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NOVEMBER 30, 1999

SMART ANSWERS
By Karen E. Klein

The ESOP: Motivator for Staff, Tax Breaks for the Boss
Last in a two-part response on giving equity to employees at closely held companies


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Editor's note: The Nov. 25, 1999, Smart Answers column looked at how private companies can issue stock options, even if they don't plan to go public (Business Week frontier Online, "The Options Option: How Private Companies Can Use Stock as an Incentive," Nov. 25, 1999).


Q: I own a thriving Web business and would like the employees to share some equity in the company. We're small and have no intention of selling or going public in the near future. Yet I've been hearing a lot about the advantages of stock options. Can you give me some guidance?

---- B.B., Gardiner, Mont.

A:While you're considering stock options, says Corey Rosen, executive director of the National Center for Employee Ownership, an Oakland (Calif.) nonprofit group, investigate ESOPs (employee stock ownership plans). "The tax advantages of an ESOP are greater [than those for NSOs or ISOs], and it's foolish for a company not to take advantage of them," Rosen says.

To set up an ESOP, according to the NCEO, the employer creates a trust fund to which it contributes company stock or cash to buy stock. The ESOP trust fund can also borrow money to buy stock. Companies can deduct from their taxable income the contributions they make to the ESOP and the payments and interest on loans the ESOP fund takes out to buy company stock. The company can also deduct dividends paid on ESOP-held stock. The owner of a closely held company who sells at least 30% of the business to an ESOP can defer capital-gains taxes on the proceeds by reinvesting them in securities of U.S. operating companies (defined as those whose income doesn't come primarily from passive investment).

Because of their borrowing power and tax advantages, ESOPs are often used to buy out all or part of an owner's interest in a company. ESOPs aren't so common in new companies, mainly because the owners want to hold their interest in the company and because the costs of setting up an ESOP (perhaps $20,000) outweigh the tax advantages and other benefits when the company is not yet profitable and doesn't pay taxes anyway. ESOPs are highly regulated, and the stock must be held for a long time under the ESOP trust fund. Only after a participant retires or otherwise leaves the company does he or she receive the stock or the cash equivalent of the shares, depending on how the ESOP has been structured. If you're not convinced that you should give up equity, consider issuing "phantom stock," certificates that represent shares without transferring ownership rights. Whenever the company is reassessed, it makes payments in cash corresponding to any appreciation in the value of its shares.

You can also explore profit-sharing and incentive plans that reward employees who meet specific productivity goals. Such plans get around a major drawback to distributing private-company stock: There's no market for it. Consequently, outside the glamorous world of IPO-bound high-tech startups, employees may not find them motivating. That's why Joseph Sherlock, a Vancouver (Wash.) management consultant specializing in small to midsize businesses, often advises his clients to use bonuses and incentives that are tied to employee performance. "I had a warehouse crew shipping product on an hourly rate. I told them if they beat my expectations of their performance by 10%, they got a 10% bonus," he said. The employees perceived the bonuses as an immediate, monetary benefit, he said. "I reduced employee turnover by 80% after I put in performance-oriented bonus systems for my clients. I doubt that the creation of an employee stock ownership plan would have had the same result."

For more information on sharing equity, contact the NCEO at www.nceo.org. The organization sells a guide for employers, The Stock Options Book," via its Web site. There are many other books on the topic. Just make sure they've been updated since 1997, when rules governing stock options were changed. Another source of information is the Scottsdale (Ariz.) American Compensation Assn., www.acaonline.org..



Have a question about running your business? Ask our small-business experts. Send us an e-mail at smartanswers@businessweek.com, or write to Smart Answers, BW Online, 6th Floor, 2 Penn Plaza, New York, NY 10121. Please include your real name and phone number in case we need more information; only your initials and city will be printed. Because of the volume of mail, we won't be able to respond to all questions personally.

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