The Employee Ownership ReportConcisely written for leaders in employee ownership companies and for service providers in the field, the NCEO's bimonthly newsletter, the Employee Ownership Report, is the most efficient way to stay informed about legal issues, current events, best practices, breaking research, management approaches, and communications ideas for employee ownership companies.
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Read a sample issue of the entire newsletter (September-October 2015).Sample Article from the September-October 2018 Issue:
Control Premiums in ESOP TransactionsIn recent years, the Department of Labor has been more concerned about ESOPs paying for control when, in the DOL's view, it doesn't really need to do so or is acquiring control more in form than substance. This article looks at several scenarios in which the ESOP may not be able to pay a control price.
Of course, the most obvious case is when the ESOP buys a minority interest. But it might also be inappropriate for an ESOP to pay for control in a transaction that is one part of a series of transactions designed to acquire control, such as when the ESOP acquires majority ownership but there are significant control constraints. Another example might be when the ESOP buys additional shares after it already owns a majority of the stock.
Multistage TransactionsMany ESOPs are designed to buy a minority of the stock in the initial transaction with the intention of buying additional shares sufficient to acquire control or even 100% ownership over time. Properly structured, an ESOP can pay a control price throughout this process, but several conditions must be met at the time of the initial transaction:
- The ESOP must have the right (but not the obligation) to buy additional shares after a specified and reasonable period of time (such as when the first note is paid off or sooner). If the company cannot borrow money to fund the acquisition, the seller must, in advance, agree to take a seller note.
- The ESOP trustee, from the first transaction, must have voting control of a majority interest, usually through the grant of a proxy for a sufficient number of shares. Some advisors say it is sufficient for the ESOP to have voting control over responding to an acquisition, but this position may be too aggressive for the DOL and the courts.
- The ESOP should be able, at the trustee's option, to purchase shares for the same price as any other thirdparty buyer and to veto any third-party purchase.
- If the additional purchase is at control price, participant shares should be valued at that level even if the ESOP never acquires control.
Control in Form, But Not in FactIn recent years, the courts have sided with plaintiffs when the control of the ESOP trustee is limited by covenants and practices at the company level. Most prominently these include:
- Covenants on seller notes that provide that company funds cannot be used for a variety of purposes without the seller's approval.
- The use of non-voting preferred shares that are convertible to voting common shares (this is far less common today than it was in the past, however).
- The ability of the seller to appoint board members and/or continue to serve on the board.
Buying a Minority Interest When the ESOP Already Has ControlIf the ESOP already has a majority interest and now buys additional shares, it may be able to pay a control price if this was part of the kind of phased transaction described above. If not, however, there seems to be little compelling interest for the trustee to pay for control any more than it would for a theoretical outside investor buying such an interest.
Levels of ControlMany ESOP valuations take a nuanced view of control. At the highest level, the ESOP owns a sufficient interest to control decisions even if the by-laws require a super-majority vote on some issues. If the ESOP does not have that level of control, then the control price may be reduced, but not eliminated. That same logic would apply to other limitations on control, such as loan or governance covenants or minority shareholder rights.
Losing ControlWhile not common, occasionally ESOPs go from a controlling to a noncontrolling position. In these cases, it is prudent for the trustee to continue to buy shares from departing employees at a control price. In addition, because the loss of control represents a loss of value to the ESOP trust as a whole, the trustee may want to negotiate something in return for the trust as well, such as a commitment to additional cash contributions to the plan for a period of years.
This article draws in part on the article "ESOP Trustee Considerations in Multistage ESOP Stock Purchase Transactions" by Scott Miller of Willamette Management Associates in the Spring 2018 issue of their publication Insights. Any conclusions, however, are ours.