When all the staff own a veterinary hospital

Practitioners recount benefits, pitfalls of employee stock ownership plans

November 1, 2022 (published)
Photo courtesy of Annette Engler
Team spirit: Annette Engler (center front), who set up an ESOP at a veterinary hospital in Michigan in 2016, is photographed with some of her staff during a baseball-game outing.

Approaching retirement, most owner-practitioners sell to a trusted colleague or court a big corporation capable of paying a handsome sum for their veterinary business. Some owners, however, have in mind buyers who may be of more modest means.

Employee stock ownership plans (ESOPs) allow proprietors to sell their company to the entire rank-and-file — whether they're veterinarians, veterinary technicians, kennel workers or reception staff — all while getting a decent sale price in the process.

Complex and often time-intensive, ESOPs are rare in veterinary medicine. But rising ownership concentration in a profession that is struggling to retain talent is inspiring at least a few practitioners to try them out.

Among them is Dr. Randy Spencer, who set up an ESOP last year at 1st Pet Veterinary Centers, which has three hospitals in Arizona that employ a combined 300 people.

"I've always felt that veterinarians do pretty good, but for our technicians, our customer service representatives, and others, there's not a retirement plan there for them," he said. "That's what intrigued me about an ESOP. I'd been looking for a way to keep our people for the long term ... providing a great future for those who stay with us."

Spencer also wasn't keen on the idea of selling to a consolidator, which he feared might compromise the legacy of the business by prioritizing profits over caring for animals and staff.

Further down the track is Annette Engler, who in 2016 set up an ESOP at Union Lake Veterinary Hospital in Michigan. At the time, a junior partner wanted to sell his 25% stake in the business but couldn't find a buyer. He sold the stake to the ESOP, which has about 70 employee shareholders.

"It's going very well," Engler, a veterinary technician and the hospital's administrator, said. "The employees reap the benefits of their hard work and feel like they're valued, like they're part of the profitability of the practice."

How they work

In brief

Establishing an ESOP involves setting up a trust, which then buys all or part of the veterinary business from the seller. Employees are allocated shares in the trust, giving them a direct stake in helping the business succeed. They don't have to pay anything for their shares: The trust funds the purchase of the veterinary business with a loan, paid off over time using the business' profits.

Loans to ESOPs can be provided by a bank or the seller. The latter occurred at 1st Pet: Spencer lent the ESOP the money it needed to buy his business from him. He'll get the money back, plus interest, as the business pays off the loan — provided it remains sufficiently profitable.

ESOPs are found in various countries, such as the United States, Canada, the United Kingdom and Australia, and generally are given generous tax treatment by governments. Under U.S. law, sellers into ESOPs don't have to pay capital gains tax if they invest their sale proceeds into stocks and bonds. The ongoing shareholders of ESOPs reap tax benefits, too. ESOP profits typically aren't subject to federal or state corporate taxes.

"While we don't mind paying our fair share of taxes, we would much rather take care of our employees who are putting their blood, sweat and tears into the practice," Engler said. Union Lake's ESOP, now six years old and still owning 25% of the hospital, has paid off its debt, she said, and some of its veterinarians own stakes of substantial value.

"I think it took a while for people to understand exactly what it meant," Engler said. "I think they thought it was like a profit-sharing plan where they were going to get a couple of hundred dollars a year.

"Then they started realizing — they get a stock statement every year, and they started to see that their balances were in the thousands and sometimes tens of thousands."

How many shares each employee gets in the ESOP usually is determined in proportion to the size of their salary and/or how long they've spent at the business.

'Flaming hoops'

For all their purported benefits, ESOPs have drawbacks and may not be appropriate in all circumstances. For one, ESOPs are complicated, highly regulated structures that proponents say should be set up with the assistance of lawyers and financial advisers with specialized knowledge of how they work.

Hiring all that help translates to high set-up costs. Ongoing expenses can include performing mandatory annual audits, independent valuations and employing a trustee to oversee corporate governance.

"It was intense," Spencer said of starting 1st Pet's ESOP. "It probably took about seven months to land after we decided to set it up, and we had to jump through a lot of flaming hoops as fast as we could." Still, he anticipates the tax benefits associated with being a 100% ESOP will more than cover the administrative burden.

Given the upfront costs and complexities involved, the National Center for Employee Ownership, an advocacy group, generally recommends that businesses considering an ESOP have at least 15 employees. "There are a handful of ESOPs with under 10 employees, and a larger number between 10 and 20, but in most cases, at least 15 employees is a reasonable starting point," the NCEO advises.

Perhaps reflecting the complexities, the number of ESOPs in the United States has declined slightly each year since 2014, according to NCEO figures. In 2019, the latest year with available data, the number of ESOPs stood at 6,482, with 13.9 million total participants. That's down from 6,717 with 14.05 million participants in 2014.

The decline comes despite academic research indicating that ESOPs tend to perform better than non-ESOPs financially and in terms of employment stability, according to papers cited by the NCEO.

ESOPs can have a limited shelf life even if they succeed. There is nothing to stop employees from eventually selling out, as was the case in 2019, when a craft beer ESOP, New Belgium Breweries, was sold to Japanese brewing giant Kirin. The outcome wasn't necessarily bad: More than 300 employees received over $100,000, and some much more than that, out of a total payout of nearly $190 million, according to company founder Kim Jordan.

Additional hurdles

Factors that can add layers of complexity include, in the case of veterinary medicine, a company's geographic location. Some states mandate that veterinary companies must be owned by a veterinarian. That means anyone wanting to establish a veterinary ESOP in those states must do the same thing corporate consolidators do to get around those rules: Set up a separate management company to hold various assets and do a joint-venture deal with the veterinarian-owned company.

Moreover, ESOPs can be set up only by so-called C corporations or S corporations, which have more rigorous reporting requirements than the limited liability company (LLC) structure favored by many small businesses.

LLCs can be transformed into C-corps or S-corps, but that transformation may trigger tax expenses, warns Dr. Beth Davidow, a veterinarian based in Seattle and board member of the Veterinary Information Network, an online community for the profession and parent of VIN News.

"What's really hard about ESOPs is the rules are really complicated," Davidow, who blogs and lectures about ownership issues in the veterinary profession, said. "The business structure that you've chosen or the business structure that you're currently in may make it easier or harder to set one up."

Davidow and her partners considered an ESOP about 10 years ago for their LLC practices but found it too complicated and costly to proceed.  Not to be deterred, she is co-founding another veterinary emergency and critical care hospital, and employee ownership is the partners' end goal.

"This isn't something to decide to do six months before you want to retire," Davidow said. "You need a three-year runway at a minimum to think about this."

Having an LLC structure doesn't necessarily put an ESOP out of reach, according to Tom DeSimone, a director at Prairie Capital Advisors, which helped Spencer set up 1st Pet's ESOP. He reckons the conversion to a C-corp or S-corp is relatively straightforward and can be done in a manner that minimizes tax liability. "It can be accomplished through a little bit of reorganization work, creating a brand new holding company, which houses your ESOP.”

Preparing for a rainy day

Once an ESOP is in place, a key risk is that multiple staff leave at once. Because employees in ESOPs are paid out the value of their shares when they leave, a spate of departures could put heavy pressure on cash reserves.

"That's the biggest bugaboo," Spencer said. "As you get down the road and people start retiring, you have to have enough money to send their way."

Consequently, it is considered unwise to set up an ESOP for a business that lacks a track record of profitability. "You have to start saving now for that eventuality, just like if you need to buy a new piece of equipment like an X-ray machine or CT," Engler said.

Most ESOPs also have so-called vesting periods, typically five or six years, during which employees can't access their shares or can access only a portion of their value. Once staff members leave, their payouts can be spread over a few years to soften the blow to the balance sheet.

Looking at the bigger picture, ESOP proponents contend that giving employees a greater stake in the business acts as a strong motivator for them to stay. They stress, however, that an ownership culture also must be fostered that allows the rank-and-file a greater say on how the business is managed.

A failure to do so can cause an ESOP to crumble, as was arguably the case with United Airlines. The U.S. carrier established an ESOP for pilots and machinists in 1995 and initially saw a bounce in its share price. By 2002, following tensions with unions, the airline had gone bankrupt.

For Spencer, the desire to establish an employee ownership culture came first — before he knew what an ESOP was. Each month, he huddles with employees to share details of company financials and encourages them to suggest how the business can be improved.

An ESOP consolidator

There is another potential pitfall associated with ESOPs. By law, they are required to pay "fair market value" for what they buy — a legal term for the price a willing buyer would pay a willing seller, assuming neither party is under duress.

Applying fair market value might limit the amount of money a seller can receive for their veterinary business, especially if a bank is needed to fund an ESOP purchase. Conversely, selling to a corporate consolidator might attract a higher bid, in part because the consolidator can achieve cost savings by eliminating overlapping expenses and benefiting from economies of scale.

At least one company is trying to combine the best of both worlds. Galaxy Vets was set up last year with the aim of becoming part ESOP, part corporate consolidator. The company, incorporated in Delaware, is in talks with private-equity investors that would potentially take a "significant" minority stake in the business, with the ESOP holding a substantial minority stake, too, Galaxy's founder and chief executive Dr. Ivan Zakharenkov said.

Zakharenkov declined to disclose how many practices Galaxy owns, saying only that the company expects to have 12 by the end of 2022. Before establishing Galaxy, he spent 12 years practicing in Canada, often in emergency settings, before creating workflow optimization software SmartFlow, later acquired by Idexx Laboratories. He said he was inspired to set up Galaxy by what he saw as a failure by consolidators to look after staff.

"Consolidation is essentially failing right now," Zakharenkov said. "Hospitals are closing because there's not enough people on their staff to go around."

The benefit of bringing private equity to the mix, Zakharenkov maintains, is that Galaxy can offer more money to acquire practices than your average ESOP.

To be sure, private equity groups typically are short-term investors, selling, or "flipping," assets a few years after they buy them. They also have a reputation for cutting costs as they try to offset the lofty prices they pay for assets and satisfy their backers' demands for high returns.

Zakharenkov hopes to recapitalize Galaxy, though he's set a longer-than-average investment horizon of five to seven years. His preference is to do an initial public offering that would see Galaxy's shares listed on the stock market. If the stock market is unattractive at the time, he said, the company would consider other exit strategies, including selling to another company that kept "veterinary medicine in the hands of veterinary teams."

He rejects the idea that adopting a private-equity-backed model is at odds with a desire to improve working conditions for staff, positing that Galaxy's ESOP component offers employees a share in the spoils.

"I think everybody benefits," Zakharenkov said. "The employees are motivated to stay and build this. The investors are motivated to invest. And the management team is excited because our purpose is to decrease burnout in this domain, and I think it will serve that purpose."

Alternatives to ESOPs

For practices that are reluctant to join a large group such as Galaxy or too small to form an ESOP on their own, there are other pathways to achieving employee ownership.

Michael Dicks, a former chief economist of the American Veterinary Medical Association, said employees in LLCs of any size can be granted equity in a business via profit-share or partnership agreements. Alternatively, practices might consider partnering with companies that can handle the regulatory and reporting burden of an ESOP on their behalf.

Without referencing any companies or their models, he said he is wary of ESOPs being used by consolidators. "Most are going to tell everybody 'We're going to do all these good things for you, we're going to bring in profit-share,' but after five years, they're going to flip them," he said.

Dicks currently is data chief of Erupt, a consultancy that assists practice owners wishing to sell but not to a consolidator. He maintains that hefty bids lobbed by private-equity backed groups may not be as lucrative as they first appear when one considers the inherent earnings potential of most veterinary practices.

"The critical point here is that an ESOP is a legal entity that has paperwork requirements, and most practices, they're just too small to want to do all the paperwork," Dicks said. "But you can do it off-the-books. You can do exactly the same thing as a management strategy."

Still, ESOPs have unique tax advantages, which, in Galaxy's case, Zakharenkov said will allow the company to offer more competitive prices for assets.

"Like with anything, there's always alternatives, and they come with their own pros and cons," said Prairie's DeSimone. "There's profit-share plans, and companies can even put stock inside a plan and allocate stock. But an ESOP is the most tax-advantaged way of doing things."

Should another practitioner owner want to consider an ESOP, Engler's first piece of advice is to seek assistance. "It is important to have a team of people — I have an ESOP attorney and an administrator — who know the ESOP in and out," she said. "I do some of the management of it, but it is not a self-managed plan, by any stretch of the imagination."

For his part, Spencer recently employed a chief financial officer part-time to help him keep on top of things. "When people ask, I always start out by saying every case is different and, just because it's working for us doesn't mean it'll work for you," he said. "But if you're a reasonably-sized and profitable business, I would seriously consider it. Absolutely."

This story has been changed from the original to clarify how shares are allocated among employees.

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