Common Misperceptions About ESOP Business Transitions: A Response to a Wall Street Journal Article
Ronald Gilbert, ESOP Services
April 2010The article titled "Giving Employees a Share" (Wall Street Journal, November 17, 2009) did a good job of introducing readers to the pros and cons of employee stock ownership plans (ESOPs). The first part of the article provided a good overview of ESOP tax benefits and how these benefits compared to a sale to an outside buyer. However, the last section, "Seven Proper Steps to Creating an ESOP," made a number of statements, quoted below, that were, at best, confusing. This article addresses a number of these statements from each of the seven "steps," and clarifies gifting the company to the employees, which has been the subject of recent media attention.
The Seven "Steps"
- "Some business owners, however, might dislike the idea of losing some of their say as they lose ownership." If one or more owners wish to maintain complete control of the company, then they should sell the ESOP a minority interest. Even in a company where the ESOP owns a majority interest, the board of directors governs the company and appoints senior management and the ESOP trustee.
- "The cost of conducting an ESOP, which typically runs around 5% of the sale price, is steep." The cost of implementing an ESOP will range from less than 1% to approximately 5%. The larger the ESOP transaction, the smaller the percentage as many fees are fixed. A typical cost would be 2% to 3% of the sale price. If the ESOP is non-leveraged, the total cost should be well under $100,000. The ongoing cost of operating the ESOP may be slightly higher than operating a 401(k) plan.
- "Partners or non-principal owners...should also be willing to sell their shares." In many ESOPs, it is just the opposite. Some shareholders desire liquidity, while other shareholders want to continue to own their stock. Many ESOPs begin as a minority owner but eventually end up owning the majority or even 100% of the company.
- "Make employees aware of what is going on. Also alert them to being able to opt out of participating if they choose." Employees normally should not be made aware of what is being considered until the board of directors and shareholders have made the decision and the transaction is finalized. There are a number of reasons the ESOP may not be finalized, which would result in disappointed employees. Companies that have very participative cultures may decide to risk the possible disappointment by informing employees in advance. Employees should almost never be given the option to opt out, which is essentially asking them if they want to give up a free benefit. Almost all ESOPs are fully funded by the company; no employee funds are required, and the ESOP is usually in addition to a 401(k) plan. If the corporation already sponsors a qualified retirement plan, such as a 401(k) plan, and the ESOP is fully funded by the company, there is no reason for employees to opt out.
Step 3"ESOP payments can amount up to 25% of payroll." The contribution limit to an ESOP may be greater or less than 25% of covered payroll, depending on a number of variables. For example, dividends made by an S or C corporation that are used to repay ESOP debt are excluded from the 25% limit. In the case of a C corporation, the dividends are tax-deductible if used to repay ESOP debt or paid out to ESOP participants.
- "Get an appraisal." The most efficient way to assess the feasibility of the ESOP is to get a preliminary valuation by an independent appraiser during the feasibility study process, not after the feasibility study as the article suggested, because this ensures that the analysis for the feasibility study uses a reliable value for planning purposes. Make sure the appraiser is truly independent (note that the Department of Labor has never given any guidance as to what constitutes an independent appraiser).
- "Conversely, the value may be too high based on what the company can afford." Stock can be sold to the ESOP at a discount. The selling shareholder can also finance a portion of the transaction at a low rate of interest over an extended period of time. If the selling shareholder does hold a subordinated seller note, a warrant or "equity kicker" can be attached to the note, thus having upside potential.
Step 5"If the IRS rules unfavorably..." In over 30 years, the IRS has never ruled unfavorably for one of my firm's clients. A properly written ESOP allows for retroactive changes should the IRS decide that something in the ESOP needs to be changed. The IRS will eventually issue a favorable determination letter. This process could take several years due to the IRS submission schedule. Therefore, companies do not hesitate embarking upon ESOP operations because IRS changes can be made retroactive.
Step 6"Big banks...are generally amendable to lending to ESOPs." This is true, but regional banks and even smaller community banks are discovering that ESOPs make a very attractive lending target because of the cash-flow enhancement an ESOP can provide.
Step 7"Chose a plan trustee to oversee the ESOP, and select a board to direct the trustee." The trustee can vote the stock without direction and is the owner of the stock held in the ESOP. Employees are beneficial owners. The ESOP trustee can be independent. Individuals, typically management, can also serve as trustees. If the board of directors does decide to appoint an ESOP committee to direct the trustee as to the voting of company shares, that committee has fiduciary responsibilities and fiduciary risk. The trustee votes ESOP-owned shares for the election of the board of directors.
Thoughts on Giving Away the CompanyAs this article was finalized, there have been a number of stories on television, radio, and in the printed media about a business owner who "gave" the company to his employees, although several of the pieces imply that it was not a "pure gift."
Shares are sold to an ESOP, not gifted. If stock is actually given to the ESOP, the stockholder owes federal gift tax. The greater the value of the company, the greater the gift tax. Many states impose additional taxes. What apparently happened in the case receiving so much media attention is that the owner may have sold stock to the ESOP for substantially less than what he would have gotten from an outside buyer several years ago, and he may have seller-financed the transaction at an attractive rate of interest. (Stockholders do have the option of selling to the ESOP at a discounted price, although in today's economy, ESOPs are usually able to be very price competitive with outside buyers. See "Step 4" above.) While in the owner's mind, the ESOP transaction might be tantamount to giving the company away, the selling shareholder will almost always receive all the principal and interest payments called for under the terms of the seller financing. There is a great deal of research demonstrating that ESOP companies are more profitable and have better survival rates than their non-ESOP competitors.
A true gift is made when stockholders give their stock in a privately owned company to a charity, and the charity then sells the stock back to the ESOP for cash. The donor receives significant tax benefits. However, stockholders who actually give the company to employees will incur a substantial gift tax.
Many thousands of ESOP companies have created substantial wealth for their employee-owners over the 36 years since ESOPs became a part of the federal law, but stock is not given to ESOPs. ESOPs purchase stock, sometimes on very favorable terms. In the words of a very old commercial, "They do it the old-fashioned way; they earn it."
The author appreciates the contributions and editorial comments of Paige A. Ryan.
About the Author
Ron Gilbert is the president of ESOP Services Inc., which, for over 25 years, has specialized in U.S. and international ESOP transactions, feasibility studies, financing, plan design, communication, and ESOP privatization. Ron Gilbert serves on the board of directors of the NCEO, three ESOP corporate boards, holds membership in the European and Polish ESOP Associations, and co-authors and co-edits the 1,700-page book Employee Stock Ownership Plans: ESOP Planning, Financing, Implementation, Law & Taxation, the most complete work on the subject.