A corporate Swiss Army Knife: The Employee Stock Ownership Plan

Part 1: Introduction to ESOPs and their uses

Like a Swiss Army Knife, an Employee Stock Ownership Plan (ESOP) is a multi-purpose tool. It is a:

• Tax-qualified, broad-based retirement plan
• Strategy to expand employee-ownership to help workers build wealth and “think like shareholders”
• Shareholder exit strategy

Some proponents of ESOP strategies seem to tout them as the all-purpose solution to whatever ails a business owner – but sometimes, jargon obscures complexity and often results in confusion. This and subsequent articles will attempt to provide a clear explanation of what an ESOP is and how an ESOP may be used to achieve a variety of business objectives, noting potential pitfalls, risks, and solutions along the way.

What Is An ESOP?

An ESOP is a tax-qualified retirement plan similar to a profit sharing plan. The employer makes contributions that are deductible when made, the contributions are allocated (divided up in proportion to compensation) to participant accounts and build-up tax-free. Taxation may be further deferred by rolling a distribution into an individual retirement account (IRA).

“So an ESOP is like my 401(k) plan, right?” Yes in that they are both tax-qualified retirement plans but also no, because there are no employee contributions to an ESOP.

An ESOP is also an ERISA-covered “pension” plan designed to invest primarily in qualifying employer securities (QES). For a company whose stock is not publicly traded, QES includes the common stock with the best voting rights and dividend rights of any class of common stock. Because of this design feature, an ESOP is exempt from the requirement that its investments be diversified. This article will assume that the QES is a company’s common stock.

“What if an ESOP participant doesn’t want to invest in company stock?” In general, ESOP participants don’t control how their ESOP account is invested, the ESOP Trustee is responsible for investing the ESOP assets as a whole and each participant’s account is credited with a proportionate share of the total. An ESOP is required to offer limited diversification rights (Explained further below).

Consequences of the above:

• An ESOP must be administered consistent with the governing document (Plan Document) and the Internal Revenue Code (Code). Even a “plain vanilla” ESOP is complex, so an experienced ESOP service provider is, in practical terms, a must.
• Within the bounds of the Code, there is flexibility as to the terms and conditions of participation in the ESOP, for example, as to eligibility and vesting. 
• ESOP assets are held in trust for the benefit of ESOP participants and the trustee formally owns the shares.
• Except as to diversification of investments, individuals or entities performing fiduciary duties for the plan are subject to the fiduciary responsibility requirements of ERISA, for example, disclosure, and with respect to investments other than QES.

“Investments other than QES?” An ESOP will typically hold cash for liquidity and may also hold investments into which participants can diversify, although diversification is more typically done through a separate defined contribution plan, such as a 401(k) plan

Special ESOP rules

Because an ESOP primarily holds company stock, there are additional special rules that must be satisfied:

• Right to Receive In-Kind Distributions. The participant must have the right to receive distributions in-kind - e.g., shares of common stock, rather than in cash - unless the company’s charter or bylaws restrict the ownership of stock to current employees or qualified plans or if the company is a S corporation.
• Put Option. A participant who does receive stock must have the right to sell (“put”) it back to the company (which the company cannot refuse) (the “put option”) that is, at a minimum, exercisable during two separate 60-day periods, the first starting when the stock is distributed and the second in the following plan year after the stock valuation has been completed and communicated to the former employee.
• Voting Rights. On ordinary corporate issues (for example, electing directors), the ESOP trustee exercises voting rights in relation to the ESOP stock. In certain situations, such as mergers, recapitalizations, or sale of substantially all assets of the business, the shareholder vote is passed through to participants.
• Diversification Rights. Participants who have attained age 55 and completed 10 years of participation in the ESOP must be given the ability to diversify a portion of their account balances each year over a 6 year period, so that the account is not invested exclusively in QES.
• Independent Valuation. The ESOP trustee must determine the value of the QES at least once per year.  If the QES is not publicly-traded, the trustee must obtain a qualified independent appraisal and is responsible for selecting a valuation firm. And, although the trustee is not expected to be a valuation expert, the trustee is ultimately responsible for the assumptions, methods and formulas used, and for the accuracy of the data and math used and reported in the valuation report.

How is an ESOP a shareholder exit strategy?

Because an ESOP is specifically designed to invest primarily in QES, an ESOP can be used as part of a shareholder’s strategy for selling some or all of their ownership in a business. In other words, a shareholder can sell their equity in a company to an ESOP and, through the ESOP, to the company’s employees on a leveraged and tax-advantaged basis.

1. The employer establishes an ESOP.
2. Financing is arranged – typically, the employer will secure a commercial loan and then extend a loan to the ESOP.
3. The ESOP uses the proceeds of the loan to purchase the stock, which is held in “suspense” subject to a security interest.
   Capital gains may be deferred if the employer is a C corporation, the ESOP purchases at least 30% of the employer’s issued and outstanding stock, and certain other requirements are satisfied.
4. The stock is held in a suspense account in the ESOP as security for the loan.
5. Each year, the employer makes tax-deductible contributions to the ESOP, which the ESOP uses to repay the loan.
6. As the loan is paid off, shares are released from the security interest and the suspense account and allocated to participant accounts based on the ESOP's allocation formula.

As indicated, typically, the employer will secure a commercial loan and then make its own loan to the ESOP. This allows the ESOP to have a longer term loan than the company; for example, the loan to the company might have a ten year term but the loan to the ESOP may have a thirty year term (which a commercial lender would not agree to). 

Why would the ESOP have such a long-term loan? As noted, the ESOP repays its loan with contributions and the Internal Revenue Code limits the amount that can be contributed. Too short of loan term could require contributions beyond these limits. Also, as noted below, repaying the loan is only part of the financial commitment that goes into supporting an ESOP over the long-term.  So, lengthening the loan term is often the key to making the numbers work on a sustainable basis.

At some point, ESOP participants will become entitled to benefit payments and this will require cash to fund the ESOP cash distributions and/or satisfy put-options. To the extent shares are converted to cash within the ESOP, those shares must be either allocated to other participants (recycled) or purchased out of the ESOP by the employer (redeemed). Note that if shares are recycled, same shares are cashed-out repeatedly and if shares are redeemed, the ESOP will progressively shrink and disappear. The cost of recycling/redeeming are generally referred to as “repurchase liability” and needs to be carefully considered during the planning phase and on an ongoing basis. Either way, this is yet another set of financial obligations the company must take into account.

ESOPs seem very complicated, how do I figure out if my company can sustain an ESOP? A critical element in evaluating a potential ESOP is a “feasibility study” which examines the many financial pieces to a leveraged ESOP puzzle to determine whether an ESOP strategy appears to be financially feasible for a company over the long term (or how to modify a strategy to make it feasible).

Example Case Study: An ESOP in action

Will Robinson is the CEO and sole shareholder of Lost Space, Inc., an established and growing company. LSI stock is nearly all of his personal wealth and after 30 years creating and building the business, Will wants to diversify, retire, and bike around the world. His accountant helps him find a reputable valuation firm and a month later, they deliver their report concluding that 100% of LSI equity is worth $80 million. Will is thrilled! His lawyer helps him find a firm to set up and administer an ESOP, Desert Raven Administrators, and with the flourish of a pen, Will creates the LSI ESOP.

LSI hires Mountain County Bank to be the Trustee, qualifies for an $80 million loan from a bank with a 10 year term and proposes making an $80 million loan to the ESOP with a 40-year term. MCB hires its own valuation expert, Artic Eagle, Inc., which requests a great deal of primary source financial data from LSI. When LSI’s CFO emails the Arctic Eagle lead consultant asking if she has questions and can she provide any kind of update, the response is a one-word email “No”. Several weeks later, Arctic Eagle delivers its report to MCB concluding that 100% of LSI equity is worth $70 million. MCB writes to Will’s lawyer that it won’t pay more than $70 million and also will insist on having the right to appoint two of LSI’s seven Directors. Will’s response is “I won’t quibble over $10 million – just get it done – I’m ready to ride!” 

LSI finalizes its loan from MCB for $70 million over 10 years and its loan to the ESOP over 40 years. The ESOP buys 1 million shares (100%) of Will’s LSI stock and he bikes off into the sunset. The LSI stock goes into a “suspense account” within the ESOP trust.  Later that year, LSI contributes $1.750 million cash to the ESOP, the ESOP makes its first loan repayment to LSI, and 25,000 shares of LSI stock are released from suspense and allocated to ESOP participant accounts. The next year, the ESOP Trustee gets an updated valuation report, LSI contributes another $1.750 million cash to the ESOP, the ESOP pays its annual loan installment to LSI and another $1.750 million of LSI stock is released and allocated to participant accounts ...

Not all is at it may appear from this serene picture . . . The camera pans out from the bustling office to the desert landscape . . . to be continued!