Is your company a platform for acquisitions—the starting point of a consolidation play that could lead to profitable economies of scale and a richer valuation multiple?
It seems every company owner has seized on that approach these days, from family founders to management buyout groups to funds raised by private equity firms. What too few owners seem to appreciate, however, is that one of the most efficient M&A platforms is the Employee Stock Ownership Plan, or ESOP. I’ll explain by examining the experience of Parksite Group, a Batavia, Illinois-based distributor and marketer of building products.
First, the general benefits ESOPs bring to M&A:
1. A 100 percent ESOP-owned S Corporation, as a pass-through entity, doesn’t pay federal or most state income taxes; rather, as with IRAs and 401(k)s, the owner-workers pay their taxes when they retire, or otherwise leave the company, and withdraw funds.
In the meantime, the S Corporation—quite distinct from regular operating companies that may be taxed at 35 percent or so of profits—is accumulating pre-tax profits. This more substantial cash flow can build up for acquisitions. It pays down debt taken on to do deals. And it is the source of capital to fund investments in a plant and equipment and other expansion efforts.
2. As an ESOP, your company could also benefit from workers who act like owners, reducing waste, amping up productivity and lessening friction with management. This is far more than just a hopeful theory. A wide survey of research shows that ESOP companies outperform similar firms operating under other ownership structures.
The most recent study, by EY’s Quantitative Economics and Statistics Practice, shows that S Corporation ESOPs vastly outperform the S&P 500 for their owners. QUEST, in analyzing S ESOP filings from 2002 to 2012, found employee-owned companies delivered their worker-owners an 11.5 percent compound annual growth rate vs. 7.1 percent for the S&P 500 on a total return basis. (The QUEST study was commissioned by ESCA, a pro-ESOP organization.) Though the study measured investor outcomes, the numbers show superior corporate performance.
In a prior Middle Market Growth article, I explained how some private equity funds are investing alongside ESOPs to reap these benefits. And founder/owners can also capture 100 percent S Corporation ESOP benefits by selling to employees but retaining some ownership through structured equity.
In 1989, the original owners of Parksite—the buildings material distributor—sold 75 percent of the company to an ESOP, later selling the remaining 25 percent. In such a transaction, the company borrows money to fund the buyout, using profits over time to pay down the debt. And as the debt is repaid, shares are released to the ESOP and credited to employee retirement accounts.
By 1999, having repaid its borrowings, Parksite was a roughly $50 million-a-year company, debt free, and looking for acquisitions. The company was well-known within its industry, well-regarded by its suppliers and had built a loyal base of customers. Around that time, the owners of Plunkett-Webster, a building supplies distributor with annual sales of roughly $150 million, or three times the size of Parksite, were looking for an exit.
Despite the size difference, Parksite, with 11 years of rapid organic growth and solid results as an ESOP, had great relationships with its banks and was able to buy Plunkett-Webster for more than $50 million, borrowing the entire sum. It was perfect timing. The U.S. housing boom took off. Sales at the combined companies nearly tripled by 2006. Profits were strong. The new employees from the Plunkett-Webster acquisition adapted to the ESOP culture and became more productive. And with the favorable tax status, the acquisition debt was retired completely.
Parksite performed terrifically in an up market. But how would the ESOP do during tough times? After the financial crisis of 2008-2009, plenty of competitors in the building supply industry went bankrupt. And to be sure, Parksite felt the downturn’s pain. The company shrank and there were layoffs.
George Pattee, CEO and a 42-year veteran of the company, credits the ESOP culture of shared sacrifice and cooperation with helping Parksite to pull through. At one point, workers persuaded management to hold off further layoffs and instead cut everyone’s hours and pay; that’s a pulling-together sentiment not seen at many U.S. companies. And even amid tough times, Parksite was able to invest in state-of-the-art inventory systems that made it more efficient.
After adjustments, Parksite was profitable again beginning in mid-2009. And as the housing market recovered, the company was well-positioned, making a smaller acquisition in 2010. These days, Parksite is on the M&A hunt again, driving exceptional value for its employee-owner shareholders.