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Great Ideas from the NCEO's 2017 Annual Conference
An NCEO Issue Brief
by Corey Rosen (compiler and editor)
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Format: PDF, 24 pages
Dimensions: 8.5 x 11 inches
Edition: 1st (July 2017)
Status: Available for electronic delivery
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Communicating the Now of Employee Ownership
Employee Engagement: The Secret to Success
Leadership Development: Paths from Two Great ESOPs
Compensation and Strategy
Creating an Effective Executive Incentive Program
Reviewing the Accuracy of Your Compensation and Eligibility Administration
Should We Use Account Segregation?
Red Flags for Choosing or Replacing ESOP Appraisers
Department of Labor Investigations: What to Expect and How to Prepare
Transaction and Plan Issues
The Due Diligence Process in ESOP Transactions
Private Equity, a Strategic Buyer, or an ESOP . . . How Should My Advisors Approach a Sale of My Company?
ESOP Financing from the Lender's Perspective (Debt Markets)
Negotiating Protections for the ESOP or Sellers Related to Subsequent Events
Should You Be a "B" (Benefit) Corporation?
Lessons for Boards and ESOP Fiduciaries from the Antioch Case
About the Editor
About the NCEO
From "Communicating the Now of Employee Ownership"The model we learned in school about economic decisions assumes we rationally calculate each choice to determine what will yield the best result, and model our behavior around maximizing economic returns. We are "econohumans." Alas, you probably don't have many of these beings working for you, and probably wouldn't be that happy if you did. They aren't much fun and tend to be quite selfish.
Still, the ideas we often have in our heads about money and motivation is that people make rational economic calculations about the value of doing x to get y. So if employees are owners and contributing ideas can help the company stock value grow, then that is what they will do. In fact, research consistently shows that while this is a factor, motivation at work is a much more complex issue that revolves around perceptions of fairness, challenge, opportunity, autonomy, and recognition. Most academic economists—the ones with the rational economic actor models—would, I suspect, be insulted if you said they worked to maximize their income. They do what they do, they would say, because it is interesting, important, and challenging. We now know from decades of research that on their own, ESOPs have little impact on company performance or employee behavior. But combined with ownership culture work practices (discussed below), they have a powerful impact. By the way, just having an ownership culture and no ownership does not work very well either.
Another problem is that people vastly over-discount future benefits. In a number of experiments, people are asked if they would take, say, $5 now or a guaranteed $10 next year. Most take the money now, even if the amounts get larger. That's why it's so hard to get people to put more into their 401(k) plans, despite the huge immediate return from not paying taxes and maybe a match to boot, or put money aside in a stock purchase plan that offers a guaranteed discount off the lowest price when they actually buy the shares. People tend to have an optimism bias—"I can deal with retirement later"—as well as an unrealistic idea of how likely they are to change jobs, so these just add to the problem.
People also value losses more than gains. Ask people if they would take a double-or-nothing bet on $50 they have already lost, and most say yes. Ask for the same bet on $50 they have gained, and most say no. This asymmetry of risk assessment is why people hold on too long to stocks that have lost money in stock markets, but are much more ready to sell at equivalent levels of gain.
An ESOP is a far-off, uncertain benefit, so add the time and loss aversion discounts together and you can see why even people thinking in more purely economic terms may not be that jazzed by your ESOP announcement.
But what if your communications added more about what ownership means now? Maybe something like this:
From "Creating an Effective Executive Incentive Program"Getting the right incentive compensation program can be challenging in any context. In ESOP companies, there is the added layer of fiduciary responsibility to make sure the company does not waste corporate assets on unnecessary, unjustified plans.
Following some key guidelines can help. First, when using compensation data, understand that it can be hard to tailor to a given company because the survey samples are often selective and are a poor match for your company's demographics and compensation philosophy. So use the data as a guide. Are you a clear outlier—below or above the dataset? If so, then you may need to rethink whether you can justify your use of the data. Carefully evaluate how the data sample was constructed and how well it represents your company. Finally, remember a key goal of incentive pay is retention. Are you losing people, or do you never lose them? If you are not losing people, then changes in incentive pay are less compelling, and you need to focus on whether they would change what decisions people make rather than how motivated they are.
A first step is to think about your compensation philosophy. Doing and documenting this at the board level helps to evidence a reasoned process. The philosophy should discuss the process for setting pay, positioning on key elements of pay, aligning pay with corporate objectives, and aligning pay with culture. Having outside board members with industry experience is a valuable part of this process.
From "Should We Use Account Segregation?"ESOP companies may want former employees not to participate in either the potential gains or losses of company stock before they get their distribution. While they could simply make a distribution on termination, many companies fear that would encourage people to leave to get their account balances, and so want to retain a delayed distribution rule. Segregation also frees up more shares for reallocation to help deal with potential have/have-not problems and may help manage cash flow when share prices are rising faster than the company's cost of money.
On the other hand, segregation means an accelerated cash requirement because shares are repurchased and reallocated sooner. These reallocated shares will also need to be repurchased again sooner, so the turnover of shares is higher. Segregating in an immediate lump sum may result in challenges, including variable cash requirements and a limited planning horizon to come up with cash.
In using segregation, the plan must describe the circumstances when segregation or reshuffling will take place. The administrator or fiduciary cannot use discretion to determine which participant accounts will be segregated. Segregation must be implemented in a nondiscriminatory manner. Once an account is segregated, it may also be unsegregated, unless the participant satisfies the requirements for account diversification (over age 55 and 10 years in the plan) and has elected diversification. Segregation does not change the distribution rules. The account of a terminated participant can be reinvested in cash or other assets, and can be held in the plan until the participant is entitled to take a distribution of the account balance under the normal plan rules. Segregated accounts can be invested in the same investments as other non-stock investments in the ESOP. The investment of the replacement assets needs to be prudent, but does not need to mirror the return on the stock.
From "Negotiating Protections for the ESOP or Sellers Related to Subsequent Events"Clawbacks are more likely if the purchase price is at high end of the fair market value range; the company has limited or inconsistent earnings history; there is significant customer concentration; and/or the industry is volatile, cyclical, or in decline.
A protection mechanism for sellers is an earnout. This is commonly used in M&A transactions to provide sellers additional upside (i.e., an increase in the purchase price) if certain targets or thresholds are met or exceeded. The negotiated terms are similar to those in a clawback, but in reverse. Earnouts are usually settled in cash instead of an increase in the seller note face amount. They are far less common in ESOPs, but may make sense if the business has significant, if uncertain, upside potential and the ESOP trustee is not willing to give any credit for these possibilities.
Misrepresentation of the business in usually addressed with representations and warrants that certain characteristics or conditions of the business are true. Representations and warranties are outlined in the purchase agreement and typically include that:
- Financial statements are accurate
- Taxes have been paid
- The company owns its assets
- There are no environmental issues
- Material contracts are disclosed
- Relevant litigation is disclosed
- There are no undisclosed liabilities