HOW TO MAKE AN ESOP WORK

With a 1989 ESOP, Multiplex Co. soothed disgruntled family shareholders. Now management is listening closely to its new employee-shareholders.

By Stephen J. Simurda

For some time, J. Walter Kisling's relatives had been getting on his case. Kisling is chairman and CEO of the Multiplex Co., in Ballwin, Missouri, which makes refrigerated-beverage dispensing equipment for the fast-food industry. He and his three sisters owned 80 percent of the family company founded by their father. Their 14 children and more than a dozen grandchildren also held some shares.

J.W., as everyone calls him, had worked hard to transform a manufacturing company that was on the verge of bankruptcy 20 years ago into a successful $25 million enterprise, and he believed that to keep the company on its upward growth path for the benefit of all family shareholders, profits should be plowed back into the business. His problem was that he did not control the company: He and his sisters, none of whom worked in the business, each owned 20 percent of the stock. That meant about 77 percent of the company was owned by family members who were not involved.

Only Kisling, his son, Wally Jr., and his nephew, Daniel Scott, were in the business. This selectivity bothered some family shareholders. "They don't understand why their son can't just walk in here and take a job starting at $50,000", says Kisling. "We have a lot of family in remote locations with little knowledge of the business and little interest."

Since Multiplex is privately held, discontented shareholders could not easily find buyers for stock. What's more, Multiplex had paid only one $1 dividend in its history. At annual shareholder meetings they badgered him about liquidity, about lack of income from their holdings, about the size of executive salaries.

A potentially bigger problem was also looming. At 53 years of age, J.W. was the baby of the family. Two of his sisters were widows in their 60s, and the third was past 70. Kisling knew it was only a matter of time before their children faced an enormous estate-tax problem. To protect the wealth of his own and his sisters' families — and avoid further trouble within the shareholder group — Kisling had to do something with the business.

The answer to these diverse problems proved to be remarkably simple. Three years ago Multiplex started an employee stock ownership plan, under which a trust purchased 30 percent of the company's stock from the family for $3.2 million and distributed the shares to the company's 60 salaried employees.

The way the Multiplex plan is structured shows how an ESOP can satisfy the interests of different family business constituencies. By means of the ESOP, Kisling was able to soothe his relatives, help them avoid onerous estate taxes, and give loyal employees a stake in the business, all while consolidating control with those who work in the business and are responsible for its success.

To appreciate how it was done, and the neat symmetry of the result, it's helpful to know a little about the company's history.

The original manufacturing enterprise, founded in 1936 by J.W. Kisling Sr., was called Kisco Co. and made hassock fans. Those round floor fans were popular until the 1950s, when the spread of air-conditioning cooled the fan business considerably. As a result, Kisco Co. began to shift into defense work. During the Vietnam War the company employed 1,000 people on three shifts making ammunition casings.

Profits remained high throughout the 1960s. But because defense work is cyclical, the Kislings decided in the 1970s to diversify. They bought Multiplex Co. at a fire-sale price of $70,000 ("It was losing lots of money," recalls J.W.), and ran it as a separate company with the same ownership structure.

During the 1980s, as Kisco Co.'s business slowed down, family members started getting restless with the company's management of their investment. They would complain about not receiving any dividend income and ask why executives continued to get paid the same salaries whether or not the company made a profit.

These pressures, combined with Kisco's sinking fortunes, took their toll on Kisling, who was then running the business with his brother-in-law, J.T. Holden. "I kind of got beaten up a little bit," J.W. recalls. When the brother-in-law announced he was ready to retire in 1985, the pair faced a tough decision about the future. The near term prospects of Kisco were dim. Multiplex, on the other hand, was growing steadily. Further, Kisling realized that down the road his children and his sisters' children faced massive estate taxes from the stock they would eventually inherit. With family members clamoring for cash, J.W. and his brother-in-law decided to sell Kisco.

The sale didn't solve Multiplex's basic ownership problem, which was that nobody had a majority control of the company. And family members were appeased only for as long as the money from the sale of Kisco lasted." It was like giving them an aspirin," Kisling says about the disbursement of profits from the Kisco sale. "Their headache — the problem — just went away until the money ran out."

When J. T. Holden died soon alter his retirement, Kisling realized that the estate tax problem had not been solved either. Much of what Holden's wife (Kisling's sister) inherited was stock in Multiplex. When the widow died, their children would need cash to pay taxes on that stock, which had appreciated in value. Likewise, when he and his two other sisters died, their children would face the same problem. The company had grown in value to the point that, in the event of the death of a major shareholder, after estate taxes there would be very little left in the estate except Multiplex stock," Kisling says. "I don't want everything I leave them to be Multiplex stock. It only perpetuates the problems my brother-in-law had in our generation, except that the numbers get bigger."

Members of J.W.'s generation had gifted stock to their children in order to reduce the eventual estate-tax burden. But the parents were apparently too late in deciding to look into the idea, common in estate planning, of buying life insurance that the children could use to pay estate taxes after their deaths. ("The people are too old," Kisling explains. "It was too expensive.") Kisling's son, Wally, 32, who is Multiplex's director of international operations, echoes his father when recalling the concerns of his own generation: 'The Multiplex stock could have been a burden. I could imagine the heirs of the deceased relative having to sell all of their parent's liquid assets just to pay the inheritance tax on a stock that returned them nothing."

A development in 1986 made Kisling realize that an ESOP was the best way to go. When the business moved from its longtime St. Louis headquarters to a suburb, he created a limited partnership to buy the new facility and lease it back to the company — a common arrangement that reduces capital borrowing for the firm and gives investors a fairly safe return. He offered the investment to all family shareholders. Only two shareholders, besides his own immediate family members and Dan Scott, took him up on it. "I realized then that they had about as much interest in the company as [they would] if it were General Motors."

The ESOP trust was funded on March 17,1989. To purchase the stock for it, the company took out a loan of $3.2 million, which under federal law can be paid back in pre-tax dollars — a major incentive for an ESOP-type plan. Kisling and his three sisters each sold 7 percent of the company to the trust, and another 2 percent was acquired from stock held in the company treasury. Each employee received a percentage of ownership, depending on salary and length of employment. Technically, what the employee owns are shares in a beneficial trust that holds Multiplex stock — not the stock itself. An ESOP committee appointed by the board of directors instructs the trustee on how to vote the stock. (Most often, the committee and the trustee are the same person or persons.)

J.W. and his three sisters received roughly three-quarters of a million dollars, on which they did not have to pay any taxes. Under federal tax law, if a company sells at least 30 percent of its shares to an ESOP, shareholders can avoid capital gains taxes if they reinvest the money in the stock of another U.S. company within 12 months.

Kisling's sisters were able to make new investments that provide them with dividends and a modest extra income, which means that their children will have liquid assets when their parents die. In fact, if those investments are not cashed before the parent's death the children get another big advantage. The tax basis for those investments gets stepped up to the value at the time of the last parent's death. In other words, the heirs effectively avoid taxes on their parent's original stake in the family business and on the gains from new investments made after they sold stock to the ESOP

Besides giving family members liquidity and easing the estate-tax concerns, the ESOP consolidated control of Multiplex under one roof. Kisling's immediate family, his nephew, and the employees now own just over 50 percent of the stock.

Multiplex employees seem pleased with the ESOP, which replaced a modest profit-sharing program. The average salaried employee is getting nearly $8,000 worth of stock a year, and, if the company keeps growing at its present rate, will continue to do so until 1996. Charles Seibert, manager of financial services, says that, based on a recent appraisal of the stock's value, each employee has received about two-and-a-half times as much as he or she would have gotten in distributions under the profit-sharing plan.

Randy R. Castle, senior director of manufacturing, says Multiplex's profit-sharing plan "wasn't a real big nest egg, but the ESOP is more of an opportunity. If we can grow the company and have the total value appreciate, it means more value for us. Everybody feels it's a better deal."

The downside, of course, is that employees can't cash in their holdings whenever they want. Although some ESOPs permit them to take out funds under limited conditions — for example, to pay heavy medical costs — generally an ESOP is viewed as a form of retirement fund from which shareholders do not receive cash until they retire or otherwise leave the company. These funds are not as liquid as profit-sharing plans, which usually have diversified portfolios with publicly traded securities.

Multiplex's motivation for starting an ESOP had as much to do with control of the business as with liquidity. Richard B. Rose of Menke & Associates, the San Francisco consultant that designed the ESOP for Multiplex, says liquidity is the goal for some 75 percent of the firms that set up the plans. ESOPs have been viewed as a device to fend off takeovers, catch an easy tax break, raise capital to repay debt, or rescue a dying business. While ESOPs may be helpful for some of these aims, they have a better chance of success when the company adopts them from a position of strength.

Rose says the scenario that typically leads a family business to an ESOP goes something like this: "The owners of a company want to put some cash in their pocket, and the choices are selling out, merging with a bigger company, going public, or selling stock back to the corporate treasury. The ESOP is a fifth alternative."

Selling stock to the corporate treasury does not offer the same tax advantages as an ESOP. Selling the business is a drastic step, especially when there are family members who still want to work in it. And going public imposes an entirely different management style on the company, requiring, among other things, full disclosure, and subjects the price of the stock to market volatility.

Donald M. Israel, a partner specializing in ESOP design at Benefit Concepts New York Inc., also points out that selling or going public are probably not the best ways to go in the current economic climate. Banks are reluctant to finance risky expansion plans during a downturn in the economy, Israel points out, but lending for a stock purchase poses fewer risks. "As a result, ESOP transactions are probably a little easier to do than other deals," Israel says.

For all the advantages of ESOPs, the idea of giving employees part of the company doesn't sit well with all family business owners. The thought of sharing control meets resistance in many firms, especially those that have been run in a patriarchal manner. Not every family chief executive is willing to listen to employees, to respond, and especially to share financial information.

Experts acknowledge that the family which is unwilling to offer a greater level of participation to employees may not be suitable for an ESOP. But they argue that the family does not have to give up that much control. Rick Rose, whose firm has helped create more than 800 ESOPs, says that control of the company need not change at all, since ESOP stock is voted by a trustee who receives instructions from an ESOP committee appointed by the board of directors; presumably, the board will remain in the family's hands.

As for disclosure, the business is not required by law to hold an annual meeting or share financial information with employee-shareholders. It is only obligated to provide employees with annual statements of account showing how many shares of that beneficial ownership they have and what each share is worth. "You don't even have to tell them how much you made," Rose notes.

Still, Rose and others point out, that isn't the best spirit with which to enter an ESOP. J.W. Kisling was accustomed to meeting with all employees at quarterly breakfasts to brief them on the company's outlook and strategy. Now he has started monthly roundtables with just a dozen people at a time to discuss where the company is headed and whatever else is on everyone's mind.

Kisling has also instituted an annual meeting at which he reveals financial information. "We go through the balance sheet and the profit-and-loss statement," he says. But nothing is given to employees in writing about the firm's financial condition. "We still are a private company, and our results are confidential."

Recently, Kisling invited every employee to submit three ideas that could save the company at least $1,000 each. Although a number of good ideas were received, Multiplex managers feel that the new employee-owners still haven't taken as much initiative as had been hoped. "Maybe we haven't done as good a job of communicating and selling the program as we should," admits William K Jenkins, Multiplex's president.

Kisling doesn't deny that communication with employees has not been entirely effective. "I will be the first to confess that we're not doing as good a job as we should be," he says, "but we just started."

Corey Rosen, director of the National Center for Employee Ownership in Oakland, California, notes that the biggest problem companies with new ESOPs have is "getting employees involved." Most companies find that just having meetings between employees and management isn't enough, he says. As for Multiplex's effort to get employees to come up with money-saving ideas, he comments, "What they've got is a suggestion box. It's a start, but they need the next step."

The next step, according to Rosen, may be to set up permanent committees of employees and management to address key issues, or to appoint ad hoc committees with both groups represented as needed. These groups cannot only come up with good ideas but can follow up and sell them to the rest of the company.

The payoff could be improved productivity. Corey Rosen says his center's studies show that companies with ESOPs that have encouraged greater employee participation have grown an average of between 8 percent and 11 percent faster a year than those that do not have such participation. At Multiplex, one measure of productivity — sales per employee — rose by 18 percent in the first year of the ESOP, but Kisling hesitates to attribute the gain solely to the incidence of ownership. "It was a good year, volume was up," he recalls. Kisling does think the ESOP has spurred productivity, but since that was not his main aim in setting it up, the company does not have a method of measuring the gains.

"If you want to do an ESOP, do it for the right reason," Kisling says. "Don't do it because it's an opportunity for the owners to get money out. Do it because you don't want to sell to outsiders. Do it because you want to see people who work at the company get something for their work. Do it to help shareholders.

"If all parties involved — the employees, the shareholders, and the company — come out well, then do it. If one party is going to benefit at the expense of another, then don't do it."

Stephen J. Simurda, a journalist in Northampton, Massachusetts, writes often about small business.

 


FINANCING AN ESOP: HOW BIG DO YOU HAVE TO BE?

ESOPs have proliferated since Congress passed the Employees Retirement and Income Security Act in 1974, which created incentives for companies to establish such plans. In all, there are now some 10,500 ESOPs in the United States, covering close to 12 million employees, according to Corey Rosen of the National Center for Employee Ownership. At least 700 new ESOPs a year were being created until the recession, Rosen says. While some are huge and well-known, like the one at Avis, the vast majority are in smaller, family businesses.

In fact, size is less important than profitability in whether a company opts for an ESOP If a company generates at least $75,000 a year in pre-tax profits, an ESOP might make sense, says Rick Rose of Menke & Associates. Another ESOP advisor, Don Israel of Benefit Concepts New York Inc., says that as a general rule of thumb, a company that wants to set up an ESOP should have at least 15 employees and more than $1 million in annual revenue. Rick Rose says Multiplex is a little larger than the average family business that implements an ESOP. Typically, a company's sales range from $5 million to $10 million. The business is often run primarily by one family member who owns a big chunk of stock and is thinking of slowing down a little.

There are dozens of different ways to design an ESOP, depending primarily on how much of the stock is to be sold and the source of financing. But the vast majority of ESOPs started at family businesses are quite similar to the type created at Multiplex. The cost of designing and implementing such a plan, according to Rose, ranges from $17,000 to $30,000.

Before going ahead, however, consider a few caveats. First, if you borrow money to buy stock for the trust you will, of course, have to pay a monthly debt service. Multiplex, for example, pays some $48,000 a month on its $3.2 million loan. One reason that steady profitability is so important to the ESOP equation is that you want to be able to pay off such a loan easily over seven years.

Second, when employees leave or retire, the company will have to cash them out. "Paying the piper," is what Rick Rose calls this emerging liability within the ESOP. The legislation creating ESOPs helps this process, however, by allowing a five-year payoff period for a retiring employee, and 10 years for one who leaves the company for other reasons. And as employees age, the company is required to put part of its stake in non-company investments. By age 60, half of an employee's vested stake must be in these liquid stocks. — S.J.S.