What makes for a good ESOP?

In our September 2010 issue of the ROG + Perspectives, my partner Ian Rusk discussed how ownership planning is the single most important factor to ensuring long-term business success. While there are many ownership options available, we are seeing more companies in the architecture, engineering, and environmental consulting industries implement employee stock ownership plans (ESOPs).

There are two contributing factors driving the increasing number of ESOP companies. First, in 1998, Congress enacted changes to the tax code that paved the way for S-corporations to sponsor ESOPs. This was a significant event because by 2009, S-corporations accounted for as many as 40% of all ESOP companies. We believe that a major contributing factor to this shift is the fact that most professional service firms choose the S-corporation structure because of its pass-through tax benefits. Secondly, the increasing number of business owners nearing retirement age has created a market where the supply of shares in closely held companies is exceeding the demand for such shares. This has forced many companies to implement ESOPs in order to make up the shortfall.

Currently, there are more than 13 million employees participating in ESOP plans with assets of more than $928 billion. The National Center for Employee Ownership list of the top 100 employee-owned companies includes 20 companies from the A/E and environmental consulting industry.

An ESOP is a defined-contribution plan that’s designed to invest primarily in a qualifying employer’s securities. An ESOP is very similar to other retirement plans, such as 401(k), 403(a) and 403(b) plans, where the employer makes contributions on behalf of its employees. All ESOPs are governed by the Employee Retirement Income Security Act of 1975 (“ERISA”). When employees participate in an ESOP, they are not technically shareholders; they are beneficial interest holders in a trust, which in turn owns stock in the sponsoring company. The subtle difference between a direct shareholder and a beneficial interest holder is very important. Participating in an ESOP does NOT give an employee managerial authority or a role in corporate governance. Instead, the ESOP participants’ interests are represented by a trustee or fiduciary appointed to represent the ESOP.

Often ESOPs are used to purchase a large block of shares held by a departing owner of a closely held company. In some instances using an ESOP will enable a departing shareholder to cash out, maintain control of the company for a period of time, and facilitate succession. Secondarily, ESOPs are used to align all employees’ interests with those of the direct shareholders. Since most companies in the A/E and environmental consulting industry generally restrict ownership to “active” employees, implementing an ESOP is a popular option for transitioning ownership because it allows companies to ensure a consistent corporate culture and business philosophy by keeping the existing management team intact.

How can you make an ESOP work for you?
Understanding the limitations of an ESOP is essential to maximizing the benefits of an ESOP. First and foremost, you should promote your ESOP as a benefit plan. Too often we hear of companies using their ESOPs as a recruiting tool by telling job candidates that they will have an ownership stake through the ESOP. Employees who are led to believe that participation in the ESOP plan is equivalent to being a direct shareholder are likely to be disappointed and fail to appreciate the real virtues of the ESOP.

Companies with successful ESOP programs tend to characterize them as employee benefits just as they would their 401(K), health insurance and other benefits. This reduces confusion with any “direct” ownership plans that the firm may also offer. The failure to distinguish between the two (direct ownership and ESOP ownership) may lead to disappointment with the rate of wealth accumulation within the employee’s ESOP account.

Based on our anecdotal evidence, we’ve found that 100% ESOP-owned companies are uncommon in our industry. According to NCEO, the median percentage ownership of closely held ESOP firms is 30%-40% of the sponsoring company’s total outstanding stock. Most firms find that key employees respond more positively to direct ownership than to ESOP ownership because they have the ability to acquire more meaningful ownership interests than would otherwise be allocated to them in the ESOP (ESOP shares must be allocated to ALL qualified employees using a non-discriminatory formula).

If your ESOP is in its early stages of implementation, be honest with your employees as to why you’ve chosen the ESOP option. Communicate that the purpose of the ESOP is to ensure that selling shareholders are able to monetize their investment without having to sell the company. More than ever, employees want to feel secure, and keeping your company intact and independent adds to that sense of security. Also make sure that the next generation understands the obligations that the ESOP will bring. These include repaying ESOP debt (if any), and managing ESOP redemption liabilities.

The Afterlife
Once implemented, don’t let your ESOP become stagnant. Many companies make the mistake of ignoring their ESOP once it has completed its initial acquisition of shares and repaid any associated debt. This eventually results in two groups of employees—the “haves” and the “have-nots.” Those that joined the firm before the initial ESOP transaction will have substantial ESOP accounts, while those that joined the firm afterward will have little to nothing in their accounts.

We once consulted with a large A/E firm with an ESOP that had been in place for about ten years. When we examined the plan we discovered that 20% of the employees held 80% of the beneficial ownership. As a result, the newer employees placed little value in the ESOP because it provided no meaningful benefit to them. This firm needed to breathe new life into its plan by “recycling” shares from retiring employees into the plan, thus allowing new employees to accumulate value in their ESOP accounts.

Leverage the Tax Benefits
For the employees, ESOPs allow for the deferral of taxes, not the avoidance of taxes. Far too often companies consider the implementation of an ESOP because they think they are “avoiding” taxes. If only this was true. Still, the ability to defer tax obligations is a significant one. As previously mentioned, an ESOP is a benefit plan in which the taxes to the employees are not realized until the employee takes a distribution.

Often, companies will buy back ESOP shares from retiring employees (instead of the ESOP trust buying back the shares) in order to manage the ESOP’s ownership interest and preserve its capacity to redeem the shares of a large direct shareholder in the future. One of the benefits of an ESOP is the ability to use pre-tax earnings to buy stock. If a company were to use its ESOP to purchase $500,000 of stock from a retiring employee, it could save up to $200,000 in taxes.

An ESOP can also be a great tool for financing acquisitions of other companies. For example, if a company were to acquire another company for $2,500,000, it would need to generate pre-tax income of $4.2 million to fund the acquisition. However, using an ESOP to acquire the company can provide two benefits; a tax savings of $1 million for the buying firm, and the potential for the seller to defer capital gains tax by taking advantage of the 1042 rollover benefit. The tax savings in such a deal are so substantial that the seller might be willing to consider more favorable terms or even accept a lower price. After all, it’s the after-tax proceeds that matter.

So, if you want to ensure a successful ESOP, remember the fundamentals: Why, What and How. Why? The essential purpose of implementing an ESOP is to create liquidity for the shareholders in a tax efficient way, while simultaneously providing a new employee benefit. What? The ESOP is a benefit plan, NOT an ownership plan. The employees do not buy the shares themselves, they are contributed to them by the company as a benefit. How? Recognize that the ESOP is an extremely tax-effective tool for managing share redemption obligations and acquiring other companies.

Going forward, we expect more companies to implement ESOPs to manage their ownership transitions. Unfortunately, we also expect some companies to terminate their ESOPs because they never fully understood their potential and failed to manage their plans as they manage other aspects of their companies. Over the years, we’ve helped many companies implement ESOPs, reenergize them, and when necessary, terminate them. If you’re considering an ESOP, or having difficulty with an ESOP you already sponsor, please contact us.