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ESOP Buyout Yields Tax Benefits for Both Parties

September 16, 1998|JUAN HOVEY

Raise your hand if this description fits you:

* You work for someone who thinks mostly about golf, not about growing the company.

* As a consequence, the company grows slowly, if at all, and you and your fellow managers feel frustrated and insecure.

* You know that if you and your fellow managers had control, you could grow the company and secure the future for yourselves and other employees.

* You have no idea how to bring this about.

What to do? Think ESOP--and listen to the story of Robert Babcock, president of NDS Inc., a manufacturer of plastic products used in landscape drainage and irrigation. NDS is based in the small Central Valley town of Lindsay and sells nationwide.

Three years ago Babcock and his management team put together an employee stock ownership plan and, using no cash of their own, bought out the founder of their company and embarked on an ambitious expansion plan.

Babcock doesn't disclose the company's revenue, but three simple facts tell you about the success story:

* At the time of the buyout, NDS employed some 120 people. It now employs about 350.

* The company made three acquisitions in the last year.

* The company's revenue doubled in the same time span.

The key was a simple ESOP, a powerful financing tool explained in this space recently. Most business owners set up ESOPs to give their employees an incentive to work hard, but you can also use an ESOP to pass control of a going business to a new generation, with substantial tax benefits to both seller and buyers.

*

When used in a takeover like that of NDS, an ESOP is a leveraged buyout--that is, the sale of a company's stock financed largely by debt. Federal law sweetens an ESOP buyout with tax advantages for the company founder who sells to an ESOP, and for the company itself, post-sale.

"Our previous owner wanted to retire," Babcock says. "We looked at a number of exit strategies and actually got close to selling to some strategic buyers in the industry.

"But the deals sounded kind of clumsy. Everybody wanted to put up only a little cash and let the business buy itself over a long period of time.

"That's good for a seller as long as the new owners run the company profitably and it grows. But you can't know that."

Enter Martin Sarafa, a director of the investment banking firm Houlihan Lokey Howard & Zukin, with offices in Los Angeles, and Churchill Capital Inc., a Minneapolis investor group that manages an investment fund specializing in ESOP buyouts.

In three months' time Sarafa and Churchill put together an ESOP controlling 30% of the stock in NDS. Churchill controls the other 70% outside the ESOP.

Churchill does not disclose the dollar value of its deals, but the NDS ESOP was financed entirely by debt; Babcock and the other employees put up no cash of their own to swing it. And it yielded two big tax advantages:

* Federal tax law permitted the founder of NDS to defer capital gains taxes on 30% of the proceeds of the sale--that is, taxes on the sale of his stock to the ESOP. The advantage did not apply to the 70% sold to Churchill outside the ESOP.

* Federal tax law also allows NDS to take a deduction against taxes on the money with which the ESOP repays the debt that financed its share of the deal. This improves the company's cash flow, making it easier for Babcock and his colleagues to retire the debt.

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They expect to retire that debt within two years, at which time the ESOP will become sole owner of 30% of the stock in NDS, with shares allocated to individual employees in amounts reflecting their compensation.

The company may go public thereafter, giving every one of its employees, even those at the bottom of the wage scale, a good chance to scoop up nice piles of cash.

The deal benefited NDS in another important way, Babcock says. Willard C. Shull, a former chief financial officer of Dayton Hudson Corp., and Gary Gottschalk, former group vice president of HON Industries Inc., sit on the board, and they bring big-company expertise to NDS' operations.

All in all, the deal has done good things for NDS and for the people who work there, Babcock says.

"An ESOP is a fabulous way to bring all employees into an equity position in a growing company," he says. "Without taking anything out of your own pocket, you gain control over your own destiny."

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How to get financing will be a topic of The Times' Small Business Strategies Conference Oct. 17-18 at the Los Angeles Convention Center. Columnist Juan Hovey will be featured. He can be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.

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