By Dave Donelson
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.