Is Employee Ownership Right For Your Agency? Part I

IS EMPLOYEE OWNERSHIP RIGHT FOR YOUR AGENCY? PART I

by Carol Hammes

Offering your employees the opportunity for agency ownership can help attract and retain quality people.

Independent insurance agencies face the challenge of providing incentives that reward individual employees for their support of the group effort. Sooner or later, most agency owners will need to decide whether to give their employees the ultimate incentive: The opportunity to obtain equity.

Two decades ago, the term equity was almost always associated with actual ownership in an agency through the transfer of stock or partnership shares. Today other options can give deserving employees a piece of the action without compromising agency perpetuation plans or the principals’ voting rights. Although an employee’s contribution to achieving agency goals should be a criterion in selecting future owners, don’t base the decision to share agency ownership solely on the desire to reward performance. If your best producers or managers lack the other qualities that you want in fellow owners, offer them other types of incentives.

These ownership incentive options include:

1. employee stock ownership plan (ESOP)
2. individual stock ownership
3. phantom stock/performance units
4. vesting in a book of business

This article will discuss the ESOP and individual stock ownership options. A second article will focus on the phantom stock/performance units and vesting approaches.

In evaluating your options, remember that implementing any type of equity-sharing program is more permanent than simply giving a raise or bonus. Before tying individual performance to the value of a book of business or of the agency as a whole, all of the owners need to evaluate their own personal desires and to jointly decide what they want for the future of the agency. Consider each alternative in the context of the goals of the existing ownership group, based on their compatibility with the bigger picture.

EMPLOYEE STOCK OWNERSHIP PLANS

An ESOP is an employee benefit plan in the form of a trust fund that invests primarily in agency stock. In effect, it’s a deferred compensation plan in which employees participate in the ownership of the agency based on their salary and length of service. Setting up an ESOP lets owners give employees the opportunity to share in the growth of the agency, without taking a reduction in take-home pay, as they would if they were to buy stock directly. Basing salaries on individual performance means that the employee’s contribution to the ESOP will also be based on performance — so the plan can provide an incentive program that rewards both individual and group results.

ESOPs were popular in the 1980s more as an internal perpetuation mechanism than as an employee incentive program. Although changes in the tax laws have reduced some of the benefits in using ESOPs as perpetuation financing plans, they still offer an attractive ownership transfer option for agencies that meet certain stringent criteria:

1. The agency principals must favor employee ownership; however, it’s not necessary to give ESOP participants voting rights.
2. The agency must have a large enough profit potential (22%) and high enough eligible payroll costs (at least $500,000) to fund the ESOP and its relatively high administrative costs.
3. Agencies in which revenues and profits haven’t been growing at a healthy rate might risk having the stock price decline after they implement the ESOP and should probably hold off on adopting the plan until stability returns. A number of appraisal methods can be used to determine fair market value.
4. At least one person in the agency must be capable of running the place after the current owners leave or start to slow down. Although ESOPs can help with the financial aspects of perpetuation transfers, they can’t provide ongoing management direction for the organization. In short, no matter what your plans for perpetuation or employee participation, your agency still needs strong leadership.

Agencies that meet these criteria can enjoy significant advantages by adopting an ESOP:

• Tax benefits: A tax free (Section 1042) sale provides the single greatest benefit of an ESOP. The selling shareholder may sell at least 30% of the agency’s value to an ESOP. They then borrow 90% of the amount and buy a corporate bond, which provides the funds to buy the Qualified Replacement Property (QRP). In other words, the seller needs only 10% of the amount of the sale.
• Higher agency value: Sellers can obtain a better price for their shares because the ESOP will enhance the cash flow available from the agency. The reason: The appraisal is done under Revenue Ruling 59-60 of the IRS Code for Estate Value (created by the IRS to increase the value). Sellers can also start to get their equity out before they retire.
• Deductible debt service: The principal of the loan is paid from a tax-deductible contribution from the agency to the ESOP.
• Greater stock liquidity: This is assured by making cash contributions to the ESOP and selling agency stock to the plan. It is not selling to a minority shareholder because the agency owners control the vote and the ESOP. The ESOP can provide both a market for agency stock and a valuation basis for estate planning purposes.
• Improved employee morale and productivity: A number of studies have shown that, all other things being equal, agencies with employee ownership have higher morale and improved levels of productivity. An ESOP should enhance teamwork in agencies that already enjoy good employee relationships. Be sure to communicate the benefits of the plan to your staff.

On the other hand, ESOPs have two disadvantages:

• Cost: An ESOP should cost approximately $10,000 to set up, plus another $7,500 for the initial appraisal. Annual administrative costs will be $1,500, plus $25 per participant. In a leveraged ESOP, the agency must make a predetermined contribution every year to meet the loan payments — a commitment that can be difficult during tough times in the market or economic cycle. If the agency has a large number of older employees who’ve been with the firm for a long time and are making pretty good salaries, the buyout obligations could be significant in the not too distant future. The remaining agency principals need to be careful how they spend money because their fiduciary obligation to the employees and the stock value will have to take precedence over personal goals in making management decisions on spending the agency’s money.
• Regulation: ESOPs come under federal ERISA guidelines and restrictions that can impose a heavy fiduciary responsibility.

Agency principals who are considering an ESOP should investigate the pros and cons and have a feasibility study done by a reputable financial consultant with experience in insurance agency situations. This research should include talking with the remaining agency principals in firms that instituted ESOPs several years ago. Asking the principal who sold out and got top dollar for the shares about the advantages of an ESOP won’t give you the complete story.

INDIVIDUAL STOCK OWNERSHIP

Agencies that plan to perpetuate internally will be looking for employees with an entrepreneurial spirit, a desire to participate in management, and a willingness to contribute to the buy-outs of retiring owners. Most employees will say that they’d like to be owners, but when push comes to shove only a small percentage of them are willing to make the financial and personal sacrifices associated with a major ownership role. Promising ownership when you hire someone is like playing Russian roulette with five loaded chambers. No matter how qualified a candidate seems, you can’t know at that point whether they’ll work out as an employee, much less as a potential agency principal.

The initial employment contract and/or compensation plan can certainly indicate an intent to consider the person for ownership, as long as it spells out the criteria (on both sides) for this to occur. The contract should present a specific timetable for the decision. Just saying to someone “if you do a good job we’ll make you an owner” won’t cut it. How do you define “good job?” When will you make the ownership decision? How much ownership are you talking about? Will the stock be given to them, or must they buy it and at what price?

Because it generally takes an employee several years to acclimate to the agency environment before producing at an optimum level, most agencies will consider someone for ownership only after they’ve been employed for at least two years. At that time, successful candidates will be allowed to either:

1. Purchase stock immediately (with or without a discount).
2. Receive a stock option for purchase (usually at a discount or with a frozen value).
3. In the case of a family situation, be given stock. Depending on the perpetuation goals and personal wishes of the principals, ownership can take the form of voting stock, non-voting stock, or junior stock.

If you’re giving a discount or the amount of stock being offered is flexible, it’s appropriate to base your decision on some measurable aspect(s) of the individual’s performance as a producer or employee. These might include: Prospects obtained; effective hit ratio; commissions written; department/unit growth or profit; professional designations; etc. However, take care not to offer too much of a discount from the value that the current owners are using for their Buy-Sell formula.

Because there’s a finite amount of money available for perpetuation, if the new owners don’t put enough into the ownership pie (directly or by way of increased production with lower compensation percentages); make sure that there will be enough capital available to buy out the existing owners when they retire.

The second part of this article will focus on two other ownership incentives: Phantom stock and vesting in a book of business.

To be continued.

The late Carol Hammes, principal of The Middleton Group, was one of the Independent Agency System’s most widely respected management consultants. She will be sorely missed.