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Value Series: Part Five

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Although many entrepreneurs might be more interested in sustaining or growing their enterprise, each owner will eventually need an exit strategy. Last week, we showed you how some business owners are passing their companies on to the next generation, either to a family member or not, through a succession plan. This week, we'll examine a lesser known strategy that is gaining popularity in Canada: exiting via an employee stock ownership plan (ESOP).

Traditionally, an employee stock ownership plan is used by businesses as an incentive to attract and retain top talent and to create a sense of ownership in the company.

But in the last 15 years, some Canadian business owners have also used an ESOP structure to transition out of their business, said Perry Phillips, the president of ESOP Builders Inc., a company that helps businesses create employee stock ownership plans. As opposed to a management buyout, where key members of an executive team buy a controlling interest in the company, employee stock ownership can take on a variety of forms. Ownership can be limited to key members on staff or it can be broad-based, and offered to anyone within the company. And owners who are seeking a gradual exit over time can retain the lion's share until they want to give it up.

"In an ESOP environment," Mr. Phillips said, "you're not relinquishing control until you're ready to leave."

But not all companies are suitable for this type of transition, he said. When ESOP Builders Inc. was founded 15 years ago, the majority of its clients were high-tech start-ups, with owners and employees who hoped to mimic Microsoft's success. Over the last few years, he said he's seen a variety of types of businesses make the transition.

"It's right across the board," Mr. Phillips said. "If there's a major labour component to the company, then an ESOP can play a role. We've seen architectural firms, financial companies, manufacturing wholesale distribution - they're all dealing with this demographic shift. They're all in a position where, whether it's going to be in the next 10 years or so, they're looking to exit."

Although many different types of industries may be suitable for an ESOP, smaller to mid-sized companies that have an employee-focused culture are more likely to be receptive to the idea. Viive Tamm, the president of Tamm Communications, a Toronto-based advertising and branding agency, chose an ESOP as her exit strategy because she wanted to reward her employees for their work in creating the successful business.

"We have a staff that I think is just absolutely incredible," Ms. Tamm said. "We start everyone with four weeks of vacation, there's all kinds of perks, and we've actually made the top 100 employers list. I said to [my husband]many years ago, 'I'd love to figure out a mechanism where the company belongs to the employees.'" Ms. Tamm researched the efficacy of ESOPs compared to other exit strategies, and found that although there have not been comprehensive studies on ESOPs in Canada, American numbers show that a business has a good chance of succeeding post ESOP transition. A Rutgers University study, completed in 2000, surveyed 250 companies with employee stock ownership plans and compared their performance to companies without them. ESOP companies increased sales by between 2.3 and 2.4 per cent each year.

By selling 49 per cent of the business to her employees, Ms. Tamm hoped that the company will flourish as workers take on ownership, and that through the success of the business, all parties will benefit. She has retained the lion's share of the company, although she believes that one day her employees will approach her to buy out the other 51 per cent. But for now, she continues to be involved in its operations and her name is still on the door.

"A major element is legacy," Mr. Phillips said. "[Business owners]feel like they have created a culture. In companies that founders have created, they're just like their children, and it can be very hard to leave it. They have a name in their community, a name on their products, services. They have relationships with their employees. Once you sell your company, you lose all that."

But unlike a succession plan where ownership changes hands from one to another, an ESOP structure allows for more flexibility. Owners like Ms. Tamm are able to sell shares over time. The tricky elements of succession planning, like grooming a new management team, can be achieved over a period of years, even though the ESOP structure can be implemented between three and six months.

But even though exiting with an ESOP may give an owner more control or flexibility in how it's achieved, the financial drawbacks can be significant. Unlike the United States, where ESOPs are regulated by the government, and owners and employees are offered tax breaks in exchange for their participation, no such federal legislation exists in Canada. Instead, ESOPs are regulated at the provincial level, and no incentives are offered to owners of businesses looking to sell in this way. In some provinces, like British Columbia for example, employees may receive 20 per cent in tax credits if they're purchasing equity interest in an employer's company.

And because ESOPs are designed to retain employees in the long-term, getting one's money out may take some time or have to happen over a period of time, depending on the shareholder agreement. According to David Clark, a corporate lawyer with Toronto-based Dale & Lessmann LLP, some agreements may stipulate a holding period of one to two years, when shareholders are prohibited from selling. Employees who wish to leave the company may not get all of their money up front, even after a holding period. If another employee does not want to buy the shares, the company will have to buy shares back, which may have to happen over time if it's a large sum.

Matthew Tevlin, a corporate lawyer who specializes in mergers and acquisitions for Toronto-based firm Torkin Manes LLP, warned that companies also have to disclose information, like their business secrets or financial reports, to show full transparency to their buyers.

"If you disclose some of the financial information and the deal does not close, and you've shown them how much money you've been making off their backs for so many years, they'll probably be disgruntled or unhappy about it," he said.

But Mr. Phillips warned that it may be more difficult for companies to find buyers as an increasing number of small to medium sized business owners are expected to be seeking some form of an exit. He expects many business owners will be looking at ESOPs as an alluring alternative to selling.

On Friday, we'll delve deeper into the ESOP process to explain how it works, and what major factors a business owner must consider in order to make a successful transition.

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