In the midst of the bustle of running your restaurant, perhaps you sometimes pause to remember when you first opened your doors. Do you think about that future day when you’ll make your exit?
Barbara Gabel and Zach Zachowski, who are self-described “think-ahead types,” began to consider their exit strategy when they reached their early 50s. The husband-wife team had no family member to take over Zachary’s Chicago Pizza in Oakland, California, and they balked at the notion of selling to just anybody.
Would a new owner maintain the product quality and workplace environment that had made the restaurant a Bay Area icon, as some observers have described it? What would happen to employees, many of whom had worked at Zachary’s for a decade or two?
“Even a benevolent owner could come in and change the dynamics, the mojo, the benefits, the pay,” Gabel says. “We didn’t want that.”
The solution the couple struck on was an employee stock ownership plan (ESOP), established at Zachary’s in 2003.
Currently there are about 11,500 ESOPs in the United States, covering 10 percent of the private-sector workforce, according to The ESOP Association in Washington, D.C. “An ESOP is similar to a profit-sharing or 401(k) plan in many ways,” explains Corey Rosen, executive director of the National Center for Employee Ownership in Oakland, California. “But unlike those plans, an ESOP is designed to invest in company stock.”
The company puts money into the ESOP and gets a tax deduction for doing so. The ESOP uses that money to buy company shares from the owners; employees don’t pay for shares out of their own pockets. That’s a tough concept for people to comprehend, Rosen acknowledges, but it’s critical to an ESOP’s essence.
“If employees had to buy stock with their own money, it would never happen,” he says. “An ESOP is a way for the company’s tax-deductible future earnings to purchase shares from the existing owner.”
To be a viable candidate for an ESOP, a company should be profitable and have a healthy cash flow. Depending on company size, it costs at least $40,000 to create an ESOP, plus $12,000 or more for annual maintenance fees, Rosen says. A restaurant should have at least 20 employees and sales of $1 million or more for an ESOP to make sense, he adds.
ESOPs are complex, and, because these are tax-deferred employee retirement plans, they’re subject to Internal Revenue Service and Department of Labor rules. For instance, all employees age 21 or older who work at least 1,000 hours a year must be allowed to participate.
To install an ESOP, a company must be either an S or C corporation, or convert to one. In a C corporation, an ESOP allows the owner to defer capital gains taxes on the sale proceeds by reinvesting that money in other securities. The ESOP must own at least 30 percent of the stock for this deferral to kick in.
An S corporation with an ESOP offers a different tax advantage, according to Jude Anne Carluccio, chair of the ESOP practice group at Barnes & Thornburg LLP, a Minneapolis law firm.
“In an S corporation, which a lot of small businesses are, the ESOP is considered a tax-exempt shareholder,” she explains. “So cash that otherwise would go to pay taxes at the shareholder level is instead used to help fund the ESOP’s stock purchase. Or, if the S corporation is owned 100 percent by the ESOP, (it is) kept in the company to fund company growth initiatives.”
Still, with all the tax advantages, another factor often poses the strongest appeal to owners. “Most small business owners I’ve worked with want to keep their dream going,” Carluccio says. “That’s one of the big pluses of the ESOP as a transition vehicle. It allows owners to perpetuate the dream they’ve actualized.”
In 2000, Johnny Huntsman set up an ESOP at Johnny’s Pizza House, headquartered in West Monroe, Louisiana. The company now has 28 area locations. “He wanted an exit strategy,” says president/CEO Melvin DeLacerda, “and he wanted to reward employees who had helped him build the company. The ESOP accomplished those goals.”
DeLacerda, who started at Johnny’s 30 years ago when he was a high school student working part time, believes the ESOP is a valuable retention tool. “Our turnover for managers, and even assistant managers, is extremely low,” he says. “A lot of things enter into that, but the ESOP plays a big part.”
Still, employees often are skeptical when they first hear about the ESOP, DeLacerda admits. They can’t believe it costs them nothing, and they don’t fully comprehend the benefit until they see it. “We have store managers and even delivery drivers who have account balances that amaze them,” he says. “They never could have saved that much on their own.”
Today the ESOP owns 62 percent of the company’s stock, while Huntsman retains 19 percent. Two other individuals hold the remainder. “Johnny is tickled to death about how well this has worked,” DeLacerda says. “We now have an ownership culture among our employees. Even though we had a good culture to begin with, the ESOP has solidified it.”
At Zachary’s Chicago Pizza, which now has three locations, the ESOP owns 100 percent of the company. Gabel and Zachowski turned over the last 25 percent to the employees on July 25, 2010, the company’s 27th anniversary. “As Zach put it, ‘It’s their turn now,’” Gabel says. “This was a good way for us to go out.”
It’s also a good deal for employees. Kevin Suto started out at Zachary’s in 1984 as a dishwasher and rose to the position of general manager. “I’ve done pretty much every job there is here,” he says. Last summer, Suto became the new CEO and chief financial officer. Now 44, he looks forward to the ESOP providing him an attractive retirement payout.
That’s if, of course, the business continues to succeed. “Your stock is only as valuable as the company is,” Suto says. “So there’s a motivation for all of us to leave the company even stronger than it was when we arrived.”
Dianne Molvig is a freelance writer in Wisconsin.