Employee Stock Ownership Plans - A Contrarian View

Employee Stock Ownership Plans (or ESOP’s) are complicated financial arrangements designed for an entrepreneur/owner to receive a tax break for selling some portion or all of his company to the employees of that company.

Financing succession in this way is a remarkable idea, first legislated in 1977 by Senator Russell Long. Mr. Long did his thinking along with Dr. Louis O. Kelso whose many writings on wealth redistribution are well-known in this area. In theory, it is a marvelous arrangement. In practice things get a lot more complicated, especially if the company experiences a financial downturn.

Founders of privately held companies have traditionally begun thinking about how to “take chips off the table” in their mid-50s. They have two overriding concerns: how to avoid the double-tax bite of selling their stock and can they find a buyer who will pay what they would like to think the company is worth.

ESOP’s provide good solutions to both of these problems. As long as cash flow is strong enough, an ESOP is a ready purchaser of the stock. Even better, as long as a founder can get an independent valuation firm to sign off on it, the entrepreneur can have a lot of input on the value of the company. Even more exciting, as long as an entrepreneur sells at least 30% of his stock to the ESOP, the money is his tax-free. Not tax-deferred, but tax free, as long as he keeps it in government securities for a short period.

A common arrangement, then, is to sell 30%. The entrepreneur retains control with 70%, and can name himself as the sole trustee of the ESOP trust, which is now the owner of 30% of the stock. effectively making no changes in his ability to solely run the company.

The administration of ESOP’s is a lucrative business. There are many independent firms whose sole business is administrating pension plans and profit sharing plans, but divisions of big CPA firms also often administer ESOP’s. Most owner/entrepreneurs hear the details about ESOP’s through the many direct mail pieces and free seminars offered by the administration firms. If an administration firm can entice an owner to set up an ESOP, it means about $5,000 (at the low end) to $30,000 a year in administration fees as long as the company maintains an ESOP. The set up fee for all the legal work, etc. is $20,000 to $50,000 for the first year. An independent valuation (required annually) is another $5,000 to $15,000 per year.

Part of the work of the administration firm is to do the initial presentations to the understandably skeptical employees. The announcement is generally of the “too good to be true” variety and goes something like this: “Mr. Smith, your founder, has generously decided to sell 30% of his interest in our company to you, the employees. The best news is that you don’t have to put up any of your own money - the sale comes out of the earnings of the company. As Mr. Smith gets paid for his stock over time, stock is also being added to individual participation accounts for each employee, making each of you a part owner. If you stay with the company long enough, and the value of the stock continues to increase with the growth of the company as we truly believe it will, each of you could retire a wealthy person.” Then several examples are shared of companies whose employees, including several janitors, are now millionaires. The increases in value will come both from good management decisions and from the increases in productivity of the employees. In other words, if you work hard, you will be rewarded.

And indeed, over the first few years of an ESOP, it has been demonstrated that there are real productivity increases, and employees early to retire often get some good money.

But an ESOP is a very complicated arrangement. Although most employees who are participants in ESOP plans are referred to in the administrators’ marketing pieces as “owners” they are in reality the beneficiaries of a trust fund in which the real “owner” and decision-maker is the trustee. And the trustee is generally the entrepreneur/founder, at least while he still owns 51% or more of the company stock.

Very few employees, even financially sophisticated ones, truly understand how an ESOP works. There are employee-oriented brochures and other educational information put out by the ESOP Association (www.the-esop-emplowner.org) and the National Center for Employee Ownership (www.nceo.org) and they are well done. They just don’t begin to cover all the negatives, but focus, understandably on motivating employees with the word “ownership”, and all the wonderful benefits that could come their way if everything goes well for the company. The biggest question, of course, is this: “How much money will I get when I retire?” The possibilities range from zero to a large sum of money, but there is no way to narrow down the assumptions one has to make to make a reasonable guess. When a financial planner makes interest rate assumptions to advise on investment decisions, it is based on a diversified portfolio of stocks, bond, real estate, or other investments that have a long track record. None of this can be done with an ESOP, which law, must be invested in its own stock - stock for which there is no other market.

The ultimate benefit of an ESOP to most employees is not, then, easy to assess. At its heart, the relationship between employer and employee is an even deal: an hour’s work for an hour’s pay. It is harder and harder to recognize this basic truth with the changes to that arrangement that have occurred over the past twenty years. There is no question that employees have benefited immensely from the perks that have been added to salary: bonuses, vacation and sick pay, health insurance, life insurance, dental and vision insurance, retirement benefits, and more. But 1977 added the ultimate employee benefit by law - the ESOP. The ultimate benefit is the exchange of the relationship, where, over time, the employee becomes the owner.

The employee is asked and then expected to think like an entrepreneur, and in theory, to take on the risks and the rewards of the entrepreneur. But given the continually increasing protections for employees and employment, ERISA, the Department of Labor, and the IRS keep a close eye on ESOP’s. Companies with substantial ESOP’s should expect to be audited frequently.

An ESOP can be run just like any other company, although many are highly participative. This happens for two reasons: First, the best way to get the productivity bump that is so highly publicized with ESOP’s is to give employees more input and more power in the decision-making process. While motivating at first, this loses its newness after a few years, and like any other organization, change happens relatively slowly, demotivating the most aggressive employees. Secondly, the company is now subject to a higher degree of regulatory scrutiny, and most find that since they have to be careful about uses of money that they might as well get credit for it with the employees, and they begin open-book management practices.

But deals that are uneven rarely work in the long run. Reward without risk becomes entitlement, and that is often what an ESOP becomes in the minds of employees.

Just Some of the Problems Encountered by ESOP’s:

1. Independent valuation. Valuing a company whose stock isn’t publicly held is always problematic. The basis of the valuation is a weighted combination of cash flow and comparable companies. The first (and most important) valuation is done before the ESOP is created. Valuations thereafter there is a discount for lack of marketability, virtually guaranteeing that the second valuation will be lower than the first, unless the company has increased its value tremendously (unlikely with all the other changes occurring). Once a company has an initial valuation, subsequent valuations tend to be boilerplates, and can be had for as little as $3,000 a year, for about a half-day’s work for the valuation professional. Valuators try to avoid wide swings in valuations from year to year, since they are aware that these can have drastic ramifications in bank loans and in employee morale, even if they are warranted. Also, ESOP’s aren’t required to have audited financials, which might be one source of protection. Annual audited financials are seen as a financial burden on small companies and as a deterrent to setting up an ESOP and are therefore not required.

2. Repurchase Liability. Repurchase liability is the current value of future distributions to employees. It stems from the fact that ESOP participants have a put option on their ESOP shares when employment is terminated. Studies can and should be done to help the company plan to meet these future obligations when they come due. This liability is dependent on the average age of the workforce, expected turnover, and of course, the increase in stock value over time. An ESOP is a qualified pension plan and is subject to traditional vesting. A new plan can, and usually does, grandfather in time already served in employment, creating an immediate repurchase liability. It generally is not an early priority of an ESOP to plan for later stock repurchases, since it has so many other financial obligations, primarily to the founders and to a bank when the ESOP is created.

So far, GAAP hasn’t produced a good way to account for changes to the Financial Statement with an ESOP. Of concern with major purchases on credit, landlords, and bankers, ESOP’s often show negative equity. In addition, there are many gray areas in ESOP accounting and law. The best fiduciaries can do is rely on some IRS Private Letter Rulings, and some conflicting findings of the Department of Labor.

3. Annual Valuations/Potential Downside for the Employee. Once the value is set, prior years’ retirees are stuck with that number. For example, an employee has been working for an ESOP company for 15 years, and decides to retire at 55, in December 1997. There is generally a “year break in service rule” meaning that, assuming that the employee has not returned to work, the value of the benefits to be paid out will be set by the stock value at year-end 1998. This company has done very well and the employee has seen his per share stock value rise from $20 a share in 1982 to $80 a share on his retirement date in 1997. Unfortunately, this was a bad year for the company and two clients with 50% of the company’s revenue left to do business with competitors. By the time the year break in service is over, the stock has now been valued at $40 a share, and the employee has lost half of what he had expected to be able to retire on.

4. Annual Valuations/Potential Downside for the Company. Unfortunately for the company, it can also go the other way. An ESOP is not a pre-funded mechanism for retirement, and individual accounts are set up on paper only - distributions are made out of the continuing earnings of the company. For instance, using our prior example, the employee retires in 1996 instead of 1997, so after his year break in service, his stock is still valued at $80 per share. That value is now set and his total benefit, although paid out over time (usually five years) cannot change. Continuing the example, the company has a disastrous year, and its earnings are far below where they were expected. It still owes this employee that same amount of money, even if other employees who retire months later aren’t as lucky. Timing is everything. For companies experiencing a downturn (and over the life of a company, which ones won’t) money has to be taken out of earnings to go to paying terminating employees, money that cannot be used for R&D, marketing, or acquisitions which may be vital to the long-term success of the company.

5. Employee Expectations of Equality. Employees also start believing the press that they are owners and begin to expect owners’ perks and participation in decision-making beyond what their expertise would suggest. “If I’m an owner, why do the managers get cars/trips/bonuses, etc. and I don’t. Shouldn’t we all be treated equally?” Also, “I am an owner here, and I think Sally should be fired. She isn’t very good with people. Who do I talk to to make that happen? Can we take a vote?” There is a level of anger and resentment that builds with decisions that managers make, even if employee participation was sought and encouraged. Although many employees want to be heard, they aren’t entrepreneurial risk-takers and don’t want the level of responsibility to make decisions and be accountable for their consequences on a company-wide level.

6. Employee Expectations of Benefit Increases. Employees generally expect their benefit amounts to increase every year as they do with most of the benefits employees receive. Although it is explained that like any stock, values go up and down, many employees are truly angry and feel they have been sold a bill of goods only intended to get them to work harder if the stock value goes down. Employees receive annual “participation certificates” that look like stock certificates and detail the amount in the ESOP pool that has been allocated to them at that point in time. Adding to the difficulty is that the valuation is done once a year, so employees have to psychologically live with a lower value for a year, even if they believe the company is increasing in value during the following year. A publicly traded stock has daily or even hourly changes in its value. Even if management does an outstanding communications job, employees believe that this is the amount of money they would get if they retired today. I had one employee try to use the certificate to prove to a mortgage lender that he had assets to qualify for a home loan. Another employee told me he needed $3 million to retire and put his kids through college and was angry because I couldn’t tell him that the ESOP would provide that for him.

7. The Myth of Employee Ownership. Although the plan is called an employee ownership stock plan, individual employees do not own stock, although you wouldn’t know that from reading the promotional brochures. The only way to sell employees on working harder is to offer them a benefit, and the word “owner” is something to which many people aspire. Conversely, “employee ownership” makes it difficult to terminate employment. How do you fire an owner? Literally, of course, it is no different than in any other company, however there is a certain invulnerability assumed after hearing so much about themselves as owners did. Terminating employment becomes a much more public event, one for which employees want detailed explanations, even if they violate a departing employee’s privacy.

In addition, there is an odd wrinkle for an ESOP that has lived beyond its early years and has paid back its loans. After this time, all shares have been allocated, leaving nothing for new employees who are hired, making only certain employees “owners”. There are a variety of ways to deal with this, including diluting the original shares by issues new shares, but none work well over the long run. (For more, see NCEO.org/ columns for David Johanson 2/9

8. Employee Cynicism. Some employees are very skeptical of the whole arrangement and vocalize their belief that they won’t see any of it when it comes their time to retire - much like some of the baby-boomer current thinking about Social Security. This undermines the whole ESOP idea and creates an air of cynicism about other areas in the company. There is a sense that this is a scheme designed to benefit someone, but probably not them.

9. Reduction or Elimination of 401(k) and IRA Contributions. The IRS currently limits employee benefits to a maximum 25% of payroll. If the ESOP is highly leveraged, the company may choose (at its discretion) to use that maximum amount toward the ESOP to get the greatest tax benefit and to be able to pay down its loans quickly. In this case, a 401(k) plan could not receive contributions (employee as well as employer matching) and most surprising to most people, the employee could no longer make tax-deductible contributions to at IRA. This 25% amount includes 401(k) employee contributions, so that if a company wanted to keep a popular 401(k), it might only allow an employee 10% contribution, it might match with a 5% contribution, and leave 10% towards an ESOP contribution. In some circumstances it is also allowable to use a 401(k) plan to fund an ESOP, but one can only imagine the risks to the employees who put all their retirement money in the ESOP basket. (See NCEO.org columns for David Johanson 2/96)

10. Time and Money Required for Administration. Many professional ESOP administrators unwittingly or self-servingly downplay the time it will take for the company’s executives, accounting and human resource staffs to answer questions, do paperwork, and perform general administrative duties surrounding the ESOP. It can be a tremendous distraction for a staff that needs to focus on effectively running a growing business. In addition, the money required not only for annual valuations and administration is substantial. HR problems are complicated, legal problems are complicated, and new types of advisors, such as ESOP counsel are probably going to be necessary. It is important to note that all of the ESOP-related expenses are borne by the company, even if they solely benefit the departing founder/owner. It is also important to remember that the company has, in essence, set up a pension plan for employees, something rare in today’s small business environment, which adds to its cost of doing business, putting it at a possible disadvantage relative to its competition.

11. Limited Company Options. It is very difficult to sell a company with a substantial ESOP - most potential acquirers are not interested in having employees as partners. In fact, forming an ESOP has been used as a strategy to thwart hostile takeovers. An original founder/owner will generally sell up to 50% or will sell 100% so as not to remain as a vulnerable minority stockholder. At the same time an ownership change is taking place, the company is acquiring bank loans for any of three purposes: to fund the sale, for operating capital for a cash depleted company, or to fund growth. As we’ve said, many times the founder is the spirit and has provided most of the entrepreneurial thinking for the company, and sometimes even the sales contacts. Often, too, his ego has required that his top executives are in agreement with his decisions and he doesn’t usually attract CEO-caliber managers, so there are no ready successors. He takes out both the cash and the top management know-how of the company, and leaves the employees to run themselves.

Add to this that the owner for privately help companies generally must personally guarantee bank loans. Who guarantees a loan to an employee-owned company? No one employee owns enough to want to put his house up as collateral. I was asked to do this as the CEO, but I only owned 8% of the shares - why would I take such a great risk for such a small reward?

12. Conflicts of Interest. It can be difficult to optimize the interests of all parties and maintain the fiduciary duties required. When owners decide to sell some of their ownership, they want to do so without losing control. However, when you have an ESOP, you now have two owners, and these ownership interests are distinct. Founder/owners resist however, having professional advisors representing the separate interests. Also, the duties of a trustee can be at odds with the interests of the founders and even the successor CEO. This adds another level of expense for an ESOP company if it decides to have separate professionals for each interest.

Specifics of the Merritt Publishing Case

In the case of Merritt Publishing, we faced all of these obstacles. The Merritt Publishing ESOP was set up in June of 1990, and funded backwards to make its official start date April 1, 1989. Bo Merritt, its 75-year-old founder, sold the employees 40% of his company. He and the independent valuator decided on a total company value of $3.5 million. In exchange for the stock, the Merritt family took about $750,000 - all the cash in the bank accounts, and sold a building owned by the company, also for approximately $650,000 for a total of $1.4 million. The founder died at the end of 1991, and the family wanted their money out, but couldn’t sell to anyone but the employees because of the ESOP. They also didn’t want to guarantee any bank loans, so we set up an ambitious plan to pay them off over three years from the earnings of the company. These same earnings should have gone toward growing the company, but were used to pay distributions to employees who left and to pay the founders. It left the company weakened considerably, and the employees ultimately demoralized over three years of no salary increases and inadequate resources. The price per share dropped dramatically over the period, and although the founding family was bought out in 1996, the company was sold in 1998. The final per share price was about $5.

I was the successor CEO of the company, from February 1990 to its sale in August 1998 and a trustee of the ESOP during that entire period. I had been the firm’s Editorial Director, when promoted to President, and didn’t have any financial background. It took me several years to completely understand all the ramifications of an ESOP, and even then, I couldn’t see that the company couldn’t withstand all of its financial obligations.

The ongoing negotiations with the family after the founder’s death took much of my time for over two years. The family lived across the country, and their emotional involvement with the company that bore their name was understandable. They remained on the Board as a majority for five years, until the sale was complete in 1996.

We did pay the founding family, the retired employees, and all of our creditors at the time of the sale. The biggest losers: the long-term employees who saw the company through all of these struggles and ended up with a fraction of its expected value. The biggest lesson, when you put your retirement eggs in the ESOP basket, you are investing in very risky small company equities, and even worse, only one small company instead spreading the risk. The ESOP is a wonderful vehicle for owners and founders who are leaving the business. It is a huge risk for the retirement plans of remaining employees, and worse, puts the entire company at risk. Too many people want their piece of the company simultaneously, and there often isn’t enough cash to do that and finance the company’s operations at the same time.