ESOPs can be complex plans with lots of moving parts. It is easy to overlook something you should or could do because your advisors, who may be very well qualified, forget to tell you or assume that someone else would tell you. Moreover, many ESOP companies have one or more advisors who have limited ESOP experience and thus may well miss an important obligation or opportunity. This short book is designed to help you know exactly what your advisors might not be telling you and what they should be. Each chapter starts with a story about a company's ESOP gone wrong and what could have been done. It then follows with step-by-step descriptions of what you need to expect from your key advisors. The chapters cover in turn lawyers, appraisers, administrators, and trustees.
Table of Contents
1. How Many Lawyers Does It Take To...?
2. Best Practices and Common Mistakes in ESOP Company Valuations
3. What You Should Expect from Your ESOP TPA
4. Best Practices for ESOP Trustees
From Chapter 1, "How Many Lawyers Does It Take To...?"
It almost goes without saying that selling shareholders require representation on the flip side of all of the ESOP's transaction issues. The commercial law issues include the terms of the transaction, loan agreements, collateral, and guaranty agreements. The entire ESOP planning process will trigger a need for estate planning and tax advice that is personal to the sellers, and not at all relevant to the ESOP. ESOPs are often relevant in complex estate planning structures and may be recommended or implemented by attorneys with specialized practices that include estate planning. It is very common for the seller's counsel to be the lawyer or firm that handles these personal legal matters for the sellers. Handling the seller-side issues in a stock sale transaction is typically within the area of competence for such lawyers or their firms.
Unfortunately, all too often sellers who are embedded in the company feel that the ESOP lawyers working with their consultants should be able to get the work done as corporate ESOP counsel, or as ESOP counsel, and the sellers will be fine and won't need their own lawyers. The best practice is that sellers clearly and always have their own counsel. It is the first and best additional lawyer to bring to the table. It starts to free up the other advisors to do their job with minimized conflicts (real or perceived).
From Chapter 2, "Best Practices and Common Mistakes in ESOP Company Valuations"
Recently, a friend of ours who serves as an ESOP trustee called to ask a favor. A valuation firm with whom she works had just delivered the valuation update report for ESOP administration purposes, and the conclusion of value was much higher than expected. It was so high that the trustee and the company's CEO were both concerned that the company wouldn't be able to satisfy its repurchase obligation while also making certain necessary capital investments without incurring a significant amount of debt. "Something doesn't seem quite right," she said. "Could you take a quick look at the analysis and let me know what you think?"
As it turns out, the valuation professional who performed the analysis works for a regional CPA firm without much specific experience in valuing ESOP-owned companies. In his analysis, he relied upon a single valuation method: the discounted cash flow (DCF) method. In his DCF method analysis, the valuation professional didn't tax-affect the subject company's projected cash flows under the premise that the company is a 100% ESOP-owned S corporation, and is thus exempt from federal income taxes—which is inconsistent with the standard of "fair market value" by which ESOP company valuations are bound. Worse, to calculate projected free cash flow, the valuation professional neglected to deduct the company's projected capital expenditures. It was therefore no surprise that the trustee and the CEO were concerned about the company's ability to make these investments, since these investments weren't reflected anywhere in the analysis. Since the valuation professional came to his conclusion by only using one valuation method, there were no other indications of value from alternative valuation methods to serve as a reasonableness check.
From Chapter 3, "What You Should Expect from Your ESOP TPA"
One of the most common operational errors is when the definition of compensation provided to the TPA does not match the definition of compensation in the plan document. There are several alternative definitions, and it is important that both the TPA and the PA understand the specific definition used. If the compensation actually used in the allocations of employer contributions, forfeitures, and so on does not match the definition in the plan document, it is an operational error for failure to follow the terms of the plan document.
As a part of this process, it is typical for the TPA to review the census data for missing or inconsistent data. For example, the TPA may notice, based on Social Security numbers, that a new employee is actually a rehired employee even though no rehire date was provided. The TPA will typically review the information to make sure the compensation seems consistent with the hours worked, date of hire or termination, etc.
From Chapter 4, "Best Practices for ESOP Trustees"
We took over as successor trustee for an ESOP that had hired experienced ESOP legal counsel, an experienced third-party recordkeeper, an experienced valuation advisor, and even an institutional trustee. Unfortunately, although the advisors were all experienced, they did not communicate with each other very well.
The recordkeeper had not spoken with the prior trustee or legal counsel. The recordkeeper did not question the trust accounting statements when the trust statement reflected activity that was contrary to what the plan sponsor said had transpired. Legal counsel was not brought up to speed regularly, was involved only when the plan needed amending, and had no idea there were potential prohibited transactions. By examining the trust statements and the participant allocation reports, it appeared the prior trustee did not review the allocation summary or question the differences between the allocation reports and the trust accounting statements.