ESOPs --- Obstacles and Solutions
Employers express various concerns when they consider establishing an Employee Stock Ownership Plan (ESOP). Now that ESOPs have been around for over 35 years, the ESOP advisory community has developed responses to many of these concerns. This article will address some of the most common ESOP obstacles and their solutions.
Debt Service - OBSTACLE: Debt service may create a retirement expense that is too high relative to payroll. SOLUTION: Redeem/retire some of the shares, thus lowering the remaining value of the ESOP transaction.
Loan Duration - OBSTACLE: Seller wants to be paid in 5 to 10 years; but the retirement expense would be too high. SOLUTION: An “outside loan” can be for the short duration; while the “inside loan” to the ESOP can be for a much longer duration.
Cash Flow - OBSTACLE: Having enough cash to service the debt as well as buying back shares from ESOP participants who terminate employment. SOLUTION: The plan can be drafted so that other than for normal retirement, death, or total and permanent disability, all other buybacks will be postponed for some period of time, with the option to pay early if cash permits.
Management “Skin in the Game” - OBSTACLE: Allocating ownership pro rata pay might not be as appealing as management wants. SOLUTION: After taking into account all the tax advantages, having long-term management share in ESOP forfeiture reallocations, and using some non-qualified plan arrangements or stock options, management often comes out ahead even when the ESOP owns 100% of the company.
Selling Owner Financing the Deal - OBSTACLE: Owner wants to be bought out in a lump sum. SOLUTION: With CD and bond yields as low as they are, often the selling owner is better off taking a note that pays a decent yield. Warrants for deferred payments can sometimes increase the portion of the buyout that is treated as a capital gain.
Consulting Fees - OBSTACLE: Some advisors want to charge a large one-time fee that might be 5% to 10% of the value of the company. SOLUTION: Pay advisors who work strictly on a time-and-expense basis.
Seller concerned about accepting a note then walking away - OBSTACLE: The owner doesn’t want to give up all control. SOLUTION: Selling owners almost always stay in the picture for some time, as an executive, a board member, and/or a Trustee for the ESOP.
Planning for Lean Years - OBSTACLE: Concern about lean years. SOLUTION: Structure the ESOP loan so that the duration is longer than you actually expect to need. In lean years you can follow the schedule. In years that cash flow permits, you can make additional payments toward the debt. Word the note so that early payments reduce future amortization payments while leaving the original duration alone.
Managing Employee Expectations - OBSTACLE: Employees will see large balances, consider leaving, and expect immediate payment. SOLUTION: Make clear in the Summary Plan Description (the booklet to employees) and all communications that this is a retirement plan, and benefits are not expected to be paid until retirement, disability, death, or after the loan is paid off. It is common for ESOPs to have at least a five-year waiting period for benefits to be paid.
Former Employees with Company Stock - OBSTACLE: Many employers don’t like former employees (who are waiting on a distribution that won’t occur until years down the road) to share in the company’s stock dividends and appreciation. SOLUTION: If the cash is available, “reshuffling” can be adopted whereby the former employees are put into “other investments” while all the current stock is owned by actively employed participants. The topic of reshuffling was addressed in an article in our Spring 2012 newsletter, “Employee Stock Ownership Plans and Rebalancing.”
There are legitimate concerns that must be addressed when considering the establishment of an ESOP. However, a carefully designed ESOP can provide many benefits to owners and employees. According to the Employee Ownership Foundation, ESOP member companies continue to have increased share value, better productivity and overwhelming support among leaders of the companies. The Foundation has been conducting an annual survey of ESOP member companies for more than 20 years. Since the survey began, 93.3% of survey respondents reported that creating employee ownership through an ESOP was "a good business decision that has helped the company." Since 2000, this figure has consistently exceeded 85%. In addition, 76% indicated the ESOP benefited the overall productivity of the employees.
If we can help you consider an ESOP, please don't hesitate to contact us.