Chapter 11

Practical Considerations and Employee Stock Ownership Plan Resources

Professionals who are interested in working with clients on possible employee stock ownership plan (ESOP) installations or who wish to learn about this field will gain an understanding from a number of time-honored best practices. ESOPs are not always a logical or even desirable option for certain closely held companies. It is most efficient to quickly qualify the likelihood of a potentially successful ESOP installation. By recognizing a manageable set of variables, ESOP candidates may be quickly screened for suitability. Absent these best practices, the candidate may still be a suitable prospect, but the professional adviser is on notice that the installation will likely be a challenging assignment.

Finally, a number of ESOP-related resources are identified later in this chapter. Only resources that are likely to be readily available are listed. Older ESOP resources may be hopelessly outdated because there have been significant and sweeping changes in ESOP legislation in the past few years.

Qualifying ESOP Candidates

ESOPs are generally a far more viable alternative for the business owner to consider, but there is often a significant amount of misunderstanding about the mechanics of an ESOP. Misunderstandings about the technical aspects of an ESOP installation are the most common reason for business owners to reject the concept, in our experience. The following observations are offered to assist professionals and owners to quickly determine if a company is a strong candidate for an ESOP.

Qualities of Successful ESOP Candidates

This is a very general heading, and it is emphasized that a successful ESOP installation is a culmination of many complex factors coming together:

• The candidate is typically a successful and profitable company. If the candidate is not already profitable, it becomes a serious challenge to determine how the ESOP will be able to purchase any stock.

• The candidate is well-established and, often, a market leader. Well-established companies exhibit the predictable cash flow that is essential for an ESOP carrying acquisition debt.

• The candidate communicates with its employees. Communication is typically achieved through a number of vehicles, such as quality programs, strategic planning, open door policy, newsletter, bulletin board, and so on. Communications is an integral part of building a company culture of ownership that is the heart of successful ESOP installations.

• The candidate has qualified management. The candidate may be in virtually any industry; the difference between successful ESOP installations and unsuccessful attempts is often in the depth of management.

• ESOPs often succeed when there is a reasonably high incidence of employee education. Additionally, ESOP success is enhanced when the employees have a significant amount of direct contact with customers or clients.

• The candidate has an established company culture. In many cases, well-established companies in smaller communities excel as ESOPs due to a close bond that already exists among associates. Of course, the same holds true for any company with an established culture, regardless of location.

• Relative size is not a limiting factor. Companies that employ only 15—20 associates may be excellent ESOP candidates. Very small companies with fewer than 10 employees may not have enough inherent value to warrant the expense of an ESOP. Very small companies that are S corporations may also be subject to ESOP anti-abuse statutes.

• Time is an ally of an ESOP. It takes years for the ESOP to pay for the employer stock. The sooner the selling shareholders begin the process of transition planning, the more options they have and the greater the likelihood they will receive an enhanced value for their stock.

Characteristics of Less Successful ESOP Candidates

Generally, we focus on the many reasons why ESOPs succeed, but a number of items commonly define an ESOP in a failed installation, an installation where objectives have been clearly missed, or simply an unsuitable match:

• The business owner is focused only on the tax benefits of the ESOP. Such an owner is typically oriented to tax benefits, with no interest or commitment to communicating the ESOP to employees. Although the tax benefits are often the first serious attention an ESOP receives, a broader commitment to the long-term interests of the company is important.

• Senior management is autocratic, with little likelihood of changing. Such an outlook is antithetical to building a company culture of ownership. If the ESOP is to have a reasonable chance of success, it is often the vehicle to provide autocratic senior management (typically the selling shareholder) with a complete exit.

• Business owner delays transition planning until a crisis arises. The crisis often is failing health. As mentioned, time is an ally of an ESOP. If there is little time for a smooth transition, it is often impractical for the ESOP to be the exit vehicle. The amount of ESOP-related debt to purchase the entire equity stake of an owner (often a sole shareholder) in a single transaction is not manageable for the company.

• Type of industry may not be a good candidate. There are a few industries where an ESOP may not work due to the high value of the company stock in relation to the qualifying payroll. An example of such an industry is natural resources, where the value of the resources is very high in relation to the company payroll. It may not be practical to sell stock to the ESOP because the amortization period could be prolonged beyond reasonable limits.

• Size of company. An ESOP may not be practical in very small companies with limited employment. The ESOP anti-abuse legislation is aimed specifically at small S corporations. Candidates with fewer than 10 employees may not be very suitable.

• Financially challenged company. Companies that are marginally profitable or losing money are, at best, questionable ESOP candidates. The long-term orientation of the ESOP makes such an investment a questionable endeavor. The facts change somewhat when the ESOP is proposed as one acceptable way to preserve jobs.

  1. — Saving jobs is a harsh reality that likely means employees will be making compensation concessions to provide the resources the company requires to service acquisition-related debt. Under such circumstances, the company stock must be valued for the purposes of an ESOP, but a significant amount of caution should accompany the valuation analysis. If the company fails for any reason, the price paid for the stock will be questioned, and those questioning the value of the stock will have the benefit of perfect hindsight.

• Highly cyclical or volatile companies. Companies in highly cyclical industries should be analyzed over at least one full business cycle, if practical, to assess the relative risk environment. Operating results should be considered over a longer term. If the ESOP is installed, there is the high likelihood that the company will go through additional business cycles in the future. The company must be able to meet ESOP-related obligations over a range of financial results. It is questionable to view the company from a financial perspective based on a few carefully selected years chosen by management.

• Companies in a start-up mode. Such companies may wish to share ownership with employees. Although this is a commendable goal, the financial reality is that the business owner may surrender a significant percentage of ownership and receive very little in return financially. Such companies typically have little operating history and, often, modest stock value.

  1. — When the uncertainties of achieving the future prospects are unknown or speculative, caution should be exercised when assessing the value of the stock. Generally, if the company is successful, it is often practical to allow the value of the stock to increase as the company demonstrates financial success.

Practical Insights Summary

ESOPs are a wonderful option for many closely held businesses to consider. The S corporation election expands the range of ESOP applications significantly. However, ESOPs may not be an appropriate match for many candidates for the reasons just listed. Carefully qualifying ESOP candidates will ultimately result in successful installations.

Overview of ESOP-Related Resources

A wide range of resources regarding ESOPs are available to professional advisers. The listing that follows is intended to highlight a number of the currently available and easily located sources.

It is emphasized that two of the best sources of information are the ESOP Association (EA) and the National Center for Employee Ownership (NCEO). For that reason, each is listed separately with an indication of most major publications and resources offered.

The focus of this listing is to identify resources that are helpful in understanding ESOPs. Many articles published in professional journals are not considered because they are often very difficult to locate. If you have a specific request for technical information, you are directed to the EA or the NCEO. Both organizations are virtual wellsprings of information and resources. Their staffs are helpful and friendly; they genuinely want to help you understand ESOPs.

The following resources are not listed in any specific order. The resource headings have been organized to assist in the search for relevant data.

The EA Publications

Helpful publications include the following (not an inclusive list; contact the EA):

• An Introduction to ESOP Valuations

• Annual Conference CD and Annual Conference Book (conference books have been discontinued in 2011) (a collection of presentations made at the Annual Conference in May)

• How the ESOP Really Works

• Journey to an Ownership Culture: Insights from the ESOP Community

• Legislative, Regulatory and Case Law Developments: A Year in Review (annual update on technical and legal developments)

• Structuring Leveraged ESOP Transactions

• The Definitive Guide to ESOPs (two-volume set from the Employee Ownership Foundation)

• The ESOP Association Administration Handbook

• The ESOP Report (monthly publication)

• The EA Membership Directory

• Two-day ESOP conference proceedings book (a collection of presentations made at the traditional two-day conference in Las Vegas each year)

• Valuing ESOP Shares, Revised 2005

NCEO Publications

Helpful publications include the following (not an inclusive list; contact the NCEO):

• ESOPs and Corporate Governance

• Employee Ownership Report (periodical of the NCEO)

• Leveraged ESOPs and Employee Buyouts

• Selling Your Business to an ESOP

• The ESOP Reader

• Wealth and Income Consequences of Employee Ownership: A Comparative Study from Washington State

The Ohio Employee Ownership Center

The Ohio Employee Ownership Center (OEOC) was founded in 1987 and is affiliated with Kent State University. The OEOC is a nonprofit organization dedicated to assisting business owners with transaction planning, most typically involving ESOPs. The OEOC will actually help business owners develop succession plans and assist in assembling a team of experienced professionals to meet goals.

The OEOC is one of the few places where you can find information on employee cooperatives (similar to ESOPs but with significantly fewer tax benefits).

Other ESOP Resources

• Blasi, Joseph, Richard Freemen, and Douglas Kruse, eds. Shared Capitalism at Work: Employee Ownership, Profit and Gain Sharing, and Broad-Based Stock Options. Chicago: University of Chicago Press, 2010.

• Blasi, Joseph, and Douglass Kruse. The New Owners: the Mass Emergence of Employee Ownership in Public Companies and What It Means to American Business. New York: HarperCollins, 1991.

• Blonchek, Robert, and Martin O'Neill. Act Like an Owner: Building an Ownership Culture. Hoboken, NJ: Wiley, 1999.

• Gates,Jeff. The Ownership Solution:Toward a Shared Capitalism for the 21st Century. New York: Basic Books, 1999.

• Hitchner, James. Financial Valuation: Applications and Models, 3rd ed. Hoboken, NJ: Wiley, 2011. (See chapter 16 on ESOPs.)

• Howitt, Idelle, and Corey Rosen. Employee Stock Ownership Answer Book, 3^rd ed. New York: Aspen Publishers, 2011.

• Pratt, Shannon, and Alina Niculita. Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th ed. Ohio: McGraw Hill, 2008s (See chapters 32—33 on ESOPs.)

• Reilly, Robert, Robert and Schweihs. The Handbook of Advanced Business Valuation. Ohio: McGraw Hill, 1999. (See chapters 11—12 on ESOPs.)

• Stack, Jack, and Bo Burlingham. The Great Game of Business: Unlocking the Power and Profitability of Open-Book Management. New York: Currency/Doubleday, 1994.

• ——— . A Stake in the Outcome: Building a Culture of Ownership for the Long-Term Success of Your Business. New York: Crown, 2003.