Health Care ERP Implementation Rescue
Mike Madden
Audit Senior Manager, EKS&H
[email protected]
Sandy Shoemaker
Partner, EKS&H
In what may be the first sign of a trend in the craft brewing industry, both New Belgium Brewery in Fort Collins, Colorado, and Deschutes Brewery in Bend, Oregon, have completed a sale of at least part of the company to its employees. New Belgium transitioned from a partial to full ESOP-owned business and Deschutes has initiated a minority-ownership ESOP model. These craft breweries, some of the largest in the industry, join several smaller, local, ESOP-owned breweries including Heartland Brewery, in New York City, New York, and Full Sail Brewery, in Hood River, Oregon. Full Sail completed its complete ownership transfer to employees in 1999, and Heartland completed its partial ownership transfer in 2007. While these craft breweries have found ESOPs to be the right option for them, it is important to consider all the advantages and disadvantages of such a change. Furthermore, investigating multiple business ownership options is an essential part of the strategic-planning process for the eventual ownership transition of every business.
ESOP Advantages for Craft Breweries
The ESOP model offers several unique benefits to the owners and founders of craft breweries.
First is the potential impact on sales and employee growth, as well as employee satisfaction. The most comprehensive and significant study conducted on ESOP performance, conducted at Rutgers
University, found that sales, employment, and sales/employee grew by about 2.4% per year, over what would have been expected absent the ESOP. An earlier study showed similar results, identifying sales growth rates of 3.4% per year higher and employment of 3.8% per year higher post-ESOP, than what would have been expected based on pre-ESOP performance. The ESOP strategy can also create an important incentive for employees to remain with the company. The 2010 General Social Survey found that while 24% of employees without stock ownership structures intended to leave their companies in
the coming months, only 13% of employees with stock ownership had those intentions1.This strong
evidence supports the notion that increased employee loyalty is often an important benefit of a well-managed ESOP-owned company.
Another important benefit to the ESOP model is the liquidity event that allows current owners to sell stock but still keep the company in the “family” of its employees and managers. A sale can be the result of an owner’s desire to exit the business entirely, or an owner’s interest in sharing the benefits of ownership with their employees while accomplishing the diversification of their personal assets. In the latter case, an owner would maintain partial ownership and management control. The partial or minority-owned ESOP is particularly significant because of the challenge that often exists in being able to find a buyer who will take a minority interest in a privately held company.
ESOP transactions also offer some interesting tax benefits to both the selling shareholders and the ongoing ESOP-owned company. For the shareholders selling to the ESOP, the proceeds from the sale can be income tax deferred if they are invested in a qualified replacement property (QRP) within one year of the sale. QRPs include public and private company stocks and bonds. However, this tax deferral is available only if the company is a C corporation at the time of sale. Another significant tax benefit involves reducing the brewery’s ongoing taxable corporate income. While disposing of most QRP results in taxable gains, making gifts of QRP does not. Individuals can make outright gifts in trust to charities, charitable trusts, or non-charitable beneficiaries.
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Though the tax avoidance may be limited in some situations, owners may be able to receive an income tax deduction for the gift without incurring offsetting capital gain on the QRP’s disposition. For craft breweries that operate as a subchapter S corporation, the ESOP’s share of corporate income is income tax free.
A third significant benefit to utilizing the ESOP model for craft brewery founders and owners is as an estate planning tool. The liquidity that an ESOP sale can create may result in increased cash flow. This cash can be used to pay bequests, taxes, debts, and estate administrative expenses. Additionally, the required independent stock valuation for an ESOP transaction may reduce the chance of a valuation dispute with the IRS after the death of the shareholder. Another advantage this tax strategy is that while disposing of most QRP results in taxable gains, making gifts of QRP does not. Individuals can make outright gifts in trust to charities, charitable trusts, or non-charitable beneficiaries. Though the tax avoidance may be limited in some situations, owners may be able to receive an income tax deduction for the gift without incurring offsetting capital gain on the QRP’s disposition.
Disadvantages to ESOPs for Craft Breweries
While there are many benefits to craft breweries who engage in ESOPs, this ownership structure is not the right solution for all companies. ESOP ownership is not a panacea and the challenges and risks sometimes outweigh the benefits and needs to be well understood. These challenges range from the costs (both during the setup and the ongoing maintenance costs), to creating an undesired
investment, in addition to issues related to significant changes in company value.
With an ESOP, the cost of the initial transaction as well as the ongoing administrative burden and expenses can vary widely and include initial setup fees, consulting fees, legal fees (for both ESOP, owner representation, and the company), administration costs, annual business valuations and audits, trustee fees, etc. Should the trustees or executives of the business eventually make the decision to sell the company to an outside party; an ESOP can add complexity to the transaction or scare off a potential buyer who is unfamiliar with the ESOP vehicle. These challenges alone may deter prospective buyers from considering the purchase of an ESOP-owned company.
Creating an undesirable investment for employees of a brewery is another potential pitfall to an ESOP. Diversification is an important aspect to any investment strategy, and ownership in an employer may not be in the individuals’ best interest. While almost everyone reacts positively to the general idea of being an employee owner, some employees are not prepared for the risks of owning a small business. Business success is not guaranteed and changes to the value of the company—both positive and negative—pose potential challenges. Should the value decrease, employees may feel the ESOP is a less attractive option than a more traditional profit-sharing or 401K plan. However, it is important to
remember that many ESOP companies are still able to offer traditional 401K’s and incentive or
performance-based bonuses. If the value of the stock appreciates significantly, on the other hand, the ESOP and/or the company can be challenged to generate sufficient cash to repurchase stock upon an employee’s retirement or separation from service. As ESOP participants exit the plan via terminated employment or retirement the company could be responsible for payouts if the ESOP does not have the necessary cash (i.e. founders of the company or long-term executives with large balances). These challenges are key planning items that are often addressed by the company during strategic planning sessions with key advisors.
Finally, the long-term implications of ESOP ownership on the company’s ability to motivate and reward its leaders should be carefully considered. The next generation of leaders will be employees, and not necessarily part of the founding of the company. Within the ESOP, stock ownership cannot be driven by performance, merit, or the importance of the role the employee plays. As a result, in mature ESOPs it is not uncommon for key leaders who drive the company’s success to be frustrated by their lack of concentrated ownership. There are plenty of ways to reward leaders other than ESOP ownership, but sometimes the long-term implications can be the loss of entrepreneurial spirit.
This is important to consider when there is a transition that takes place from a closely held business, where the founders and key leaders are true entrepreneurs who realize the primary benefit of stock appreciation.
Other Business Transition Strategies to Consider
While the ESOP model has worked for several craft breweries, other business succession strategies may be a better fit for other organizations. Keep in mind, the right transition plan might be a combination of strategies, including an ESOP.
Management buyout is a common alternative to an ESOP that may work better in some situations. Particularly appropriate when an executive team has been instrumental in the growth of the company, in this model a management group borrows against the company assets and cash flow to redeem the principal shareholder’s value. Sometimes this model can be more lucrative than an outside sale, since management may place a higher value on maintaining the business than would an unrelated investor. Challenges however also exist with this model. The selling owner is less likely to receive all proceeds in cash, and the highly leveraged nature of the deal can limit a company’s ability to pursue growth opportunities.
Transition to a family member is another transition-planning option. The primary benefits of a family business transition include a smooth, possibly invisible, transition for customers, employees, and vendors; the opportunity to create a long-term family legacy; and a limitation of business transition costs. However, the value of the company and retirement funding for departing shareholders can become an issue in this process. Family business transitions, like all business succession options have their own unique set of additional risks and challenges.
A strategic sale or merger is a third option. Though negative impressions exist to this option in the craft brewing industry (largely because of the culture many owners are trying to build in their organization), it remains an important and viable option for some brewers. Acquiring entities may be interested in entering a new market or adding strong brands or brewing capacity, or they may be interested in buying into the rapidly growing craft brewing industry all together. In the right situation, this option can yield the highest business value from well-financed buyers, though disadvantages include the potential negative reaction of devoted employees and customers.
The key in these and all succession alternatives, including the ESOP model, is for the craft brewery owners to define their individual and business transition goals.
Five Key Considerations for Business Succession Planning
1. The importance of defining objectives, goals, and your preferred time frame cannot be overstated. Owners should consider the business life cycle, progress, significant milestones, and upcoming opportunities and challenges. It is imperative that you be aware of your priorities because these will impact all subsequent choices and plans.
2. Though owners may be interested in completing the process during a very short time line, parties should be prepared for a six-month or greater investment of time. The sale of a business can be stressful and time intensive and being prepared with the right expectations related to timing can make the transition easier and smoother. On the other hand, artificially extending the time it takes to complete a transition can also kill a deal. Brewery owners should be prepared to separate when they begin the process of actively seeking buyers.
3. Gather current financial information. Being able to provide prospective buyers current sales, cash flow, accounting, etc., information is critically important. This information should be gathered for the most recent three to five years. Budgets, forecasts, major accounts, and business plans will also be helpful to prospective buyers interested in getting a sense of the future potential of the brewery.
4. Maximize the value of your business and reduce risk. You should seek access to current data on similar transactions and assess the factors that currently drive value for your craft brewery. Do you have IP protections? Recipes and processes documented? Contracts with key customers and suppliers locked down? Agreements with brewmasters and key staff? All of these issues represent opportunities to significantly increase business value—or risk losing a deal. 5. Seek qualified and professional advisors. These individuals should be experts in their field
(accounting, law, finance, etc.) and should be able to help you with many of the above
considerations in addition to identifying which business succession plan option is right for you, be it ESOP or something else. A small investment in these types of specialists up front can save you money and maximize the outcome in
