Ian: Welcome to the Business Coach Podcast, an advice-oriented series that tackles the top issues and opportunities facing Canada’s small businesses.  I’m your host, Ian Portsmouth, the Editor of PROFIT Magazine. And we’ve developed this podcast in cooperation with BMO Bank of Montreal.

People will always take better care of things that they own versus the things that they don’t.  Then entrepreneurs would do well to cede some ownership in their firms to their staff.  Employee share ownership plans offer one way to turn staff into shareholders, and joining me to discuss the so called ESOPs is Perry Phillips.  Perry is the owner and president of Toronto-based ESOP Builders Inc. which helps companies develop employee share ownership plans.  Perry, welcome to the Business Coach Podcast.

Perry: Thanks, Ian.

Ian: So Perry, a lot of business owners go into business because they want independence both from a financial perspective and from a managerial perspective.  So why would an entrepreneur want to share ownership of their company with their employees of all people?

Perry: Well, that’s a great question.  There’s been studies both in the United States and Canada that show not all owners are actually good ESOP candidates and one out of four actually for small medium-sized companies would be good candidates for an ESOP.

The main reason for doing employee share ownership plans is to engage your workforce, engage your employees to be better than they are and to have the same type of goals than the owner has in growing the company, and that leads to higher productivity, and that leads to a higher profitability.  And the other one is attraction, retention of employees.  ESOPs have been shown in the past to help you keep your key people and to attract new people.

And number three.  As you know, the demographics of our society are that owners who have created their companies, started their companies about 20, 25 years ago are now looking at what are they going to do in terms of transitioning or selling their companies.  And one of the routes that they can look at is selling to their employees.  So those are the major reasons that an owner may want to look at an ESOP.

Ian: So what in a nutshell is an ESOP? Is it kind of like the private company, one company version of a mutual fund?

Perry: No, basically an ESOP encompasses the sale of actual ownership in the company to the employees over time.  And it’s a legal document that is created that puts into place that transfer of ownership, and what it does is actually lay the foundation for employees to start acting and thinking as owners do.

Ian: And you mentioned that it governs the sale of shares to employees.  Are they necessarily sold or can they sometimes be granted or earned?

Perry: They can be granted or they can be purchased.  Our philosophy and certainly over the last 15 years we’ve seen it in our client base is that 95 percent of owners want their employees to actually purchase shares.  And the reason for that is that you want the employee to know that there is a responsibility here and they have a real risk of their investment going forward, and that risk is what helps solidify that kind of ownership mentality.

Ian: So it’s all about having skin in the game so to speak?

Perry: Basically correct, that’s right.

Ian: What if any rights come with those shares?

Perry: Well, under the Security Act of the various provinces in Canada, there are rights and obligations you have as an owner of a company, and those laws protect both the minority shareholder who would be the employee, they also protect the owner.  The rights of the employee go along the lines of for example seeing financial information, being aware of more transparency within the corporation, and being protected from the owner if they decide to create a fraudulent type situation and that’s called minority share rights.

Ian: Now entrepreneurs don’t want to turn themselves into minority shareholders of their company, so what limits are typically placed on the amount of ownership that employees get?

Perry: That’s correct.  They way we approach it is that because you’re looking at privately held companies that are looking at transitioning their companies over time, the owner should never, ever get into a situation where they sell a position where they become minorities themselves until such time as they are ready really to get out of the company.  So the owner should maintain control until that point.  Up to that point, they can sell 10, 20, 30, 40, even 49 percent of the company and continue the company along those lines.

Ian: Now it’s easy in publicly traded companies to determine the value of a share, it’s whatever price it’s selling for on the open market, but within a private company how do you value the shares that would be granted to employees in an ESOP?

Perry: Valuation for privately held companies is as you say it’s very different Ian than valuating a public company.  There is an institute called the Canadian Institute of Chartered Business Valuators started in the early 1970’s that have built up a body of knowledge on how you value privately held companies, and they have created what’s called a Generally Accepted Valuation Principles.

And there’s two major principles.  One is when you buy a company that’s going concern.  And going concern just means that you’re able to meet payroll every week.  Basically, if you were going concern then you’re either valued on the value of your assets or the value of the cash flow that you’re able to generate going into the future.  Those are the two major methods that you have to use in evaluating the company.

The asset basis, of course you look at the balance sheet and you revalue all the assets that are on your balance sheet to their current market values.  And on an earnings-base you’re looking at a rate of return that that cash flow will give you for the risk you’re taking in that industry and in that company.

Ian: Now given that the companies can’t do a valuation on a frequent basis, does that put limits on how often shares can be granted under an ESOP?  Clearly it’s not like a public company’s employee ownership plan where people get granted shares or purchase shares on a monthly basis.

Perry: Normally because of the cost and because of the time involved, you do it once a year.

So after you get your financial statements for the year then there’s another offering for that year.  So the valuation is actually done once a year and a new offering is made to the employees.

The other aspect is we’ve seen some companies do it sometimes semi-annually, but I would say well over 90 percent of companies in the private sector will do it about once a year to keep the cost down and to keep their employees focused on the growth of the company and not worrying about where the value of the company is at any particular moment day-by-day.

Ian: And one of the problems with owning shares in a private company is that there is no open market for those shares.  That makes them a relatively illiquid piece of equity.  How do employees cash out of an ESOP?

Perry: Well, when we do ESOPs for companies and we talk to the employees, the first question they have is well, how do I get out?  Okay, so they’re very knowledgeable when it comes to their own money.  And the way you do that is two ways.  One is called the shareholders agreement.  The shareholders agreement identifies all the trigger points or all the points where the employee will get their cash out of the company.  So for example, death, disability, retirement, termination with or without cause, bankruptcy, matrimonial.  There’s six or seven events that will liquidate the employees’ shares.

The other aspect to that is if the company is purchased or bought out then the employees would also be part of that.  One other thing we do put into the agreement is called a mini-market.  So once a year the employees can put shares for sale, and other employees can buy them.  It’s done once a year.  It’s controlled by the company.

The valuation is fixed, so you don’t have a bunch of employees over coffee deciding what they’re going to pay that day for value, and that creates basically a mini-market within the company itself.  And it helps create liquidity for people that let’s say need to sell some shares for a college education or a new car or a new house, whatever the reasons are, but they need some liquidity on their shares.

Ian: Now earlier on you mentioned that an ESOP is a good fit for one out of every four business owners, so it’s not a good fit for the majority of them.  How do you know whether an ESOP is right for you and your firm as an entrepreneur?

Perry: Basically, we recommend you do a feasibility study first to find out if it is good for you because as you say one out of four makes a good fit, and what we tend to do in that feasibility is number one, is the owner willing to share and understands the philosophy that it may be better to have a smaller piece of a bigger pie.

What we find in that feasibility study is that sometimes the owners really don’t buy into that philosophy and the ESOP is not going to fly.  You need a history of profits.  It’s important that the company either have a history of profits, or has the potential for profits in the future.  We also find that it’s important that the employees are willing to step up.  Not all employees want to be owners.

It’s an incredible idea but what we found and there’s been studies that verify this over the last 30 years is that one out of ten people are totally risk averse, and no matter what you offer them in terms of incentive or grants or whatever the program is, they will not purchase shares in your company.  It’s the other 90 percent that you want to engage in the growth of your company, and those are the people that you want to reach.

As an owner you have to have the desire and the confidence that you’re able to share financial information.  For owners that don’t want to share certain financial information this can be a problem, and it’s not that you have to disclose salaries or anything of a particular nature, but you have to be able to address that issue of financial information and how much is relevant to your employees.

And last but not least is you do need what we would consider an open and communicative culture within your organization.  If you have everything closed to the vast, non-transparency, people not talking to each other, that’s not going to be a good ESOP.

Ian: And I guess the question on everyone’s minds right now will be how much do they cost to implement?

Perry: Generally, for a small medium-sized company, there’s four components to every ESOP.  As we say, we recommend you do a feasibility study to make sure number one, that this makes sense for you, or are there other alternatives that would be better suited for what you’re trying to achieve.  The feasibility study runs between $5,000 and $7,500.

If you then go into the full phase of implementation, communication, and education of the program to your employees, then you’re looking at ESOP design roughly between $15,000 to $20,000, $25,000.  You’re looking at the valuation for a small, privately held company going in between $5,000 and $10,000.  And of course you only do the valuation going in once and then you come up with a formula which you use every year to minimize the cost.

That also includes any tax analysis and also tax structuring.

And last of course, you need the legals.  And the legals are focused purely on creating what we call the shareholders agreement.  And one of the things that you have to make sure in the phase II operation when you’re putting in the ESOP is that you get the employees involved.  It’s very, very important to get the employees involved to create what we call the ESOP blueprint.

And you then take that blueprint and you present it to the lawyer and say okay, here is what we want, it’s written in English, and we want this written up in legalese and that becomes your shareholders agreement, and that’s basically the process.  So all in, you’re probably looking between a $15,000, $20,000 on the low-end to probably about $50,000 on the high-end.

Ian: Perry, thanks for joining the Business Coach Podcast.

Perry: Thanks for having me.

Ian: Perry Phillips is the owner and president of Toronto-based ESOP Builders Inc.  That’s it for another episode of the Business Coach Podcast.  Be sure to check out other episodes which you can download from BMO.com/coach, profitguide.com and iTunes.  For other tools to help you build your business, visit the small business resources section on BMO.com.  Until next time, I am Ian Portsmouth, the Editor of PROFIT Magazine, wishing you continued success.

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