And now, for something completely different. . .
The last two blog entries have dealt exclusively with one type of ESOP, the Employee Stock Option Plan. If you have read those entries, you know that I am not a big fan of such plans. In this third and last installment of the three-part series on ESOPs, we are going to look at an entirely different type of ESOP, the Employee Stock Ownership Plan. What a difference a word can make. This type of ESOP, while not appropriate for every company, can be an enormous benefit when all the right pieces fall into place.
A TRUE WIN/WIN
The term win/win is thrown around rather blithely, but in the case of an ESOP it is really quite accurate. An ESOP simultaneously does all of the following:
- It provides an exit strategy to owners of privately held businesses by using company profits to fund the sale of the business to the employees.
- It enables employees to acquire ownership in their company without having to invest their own money.
- It creates a beneficial relationship between the company and federal and state governments by allowing the Company to use pretax profits to fund the buy-out of the owners.
- It provides significant tax and retirement benefits to the employees after they become owners.
- It provides continuing tax advantages for the company after the original owners have sold the business to the employees.
That is the essence of an ESOP. Of course, the devil is in the details and ESOPs are usually highly complex to set up and administer. But beyond the near term financial benefits already mentioned, there are a host of other benefits:
- Because ESOPs are wholly or partially employee-owned, they tend to have a very unique corporate culture that is built around openness, fairness, and egalitarianism.
- ESOP companies tend to enjoy unusually high productivity that stems from high levels of employee involvement.
- ESOP companies tend to place high importance on employee education, participatory decision-making, and open communication.
In general, this makes them a lot of fun to work for.
THERE ARE SOME DISADVANTAGES
As I mentioned earlier, ESOPs are not for everyone, and it is important to consider the downside before taking the plunge. Here are a few things to keep in mind:
- Availability of Financing -- Fortunate are those companies that are able to finance the sale of the company to employees through cash-flow and associated tax benefits. But most often some form of financing is required. If the transaction is financed with a bank loan, the company must have the ability to qualify for this loan. Otherwise the seller may have to give a personal guarantee and/or self-finance the sale.
- Disclosure -- ESOPs are required by law to produce a considerable amount of paperwork for the government and the employees.
- Valuation -- ESOPs must secure an independent valuation each year to establish the value of the stock.
- Liquidity -- In order to fund transactions as employees leave and/or retire, an appropriate amount of cash must be kept on hand to repurchase their stock. This is not normally a problem for the first few years, but it must be carefully managed after that.
- Fiduciary Liability -- The plan committee members who administer the plan are deemed to be fiduciaries and can be held liable if they knowingly participate in improper transactions.
- Stock Performance -- If the value of the business does not increase over time, the employees may feel that they would rather have a cash incentive rather than the deferred benefit provided by an ESOP. In the extreme case, if the company goes out of business, employees stand to lose everything in their ESOP account.
THE BOTTOM LINE
Clearly, the brief and simple description of both types of ESOPs reveals the complex nature of these types of pay plans. To sum it up, I would steer clear of Employee Stock Option Plans in favor of annual cash incentives (provided the cash incentives are self funding and the company can afford them). I encourage owners of privately held businesses who seek an exit strategy to look into Employee Stock Ownership Plans as they provide intriguing possibilities
Check these links for more information on Employee Stock Ownership Plans:
Menke & Associates -- Consulting firm specializing in setting up and administering ESOPs
National Center for Employee Ownership -- National association made up primarily of ESOP organizations
Great Game of Business -- Organization dedicated to disseminating the principles of employee ownership