As Eugene C. Barton, a second-generation lumberman in Jonesboro, Ark., entered his golden years in the 1960s, he wanted to make sure his firm, E.C. Barton & Co., carried on after he was gone. With little interest from his own family to stay in the business, he transferred ownership to an employee-run board of directors, and gave it the mission of maintaining the company as an ongoing concern. By 1975, that board chose a new ownership structure for the operation, one that Congress had recently introduced: an employee stock ownership plan, or ESOP.

"The ESOP was the perfect thing for our company because it allowed the employees to own the company in perpetuity," says Tom Rainwater, treasurer at E.C. Barton. "Mr. Barton set up the original ownership board, which became the ESOP, for a few reasons. He felt that if employees had ownership, they would be more responsible. If they were more responsible, they would develop better work habits. And if they developed better work habits, it would improve the performance at each of our locations. You can see how it plays out down the line."

A 100% employee-owned company since 1998, E.C. Barton & Co. now boasts 140 locations in 13 states, with current year revenues projected at $350 million, compared to just $19 million in 1975. Many of the firm's 1,200 employees count balances in the high six-figures in their ESOP-funded retirement accounts. While the firm doesn't attribute all of that growth to its ESOP structure, Rainwater says it is one factor of the firm's success.

Once considered exotic, ESOPs are widely popular among small and medium-sized businesses. While there were just 200 ESOP companies in the U.S. in 1974, there are almost 11,000 today, most with fewer than 250 employees, according to the ESOP Association, an industry trade group in Washington. That growth among small companies has come for good reason. Not only have ESOPs paid off big for employee-owners such as those at E.C. Barton, but studies have shown that ESOPs result in increased sales, and that ESOP firms are more likely to stay in business. At the same time, ESOPs can provide an effective exit strategy for founders and owners who don't have family interested in maintaining a business.

"For someone who's looking for a way out but wants to make sure the business keeps going, an ESOP is an excellent vehicle," Rainwater says. With credit tightening and fewer deals in the acquisition pipelines in general, ESOPs also can provide an alternative to selling to someone else for less than an owner hoped. Beyond that, there are big savings on taxes while rewarding the front-line employees who helped build the business.

But things can go wrong at a poorly planned ESOP. The key to success, observers say, is to understand the process, educate employees, and groom the company's future leaders.

"ESOPs are definitely complex," says John Ganahl, CFO at Ganahl Lumber, an eight-yard shop in Anaheim, Calif., whose revenues have grown from $3 million to $291 million since the firm set up its ESOP in 1976. "Ours is about as vanilla as it can get, but it's still not a simple process."

Here's how it works: before retiring, an owner sells his shares in the company to a trust. That trust is usually financed by a bank, which lends money to the ESOP against the company's future earnings. In fact, a "leveraged ESOP," the most common kind, is pretty much identical to any other kind of leveraged buyout: the company takes on debt to buy itself, and has to pay that money back down the road. Owners also have been known to carry the note on that debt themselves, in effect allowing employees to pay them later.

As a company pays down that debt, workers receive shares of the firm through a vesting schedule based on their salaries and time at the firm. When an employee leaves or retires, the ESOP buys back the shares, providing an easy way for the worker to cash out at the end of a career. The plan is free for workers; they don't contribute any money to it. It can be set up at any time, and the owner can sell all or just part of the company.

But there can be snags.

One of the sticking points comes from valuing the company in the first place, a step required by law to be conducted every year by an independent third party. Value it too high, and the company risks taking on too much debt. Value it too low, and an owner doesn't get what he feels he deserves. "It's very easy to overburden the company with ESOP debt," says D.S. Berenson, a partner at law firm Johanson Berenson in McLean, Va., which specializes in ESOP structure. "Obviously, that becomes an even more serious issue if you're using a bank in terms of calling in the loan."

Another hurdle is the initial cost of setting up an ESOP and the ongoing expenses it takes to keep it running. "We probably pay $17,000 a year in administration fees and another $5,000 for the annual valuation," Ganahl says. Adds Berenson, "The downside of the ESOP is that it's complicated, it's expensive, and there are ongoing costs."

For those reasons, people who have gone the ESOP route say it's crucial to get an expert consultation on doing it right.

"The main challenge is to get people with specific expertise in ESOP governance to write and develop your plan," says Phil Skarada, president of Altoona, Pa.-based Your Building Centers, a 14-unit operation that grappled with ESOP-specific bookkeeping issues when it set up its plan in 1989. "A lot of local attorneys and local accountants don't really understand ESOPs."

The good news is that companies can deduct both the principal and interest while paying back the loan used to fund the ESOP initially. And at an S corporation, there's no income tax on the percentage of stock owned by the ESOP, meaning that a 100% ESOP company pays zip to Uncle Sam come April 15.

For that reason, many companies set up ESOPs for the cash flow benefits that come from the tax savings. In fact, that was part of the motivating factor at Ganahl. "We were a growing company, short on cash," Ganahl says. "By making a stock contribution, we could take a tax deduction, which helped save cash."

There are advantages for the owner-seller of a C corporation, as well. If the owner sells 30% or more to the ESOP, she can defer taxes by investing the money back into the stocks or bonds of other U.S. companies. Then if she dies before cashing out, the heirs don't pay any tax on the gains. Or an owner might sell stock in a C corporation to defer taxes, and then after a few years, the company converts to an S corporation to take advantage of those special tax benefits.

"Basically, you're selling your company for pre-taxed cash flow, and then you can defer the capital gains on the transaction indefinitely," says Walter Zweifler of New York-based Zweifler Financial Research, which conducts ESOP valuations.

At many firms, though, the value of ESOPs is somewhat less tangible, even if it's no less real. "People see that their future is tied to the success of the company," says Ganahl. "You get a lot of people working hard together to be successful, and we have been."

–Joe Bousquin