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News


In the news: ESOP's Align Company Culture and Owner's Exit
July 30, 2018

 

Jeff Burd

Editor - BreakingGround

July/August 2018

 

On March 29, the two owners of Rycon Construction Inc., Todd Dominick and John Sabatos, announced to their employees that they were selling their stakes in the general contracting firm by creating an employee stock ownership program (ESOP). The move made all the salaried employees of Rycon Construction the new owners of the 29-year-old company that Dominick and Bill Taylor founded in the basement of Dominick's Bethel Park home.

"The idea of an ESOP came along about two-and-a-half years ago," says Sabatos. "We started getting serious about it maybe a year ago and finalized it at the beginning of this year."

Sabatos came on as the partner to buy Taylor's share of the company in 2011. Vice president of operations at Rycon earlier in his career, Sabatos was working with developer DDR Corporation when he was approached to re-join Rycon as an executive and owner. Focused on growing Rycon's business as the economy began to recover in 2011, Sabatos says that transitioning the ownership of the company became a conversation about five years later.

"As the years went on there were several options that we had," he explains. "One was that I buy Todd out. Another was to bring in another partner or partners in and the third was an ESOP. One of the things that made an ESOP attractive is that Rycon really isn't a family-owned company. Todd's kids aren't interested in the business and mine are not either. The other thing is we think it's a good thing for the company. The employees are incentivized to maintain the progress and integrity of the company after we're gone. And it's an exit strategy for us."

When a company wants to set up an ESOP, it establishes a trust fund. The company then contributes new shares of stock or cash to buy existing shares. The shares are divided among employee accounts within the trust. ESOP shares are viewed as qualified retirement plans by the Internal Revenue Service (IRS). Vesting schedules vary between individual plans, but employees must receive vested benefits on either a cliff vesting schedule, which is 100 percent vested after three years or less, or on a graded vesting schedule, which provides 20 percent vesting every year after the second year of employment.

Employees receive the vested portion of their accounts at either termination, disability, death, or retirement. These distributions may be made in a lump sum or in installments over a period of years. If employees become disabled or die, they or their beneficiaries receive the vested portion of their ESOP accounts right away.

Steve Goodman, partner at Lynch, Cox, Gilman and Goodman, is an accountant and consultant specializing in ESOPs. Goodman guided Rycon through the process. He says that ESOPs are gaining in popularity.

"Eight years ago, four percent of American workers had their retirement plans under ESOP. Today that number is 11 percent," Goodman states. "ESOPs have been around since the 1950s, but in 2002 the rules for 'S' corporations were amended to allow ESOPs as owners."

ESOPs are beneficial to business owners in several ways. The owner can sell part or all their shares to their employees, while still retaining control of the business operations. Establishing the ESOP trust also ensures there is a market for the owner's shares. Transfers to an ESOP allow the business owner to defer or bypass capital gains taxes. ESOPs come with even more tax benefits: contributions of stock and cash are both tax-deductible. In addition, when the ESOP is used to borrow money, both the loan repayments and interest are also tax-deductible. That tax advantage can translate into huge annual savings.

"If I borrow a $100 from you and, at the end of the year, have paid you back $110, I can take a deduction for the interest I paid you but not the principal," Goodman explains. "But if an ESOP borrows a $100, the company will pay that off by making a $110 contribution to a retirement plan because that's what an ESOP is. Both the principal and the interest payments are deductible."

A sale such as the one that Rycon's owners did has an enormous tax advantage over other sales options. Dominick and Sabatos financed the purchase of the company by the employees but the ESOP method means that no cash was needed to transfer the ownership. The note to the former owners is paid by the ESOP with funds from the company's profits. Those profits aren't taxable because the ESOP is a qualified retirement entity. In this case, Rycon's future profits will be used to fund a retirement asset, from which the notes due Sabatos and Dominick will be paid. Funding in excess of the amount needed to pay the note increases the employees' ownership accounts.

"Todd and John decided to be the bank. They sold their stock in exchange for a note. They will end up paying capital gains on the sale but look at the benefit to the company," Goodman says.

"The term for the transaction is 'seller-financed'," says Ron DeMay, controller for Rycon Construction. "A portion of the future earnings of the company goes to pay the note and the remaining earnings go to the current owners in the form of shares in the company." Pittsburgh business owners have earned a reputation for caution and skepticism. When asked if Dominick and Sabatos exhibited that skepticism in evaluating the ESOP as too good to be true, Goodman laughs. "Of course they did," he says. "Everyone does when they first hear about an ESOP."

There's an element of "too good to be true" to the tax-free way an ESOP operates, but there are aspects of how an ESOP works that make it suitable for some situations, not all. Dick Spence, partner at Hill Barth & King, sees ESOP as an alternative that should be explored by owners who are looking at their transition options.

"The downsides are that you have to have a valuation every year and when people retire or leave you have to pay them out. You also have to have a steady business because you need to have cash every year," he explains. "Not enough owners look at ESOPs. What scares people away is the cost of setting an ESOP up. It can run $150,000 to set up and the cost of compliance is higher than normal because you have to value the company each year. But the tax savings are enormous."

Goodman notes that the costs associated with creating an ESOP have come down. Legal fees once topped $250,000 and the business valuations tended to be all over the map. That made arriving at a sales price difficult and could leave the resultant employee-owned entity unfairly strapped, or the sellers unfairly compensated for what they built. Today, firms specialize in ESOPs and have standardized fees. Business valuation specialists have more experience with companies in a broader variety of industries and better understand the added value that the ESOP brings to the company's income through the tax savings.

Banks have become more comfortable with ESOPs too. Many have created ESOP departments and are willing to be financiers of the ESOP transaction. As business lenders, banks have come to understand that an ESOP as a borrower poses much less of a risk of non-payment, since the underlying company can use more of its earnings to repay a loan than a company that will have to pay corporate income taxes on profits first.

An ESOP transition also helps owners deal with one of the bigger stumbling blocks to transition: the question of who is going to run the company. Once established, the ESOP is managed by a board of trustees, which usually include the company's leadership at the time of the sale. Other trustees will be those with an interest in the firm, like lenders, surety partners and the employees. In most cases, those interested parties want to see the business's success continue. That's been the case with Rycon's sale, where a trustee representing the employees' interest in the ESOP serves on the board and supports keeping the leadership team intact.

"Todd and I aren't going anywhere right now," says Sabatos. "I'm 52 and I actually signed a ten year contract with Rycon. Todd will be here four to six more years. That's our plan. Nothing is changed operationally with the company. We still run the company and the ESOP and the trustees want us to continue to run the company the way we have." Sabatos says that he expects that it will be a while before the new owners of Rycon Construction begin to see how the appreciation of the business's value affects them. The first statements of share value won't even be issued until later this year. But he believes that the ESOP participation will be valuable to Rycon's employee retention and recruitment efforts, a benefit that is doubly important at this point in the construction cycle. He says he has already seen shifts in the way people are thinking and acting in just a few months.

"It's been nice. People seem to be genuinely excited about being an owner of the company," he says. "Somebody will ask me a question about whether we should sponsor this golf outing or buy this piece of equipment and I say, 'What do you think? You're an owner of this company' so that's been kind of fun to watch.

"I want people to like working here. That's very important to me and Todd. If they like it here, they do well and the company's more profitable. We wanted to have a transition so that the next group of young people run Rycon and have nice careers, have a nice life. The ESOP helps with that. We intend to move the company forward with the people that are here. We tell the people that come to work here that whoever's going to run the company is already here."

 

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