Steps to Setting Up an ESOP
If you have decided an employee stock ownership plan (ESOP) is worth investigating, there are several steps to take to implement a plan. At each point, you may decide you have gone far enough and that an ESOP is not right for you.
(1) Determine Whether Other Owners Are Amenable
This may seem like an obvious issue, but sometimes people take several of the steps listed below before finding out whether the existing owners are willing to sell. Employees should not start organizing a buyout unless they have some reason to think the parent firm is willing to sell (it may not be, for instance, if its goal is to reduce total output of a product it makes at other locations). Or there may be other owners of a private firm who will never agree to an ESOP, even if it seems appealing to the principal owners. They could cause a good deal of trouble down the road.
(2) Conduct a Feasibility Study
This may be a full-blown analysis by an outside consultant, replete with market surveys, management interviews, and detailed financial projections, or it may simply be a careful business plan performed in-house. Generally, full-scale feasibility studies are needed only where there is some doubt about the ESOP's ability to repay the loan. Any analysis, however, must look at several items. First, it must assess just how much extra cash flow the company has available to devote to the ESOP, and whether this is adequate for the purposes for which the ESOP is intended. Second, it must determine if the company has adequate payroll for ESOP participants to make the ESOP contributions deductible. Remember to include the effect of other benefit plans that will be maintained in these calculations. Third, estimates must be made of what the repurchase obligation will be and how the company will handle it.
(3) Conduct a Valuation
The feasibility study will rely on rough estimates of the value of the stock for the purpose of calculating the adequacy of cash and payroll. In public companies, of course, these estimates will be fairly accurate because they can be based on past price performance. In private companies, they will be more speculative. The next step for private firms (and some public companies as well) is a valuation. A company may want to have a preliminary valuation done first to see if the range of values produced is acceptable. A full valuation would follow if it is.
Doing a valuation before implementing a plan is a critical step. If the value is too low, sellers may not be willing to sell. Alternatively, the price of the shares may be too high for the company to afford. The valuation consultant will look at a variety of factors, including cash flow, profits, market conditions, assets, comparable company values, goodwill, and overall economic factors. A discount on value may be taken if the ESOP is buying less than 5% of the shares.
It is a best practice that the appraiser for the ESOP transaction not be the same appraiser that performed a preliminary valuation for the company or selling shareholder. Having the same appraiser who did such a valuation cross over and now work for the ESOP itself raises questions of objectivity and independence, and increasingly is frowned upon by government regulators. Furthermore, the ESOP trustee, not the company or seller, should select and hire the appraiser for the ESOP transaction and ongoing yearly valuations. The company may pay the appraiser's bills, but the appraiser's client is the ESOP, and the trustee should not only hire the appraiser but also carefully scrutinize the appraiser's work product and its assumptions.
(4) Hire an ESOP Attorney
If these first three steps prove positive, the plan can now be drafted and submitted to the IRS. You should carefully evaluate your options and tell your attorney just how you want the ESOP to be set up. This could save you a considerable amount of money in consultation time. The IRS may take many months to issue you a "letter of determination" on your plan, but you can go ahead and start making contributions before then. If the IRS rules unfavorably, which rarely happens, normally you just need to amend your plan.
(5) Obtain Funding for the Plan
There are several potential sources of funding. Obviously, the ESOP can borrow money. Banks are generally receptive to ESOP loans, but, as with any loan, it makes sense to shop around. Sellers or other private parties can also make loans. Larger ESOP transactions can also tap the bond market or borrow from insurance companies.
Another source of funding is ongoing company contributions, aside from loan repayments. While ESOPs must, by law, invest primarily in employer securities, most ESOP experts believe they can temporarily invest primarily in other assets while building up a fund to buy out an owner.
A third source is existing benefit plans. Pension plans are not a practical source of funding, but profit sharing plans are sometimes used. Profit sharing assets are simply transferred in whole or part into an ESOP. Many ESOP companies do this, but it must be done cautiously. If employees are given no choice in the switch, trustees of the plan must be able to demonstrate that the investment in company stock was prudent; if they are given a choice, there could be a securities law issue.
Finally, employees can contribute to the plan, most commonly by wage or benefit concessions. Most ESOPs do not require these, but they are necessary in some cases. Clearly, this is an issue that must be handled very carefully.
(6) Establish a Process to Operate the Plan
A trustee must be chosen to oversee the plan. In most private companies, this will be someone from inside the firm, but some private and most public companies hire an outside trustee. An ESOP committee will direct the trustee. In most companies, this is made up of management people, but many ESOP firms allow at least some nonmanagement representation. Finally, and most important, a process must be established to communicate how the plan works to employees and to get them more involved as owners.
For a book-length orientation to how ESOPs work, see Understanding ESOPs.