Owned and Operated by Our Employees

There are multiple costs to employee ownership, but benefits include lower taxes and motivated workers

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     Photo: iStockPhoto.com

Don Morrison Can readily list the equipment and vehicles his Kapolei company purchased in recent years.

Morrison, CFO of Pacific AquaScapes Inc., says money was available for the acquisitions because of the company’s Employee Stock Ownership Plan, which shields the company from federal and state income taxes. It allows the company to reinvest more of its profits.

“That makes the ESOP attractive,” says Morrison, who says the purchases helped give the company a leg up on other designers and builders of water features for resorts and high-end homes.

Indeed, dozens of small businesses in Hawaii say their ESOPs and other forms of employee ownership help lower taxes and increase employee motivation. They acknowledge that set-up costs and paperwork can be a burden, but insist that, overall, employee ownership is a bonus for their operations.

     Employees of pacific consulting services inc., a small
     archaeological and environmental consulting-services firm,
     can buy stock in the company.
     Photos: Courtesy Pacific Consulting Services Inc.

“It certainly provides superior motivation if you own a piece of the rock,” says Rick Holasek, president and CEO of NovaSol, a high-technology and research company that began as an ESOP in 1998 and later converted to straight employee ownership.

“We had some real tough times in the beginning. People went to great lengths to prevent the company from failing.”

No one knows exactly how many companies have ESOP or employee ownership in the state, but some people estimate there are 75 or more ESOPs, many of which are small businesses. That’s a healthy number, given the size of the state, says Greg Hansen, an attorney at Case Lombardi and Pettit, who advises on ESOPs. (Among the handful of other Honolulu attorneys who provide similar expertise are Carlsmith Ball’s John Khil and Harry Oda.)

Many of the local employee-owned companies are in the construction business – such as Allied Builders System and Shioi Construction – but others are in a variety of industries and include DTRIC Insurance, Jeans Warehouse, Chart Rehabilitation of Hawaii, Aqua Hotels & Resorts, Roberts Hawaii, Maui Divers and HPM Building Supply.

“Hawaii’s percentage of ESOPs on a per-capita basis is really quite high,” says Hansen, but he adds that such plans aren’t for everyone.

He notes there are no legal rules limiting the size of ESOPs, just practical ones. There are costs for the attorneys who usually quarterback the process, independent appraisals and third-party administrators. There also can be consultants who draw up the plans.

Each deal is different, but, in general, an appraisal can cost $10,000 or more, while attorney’s fees for set-up may range from $25,000 to $40,000.

The federal Employee Retirement Income Security Act, which governs ESOPs, also requires an annual appraisal that is part of the plan’s continuing costs. Most companies hire an administrator to handle all of the paperwork – there are reports to be sent to each participant annually, vesting schedules to be maintained, tracking of tax laws and other chores that are best handled by someone who specializes in them. The appraisal and administration costs can easily run $20,000 or more a year.

Because of this, Hansen says, the smallest companies he sees usually have 15 to 25 employees and an ESOP transaction size of not less than $1 million, but preferably $2 million to $3 million.

     Pacific Aquascapes’ nonunion employees are owners of the
     company. that means those employees are more careful about
     expenses and think often about ways to increase revenue,
     says CFO Don Morrison.
     Photo: David Croxford

“Having said that, I’ve got one client in Alaska that is an engineering firm with five employees,” he says.
The national ESOP Association says roughly half of ESOPs in America are set up as part of an exit strategy for owners looking to sell. About a quarter are initiated as an additional employee benefit and others seek them because they see employee ownership as an attractive model.

To a lesser extent, ESOPs are set up to finance expansion, spin off divisions or take a company private. In some instances, employees band together to buy an operation that otherwise would close.

“Basically, if you’re a sole owner and you want to have a succession plan, this is the best plan to go with,” says Wayne Wong, CFO of Geolabs Inc., Hawaii’s largest independent geotechnical consulting firm.

Not every business owner can find a buyer and, even if successful, may face business broker fees that can run as high as 10 percent.

Other owners turn to ESOPs when they find their children are uninterested in running the business. Selling out via an IPO really isn’t an option for most Hawaii companies.

Moreover, the owner may enjoy capital-gains tax benefits, depending on the size of the ESOP. If the sale is to an ESOP holding at least 30 percent of the company’s shares after the transaction, the tax can be deferred if the proceeds are rolled over into a qualified investment.

If 100 percent of the stock is sold to an S corporation – a corporate structure under which companies pass income, losses, deductions and credit through to their shareholders – the company can escape paying federal and state income taxes.

Hansen last year set up an ESOP for an engineering company that saved it roughly $1.5 million a year in taxes. That compares to the $80,000 to $100,000 it cost to set up the plan. Moreover, the fees were less than if a big California firm had done the work.

“It’s the old conundrum of living in Hawaii – it costs you more (to live here) and you get paid less,” says Hansen.
There are also tax deductions for companies making annual contributions to an ESOP plan.

“I think we have an edge from that perspective,” says Wong, who explains that Geolabs has plowed some of its tax savings back into the business, buying more sophisticated equipment that allows workers to become more productive.

Geolabs’ ESOP was set up in 1991 and now covers the company’s 63 employees. The workers must stay at the company six years before they’re fully vested.

Pacific Aquascapes set up its ESOP in 2003 as the owner looked for an exit strategy and the employees pushed for a plan. The ESOP covers nonunion workers, since the firm’s unionized employees already had a retirement plan.

“It just worked for both sides,” says Pacific Aquascapes’ Morrison. “There’s a million ways of doing it. You just need a good attorney and a willing set of buyers and sellers.”

The ESOP has paid off in a number of ways: Morrison says ESOP participants are more mindful of expenses and how to increase revenue. “There’s no question in my mind,” he says.

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