Giving Employees A Piece of the Business

Questions about the future often keep business owners up at night, staring at the ceiling and wondering things like: how do I keep good staff from going over to the competition, when is a good time to exit and will my legacy live on in the business?

In the real estate development and construction industries, these concerns are even more relevant as companies’ most valuable assets are their people. An experienced, dedicated worker can often do more to improve margins than the most expensive piece of equipment.

One way to inspire that dedication while securing your own legacy is through an Employee Share Ownership Plan (ESOP).

Sharing the Gains – and the Pains

An ESOP is a program that allows employees to acquire an ownership interest in the company that they work for. It can take a variety of forms - equity shares, share options, stock appreciation rights or some combination - but the basic premise is that some or all of the employees share in the risks and rewards associated with owning the company.

“The advantages of an ESOP include attracting and retaining key employees, motivating owner-employees to improve productivity and efficiency and increasing the value of the business for the benefit of old and new owners,” says Craig Law, CPA, CMA an exit planning and ESOP specialist at MNP.”You also get to choose the people who invest in the company, people who share your values, are imbedded in the culture and bring hands-on experience.

“Employee share plans are common with construction companies, because much of the value in a construction company is in its people,” says Lynne Fisher, senior manager of MNP’s ExitSMART ™ program. “Margins are really thin in the construction industry, so if you can attract, retain and motivate more productive people, it makes a difference.”

There are numerous options and characteristics that can be defined to create an ESOP to fit the unique needs of a company. Owners and employees are consulted and various factors are considered in developing an ESOP design. A critical first step in setting up an ESOP is to determine eligibility criteria for who could own shares, Law notes. Other key considerations in the ESOP design include the desired level of participation for each type of employee, methods that will be allowed for entering and exiting the ESOP and any special incentive programs.

It might sound simple and straightforward, but ESOPs typically don’t happen without a few challenges. Mostly, there is apprehension because owners, employees, or both, have trust issues. Owners fear employees will interfere with their decision-making. Employees fear the owner will take advantage of them or they could lose their investment. It is the job of the ESOP designer to ensure all areas of concern are addressed and properly explained to both owners and employees.

Case Study

Construction Company A wanted to set up a retirement plan for its five founders that could be phased in over a 10-year period. They were looking for a way of transitioning ownership to a new group of people while paying off the original owners as they went their different ways at different times.

The model that was settled on was fairly common – they decided to sell most (90 percent) of the shares to three key managers, then offer another 10 percent to selected employees under an ESOP holding company. It was decided to offer shares to employees who had achieved a predetermined level of responsibility within the company, thus demonstrating a level of leadership. Employees also had to have been with the company for at least two years (to indicate stability).

The employees contributed 25 percent of the share value, in cash. This is particularly important in the case of succession, with owners who need to be paid out, the 25 percent down payment is a way of getting cash immediately. The remaining 75% of the share purchase was financed by an outside lender.

As a result of the ESOP, the company was able to both effect a smooth transition to new ownership while retaining its best employees and secure immediate financial benefit to the founders.

While this example highlights a private company, ESOPs can and do work for companies of all sizes and industries and in both private and publicly-traded companies. For public companies, an ESOP is simply a different form of bonus or pension compensation. In the private sector, sharing of ownership is usually more interesting because the employees are more closely involved and able to contribute to the success of the company.

Benefits

Most project contracts are structured around meeting deadlines, with penalties being levied against the contractor if timelines aren’t met. ESOPs provide an incentive to keep on time and budget when the rewards are personal. “It’s project management by people who are literally and figuratively invested in the company; they are more attentive to delivering quality and spending time and money efficiently when the success of each project reflects on the value of the company and their investment in it. Not surprisingly, there is typically much less turnover and increased profit margins with successful ESOPs,” says Fisher.
There are also significant tax implications and savings for both the original and the new owners, such as:

• Potential for capital gains tax treatment on growth in the value of the ESOP investment
• Ability for owners and employees to utilize their Lifetime Capital Gains Exemption
• Deferral of tax on private company stock option compensation until the shares are sold
• Potential deductions for one half of the stock option benefit
• Provincial government ESOP incentive programs

Ownership Changes Everything

Studies consistently show ESOP companies outperform non-ESOP companies in virtually every important measure. An ESOP could be an invaluable method for a company to attract, retain and motivate key employees by engaging them as owners. It can also help develop new leaders and, when the time comes, facilitate an ownership transition that retains the vision, the values and the legacy of the departing owner.
From the employee’s perspective, the benefits of an ESOP include:

• Clear alignment between company and personal goals
• Ability to contribute to company and personal growth and success
• Recognition for commitment and contributions
• Potential to improve long-term personal wealth

When done properly, the ESOP will increase company growth and profitability while providing both old and new owners with greater personal financial success and a far more interesting and enjoyable workplace.

Risks

There are, of course, some costs associated with ESOPs. Implementation of the ESOP involves translation of the design into legal documents, valuation of the company to determine the appropriate price for the shares and informed decisions by employees regarding their level of participation. The company then has the ongoing obligation to administer the ESOP in accordance with the legal documents and in the spirit of the ESOP design.

Done without enough thought and preparation, an ESOP can have disappointing results. Law notes, “It is critically important for the owners to clearly define their objectives and ensure the ESOP is designed accordingly. Usually it is a good idea to include the potential investors in the design process to consider their interests and help ensure there is clarity for all participants in the objectives and the features of the ESOP. Equally as important is ensuring that all potential investors are completely informed about the ESOP including the roles and responsibilities of all parties and the expectations and possibilities, favourable and unfavourable.”

“You want to ensure you attract the right people and for the right reasons”, says Fisher. “You want to encourage team members who are committed to long term success, are experienced, believe in the company’s values and culture, and are capable of leading the company in bad times as well as good. You want people who will be real owners, not just employees – and that takes time and dedication.”

Before engaging in an ESOP, owners and employees should always seek independent legal, tax and investment advice on how the proposed plan would impact them personally.

To learn more about how MNP can help you design an Employee Share Ownership Plan, contact:

Lynne Fisher, Senior Manager, ExitSMART
T: 780.401.7085
E: [email protected]

Craig Law, CPA, CMA, Senior Manager, Consulting Services
T: 204.788.6079
E: [email protected]