Employee Stock Option Plans

An ESOP's Tale
by Carol Lippert Gray

An IPO in which the dominant shareholder is the company's own employee stock option plan is a rarity. But Sawtek's CFO is bullish on the concept.

Ray Link had had no experience with either employee stock ownership plans or IPOs before he became vice president of finance and CFO of Sawtek in 1995, when the company was on the verge of going public with an ESOP as the dominant shareholder. He had written his Wharton MBA thesis on corporate pension plans. The rest was trial by fire.

Sawtek had been incorporated in 1979 in Apopka, Fla., just outside Orlando, by four former Texas Instruments employees. They wanted to develop, manufacture and market a broad range of electronic components for both consumer and military applications based on surface acoustic wave technology. "From 1984 to 1990 the company was relatively stagnant, with the bulk of its revenue through military applications," Link says. In 1991, Sawtek's founders decided to buy out the investors who had provided seed money. So the company borrowed $4 million from its commercial bank and loaned it to the ESOP to finance the purchase of over 8 million shares of common stock. "It was relatively straightforward," Link explains. "The stock was 22.5 cents a share on a split-adjusted basis and nobody saw any tangible value for some time. Many people decided to cash out and leave."

Then, in 1994, after one founder died and another wanted to leave the company, Sawtek borrowed another $1.7 million; the ESOP bought another million and a half shares of common stock. The first loan was repaid in 1996, resulting in the allocation of the related shares to the participants' accounts. And, notes Link, "As wireless applications for our products grew, so did the company's revenue."

Sawtek went public in 1996 at a split-adjusted price of $6.50 a share. The ESOP held as much as 65 percent of the stock at one point. "All of a sudden," Link says, "the value of the ESOP was real and represented fairly big bucks." Behind the scenes, though, things were complicated.

Telling It Like It Is
There are roughly 10,000 ESOPs in the United States, according to the ESOP Association in Washington, D.C.; about 1,000 are in publicly traded companies. But Michael Keeling, the association's president, says Sawtek is unique for several reasons.

First, he says, the company maintained its ESOP after going public (although the ESOP did become smaller). "An ESOP tends to get terminated after an IPO, because it can create misleading financial statements," Keeling notes. "ESOP shares have to be counted at market value as annual compensation costs. Higher compensation costs equal lower earnings per share. So it's difficult for a public company, particularly a mid-sized one, to maintain an ESOP after an IPO."

Then, Keeling notes, "You need enough shares out in the marketplace to give liquidity. A mid-sized company putting more shares in an ESOP might not make for a good-sized market. A huge company with millions of shares outstanding might still have difficulty with that."

And, he adds, "The thing about going public is, you've got to reach a critical mass, given all the overhead and extra expense of being public. You have to ask whether you're large enough; do you have enough gross revenues to afford SEC registration and compliance? What Sawtek did is a good model if you're there. When a company gets to be around $100 million, going public starts to become an option, although to me, $200 million in revenue is more viable."

And Sawtek's IPO was far from cut and dried. "As a private company, when employees left, we had a mandatory redemption liability," Link says. "The first three guys to leave would be paid, and then there'd be nothing left for everyone else." Thus, there had to be new ESOP guidelines - and a massive employee education program.

The new rules said that if an employee left the company prior to retirement, his or shares wouldn't be paid out for five years, at which point they'd be distributed over a five-year to10-year year period. "We had to explain why that was in everyone's best interest," Link notes. "After all, why would a shareholder want to buy our stock if there's a risk of everybody quitting?"

The company also instituted an in-service distribution that allows between 5 percent and 10 percent of an employee's shares to be rolled over into an IRA every year. Employee education - including meetings, printed materials and investment and tax seminars - was so successful, Link says, "Even janitors were asking about T-72 elections for their rollovers."

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