We love our employees. We think we have some of the smartest, hardest working, most incredible people on the planet. They have made Lullabot tremendously successful, and we want them to participate and benefit from what they have helped create.
So we made them all owners.
Matt Westgate, a founder and, for the last few years, the primary stockholder of the company, has been talking for years about his dream of making Lullabot into an employee-owned company. After lots of research into various alternatives, we created and implemented an Employee Stock Ownership Plan (ESOP) in January, officially making Lullabot 100% employee-owned!
Employee Ownership, It’s Complicated!
Making employees into owners is a goal that’s easy to understand but complicated to accomplish. The most obvious solution—issuing individual shares of stock to each employee—actually has numerous problems. At Lullabot, we started down that route with equity stock grants and an employee stock option plan before determining that the ESOP was a better solution.
Lullabot is a Subchapter S corporation, a common type of small business organization. In this type of organization, each employee-stockholder has to show their pro-rata share of company profits on their individual tax returns and pay income taxes on Lullabot’s profits. That does not just mean federal taxes but also filing and paying personal income taxes in every state the company does business in! This tax situation turns exercised stock options or other stock equity awards into an income tax quagmire for stockholders. Another limitation of a Subchapter S corporation is that there is a hard limit, 100, on the number of shareholders it can have. Lullabot isn’t that big yet, but it could be at some point.
Lullabot could have re-organized into another corporate form, like a Subchapter C corporation, another alternative we researched. But the reorganization process is expensive and would have created a completely different set of tax problems for both the company and the employee stockholders.
An additional problem is the lack of a ready market for small company stock. At some point, employees will want to retire or terminate and liquidate their shares. If the company was publicly traded, that would be no problem; employees could sell their stock on the public market and get the current fair market value. Small corporations aren’t publicly traded, and the stock can’t be sold to just anyone.
Generally, you can only sell small company stock back to the company. But that requires that the company have enough cash to repurchase it, a process for assessing the value of the shares at that point in time, and a way to prepare systematically for future redemptions. The more shareholders you have, the more complicated that exercise becomes, and the more chance that the company would be overwhelmed by the redemption process and by unexpected needs for cash.
ESOPs address all of these considerations and more. Many companies have discovered ESOPs. The National Center for Employee Ownership (NCEO) estimates that there are roughly 6,600 employee stock ownership plans (ESOPs) covering more than 14 million participants. Most ESOPs are fairly small companies like Lullabot, although some are quite large.
The ESOP is actually a trust that owns some or all of the company's stock, and the employees are beneficiaries of that trust. The trust is technically a retirement plan, governed under the same set of rules that governs other retirement plans like 401ks. As with other retirement plans, it has a tax-advantaged status. Equity stock awards, and the pass-through corporate income for the stock held in the retirement plan, are not taxable while held in the trust. We will use those tax savings to pay for the costs of creating and maintaining the plan and managing stock redemptions.
ESOPs are regulated and protected. A third-party record keeper keeps track of how much stock should be allocated to each employee and handles the logistics of distributions and redemptions. A third-party trustee watches out for the best interests of the employee-owners and makes sure we do things like getting annual, independent, company valuations to support our stock price.
The ESOP plan spells out exactly how stock will be distributed and how, and when, employees can redeem it. Everyone must be treated equitably and should be able to see what they have, what it’s worth, and know how to redeem their ownership shares.
To implement our ESOP, we hired an ESOP specialist, SES ESOP Strategies, to navigate us through the process. We then had to find a third party to act as a trustee. After interviewing several, we chose GreatBanc Trust as trustee. Our trustee then hired a firm to determine an independent valuation for the company. SES created the ESOP trust and plan, which the trustee had to approve. Only US citizens can belong to an ESOP, so we also created a phantom stock plan so our non-US employees could participate.
Finally, the company bought back all the outstanding stock, including all the stock options previously issued to our employees. We carefully modeled the future cash flows from the changes to be sure the ESOP would be healthy. Based on our cash flow model, we determined we could pay the value of the options in cash, giving our employees a nice bonus, and we will gradually pay for the rest of the stock purchases over the next ten years.
Once the company had repurchased all its stock, we then issued stock to the ESOP, officially making the ESOP the sole owner of Lullabot.
The process of cashing out all the value of the company to create the ESOP reset the company’s value to nothing, so there is no immediate value to the employee stock. But as the company pays down the ESOP-related debt, and assuming the company continues to operate as successfully as we have operated in the past, we have every reason to believe that our new employee-owners will rebuild the value of the company in the next few years to as much or more than it was worth when we started. And everything they create will belong to them!
The next thing on our agenda is learning how to manage our ESOP. Several of us are planning to attend the NCEO annual conference in April, and we’re excited about the journey ahead. Also, we’re getting ready to do some hiring. We’d love to add more employee-owners, so keep an eye out for announcements about new job opportunities at Lullabot!
More ESOP Information
If you’re intrigued about ESOPs, the NCEO has a trove of information, including how ESOPs can be used to transfer ownership to the people who helped build the company, the benefits of an ownership culture, and measurements of the success of employee-owned firms.