Although almost 7,000 U.S. companies have an employee stock ownership plan (ESOP), many businesspeople are not well acquainted with them. ESOPs are often confused with stock option plans, which are something else altogether. They are not stock purchase plans; employees almost never buy stock through an ESOP. They do not require that employees run the company or even elect the board, unless companies want to structure themselves that way. Most people, in fact, would be well served by forgetting what they have heard or thought about ESOPs before starting to learn more about them. This book will teach you what ESOPs really are, how they work in both C and S corporations, what their uses are, what the valuation and financing issues are, what the steps to set them up are, and much more.
This book was originally published in 2008 and then updated in various respects for the 2013, 2014, 2016, and 2018 printings. In this 2020 update, the old chapter on valuation has been replaced with a newly updated discussion of how valuation works in an ESOP context. The chapter on choosing consultants was extensively rewritten to address contemporary situations and concerns more clearly. In addition, other routine clarifications and updates were made throughout the book (for example, at the end of 2019 the SECURE Act increased the age 70½ threshold for minimum required distributions to 72, so the chapter on distributions was updated accordingly).
Table of Contents
1. An Overview of How ESOPs Work
2. Selling to an ESOP in a Closely Held Company
3. ESOPs in S Corporations
4. Things to Do with an ESOP Besides Buying Out the Owner
5. Understanding ESOP Valuation
6. Financing an ESOP
7. ESOP Distribution and Diversification Rules
8. Choosing Consultants and Trustees
9. ESOPs, Corporate Performance, and Ownership Culture
About the Authors
About the NCEO
From chapter 1, "An Overview of How ESOPs Work"
Plans have one or more “entry dates” for employees once they become participants. An employee who has satisfied the plan’s minimum age and service requirements must begin participation in the plan not later than the first of (1) the first day of the plan year beginning after the date on which the requirements were met or (2) the date six months after the date on which the requirements are met. Participation can begin at an earlier date, however. Many plans, for example, have entry dates every six months or every year, and employees become participants at the first entry date after requirements are met.
Shares are usually allocated to individual employee accounts based on relative eligible compensation. Some companies use an alternative formula, generally providing some points for relative pay and some for tenure or, less often, a per-capita allocation. Generally, all W-2 compensation is counted, but there is leeway to define compensation differently, such as by excluding bonuses, provided that it does not favor more highly compensated individuals; on a more level formula, such as per capita, by seniority, or by placing a cap on pay that can be considered; or some combination of the two, such as one point for seniority and one for relative pay. If relative eligible pay is not used, plans must be tested annually to determine whether any highly compensated individual, generally defined as someone belonging to either the top 20% by payroll in the company or those making more than $130,000 per year (as of 2020), is receiving more than what the relative pay formula would indicate. In that case, the excess must be returned to the plan and reallocated to other participants. Finally, ESOP allocations can be used as a match to employee deferrals to a 401(k) plan, in which case all or part of the allocation may be determined by how much the employee defers. This approach requires complex anti-discrimination testing for both plans. Relatively few ESOPs use this approach.
From chapter 4, "Things to Do with an ESOP Besides Buying Out the Owner"
In the simplest approach, the company just contributes stock or cash to buy stock to a nonleveraged ESOP. The contribution may be based on what employees defer, on company profits, or a straight percentage of pay formula. In a more sophisticated approach, the company sets up a leveraged ESOP that borrows money to acquire shares. The allocation of stock from the leveraged ESOP is used to determine the match. For instance, say employees are putting $1 million into the 401(k) from their own deferrals. A leveraged ESOP might acquire 100,000 shares at $20 per share with a 10-year loan and repay 10% of the principal each year. Stock with an original cost of $200,000 per year and $20 per share per year would then be allocated as an employee match in the first year.
But now say that in year two, the stock is worth $25 per share. Now, $250,000 in stock value will be released to employee accounts. If a few years later the stock goes to $50 per share, then $500,000 would be released. Unless payroll deferrals have grown as quickly, employees will be getting a larger match to their 401(k) accounts. The actual cost to the employer will be the same $20 per share, and the amount of the contribution the company records for purposes of contribution limits will also be $20 per share. Accounting rules stipulate that the value declared for the income statement, however, will be the value of the shares when released.
From chapter 5, "Understanding ESOP Valuation"
The ESOP community is adopting a firmer and simultaneously more nuanced position regarding the attributes and value of “control” in ESOP transactions and valuations. Under a more nuanced framework, the appraiser typically starts by determining a value for the enterprise as a whole based on the supposition that regardless of how much the ESOP owns, the company will endeavor to use its assets in a financially responsible and optimal way. The premise is that similar to that applied to public companies, where there is rarely a singular controlling owner and the business is operated with the objective of maximizing shareholder outcomes. Executives and managers in public companies who fall short of achieving shareholder objectives on a standalone basis, whether due to suboptimal results or industry disruption (among other reasons), may find their businesses exposed to strategic events, including mergers, acquisitions, and/or divestitures, whereby the new or successor business is expected to provide superior investor outcomes that result primarily from enhanced cash flows. In contrast, if an industry player perceives opportunity in a business combination with a lesser and/or optimizable target, there will be strategic acquisitions aimed at enhancing value outcomes for all (i.e., 1 + 1 = 3). When these events occur and the underlying pre-transaction values are compared to the transaction values, there is almost universally a measurable value premium. Generally, this premium results from the expectation that cash flows and the resulting investor outcomes from a business combination will be superior to that of a standalone going concern, even under the presumption that the standalone enterprise is already reasonably optimized.