For many years, we at the NCEO would hear stories about ESOPs that made us wince. People experienced problems, sometimes serious ones, that good and timely advice would have prevented. As these stories mounted, it seemed we could save people a lot of headaches if we could write about some of the common (and a few not-so-common) mistakes ESOP companies make and how to avoid them.
Rather than just another long checklist, however, we have written this as a series of stories. The company name is usually disguised, but the scenarios and solutions are real. We engaged leading ESOP experts from all fields to help us with this task and added quite a few stories of our own. There is a good chance you will recognize your own company in at least a few of these dilemmas. If not, the book will give you greater confidence that you really aren’t missing something. Either way, you’ll sleep better at night.
The third edition (2023) makes major changes, updating some of the entries, dropping others where the mistakes are fortunately now much less common, and adding many new entries. Some of the entries from earlier editions were written by individuals who have since retired. We have retained these if they did not need updating.
Table of Contents
Introduction: Not Knowing What You Don’t Know
1. Setting Up the ESOP
Were Those ESOP Floating Rate Notes Really the Best Idea?
Warrants Are Usually Not Warranted
Maybe That Past Service Credit Was Not a Good Idea
What Is an ESOP Loan?
But My Brother-in-Law Said He’d Done Lots of ESOPs!
Gosh, It Costs That Much?
Honey, I Forgot to Mention the Options
The ESOP May Be Great for You, But It’s Not for Me
Old Harold Turned Out to Be Irreplaceable After All
We Shouldn’t Have Been So Optimistic About That Light at the End of the Tunnel
2. Executive Compensation
We Should Have Converted Those Options Before We Became a 100% ESOP
Consider Your SAR Design
You Mean Managers Can’t Get Whatever They Want? (Four Tales of Excess)
But I Could Get More Equity Without an ESOP!
3. Corporate Governance Goofs
Help—I’m Over My Head Here on This Board
They Were My Buddies and Advisors. Why Not Have Them on the Board?
Family Foibles: When ESOPs and Family Ownership Were a Tricky Mix
But I Promised My Son He Could Be Boss!
We Used to Get Along So Well: When Managers Are at Odds After an ESOP
4. Repurchase Obligations and Distribution Policy Issues
We Paid Our Loan Off Too Fast, Vested Too Slowly, Had No Inside ESOP Loan. Oops.
The Tale of the Too-Liberal Distribution Policy (with What Will Probably Be a Happy Ending)
We Had the Extra Cash, So Why Not Pay People Out Now?
We Forgot to Tell the Employees, and They Didn’t Just Get Mad, They Sued
Oops—We Grew Too Fast
Be Careful What Your Lawyer Tells You
We Needed the Cash, So We Just Borrowed It from Participants
The Security Was, Well, Not So Secure
5. Plan Administration
We Were Supposed to Allocate Shares Using That Formula?
Don’t Miss Opportunities Associated with Your 401(k) Plan
Tales from the Administrative Crypt
Funding ESOP Distributions: Can the End Justify the Means?
Our New Employees Aren’t Owners
Our 401(k) and ESOP Didn’t Get Along
What’s This Primarily Invested Thing?
We Segregated Accounts to Make Our ESOP More Sustainable for Everyone—And Got Sued
6. S Corporation Issues
But We Didn’t Mean to Be Abusive
Our S Distributions Were Great—Maybe Too Great
Our Synthetic Equity Was Creating Real Problems
Our 70% ESOP and Those Unmanageable Distributions
Too Much Cash, or When Printing More Shares Is the Answer
7. Fiduciary Faux Pax
We Picked the Wrong Trustee
Don’t Turn a Corporate Decision into an ERISA Decision
It’s Not Your Company Anymore
We Can Just Extend the ESOP Loan When We Want, Right?
I Sold My Company, But It’s Still My Piggy Bank
When Two Hats Aren’t Better Than One
Reasons to Avoid Being a Director, Officer, ESOP Committee Member, and Trustee
I’m the Trustee, and I Think the CEO (My Boss) Is Raiding the Company
It’s Not Your Job to Provide Investment Advice
When It Comes to the Future of Your Distributions, Be Careful What You Predict
We Had Indemnification. Why Pay for Insurance Too?
Indemnification Issues, Round Two: What the Courts Say
8. Valuation Vexations
The Appraisal Really Is Meant to Be by a Qualified, Independent, and Unbiased Expert
Tricky Business: What Happens When a Seller Note Can’t Be Repaid
Value Once, Value Twice, and Value Once Again
It’s Not Really Worth That Much, Is It
Our Auditor Questioned Our Valuation?159
Sometimes It Isn’t Good to Share
Paying for Control When You Don’t Have It
An Untimely Valuation
9. Financial Foibles
We Wanted to Pay Down the ESOP Loan as Fast as Possible, So We Used All the Dividends in the Plan to Make a Loan Payment
The ESOP Loan Should Have Had a Longer Term Than the Bank Loan
Our Unreasonable Dividends
Our Extremely Unreasonable Dividends
10. Cultural Conundrums
You Mean We Aren’t Really Owners?
Acquisitions and Integrations: Who You Gonna Call?
The Web of Our Ownership Culture Was Not Fully Woven
It’s You, Irv: The Case of the Owners Who Don’t Act That Way
Don’t Think the ESOP Will Be a Magic Solution for Your Culture
Questions Anyone? OK, Thanks for Listening
We Forgot the Middle Managers
We Shared the Numbers, But It Didn’t Get Us Anywhere
I Gave Them the Business, and No One Even Thanked Me
We Keep Telling Employees What a Great Deal the ESOP Is, But They Don’t Seem to Care
From Chapter 3, "Corporate Governance Goofs"
Family Foibles: When ESOPs and Family Ownership Were a Tricky Mix
Setting up an ESOP always raises important and sometimes complex planning issues, but the issues are magnified when there are multiple family members with varying roles and ownership interests—or expectations. An ESOP might be a great solution for some, and a great disappointment to others. In these scenarios, it is critical to get good outside advice to help decide whether an ESOP really can work and, if so, how to accommodate everyone’s interest.
Consider the “M&M Brothers” company (a fictional name, but a real enough scenario). Over the years, Mark and his younger brother Matt made monthly payments to purchase their parents’ shares in the company. “Grandma and Grandpa” wanted their two sons to own and run the company, even though they knew their sons were unequal in business talents. Their remaining child had a successful career and would not participate in buying any shares. The seller note provided for Mark to acquire 51% and Matt 49%. Mark is now 65 years old and leads the overall company as president, while Matt is 60 and manages the field operations of their high-growth and very profitable S corporation subsidiary. As the company was paying down their parents’ seller notes (and still are), the next generation of siblings and cousins (“the kids”), in their 30s and 40s, were taking on new roles in the company. To reduce the family tension and make things fair, Mark agreed to sell one share to Matt to make the ownership 50%/50%. As the company had more than 100 employees, there were also key leaders in their 50s who weren’t family and also managed their divisions profitably. They also shared supervision of the kids, along with the two fathers, to reduce family conflicts. If there was conflict among family and key managers, Mark would step in if needed, to settle the conflict. If there were conflicts between Mark and Matt, the board would step in. The board consisted of the two brothers and their company lawyer, who had the role of breaking deadlocks. They met as a full board annually to settle shareholder and management issues. The company’s bylaws also included a “buy-sell” agreement providing that the surviving shareholder would buy out the deceased’s spouse at a set rate and value.
Everything was fine until it was discovered that Mark had an incurable disease. He was told he had a short time to live, weeks at worst to a few years at best. That led to having more frequent board meetings to work on an ownership transition plan. Mark hired a succession planning advisor to help guide him through difficult discussions and hired an ESOP appraiser to begin the financial and transaction discussions. He also hired an ESOP attorney to provide legal insights as the process unfolded. A week or two later, Matt admitted to the board that he also had serious health issues. In a panic, Mark began working with the succession advisor to develop a management and family transition plan that included identifying potential leaders and new roles for key managers and family members. The company would also need to work on the buy-sell agreement provisions to figure out what would happen if both died around the same time. One strategy was to find a strategic buyer such as a competitor, who would buy and manage the company if key people quit. Another strategy was to sell to the kids, but that choice was not appealing because the kids were resistant to paying off their own parents. Another choice was to set up an ESOP to deal with ownership issues while motivating and retaining key people. What was not considered during this process is what the spouses for each generation thought about their husbands and children owning and managing the company. It turned out the kids would go to mom when a contentious decision was made by Matt or Mark. The result of all this is that any of the sale options would raise a lot of potentially very difficult issues.
In fact, it became clear that the families were in serious conflict to the point that Matt began to withdraw from management to work on his health issues. With Mark’s health declining, he needed to identify leaders, so he began to train and promote people, such as promoting his CFO to CEO, and letting the key managers run their divisions. The wives and kids, along with the key employees, now wondered whether people were going to stay or leave the company because all of these changes. Could the ESOP be a solution, or would too many family members feel that they did not get what they wanted? Could they all agree on a sale to another party if not?
Clearly, the family needed a process to work out all these conflicts. A logical approach would be to have a strong corporate governance system, possibly with a board with outside members. The board and key managers would need to read and understand the bylaws and make whatever changes were needed. By understanding the family system and its alliances and connections, as well as how boards work, it can be easier to implement a family council to improve communication and reduce conflict. Opening up the business books and teaching them business practices can usually mitigate conflict.
The board may then want to implement personality assessments to help with selection and promotion of key leaders and family. This effort would help determine whether the next generation of leaders is in place. If not, then the board needs to determine the next steps of developing the leadership team or acquiring/hiring from the outside. This effort may include adding additional board members or electing the successors to join the board for further training.
The next step is involving the right advisors at the right time. If the family is in conflict, bringing in an ESOP appraiser too early may cause more harm than good, with the family refocusing on money instead of getting the family to agree to leadership and planning. What typically happens is the families start to separate into those who want to buy the company and those who want to sell their interest. The moms want the kids to get along so they can continue their holiday gathering traditions. The dads don’t want the conflicts to expand into the business system.
In preparation for a final ownership decision, the owners and their families should work on their estate by preparing a will that may include trusts. Owners and key managers should complete a sudden death checklist that prepares management and their families on steps to take in the event they suddenly die or are severely disabled. Mark and Matt’s dilemma is common and avoidable. In my 40-year career, about 10%–20% of the families have had their wills and estate plans updated and ready to go. Are you a part of that 10%–20%, or does your business and estate plan look like Mark and Matt’s? If you are like the brothers, I suggest you engage an estate planning attorney, who also can set up or update your wills while providing insights to the caregiving community. You should also have your wealth advisor involved in the early stages to ensure the wealth plan and the succession plan align.
From Chapter 5, "Plan Administration"
Oops, We Forgot About the Guy Who Died
Blue Ridge ESOP Associates
A TPA takes over recordkeeping responsibilities for a mature ESOP. In reviewing participant balances, the TPA notices that one participant died 15 years earlier, and no portion of the balance has been distributed. If the participant had lived, he would be well beyond the required beginning date for minimum annual distributions. The TPA asks, “Do you know who the beneficiary is?” The company responds, “It’s his son who we think lives somewhere in California; we’re not exactly sure where.”
In the above scenario, there are three issues. First, the plan violated the timing rules for post-death distributions to a non-spouse beneficiary. The plan document and applicable regulations define when payment must commence after death and any rights to postpone distributions. Second, minimum required annual distributions have not been made, as required by the plan and applicable regulations. Third, the plan document contains a listing of steps to take to locate missing participants and the steps were not taken. Given the U.S. Department of Labor (DOL)’s stance on a plan sponsor’s responsibility for making efforts to locate missing participants, the lack of effort to find the missing beneficiary is a problem and could be construed by the DOL as a fiduciary breach of duty.
First lesson learned: The plan administrator, with TPA help, needs to understand when post-death distributions should commence. The rules are complex, especially after passage of the SECURE Act. Data to be obtained includes (1) the age of the participant at death, (2) whether death occurred pre- or post-2019 (SECURE Act), (3) whether there is a named beneficiary, (4) whether the participant is a “designated beneficiary” (generally a live person), and (5) with the SECURE Act, whether the beneficiary is an “eligible designated beneficiary.”
Second lesson learned: Failure to follow the terms of the plan can result in operational defects that require correction. Also, a failure to pay minimum distributions is an operational defect unless all reasonable efforts are to locate the missing beneficiary.
Third lesson learned: The DOL has issued fact sheets regarding a plan sponsor’s duty to attempt relocation of missing participants, and those fact sheets include best practices for staying in touch with former participants and methods for locating those that are missing.