How Do Owners Make Use of an ESOP? One More Example – Buying out an investor

Many business owners find themselves in a situation in which they have one or more investors who bought into the company some time back.  Their investment may have been helpful at the time, but as things stand today these passive investors may no longer be needed.  Still, they continue to hang on for the ride, like barnacles on a boat.  If only a buyout of these investors were affordable.

That’s the situation that one company found itself in recently.  They are a distributor of fresh produce based on the west coast, with an emphasis on imported tropical fruit – we’ll call them Tutti-Frutti.  Twelve years ago, they entered into discussions with a large, publicly traded fruit importer, ultimately resulting in a major investment by the public company, giving them ownership of half of Tutti-Frutti.  At the time, it seemed like a good idea.  But today … not so much.  The investor wasn’t earning much cash flow from the investment, and Tutti-Frutti wasn’t getting access to any of the new markets they had hoped the relationship would lead to.  In fact, the big company investment had cost them a valuable contract, disqualifying them from bidding on a good military contract that had been set aside for a small business program.

Tutti-Frutti’s founding family had seen enough.  They wanted their company back.  And the good news was that the public company was positive about the idea of turning their investment back into cash.  But how was that going to happen?  A repurchase of the stock owned by the investor would have to be undertaken as an after-tax, non-deductible expenditure.  And paying for half the value of the company on that basis simply wasn’t affordable.

The solution:  no surprise, an ESOP.  Tutti-Frutti set up their ESOP and made an offer to the investor for its stock.  With a good deal of unencumbered real estate (warehouses) and other assets, Tutti-Frutti qualified for a bank loan to finance the stock repurchase.  The loan proceeds went to the ESOP, of course, which used the money to buy the stock from the public company.  As the ESOP bank payments come due, Tutti-Frutti supplies the necessary money to make the payment – by making a fully tax-deductible contribution to the ESOP.  With federal and state corporate taxes totaling about 40 percent, the governments are effectively paying 40 percent of the loan back through these unique ESOP deductions.

We all like a story with a happy ending.  Today the outside investor is out of the picture.  The founding family has their company back in their control – and they have a strong employee incentive program in place in the form of the ESOP.  In the two years since then, the company has been thriving, growing substantially as the whole team hustles every day to make a success of their business.

The CEO did tell me one interesting wrinkle.  Not long after the ESOP transaction had been completed, a warehouse employee came to office to deliver the news that a couple of employees were stealing inventory.  The CEO was disappointed, having hoped that the employees’ participation in ownership would have improved employee behaviors.  When the CEO expressed that disappointment, the reporting employee responded “Oh no, you don’t understand.  Those guys have been stealing inventory for years.  But no one bothered to report it.  Now that it’s our company too, the rest of us won’t stand for it any more.  That’s why I’m here.”

Which leads to the question: does employee stock ownership really change employee behavior?  Does it really motivate employees to be more diligent, committed, and hard-working?  We’ll explore that question next time.

Questions?  Enter it as a comment to this post, and I’ll see about getting you a response.

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Martin Staubus is with the Beyster Institute (part of the Rady School of Management at UC San Diego) where he advises company leaders on the effective deployment of ESOPs and other stock plans.  The Institute was established by entrepreneur Bob Beyster, who grew his firm into a Fortune 500 company.  https://www.rady.ucsd.edu/beyster/

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