Building a Bridge for
Ownership Succession
By Bruce J. Reynolds, Economist
USDA Rural Development
usinesses of all sizes struggle to stay afloat during recessions, with some
eventually having to close. But small, family-owned businesses can
sometimes close even during good times for the general economy when
the owner retires. Such closures can have a major, negative impact on a
rural community.
Whether or not these businesses continue to operate after being sold may not be a
primary concern to many retirees. If the owner’s grown children are not interested in
keeping the family business in operation, an outsider may purchase the enterprise and
decide to cease the operations there. Typical buyers of small businesses are competitors
seeking more customers and inventory. They may want to consolidate rather than
increase their business locations.
A net loss for rural communities
Businesses that acquire other businesses will likely close
the new operating locations they’ve acquired when the cost
reduction of closure is larger than the expected loss in
revenue. This result depends on serving the same customer
base with fewer operating locations.
The acquiring business may even gain from closing
operating locations that, prior to the acquisition, were
economically self-sustaining. Yet, from the standpoint of the
local economy, this benefit for a business from closing newly
acquired locations is likely far outweighed by the costs of job
losses and less convenient service for local customers.
In many rural areas the former employees of a closed
business cannot find jobs without moving out of the area. For
local customers in rural communities the closing of a business
is often not merely a reduction in consumer choice, but a
major inconvenience when it means having to travel much
farther distances for shopping. If retiring owners care about
the survival of the business they built, they can take
preparatory steps to accomplish this result prior to their
retirement.
Succession planning
An alternative to selling small businesses to competitors is
for owners to develop a succession plan as a component of
their retirement plan.
When the owners’ children are interested in keeping the
family business, a relatively simple succession plan can be
worked out. When their children or other family members
are not interested, retiring owners often neglect to initiate
the process of succession planning before they retire.
If owners want their business to survive but are
considering a sale to non-family members, succession
planning is more complex. The original owner and potential
new owners (often the employees) must have a plan for
management that will keep the business operated as
effectively as it was under its former family-owners.
Some small business owners may not be aware of potential
tax savings from selling their businesses to employees. A welldesigned
succession plan is essential to transferring
ownership to employees in a way that will qualify for tax
savings.
1042 Rollover
Changes in federal tax laws in 1984 created a special
incentive for owners who sell their company to its employees.
Capital gains taxes on stock sold to employees can be
deferred by using the sales proceeds to purchase stock in
some other U.S. company. This opportunity for tax deferral
on the sale of a business is dubbed the “1042 rollover.” It
creates an incentive for proprietors or owners in a closely
held business to develop a succession plan of transferring
ownership to their employees.
The 1042 rollover has been predominantly applied to
ownership transfers under the terms of Employee Stock
Ownership Plans (ESOPs). It has been infrequently applied
to transferring ownership to worker cooperatives. One reason
for this is that many cooperative incorporation statutes
require 100-percent ownership by employees within a
relatively brief period of transition.
Accomplishing a 100-percent purchase of a company by
employees can take three to five years and be financially
prohibitive. Whether organized as an ESOP or a worker
cooperative, 30 percent of the stock must be purchased in the
first year as the minimum amount to qualify for a 1042
rollover. But ownership by a worker cooperative as compared
to an ESOP would require a larger loan, due to the 100-
percent equity requirement.
The ESOP is flexible in this regard because if outside
investors own 70 percent of a company, they can gradually
transfer more ownership to employees and take the tax
deferral on all incremental sales transfers. However, ESOPs
involve more administrative cost because of their regulatory
linkage to the Employee Retirement Income Security Act
(ERISA). Such costs include the appointment of a trustee to
administer the reporting requirements for holding employee
shares as part of their retirement plan and having an annual
appraisal of the firm’s value.
A worker cooperative is not subject to ERISA regulations,
so it is a cost-effective form of ownership for businesses with
relatively small employment and modest earnings.
Financing employee ownership
To be an employee-owned firm, a majority share of a
company’s stock must be held by the employees. The
purchase of a sufficient amount of stock shares by employees
to establish ownership and control of a business, whether
organized as an ESOP or a worker cooperative, almost always
depends on receiving a bank loan.
Lending to an ongoing concern for transferring ownership
is usually less risky than a loan for a business start-up. Yet, a
bank will consider the amount of debt the business is
currently carrying and the effect of adding more with a new
loan for the employee stock purchase. Another risk factor for
the bank in making such a loan is how well the business will
function under employee ownership and control.
Business & Industry Loan Guarantees
USDA Rural Development is authorized to provide loan
guarantees for lenders who finance infrastructure and
business development under its Business and Industry (B&I)
Guaranteed Loan Program (for more information, visit:
www.rurdev.usda.gov/rbs/busp/b&i_gar.htm).
The general objective of this program is to improve the
economy and quality of rural life. A B&I loan guarantee from
USDA reduces a bank’s risk to only 20 percent in the event of
default on loans of $5 million or less. When used for
employee ownership of businesses with a solid track-record
and sound plan for the future, this program saves jobs and
improves commercial and retail services in rural America.
Assisting a business that operates profitably in a given
location to continue to operate after its owners put it up for
sale fully meets the mission area objective.
Applying for a USDA B&I loan guarantee to support
employee ownership can make many businesses more
sustainable than they would be under a narrow ownership by
a single entrepreneur. A more widely distributed ownership
held by employees removes periodic discontinuity each time
a major or single owner seeks an exit strategy for retirement.
A wide range in age distribution of employee-owners can
stabilize a business from the standpoint of continuity in
leadership, experience and critical skills as retirements
periodically occur. Employees are highly motivated to keep a
business going because their jobs are at stake.
As of early 2008, only two B&I loan guarantees had been
made for employee ownership of a business. Both of these
guarantees were made to transition two family-owned
businesses into ESOPs. Both were provided by USDA Rural
Development’s Pennsylvania office. One was an electrician
service company. The other is described in more detail below.
Doucette Industries Inc.
The term “small business” is defined as a business with
less than 500 employees, which comprises a wide range of
companies in terms of employment, but also in the volume of
sales, assets and management complexity. Two examples of
small businesses in rural communities with modest holdings
of physical assets — one operating as an ESOP and the other
as a worker cooperative — are profiled in Rural Cooperatives
magazine, July/August 2007, pages 28-31 (past issues are online
at: www.rurdev.usda.gov/rbs/pub/openmag.htm).
Employee-owned companies are also represented in
industries with relatively complex manufacturing. Doucette
Industries, Inc. is one example. It produces a range of
standard and specialized heat exchangers for refrigeration and
air conditioning applications. It was owned by one family
until a program of employee stock purchase was started in
1993. In 2003, a complete ownership transfer to employees
was made as an ESOP company.
Headquartered in York, Pa., Doucette Industries has added
a production location in Clearwater, Fla. It has 40 employees
with annual sales that average between $6 million and $7
million. It provides customized heat exchanger development
to meet very specific customer needs. In fact, Doucette serves
customers throughout the world. Its website provides details
on its capabilities and services (www.doucetteindustries.com).
Employee ownership in stages
Doucette Industries began succession planning in 1993
when it started a program for employee stock ownership. At
that time, a father and two sons were sole owners. When it
incorporated, company stock was divided into two classes,
with voting shares of about 25 percent and 75 percent as
non-voting stock.
The father held slightly more than 50 percent of the
voting shares. As part of their compensation, in 1993
employees began to annually receive shares of non-voting
stock.
By 2003, most of the non-voting stock, or about $2.25
million worth, had been transferred to employees. To
complete the ownership conversion to a 100-percent ESOP,
$750,000 in voting shares and an additional $ 250,000 in
non-voting stock needed to be purchased. Two separate bank
loans to Doucette Industries were necessary to transfer that
amount of stock. But banks usually require some type of
personal guarantee on loans for the purchase of equity.
The USDA Rural Development office in Pennsylvania was
contacted by Doucette Industries about financing the
ownership transfer to avoid personal guarantees. After
examining the company’s financial condition and its earnings
prospects for the future, USDA approved the B&I loan
guarantee for the larger loan.
A bridge to new generations of ownership
The employees of Doucette Industries today have more
control over their economic destiny because they have a voice
in such decisions as job reductions or plant closure, as well as
in more positive directions such as hiring and business
expansion. Creating an ESOP at Doucette Industries was not
only good for employees, but also made it feasible for the
owners to defer taxes on capital gains from the sale of their
business.
The transition of family-owned businesses to non-family
members is often a far more financially difficult process than
is the sale of firms with publicly traded stock. Rural
communities also have fewer buyers for their businesses than
those located in urban areas. In turn, a closure of a business
in rural areas often results in population losses as
unemployed workers may need to seek jobs elsewhere.
The Rural Development B&I loan guarantee program has
potential to be an effective “bridge” for making it possible for
workers to keep many family-founded businesses in operation
for the future.
