The lure of ESOPs

Written by ProfitGuide Staff

Don White can still taste the frustration 10 years later. As a manager at an Alberta-based distribution firm, White hired, trained and ultimately lost dozens of workers to employee-owned businesses, which could offer something White’s former employer didn’t: a share in the firm’s success. “I knew that when I started my own company, I wouldn’t do it without an employee-owned structure,” says White, who now runs Apex Distribution Inc., which ranks 94th among this year’s PROFIT 100 companies. “I saw it as an important way to keep good people.”

Smart CEOs are always on the lookout for tools that will help attract, motivate and retain top talent, especially in today’s ever-tightening labour market. This year’s survey of Canada’s Fastest-Growing Companies shows that PROFIT 100 leaders consider employee share-ownership plans (ESOPs) part of the solution. Almost half (47%) of them run ESOPs and say they attract and keep workers, facilitate succession planning and boost productivity. (According to the Oakland, Calif.-based National Center for Employee Ownership, employee-owned firms enjoy 4% to 5% annual productivity gains in the first few years of an ESOP, double that of companies that aren’t employee-owned.) That said, a poorly structured or haphazardly communicated ESOP can splinter employer/employee trust and erode your workplace culture.

In the U.S., ESOPs take on specific, legalized structure; in Canada, the term is more loosely applied to include any plans that allow employees to purchase or be granted shares in their firm. Most ESOPs use a combination of three components: employees can purchase shares outright via share-equity plans; they can be given stock options; or, they can be granted “phantom” shares, for which dividends are paid but title isn’t legally transferred from employer to employee.

Don White stayed true to his beliefs. When he co-founded Calgary-based Apex Distribution in 1999 with two colleagues, he immediately hired a business valuator and lawyers to help put an ESOP in place at his privately held firm. White set aside a specific number of shares for purchase by his top salespeople, as well as employees at each branch of the firm; shares were added as the company grew, and new employees were allocated shares based on their role in the company. Today, the $200-million-a-year distributor of oil-and-gas drilling equipment has 3.8 million shares outstanding, about 50,000 of which change hands during its semi-annual trading periods. While some firms set up “golden handcuff” plans, in which shares have multi-year vesting periods in order to retain staff, White says his firm has had low turnover, despite allowing employees to sell their shares at any time. Of Apex’s 250 employees, 130 own a piece of the firm; the others have chosen not to buy shares, because they can’t afford to, are new to the firm or, in White’s words, are “averse to any type of investing.”

ESOP design will vary depending on your province and whether your firm is publicly traded. (The Toronto Stock Exchange, for example, requires its listed firm to follow clear guidelines on how ESOPs are built and run.) Generally, there are four primary considerations: valuation (to determine the price and number of shares that should be issued), design, taxation and legal implications. “It definitely took us awhile to understand how [the ESOP] was supposed to work,” admits White. “I spent a lot of time trying to figure out valuation and share prices.” The effort was worth it: Apex has had zero turnover in top management and sales positions, contributing to its recent year-over-year revenue growth of 100% in 2006 and 50% in 2005.

Of course, it hasn’t been an entirely smooth ride. In fact, Apex fell prey to a common pitfall in ESOP execution: a dispute among owners about how much of the company should be up for grabs by employees. As the company grew, White says his co-founders, a pair of brothers, wanted to restrict shares to a small group of employees, whereas White wanted to keep the plan more broad-based. They couldn’t agree, tensions rose and, after a falling-out, the brothers sold their shares and left the firm.

The episode fractured employee morale in the ensuing months. “First, we told them we were going one way,” says White, “and then it seemed as though we were going another.” However, White’s fight to keep the firm employee-owned has paid off handsomely. While private firms rarely see the Googlesque share-price explosions of public companies, ESOPs at private firms can nevertheless create new wealth for employee shareholders. Apex’s share value has risen from 80¢ in 2001 to $6 today, leaving some employees with retirement windfalls of more than $200,000. As for White: “Any dilution I’ve made has been compensated by our share price.”

Another key element in a successful ESOP is employee participation, say Perry Phillips, president of Thornhill, Ont.-based employee-ownership consultancy ESOP Builders. “There’s a huge morale spike after an ESOP gets implemented,” says Phillips. But if employees aren’t given the chance to participate in decision-making, they could become disenchanted and less productive. To create an ownership mentality among your staff, it’s important to link job performance to margins and share value. Sharing financial statements — and explaining what they mean — is also a must.

You should also pursue external validators of success. “It’s important for employees to know that their company is successful, that their shares are worth something,” says Mark Chaplin, CEO of Langley, B.C.-based Disc Go Technologies Inc. (No. 19), a manufacturer of CD- and DVD-repair machines. Chaplin exercises all opportunities to boost the visibility of his firm, whose ESOP dates back to 2004. He enters Disc-Go-Tech for consideration in programs that can generate publicity, such as the PROFIT 100, and retains an outside PR firm to drum up attention. Combined with monthly meetings at which he briefs all employees on company performance, Chaplin says, the PR helps highlight the value of owning a piece of Disc-Go-Tech.

When Chaplin and his two co-founders set up the ESOP, they made their motives clear: succession planning. In fact, being transparent about your reason for starting an ESOP is crucial to its success. A lack of employer/employee trust is a major reason why ESOPs underachieve. “We never saw ourselves running this company indefinitely,” says Chaplin. “We wanted to be totally up front about it with our employees.” The Disc-Go-Tech co-founders see two major options: going public or being purchased by a customer. “If we didn’t have an ESOP in place,” says Chaplin, “our employees might feel they’d automatically lose their jobs. This is a kind of protection.”

Jason DeZwirek says that his company’s ESOP has been essential to its U.S. expansion. In the early part of the decade, Kaboose Inc. (No. 16) of Toronto, began a series of acquisitions that helped transform it into North America’s largest independent family-oriented online media company. The firm needed top talent, but couldn’t afford to pay top dollar. Granting options proved a “very important tool” in luring people away from the likes of Warner Bros., Disney and Yahoo!. “[U.S. workers] are extremely focused on it,” DeZwirek says. “They’ll ask about it in job interviews.”

The key to creating a successful plan, he believes, is to be judicious in how you grant shares and how much equity you give away. At Kaboose, employee options are decided by the board on a case-by-case basis, and are almost always attached to milestones: the employee, her department or the firm as a whole must reach specific performance targets.

Since Kaboose went public in 2005, it has been particularly vigilant about the amount of stock granted to employees, holding employee ownership at 10%. For growing firms, Phillips says, it’s a good idea to limit the ESOP to 10% to 15% of total stock in the beginning. Devote too many shares to your ESOP, and you risk having too little equity to leverage into future growth capital. If growth financing is less of an issue, particularly if you’re using the ESOP as an exit strategy, you may choose to start with as much as 20%.

DeZwirek says Kaboose wouldn’t have been able to grow as dramatically as it has without employee ownership. But he also warns of the dangers of creating too much wealth for your employees overnight. “If you grant them too large an option, they may want to leave to do something else,” he says. “Look at the terms of your options and make sure you’re balancing morale with retention.”

ESOP snapshot

An employee share-ownership plan can have a profound effect on your company. Although it’s 20 years old, the most definitive study of ESOPs in Canada, conducted by the Toronto Stock Exchange, revealed that firms with ESOPs are more productive and profitable than their non-ESOP counterparts. ESOP companies in the study experienced:

• 123% higher five-year growth
• 95% higher net profit margin
• 24% higher productivity (measured by revenue per employee)
• 92.3% higher return on average total equity
• 65.5% higher return on capital

Originally appeared on PROFITguide.com