Hartford Business Journal

16 HARTFORDBUSINESS.COM | AUGUST 21, 2023 Michael Davis is the president of South Windsor HVAC sales and distribution company Flow Tech, which recently converted to an employee stock ownership plan, or ESOP. PHOTO | CONTRIBUTED Succession Planning Here's how one CT business used an ESOP as a buyout strategy By Harriet Jones Hartford Business Journal Contributor I n 2019, Rich Harper was antic- ipating retirement, and seriously contemplating the future of his successful HVAC sales and distribu- tion company, Flow Tech. "We were looking for a vehicle to transfer the company," he said in a recent interview. Harper had owned Flow Tech since 1998. Over the next two decades he grew it from three employees to about 25, moved its headquarters to South Windsor, opened a warehouse, and expanded its sales territory across New England. Also during that time — unlike most companies his size — he kept a close eye on a potential succession plan, identifying and training his successor, Michael Davis, who first joined Flow Tech as an intern in 2009. As he got ready to exit, continuity of the company culture was important to Harper, he said, as was retaining as many employees as possible to allow Flow Tech to build on past successes. They discussed a straight sale of the company to Davis, but decided that wasn't the best fit. Then, a rival company in Boston approached him, offering a buyout through an employee stock ownership plan — or an ESOP. That marriage didn't work out either. "But that sort of put the bug in my ear to say, well, let's further investi- gate ESOPs," Harper said. Eventually, in 2021, Flow Tech became a 100% employee-owned company, without an outside acquirer involved. Harper had his buyout strategy in place, while Davis became the company's new leader, as president. Planning for the future Employee stock ownership plans have been around a long time. First launched in federal law in 1974, as part of the Employee Retirement Income Securities Act (ERISA), they offer tax advantages to owners looking for an exit plan. Essentially, an ESOP sets up a retirement plan for company employees; that retirement plan buys out part or all of the existing ownership. The deal can be financed by the owner, who would then receive regular debt repayments from the company, a bank loan, or a combina- tion of both. Each employee is awarded company shares, which they can cash out when they retire. "I think it makes sense all the way around," said Harper. "The employees get ownership of it, it's a retirement plan and they don't have to put any money into it – all they have to do is just work hard. It's a tax-free entity just because it's a retirement plan. And it allowed me to get a fair price for the company." A recent survey shows that nearly two-thirds of small businesses don't have a documented and communi- cated succession plan, and only 30% successfully sell, leaving the majority without a buyer, or a concrete plan for the future. "There's this hole when it comes to succession planning," said Corey Veneziano, tax principal in professional services firm Clif- tonLarsonAllen's West Hartford office. "It's something that you really need to be thinking about five years out, or longer term, not three months from now." He said an ESOP isn't for every busi- ness, but it can be a useful tool to consider, particularly when the owner is concerned about legacy and culture, and where he or she has long-standing employee relationships. "It helps you exit the business, but it helps engage those employees even more," he said. "The work that they're doing and what they're contributing to the business directly impacts their retirement." Fair market value The downsides? Complexity and cost. ESOPs can be structured in a number of different ways depending on if the business is a C corp or S corp, and on whether the sale is financed by the seller or through a bank loan. Because they are retirement plans under the federal ERISA law, ESOPs are highly regulated. They require an independent company valuation, and the business must hire a trustee and board of directors to help leadership ensure the business is being run in the best interests of the plan. And that professional advice doesn't come cheap. "There's definitely a pretty high entrance cost," Veneziano said. Flow Tech's Davis said the company's initial transaction costs for the plan — including valuation consultants, attorneys and the trustee fee for both sides of the deal — amounted to $120,000. Other experts confirmed that figure is on the low side: most ESOPs require $150,000 or more to close. Many advisors don't recommend the model for a business with fewer than about 25 employees. In addition, there are ongoing annual costs — for a third-party administrator, valuation consultant, board of directors and the trustees — that, for Flow Tech, amount to north of $55,000 per year. Meanwhile, because the company's fair market value is established by an outside consultant for the benefit of the ESOP, it can also mean the seller missing out on a possibly inflated price on the open market. "Some owners that are really out for every last nickel, they're going to BY THE NUMBERS Employee Stock Ownership Plans 6,467 Total number of ESOPs in the U.S., as of 2020. 13.9 million The number of individual participants in ESOPs. 46 Total number of ESOPs in Connecticut, as of 2020. 10,644 The number of Connecticut participants in ESOPs. $1.8 trillion ESOP plan assets in the U.S., as of 2020. Source: National Center For Employee Ownership Corey Veneziano Rich Harper

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