like family members. The Schwab family takes the concept a step further by providing employees with an ownership stake in their company, D&H Distributing, a technology distributor based in Harrisburg, Pa. Eighteen years ago, the family established an Employee Stock Ownership Plan (ESOP), and they report that the effect on the family company has been very positive.

According to the Schwabs, D&H had about 300 employees and generated sales of $430 million at the time the ESOP was set up. Today, the company has 1,200 employees and annual revenues of $3.4 billion. D&H has had a place on Forbes' list of America's largest private companies every year since 2009 and has moved up in the rankings from No. 242 in 2009 to No. 128 in 2015.

"The employees treat this like it's their own business—because it is," says D&H co-president Dan Schwab, 47. "They literally get a share of the profits at the end of each year, so they have tremendous pride, loyalty and work ethic. Our No. 1 differentiation is our people, and the ESOP magnifies that."

Michael Schwab, Dan's brother and co-president, points out the benefit to the employees: "Even a guy who drives a forklift in the warehouse will have significant plan dollars in the ESOP [at retirement] far beyond their expectations and what they could have possibly saved for themselves," says Michael, 52.

Dan and Michael Schwab are third-generation family owners. The brothers handle day-to-day operations while their father, 80-year-old Israel (Izzy) Schwab, serves as CEO. Their sister, Amy Silfen, serves on the board of directors but has never worked in the company. The employees today own about 36% of D&H through the ESOP; the family retains the rest.

From tires to technology

The seed for D&H Distributing was planted in 1918, when David Schwab started a retread tire company in Williamsport, Pa. He invited his brother-in-law, Harry Spector (no relation to Family Business Magazine editor-in-chief Barbara Spector), to join him in the original business, Economy Tire & Rubber, which guaranteed its retreads at a time when the original tire itself wasn't guaranteed. The pair did well and soon expanded to auto parts wholesaling, then added their first electronics product, Crystal radios, in 1926. In 1929, they renamed the company by combining the initials of their first names and moved solidly into the nascent consumer electronics business, distributing brands like Philco and RCA. D&H shed the original automotive aftermarket company in 1943 to finance the expansion of the electronics business.

Over the years, D&H has evolved and expanded its brands to reflect changes in the marketplace. It added Whirlpool appliances, Cobra CB radios and Atari home computers, then technology brands like Cisco, Lenovo and Microsoft. D&H lost RCA and Whirlpool when those companies changed their distribution modes in the early 1990s; today, computer-related products represent about 80% of the company's revenues. D&H works with thousands of vendors and sells to customers like Amazon and Wal-Mart as well as value-added resellers serving numerous markets including K-12 education. The company now has five North American distribution centers, including one in Ontario.

During its evolution, "the company has gone full circle, from one branch of the family to several and back to one," says Michael Schwab. His grandfather, David, brought in his brother-in-law, his son-in-law and eventually his sons Izzy and Maurice. Other married-in family members worked at and owned pieces of the firm as well but, over time, they were bought out.

To ensure that the company would "thrive and provide for the future," Izzy says, "where it was financially feasible, we decided to buy out those relatives who were uninvolved in the business. More importantly, we took steps to build an atmosphere of mutual trust and dedication among those family members and co-owners who wanted to stay on for the long term."

A change in federal law in 1996 enabled S corporations like D&H to take advantage of ESOPs. D&H set up its ESOP in 1998. That year, the company made a contribution of $1.15 million to the ESOP, which in turn purchased about 4% of the company stock from various family owners, including Harry Spector's descendants, who had requested the buyout, according to Izzy. As part of the transaction, they also received control of a kitchen cabinet and appliance business, today known as Design House Kitchens & Appliances. Design House is headquartered in Savage, Md., and run by Harry Spector, grandson and namesake of David Schwab's original partner.

As happens in many family companies that undergo changes in ownership, there was "some fragmentation between family units," Dan says. "Today, though we are no longer proactively engaged on a social or business level, both families remain active in support of the local community and maintain a respectful relationship."

The stake in D&H Distributing held by the ESOP has since grown to 36%. "Today, the ESOP valuation is about $120 million and has paid out tens of millions of dollars as well," Michael says. About 40% of the ESOP assets are held as cash and other liquid assets so benefits can be paid without the need for debt or redemption of the family's shares.

The ESOP has never borrowed money to purchase shares, according to Bob Miller, the company's senior vice president of finance and logistics. "It's funded 100% by money pulled out of the business," Miller says. That is enhanced by the S corporation structure, under which no federal income tax on profits is imposed at the corporate level. Instead, the corporation's taxable income is reported pro rata by the shareholders on their individual returns. Since an ESOP is a tax-exempt entity, its portion of the corporation's profits is tax-deferred. Participants pay taxes when they receive retirement distributions.

"A co-owner in the ESOP gets a portion of the income there as well as their share of the growth of the profits we keep in the company," Miller says.

Investing in the future

Dan says his family has avoided taking cash out of the company. "The reason many companies don't make it past the third generation is that people take profit out of the business and don't want to put [cash] back in during tough times," Dan says. "They also don't have money to invest in future growth. We invest in our IT systems, our logistics capability and our warehouses to allow us to be more efficient five years down the road." In addition to its headquarters in Harrisburg, Pa., and its Canadian headquarters in Brampton, Ontario, D&H has warehouses in Atlanta, Chicago and Fresno, Calif.

The company just doubled the size of its Fresno warehouse by adding 200,000 square feet to the building. Solar panels were added to the roof, providing all the power the entire facility uses and then some. "It was a big short-term expense, but it will pay dividends for 20 or 30 years," Dan says.

"The family was always committed to the business," says Gary Brothers, a 35-year employee who retired as president in 2008 when Michael and Dan took over. "They were always extremely involved with the business, especially what the future looked like and what we needed to do to be a viable entity."

Brothers served as president for nine years, not only building the company but also preparing Dan and Michael for more responsibility. "My role was mentoring the boys, helping them get knowledge about all the workings of the company," he says. "Michael and Dan were ingrained in the business from the time they were born. I knew there would come a day when they would be running the place. There was never any question in my mind that I was in a transitional role between Izzy and his sons. That was OK. I retired when I was 64 because it was time for them to take control."

"We know the 'shirtsleeves to shirtsleeves in three generations' concept and are determined it won't happen here," Dan says. "Every generation has been brought up to be conservative and to work hard. We've grown on average north of 10% a year for 15 years, whereas our industry has grown only 4%."

The "Great Recession" of 2008, when Dan and Michael became co-presidents, tested their resolve while it proved the value of the Schwab family's long-term philosophy. "Most companies let go 10% of their staff, told people they could only work four days a week, eliminated 401(k) matches, shifted more of the health care costs to employees, cut advertising," Dan says. "We zigged when they zagged. We increased our 401(k) match by 50%, we increased our advertising budget, we hired more salespeople, and as our industry shrank 10% that year, we grew by 10%. The next year, too. Being private allows us to make long-term decisions."

While the financial and tax advantages of the ESOP are important, not to be overlooked is the plan's motivational value. "When you're hiring people," Miller observes, "you're not just filling a slot. For all intents and purposes, you're hiring a partner. You want them to work just as hard and as smart as you do. You want to make sure they're going to make a contribution to the corporation."

The plan reduced turnover, Miller notes. "Once you've been at D&H for five years, you're probably going to stick around," Miller says. "When you reach ten years, you really start to appreciate the value of the ESOP. It becomes very profitable to stay. Of course, the financial part is only one component of loyalty—if you don't like the people you work with, you're not going to stay."

Family governance

The Schwabs are also taking a long-term approach to family governance. Not long after Izzy turned over day-to-day management from Gary Brothers to his sons, he turned his attention to the task of preparing a set of guidelines for future generations to follow (see sidebar). "We describe it as our constitution," Izzy says.

"He saw the need for the next generation—after Dan, Amy and I—to understand how we got to where we are today and what he would expect of them if he were here," Michael says. Izzy took two years going through the company history and examining the decisions that were made. The constitution covers a variety of topics, such as "how you need to work together, how to separate family decisions from company decisions, how relatives can cause conflict within a business, how to make everyone feel they've been treated fairly," Izzy says.

Izzy says the D&H constitution "was designed to avoid the pitfalls that we foresaw which might affect the ongoing operations and the enduring future of the company. Emotional elements such as jealousy, greed and lack of trust could very easily have caused turmoil from one generation to the next. Such challenges often destroy family businesses."

This year, the Schwabs established a family council. "We try to separate ownership from management," Michael explains. "The family council helps us manage family decisions related to the business. Our generation, the next generation, Izzy, and spouses have a dialogue. We have informal relationships with our accountants, lawyers and tax advisers on how to practically step back and view our decisions, and how we move assets from generation to generation."

Michael says the family realizes the challenges it will face in future generations. "A family needs to learn to make decisions together," he says. "At some future point, not everyone is going to be as cohesive as Dan and I have been. Having Izzy's constitution and having a family council will help the next generation understand how they need to work cohesively together."

Michael's oldest son, Brett, is 24 and plans to go to New York in the fall to work for a large law firm. Michael has two younger children as well. Dan's three kids are about ten years younger, and Amy has two children who are in their 20s.

"The key to the communication with the next generation is that the door is open if you're interested," Michael says. "Talk to us about what you want to do; what's your best strategy to add value to the business? At some point, if you want a career that involves D&H, the door is open."

The company's board, which consists of Izzy and his three children, serves basically to comply with corporate legalities, according to Dan. Strategic and tactical operating decisions are made by the two brothers, their father and senior non-family executives.

D&H Distributing's headquarters includes a museum of products the company has distributed over time. It's full of big tube-type radios, wind-up record players, the first color TV set, Pong video game consoles, Palm Pilots, clunky digital cameras—each product representing cutting-edge technology of its time. Michael believes it provides a glimpse into the company's future. "It was probably impossible for the generations selling those products to envision what came next," he says. "What they knew, though, is that there will always be a need to get products from point A to point B, to offer value-added services, to offer downstream credit, to buy product by truckload and sell it one item at a time. Those distribution basics will continue."

"Today we sell in the U.S. and Canada," Dan says. "Twenty years from now it may involve South America or Europe. We're always looking to grow the business through product portfolio, geography and customer profile. The family will still be involved down the road. Whatever the latest and greatest product, we'll be selling it."

Dave Donelson is a business writer in West Harrison, N.Y.

Excerpts from the D&H Constitution

The Company

As D&H has evolved from a small company, with a small market and narrow focus, to its current size, plus the absolute need for future growth, there is good reason to have this Constitution. It should form the basis for family shareholders to make commitments to each other and trust each other in order to live and work together peacefully, happily and successfully. It is far better to be proactive making these rules and guidelines now, rather than making reactive rules for situations after they occur in the future.

Family Business Values

Our important family business values are:

• To trust in each other and develop an atmosphere of mutual honesty.

• To work hard to preserve and grow the family business for the benefit of future generations.

• To foster pride in our family and the family business, recognizing the sacrifices and accomplishments of past generations.

• To be fair and trustworthy to all family shareholders, whether they work in the business or not, and to earn the trust of all shareholders, including employee co-owners.

• To insure that individual or family greed or inflated egos have no place at D&H.

• To recognize our obligations to our employees and to the communities in which we work.

D&H is a business that must be run for the benefit of the business. If it is run for the benefit of the family, it will not survive. If the business benefits, the family will eventually be rewarded.

What you need to know about an ESOP

By Barbara Spector

Since setting up its Employee Stock Ownership Plan (ESOP) in 1998, Harrisburg, Pa.-based D&H Distributing has seen annual sales grow from $430 million to $3.4 billion. D&H's third-generation co-presidents, brothers Michael and Dan Schwab, say their ESOP has motivated employees and helped them buy out their relatives (see accompanying article). Would an ESOP also be a good option for you?

That depends, according to Rob Schatz, a partner in ESOP Plus: Schatz Brown Glassman LLP. Schatz's firm helps companies set up ESOPs—and advises distressed companies seeking to unwind their ESOPs. Schatz says several factors determine whether an ESOP will help a business family achieve its goals:

• The ESOP transaction must not overvalue the company, and the organization must be able to service the debt. The deal must not be structured solely for the benefit of the exiting owner(s); the well-being of the company and the employee-owners must also be taken into account. "In an economic downturn, a company that has been overvalued will have insufficient cash flow to support the debt that was incurred in the transaction," Schatz says. "A reasonably valued company should be able to repay the acquisition debt out of cash flow within about 10 years."

• The business leaders must plan for the repurchase of departing employees' shares. Without proper planning, repurchase liability can reduce cash flow that the company may need for other purposes, Schatz says.

Repurchase liability should be offset by the tax savings achieved through the ESOP, he notes. "A high payout due to employees is typically not a reason for failure of an ESOP," he says. "We see a lot of companies that have multimillion-dollar ESOP payouts, and yet they're generating sufficient cash flow to be able to [meet the obligation]. If you've done a repurchase liability study and understand what your obligations are, and you have a good management team in place that can prepare and plan for that, the repurchase liability should not be a reason for a company to fail."

• ESOPs do not work well in companies that shelter their taxable income through depreciation of assets; these businesses will not be able to take full advantage of the ESOP's tax benefits. The plans are also not a good option for high-value companies with low cash flow, such as a marina whose real estate is more valuable than its operating entities (restaurant, repair shop, etc.).

• The family and the management team must buy into the ESOP concept. The family must understand that they are co-owners along with all the employees, and understand the planning that must be done in order for the ESOP to function as intended, Schatz says. A board that includes independent directors can help the family leaders make good business decisions and help protect employee-owners from family members' missteps. "We've seen situations where succession management has structured incentive compensation to bleed off all the benefits and all the increase in the share value to themselves, rather than to the employees as a whole," Schatz says.

• The business leaders must effectively educate employees about ESOPs. Employees must buy into the concept that they are owners. They also must understand the risks of business ownership; if the business loses value or the company fails, their retirement payouts will be negatively affected. While employees need to recognize the investment risk, Schatz says, they should also understand that "in large part, the success of the company is in their control."

• An ESOP won't shield a company from the effects of an economic downturn. Just like any other business, an ESOP company must offer products and services that are in demand in the marketplace, and must be led by a talented management team. An ESOP company that struggles in a downturn will not be able to service its debt and will see its value reduced.

However, Schatz notes, ESOP companies tend to be better able to work through a downturn because the employee-owners are highly motivated.

"A properly structured ESOP transaction takes into account fair valuation, takes into account cash flow to service the debt, and has management buy-in," Schatz says. "And the employees generally understand what the ESOP is, how it works and what they need to do to realize their benefit."

Copyright 2016 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permission from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com

Article categories: 
Print / Download
Issue: 
July/August 2016

OTHER RELATED ARTICLES

  • Low Interest Rates — Recession or Distortion?

    Financial markets have been volatile for the better part of the last two years. In the meantime, the current U.S. economic expansion has progressed to now become ...

  • September/October 2019 Family Matters

    [[{"fid":"11287","view_mode":"default","fields":{"format":"default","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false},"type":"media","field_deltas...

  • July/August 2019 Family Matters

    Kyle Fernley has been named the fifth president of Fernley & Fernley, a 133-year-old association man­agement company based in Philadelphia.

    Fernley has also been named p...

  • Building a community

    When Family Business Magazine debuted in 1989, business leaders who had grown their companies after returning from World War II service were passing the baton to their baby boomer children...