ESOP Services recently lent me a financial model to use in my MBA class at Oxford University. They spent a lot of time customizing it for me. In the end the class I used it in was one of the most successful I have ever taught. The model was a huge part of the giant success we had with the class and the simulation. I am incredibly grateful that ESOP Services was willing to share the model with me. I can say categorically that the class would not have been nearly as good if they had not done what they did.
Said Business School, University of Oxford
From The Journal of Employee Ownership Law & Finance, Vol. 11, No. 4, Fall 1999 Published by the National Center for Employee Ownership
Ronald J. Gilbert
Joseph V. Rafferty
Before the decision to implement an employee stock ownership plan (ESOP) is made, many companies commission a formal ESOP feasibility study. Others address the issue internally. Is such a study really necessary? The authors answer this question by raising 39 questions that should be addressed prior to the implementation of an ESOP. The article also attempts to explain in summary format why these questions are relevant and to give the reader some insight into the issues that are raised.
Many corporate advisors recommend that some form of employee stock ownership plan (ESOP) feasibility analysis be performed when a board of directors, management, and shareholders are considering either installing a new ESOP or contemplating a major transaction in an existing ESOP company. These advisors contend that a comprehensive feasibility study provides a “decision package” for the board and its professional advisors to use as a blueprint for an informed decision regarding the ESOP. Nevertheless, many companies install ESOPs and operate them for many years without the benefit of a comprehensive analysis.
A feasibility study will allow corporate decision-makers to determine if, and to what extent, an ESOP can assist the board, management, and shareholders in achieving desired objectives. Both the technical and practical factors are measured. On the technical side, factors such as ESOP contribution limits, the existence of other qualified retirement plans (such as 401(k) plans) and their relationship with the ESOP, and the company’s current status as a C corporation or an S corporation must be carefully examined. On the practical side, factors such as the company’s projected cash flow and its ability to repay ESOP debt (if a leveraged ESOP is envisioned), the lender’s collateral requirements, and the projected repurchase obligation of the ESOP versus the company’s future cash flow projections must also be carefully reviewed.
Is an external ESOP feasibility study (as opposed to an internal, or “do it yourself” study) really necessary? It depends primarily on whether the parties to the decision can definitively and authoritatively answer a number of questions. Below are questions that address most, but not necessarily all, of the important issues that determine the feasibility of an ESOP or a “second stage” ESOP transaction. These issues and the many more outlined below will determine whether or not a company needs an external feasibility study.
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Transaction Design Characteristics
Plan Design Details
10. Voting Rights
Special S Corporation ESOP Considerations
Creating an Ownership Culture
Transaction Design Characteristics
This is sometimes driven by the desire for the Internal Revenue Code (“Code”) Section 1042 “tax-free” rollover for C corporations, which requires that the ESOP own a minimum of 30% of the outstanding stock of the corporation after the acquisition. The need to buy out specific shareholders or to avoid selling stock at a minority discount also may affect the target percentage to be acquired by the ESOP.
Frequently, ESOPs “warehouse” cash contributions for a relatively short period of time before the ESOP acquires stock. However, loan proceeds must be used immediately by the ESOP to acquire stock. Many ESOPs purchase shares in two or three stages over a period of five to ten years or more.
a. If leveraged, what is the preferred length of the loan?
If the ESOP is leveraged (i.e., a loan is made from a bank or other financial institution, the corporation sponsoring the ESOP, or selling shareholders) the lender normally will require repayment over a period of five to ten years. (The company-to-ESOP loan may be for a longer term than the bank-to-company loan.) Some or all of the qualified replacement property (QRP) securities may be required as collateral for the loan. Immediately following the consummation of the ESOP transaction, the per-share fair market value of the stock may drop due to the new ESOP debt that the company has incurred. Individuals seeking to sell stock shortly after a leveraged ESOP transaction has been consummated should be aware of this possibility.
b. Who sells what percentage?
Where there are multiple owners, if one owner sells first in a leveraged ESOP transaction, the other owners may see at least a short-term decline in their stock value.
c. Will there be more sales to the ESOP in the future?
d. Which transaction design yields the greatest tax savings?
Accelerating ESOP contributions reduces taxable income but increases the benefit expense to the corporation due to the fact that ESOP shares would normally be allocated more rapidly to the accounts of ESOP participants. Additionally, for a closely held company, the ESOP repurchase obligation would become an issue sooner than it would otherwise. The transaction design with the greatest tax saving is not always the most desirable.
e. How does the transaction design affect benefit policy?
A quicker repayment of the loan means employees at the early stage of the ESOP may get higher levels of benefits than employees at a later stage. By spreading out payments, contributions can be more balanced over time, but tax benefits would be delayed.
f. Is a control premium applicable?
If the ESOP will acquire initially, or has the option to acquire in a relatively short number of years, more than 50% of the company’s stock, then a control premium would normally be applied. However, the ESOP may pay less than fair market value.
g. Will the accounting treatment of ESOP debt cause the company to violate existing loan covenants or create bonding problems?
Generally accepted accounting principles (GAAP) require that the full amount of the ESOP debt be a reduction to the company’s book value.
h. What is the accounting expense to be recognized by the company when it repays an ESOP loan, and why is it different from the cash expense?
Accounting expense that must be recognized in a leveraged ESOP under GAAP is the fair market value of the shares released from the ESOP suspense account in a given year. The amount of cash contributed by the corporation to repay ESOP principal is ignored in computing the GAAP expense.
i. Will the accounting treatment of the ESOP debt have an unacceptable effect on bonding, other needs, or loan covenants?
The contribution made by the ESOP is of particular concern to companies that are publicly traded, are contemplating an IPO, or need bonding.
j. Should the company use the fair market value or the cost basis of shares to determine the size of its annual addition to employee accounts?
The plan can specify either method or can call for using the lower of the cost basis or fair market value. Using the fair market value in a leveraged ESOP could increase the room under Section 415 limits for employees to contribute to 401(k) plans because the debt of an ESOP will normally lower the fair market value of shares below the cost basis in the early years.
Not all stockholders are eligible for the tax-deferred rollover.
a. Cash flow?
b. Internal Revenue Code contribution limits?
Contribution limits are normally 25% of covered payroll, but can be more or less depending on a number of variables. Contributions to any other defined contribution plans, such as profit sharing or 401(k) plans, reduce the contribution limit. This includes both corporate contributions and employee deferrals to 401(k) plans. The 25% of payroll contribution limit to all defined contribution plans is not automatically 25%, even if the ESOP is leveraged. However, a special plan provision can raise the limit to 25% of payroll. Interest is normally excluded from the 25% of payroll limitation in a leveraged ESOP when the company passes a special discrimination test. “Reasonable” dividends on common or preferred stock also are excluded from the 25% limitation. Different contribution limits apply to C corporations and S corporations. Other factors affecting plan contribution levels include the allocation basis (see above), as well as allocating ESOP shares to plan participants at a slower rate than would normally occur due to the repayment of ESOP debt. The issue of contribution limits is a complex area which can “make or break” the feasibility of an ESOP.
c. Classes of stock?
The ESOP must own either the best class of common stock as to voting and dividend rights, convertible preferred stock that converts to the best class of common, or any class of publicly traded common stock. Convertible preferred stock may be used because the larger dividend (compared to common stock) that can be paid on convertible preferred may be necessary due to Internal Revenue Code contribution limits (see above). Convertible preferred stock could be counter-dilutive for stockholders outside of the ESOP. “Super” common stock is sometimes a viable alternative to convertible preferred stock if an adequate investor rate of return in multi-investor ESOP transactions is a critical issue.
d. Other shareholder or management concerns?
These could include passing some percentage of stock to other individuals, maintaining a certain percentage of stock ownership in the hands of certain shareholders, or the unwillingness of enough shareholders to sell the ESOP a 30% stake.
e. Availability of capital for growth and expansion?
The debt that the corporation is repaying in a leveraged ESOP can reduce or eliminate any additional debt capacity. As a result, debt capital to expand, acquire other companies, etc., may not be available when needed. As ESOP debt is repaid, shares are allocated to accounts of ESOP participants, which means a growing repurchase obligation for a closely held company. If this repurchase obligation is not properly anticipated and planned for, funds that would otherwise be used for growth and expansion may be claimed by the “buy back” obligations that the company has for participants who retire, die, become disabled, or terminate for other reasons (see below).
f. Are other sources of ESOP capital available?
These sources can include the use of the assets of other qualified retirement plans, such as profit sharing plans; wage reductions; or employee investments through a 401(k)/ESOP. All of these approaches introduce a considerable degree of complexity and additional fiduciary risk to the ESOP equation.
Plan Design Details
7. Who, if anyone, is excluded from the ESOP?
Selling shareholders electing the “tax-free” rollover are excluded from ESOP participation, along with certain family members and 25% shareholders. Part-time employees are normally excluded but do not have to be. Certain classes of employees and union members may or may not be excluded depending on a number of variables. Employees who are members of a bargaining unit that bargains for retirement benefits may be excluded from participation in the ESOP. (An ESOP, like any other qualified retirement plan, can be the subject of collective bargaining.) Occasionally, small percentages of non-union employees who are in a separate line of work, perhaps in a subsidiary company, are excluded from participation in the ESOP. Any employee with less than 1,000 hours in a year or less than one year of service can be excluded. Companies may want to expand the rules for eligible employees to increase eligible payroll, which in turn increases contribution limits. In some plans, expanded eligibility may be cut back after a few years if the plan specifies this at the outset.
8. How can sellers and family members excluded from ESOP participation be “made whole”?
Nonqualified deferred compensation agreements can be used for this purpose. The corporation promises to pay a supplemental retirement benefit to individuals who are excluded from the ESOP.
a. 401(k) plan, if any?
401(k) plans should be retained if at all possible.
b. Profit sharing plan, if any?
Contributions to profit sharing plans are normally shifted to the ESOP.
c. Defined benefit pension plan, if any?
While it is rare to find a defined benefit plan today in smaller companies, the plan may stay in place along with the ESOP if the defined benefit plan already is in existence.
ESOP participants have limited required voting rights in closely held companies, but companies can go beyond these if desired. Current shareholders may or may not be willing to share some voting rights with ESOP participants.
Vesting must be completed in three years (for “cliff” vesting) or six years (for “graded” vesting). Should credit be given for prior service?
b. Distribution alternatives
Deferring ESOP distributions and/or making ESOP installment distributions over the maximum periods allowed by law will reduce for a period of time the cash necessary to meet a closely held company’s repurchase obligation. However, for a company whose stock is growing in value, this policy ultimately increases the cost of the repurchase obligation. Many companies attempt to balance the cash flow requirements of early distributions with a policy that accelerates to some extent ESOP distributions, especially after some or all of any ESOP acquisition debt has been repaid.
c. Allocation formula
The “normal” ESOP allocation formula is based strictly on covered compensation, with the current maximum allowed by law of $160,000 per year. Alternatives include a formula that gives some credit for prior service, combined with additional points for compensation. Another alternative is to allocate ESOP shares as a “matching contribution” on the basis of an individual’s deferral to a 401(k) plan.
If there is a strong track record of ESOP performance in your industry, it will be much easier to gauge how you might expect the ESOP to perform from a motivational perspective.
If so, will what they get from the ESOP be sufficient? Will certain employees need additional ownership?
- Stock options?
- A stock bonus?
- A stock purchase plan?
- Stock appreciation rights (SARs)?
- Restricted stock?
- A combination of one or more of the above?
Frequently, an ESOP is paired with one or more of the above listed equity incentive plans to maximize equity incentives for employees.
Fiduciary and ESOP Management Issues
The majority of ESOP companies “self-trustee” their plans. Various individuals who are stockholders and/or employees serve as trustees. There are fiduciary responsibilities and risks associated with serving as an ESOP trustee, however, which may justify the cost of outside fiduciary. Potential conflicts of interest can arise. And sellers to an ESOP should never be trustees acting on behalf of the ESOP at the time when the ESOP transaction is consummated.
The ESOP committee normally directs the trustee as to the voting of shares held in the ESOP.
- ESOP quarterback (coordinator)?The coordinator may be one of the parties listed below (such as the attorney) or may be a separate advisor.
- Independent valuation firm?
- ESOP lender (if this is a leveraged ESOP)?
- ESOP attorney?
- ESOP administrator?
- Corporate attorney?
- Personal attorney?
- Insurance agent?
- Benefit consultant?
- Other advisors?
a. Can the ESOP be used to the company’s competitive advantage?
A careful study of this obligation often influences the percentage of ownership of the company by the ESOP.
Too large a repurchase obligation in proportion to available cash flow can stifle a company’s ability to modernize and compete in the long term.
a. If yes, what measures will reduce this problem?
Proper design of ESOP eligibility criteria, such as entry age and vesting schedules, and a deferred and/or installment distribution policy can assist, but the root problem may require careful study of the company’s retention system.
In many instances a closely held company is wise to adopt a policy that defers, to an appropriate extent, the payout from one to six years for other terminations. This “smoothes” (evens out) cash flow and precludes a situation wherein employees with large ESOP accounts are tempted to “take the money and run.” The ESOP rules pertaining to other terminations allow companies to wait six years before payments must begin, and then balances can be paid out in equal annual installments over a five-year period. However, if a company’s stock price is rising faster than its after-tax cost of money, delaying repurchase only increases the volatility. Thus the company must balance the need to defer distributions long enough so as not to tempt vested employees to leave to receive a benefit payment against the need to begin the payout process soon enough in order to reduce the long-term costs.
Many closely held companies will fund their repurchase obligations from annual cash flow by contributing on a tax-deductible basis the necessary cash to the ESOP to distribute cash to departing participants. This approach relies on the uncertainty of future cash flow. It also causes the ESOP repurchase obligation to grow as the repurchased shares are allocated to the remaining participants’ accounts. This can create problems for established ESOP companies in which two classes of ESOP participants emerge: some with large account balances, some with small.
The decision in a given year whether to redeem departing participant shares back to the corporation, or recycling shares within the ESOP has long-term implications of counter-dilution for the non-ESOP shareholders, taxes to the company, and the ultimate size of the ESOP. A detailed analysis of stockholder equity and ESOP repurchase obligation quantifies the differences.
A corporate funding plan that establishes tax-deferred reserves on the balance sheet to address this obligation is a wise decision—the sooner, the better. Properly structured life insurance programs can be very effective in meeting this obligation. This funding plan can frequently be integrated in a manner that facilitates shareholder estate plans as well as key executive requirements.
Special S Corporation Considerations
Analysis has shown that the long-term tax savings generated by S corporation ESOP companies can be significantly greater than for some C corporations. ESOPs in S corporations offer no Section 1042 tax-deferred sale opportunity for selling shareholders and have reduced limits on the percentage of annual payroll that can be used as a tax-deductible contribution to a leveraged ESOP. But these drawbacks are mitigated by the fact that earnings attributable to ESOP owned stock in an S corporation are free from federal (and many state’s) income tax. This tax-free income could result in an ESOP loan being repaid faster than for a C corporation. S corporation“dividends” paid to the ESOP are excluded in calculating contribution limits, and will often solve problems created by the lower contribution limits. In some companies, large ESOP accounts for selling shareholders and family members will offset the absence of Section 1042 tax savings.
The ESOP must receive its proportional share of all dividend distributions made to shareholders.
a. What uses may the ESOP trustees select for the large cash distributions that may accumulate in the trust?
The ESOP may use these funds for the accelerated retirement of an ESOP loan, the acquisition of more ESOP shares either from the company (to create capital) or from shareholders, the ESOP repurchase obligation, and/or taxable cash payments to employees to help them feel more like true co-owners of the company.
b. How can these funds promote company and shareholder objectives?
A carefully developed plan can maximize the use of savings in a manner that will balance the sometimes-competing objectives between different stakeholders.
Several changes to the S Corporation ESOP laws have been proposed, although none of them have been enacted as of this writing.
Creating an Ownership Culture
Although the answers to all 39 questions are important, the question pertaining to how well the management-employee team is effecting the culture change within the organization may provide the biggest payoff to ESOP companies. Some companies install an ESOP primarily for financial reasons such as a tax-deferred sale for shareholders and tax-favored financing for the company. Many of these companies never develop the partnering message of the risks and rewards to complement the rights and responsibilities of stock ownership. Research indicates that those companies that have effectively communicated employee ownership—thereby creating and enhancing an ownership culture among employees—have reaped the greatest success from their ESOP strategy.
Most ESOP companies eventually make some progress in communicating the impact of employee ownership. However, stellar ESOP companies achieve their full potential by creating a long-term ownership culture, stimulating creativity and innovation among all participants. The psychological reward for employees, whose personal innovations and ideas have been recognized by all to improve the organization, is quite immediate and contagious.
There you have it. Once you have answered all the above-listed questions, plus some others that your corporate attorney, accountant, or other key advisor(s) will raise, you do not need a feasibility study! However, if you are unable to answer these critical questions, a feasibility study will provide the basis for a sound decision on an ESOP strategy or transaction that will truly facilitate shareholder and company objectives.