Sustainability, largely ignored until the 1990s, has become one of the most talked-about ESOP issues. Years ago, some ESOPs were meant as one-time transactions, most ESOPs held a minority of the company's stock, even those committed to long-term ownership had not faced the issues of mature ESOPs, and people thought that communicating the ESOP was enough to motivate employees. All this is different now. Research showed that companies outperform when employees share ideas and information. As a result of the rise of S corporation ESOPs, 100% ESOP-owned S corporations are now common, and they have a major incentive to remain ESOP-owned. Companies with 100% ESOP ownership become more concerned with creating and sustaining an effective ownership culture.
As a consequence, ESOP sustainability is a perennially popular topic at ESOP conferences. Much of the discussion focuses on internal ESOP dynamics such as managing the repurchase obligation. Such considerations are critically important, but they are only part of the story. A truly sustainable ESOP company also has a strategy to maintain an effective employee ownership culture and a profitable business model. In particular, this means effective leadership succession strategies, a governance structure consistent with employee ownership, having a strategy for sustained growth, and more. This book discusses all of these issues, with references to other material that explores each topic in depth.
Table of Contents
2. Sustainable Distribution Policies
3. Sustainable Repurchase Policies
4. Valuation Issues
5. Leadership Succession and ESOP Sustainability
6. Solutions for the Have/Have-Not Problem
7. Sustainable ESOP Governance
8. Communicating ESOPs
9. Creating and Growing an Ownership Culture
10. Strategy and ESOP Sustainability
Appendix: Additional Resources
About the Author
About the NCEO
From "Should You Releverage Your ESOP to Fund Repurchases?"
An idea that has gained some currency in recent years is to partly or entirely releverage an ESOP. There are many variations on this theme. The core idea is that the company purchases either ESOP-held shares or shares from terminated employees, and then the ESOP borrows money from the company to reacquire the shares.
In the most extreme scenario, the company buys back all the shares in the ESOP, terminates it or converts it to another plan, and sells the shares to a new leveraged ESOP. Say there are 100,000 shares at $100 per share, with a total value of $10 million. The company buys the 100,000 shares, borrowing the $10 million if needed. The shares are now owned by the company. ESOP participants now have $10 million in cash in their accounts rather than $10 million in shares.
Because the plan no longer would qualify as an ESOP if the cash remained in employee accounts (because the ESOP would no longer be primarily invested in company stock), the money could either be paid out and the ESOP terminated, or the ESOP could be converted to a 401(k) or profit sharing plan. If the ESOP is terminated, everyone is vested and then receives the payout.
The second step is for the company to set up "ESOP 2." ESOP 2 borrows money to buy the shares back from the company. The shares are allocated as the loan is repaid. The effect of this is that all employees are at the ground floor of the new ESOP. Because of all the debt taken on to repurchase the shares, the enterprise value will be lower than before the debt was incurred.
Less dramatically, the company can borrow enough money to buy just some percentage of the shares in the plan, or shares from terminated employees. In this case, the plan would still be primarily invested in employer stock, so it would continue to operate, unlike the "ESOP 2" scenario above. This could be done in a number of ways:
From "Solutions for the Have/Have-Not Problem"
Account segregation (called "reshuffling" of terminated participant accounts in IRS guidance) applies only to shares held by former plan participants who are still in the plan. In account segregation, the ESOP cashes in these shares and reallocates them to people in the plan who are still working for the company. The former employees now have cash in the plan that must be invested prudently. Some ESOPs just put this money in a CD, but Department of Labor officials have indicated informally that this is not a prudent approach. Ideally, plan trustees should use an investment advisor to recommend an approach that is conservative but diversified into a higher-yielding mix of investments.
It may seem that if the company has the money to cash out the shares, it should just do that rather than retain and manage the cash until a later (often five years later) payout. Companies do this primarily to discourage employees from leaving just to get access to their accounts.
From "Sustainable ESOP Governance"
ESOP companies are increasingly using outside professional trustees. There are a number of reasons for this, but the most important are concerns about fiduciary liability for inside trustees and the belief that it is better to pay for the expertise that a qualified trustee can bring to the ESOP process than, in effect, pay internal staff to develop the skills and do all the things a trustee must do. While independent trustees are an added cost of potentially tens of thousands of dollars annually (fees depend on the size of the company, scope of engagement, and perceived risk of the engagement, among other things), that may be less than the implied cost of the staff time needed to perform these functions. The NCEO governance survey found the median trustee compensation for smaller companies (up to $50 million in sales) was about $15,000 per year, rising incrementally with size to $35,000 for sales between $50 million and $200 million, and $80,000 for companies larger than that. Fees did not vary significantly based on whether the trustee was independent or directed.
Independent trustees can be a bank or other professional trust institution or, occasionally, an individual specialized in this field. Trustees should be able to show substantial experience in the field, be willing to share (and explain if necessary) any audit or court cases they have been involved in, and be active in the relevant professional organizations. Boards need to select trustees whose style and approach is comfortable to them. If a trustee wants a more active role on the board than the company wants, for instance, or has views on issues such as the repurchase obligation, valuation approaches and assumptions, executive pay, and other issues on which the board feels differently and has good reason to believe its views are consistent with ERISA, then a different trustee should be chosen.