Is your company right for an ESOP?
There are many reasons to establish an employee stock ownership plan but not all companies will make good candidates.
Before addressing the relevant factors that typify a good ESOP company, it is important to describe what one is and how it operates.
In its simplest form, an ESOP is essentially a profit sharing plan that is designed to invest primarily in the securities of the sponsoring employer. Instead of receiving allocations of cash, participants receive shares of employer securities. In public companies, distributions are made in stock. In closely held companies, either the employer or the ESOP will repurchase the shares from the employees. This type of ESOP is known as a non-leveraged ESOP.
The vast majority of participants are covered by non-leveraged ESOPs, most of which are sponsored by banks and public companies. In my experience, most companies adopt ESOPs for a similar reason, which is to incorporate an employee benefits plan as one of many techniques to provide equity participation for a broad class of workers. The advantage of ESOPs over other types of qualified plans is that employees have the opportunity to participate in the growth of the company based upon the indirect ownership of employer stock.
Ownership of employer securities through an ESOP provides a powerful incentive, which can be used to attract and hold key employees and drive superior performance.
There are additional, powerful tax incentives for employers who adopt a leveraged ESOP. It provides a powerful corporate finance tool for owners of closely-held businesses when used as a business succession strategy. Put simply, a leveraged ESOP is permitted to borrow to purchase employer securities. Annual deductible contributions to the ESOP are used to repay the loan. This feature allows the entire purchase of shares to be effectuated with tax-deductible dollars.
The holy grail of ESOP transactions occurs when 100% of the employer stock is sold to an ESOP and the company elects subchapter “S” status. Thereafter, the company pays neither federal income taxes nor state income taxes in most states.
While no one factor is paramount, owners of good ESOP candidates tend to wish to maintain a business legacy or to keep control of the business in the family. Owners of long-standing family businesses or the independent employer community are generally good ESOP candidates. The best possibilities are with businesses located in small towns or rural areas where the owner and many employees are part of the same community.
Owners in those communities tend to have a greater affinity for their workers who are more likely to be long-term, loyal employees. As well, they are often more likely to want to preserve employee jobs in any transaction.
The corollary of job perservations is, of course, the cost. Owners whose objective is to receive the highest possible price for the company are not good ESOP candidates. In many cases, a third-party buyer has the ability to pay for potential synergies with their existing product lines, cross-selling to existing customers and other areas of possible revenue enhancement. None of these factors can be reflected in the price an ESOP trustee is able to pay. However, owners with concerns about the legacy of the company and preserving jobs tend to be willing to accept that lower price.
Another important aspect of a good ESOP candidate is an owner (and a management team) that wants to remain in control in the company and the exit the business at their own pace and not necessarily concurrent with the closing of the sale. The level of control available to a former owner who sells to an ESOP is much greater because virtually every ESOP trustee will allow current management to remain in place.
A prospective ESOP company should have a strong, consistent record of financial performance. Consistency is perhaps more important with prospective ESOP companies as the ability to repay any loan from cash flow and future profits is important.
Another factor common to both ESOP candidates and third-party sale candidates alike is a diverse customer and supplier base. In my experience, a particularly difficult issue in ESOP transactions can arise when there is a concentration of 50% or more of a company’s sales to a single client.
There are also technical issues that come into play. Generally, only a corporation is eligible to sponsor an ESOP. However partnerships and LLCs can generally be converted to a corporation on a tax-free basis (and the IRS has ruled that LLCs electing to be taxed as a corporation may sell to an ESOP). Additionally, the company should be of sufficient size to justify the cost of establishing the plan. As a practical matter, most ESOP companies should have at least 10 employees.
ESOPs are also best suited to companies with a preponderance of long-tenured employees with low turnover and a strong collegial work environment and loyalty to the business and its owner.
Setting up an ESOP
The process of establishing an ESOP can be relatively straightforward. It is simply a matter of adopting the structure, which is a qualified retirement plan, inclusive of its trust, and appointing a trustee. This is very similar to the adoption of a profit sharing or 401(k) plan by a company. Once the ESOP is established, the sale of company shares to an ESOP is a somewhat more involved process that can be compared to the sale of a business to a third-party.
In the case of most ESOP transactions, the plan is represented by a professional trustee who retains its own attorney and valuation expert. The company will have engaged its own, separate legal counsel and valuation team. Once the valuation expert determines the value for the company, based upon its past financial performance and future business prospects, the advisers on each side can begin to negotiate the structure of the deal.
Depending on the terms of the underlying transaction, it may also be appropriate to arrange for financing. In many cases, the seller will agree to finance the transaction by agreeing to accept a note for all or part of the payout.