By Corey Rosen, NCEO founder
In the past, ESOP company boards were mostly or entirely made up of insiders and predominantly functioned to fulfill required duties under state law. That began to change in the early 2000s as ESOP companies increasingly concluded that having a more formal board with outside board members could help generate new perspectives, reduce fiduciary risk, and make the plan more credible to employees. Today, 78% of ESOP companies have one or more outside board members.
Just having outsiders on the board and meeting regularly, of course, does not guarantee that boards will add value. Effective boards need several things:
Over the last two decades, I have served on multiple ESOP company boards (with the money going to the NCEO), done training for board members, and listened to hundreds of board members and experts discussing these issues. Some common themes emerge in my experience.
There are a number of different kinds of outside board members a company might seek. If a company can find a rainmaker who can help the company generate new business or negotiate better contracts with suppliers, that is a great board member to get. It's usually not easy to find someone like this, however.
Boards often look for people with industry experience, and this can be a useful tactic. The danger is that people who you know from your industry may not have new perspectives to add. One idea is to look for people in adjacent industries. These board members are familiar enough with your industry to feel comfortable with the issues that may arise but different enough to bring a new perspective. Boards might also look for people with expertise in culture or ESOPs. It is important to have board members who are willing to challenge what's going on in the company when necessary. There is a natural tendency in any group to go along and avoid rocking the boat, but that may end up making the board just a rubber stamp for management.
Finally, some boards seek to include non-management employees. This is often done on a rotating basis, with employees either selected by a vote or by an employee committee. If there is concern about fiduciary liability for these employees, they can serve in a non-fiduciary capacity.
Boards may want to evaluate their own performance and/or the performance of individual board members. The NCEO Document Library has a sample board assessment from an ESOP company.
Board members need to be able to find the sweet spot between being overly intrusive and simply approving what management does. Board members who attempt to micromanage decisions within the organization are almost invariably going beyond their expertise and knowledge of the company’s particulars. This can lead to less-than-optimal decisions and may create substantial conflicts within the organization. On the other hand, where board members do have either the expertise or their perspective to help companies think more clearly or differently about issues, they should feel empowered to do so. It may be useful for boards to periodically have a discussion about just what kinds of issues these are. Some companies provide a specific list of issues that require board input or approval. This will always include hiring and firing the CEO, but it may extend to other officers. That same pattern would apply to executive compensation. Boards typically do not make decisions on bonuses or profit-sharing plans, but they can provide useful ideas. All boards need to approve the budget, but many have charters saying they must approve projected expenditures over a certain amount. Boards, of course, also must be involved in a variety of other issues, such as responding to acquisition offers or the company itself making acquisitions.
One issue that boards often overlook is culture. We know from extensive research that creating an ownership culture is the most important differentiator between successful and less successful ESOP companies. The board should have a regular discussion about this issue. One useful approach is to have someone from the ESOP communications committee regularly make a presentation to the board. We also recommend that companies set up one or more ideas teams. Ideas teams are groups of employees who help create and manage a structured process of idea generation from employees throughout the company. Someone from these teams should also periodically report to the board. Having these reports is not only useful for the board, but it also validates the importance of these issues for employees.
Boards also have ESOP-specific issues they need to deal with. One of the most important is the repurchase obligation/commitment. This should be revisited on an annual basis. When boards are looking at capital planning, a good way to think about this is the three-bucket approach. The first bucket ensures that the company has sufficient cash on hand to deal with anticipated emergencies and cyclical variations in business. The second bucket has funds to handle the repurchase obligation. If these two buckets are filled, the remaining bucket holds money to be used for growth. Each of these buckets would require a different approach to how aggressively funds are invested.
Our governance survey found wide variation in whether ESOP company boards have committees and who serves on them. The best practice, however, is at least to have an executive compensation committee made up primarily of outsiders. If a company has audited financials, there should be an audit committee. If there are people on the committee with skills in strategic planning, it can be useful to have a separate strategic planning committee. Some companies have separate finance committees to go into financials in more detail.
Aside from these committees, it is important for the board to understand that it has a fiduciary duty to monitor the ESOP trustee. The most important part of this is to make sure that the trustee is overseeing the valuation process properly. For a useful trustee checklist that boards can request their trustees fill out, visit the aforementioned NCEO Document Library.
Finally, boards need to get the kind of information that will help them perform their function without overwhelming them. Boards should get detailed financial statements, generally on a quarterly basis. Because board members often won't be able to make sense of each line item on these statements, it's very helpful if a CEO or CFO highlights the variances both from the budget and from prior years with an explanation of what accounts for them. This allows board members to focus on key changes rather than every single number. There should also be a narrative provided to the board by the CEO on what's happening in the company. These are typically three to seven pages long and focus on important developments and challenges. This overview helps the board focus on critical issues. The board also should distinguish between forecasts and budgets. Budgets are what the company expects to spend, while forecasts are what the company expects its revenues and expenditures will be. It is helpful, both for the board and the valuation firm, for forecasts to be built from the bottom up, involving multiple people in the company to provide more checks on the accuracy of the forecast. It's also helpful for these forecasts to be stress-tested to indicate the chances of performing X amount better or Y percent worse.