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ESOP Blog

ESOPs: Common Misperceptions

[fa icon="calendar"] Jun 29, 2015 9:00:00 AM / by Kevin Long

Kevin Long

There are some common misconceptions about ESOPs that should be addressed and dispelled. Unfortunately, many less than fully informed business owners and advisers hold them as truths. Many business owners mistakenly think:

  • An ESOP is a giveaway.
  • I will lose control of my company.
  • You must disclose all financial data to employees.
  • My employees cannot pay me what my business is worth.
  • My employees are not interested in an ESOP.
  • ESOPs are for failing companies.
  • ESOPs are forever.
  • Anyone can do the required appraisal.
  • The ESOP must replace all retirement plans.
  • The ESOP’s stock repurchase liability will kill the company.

The truth is, selling to an ESOP is not a giveaway because the ESOP is permitted by law to pay an appraised fair-market value for the shares. Nothing is given away for free. Even in situations where an ESOP is funded with contributions of newly issued shares, in most situations, the contributions are in lieu of cash contributions or represent tax- and cash-flow advantages to the company that cannot be obtained with another type of benefit plan.

Immediate loss of control is not a concern insofar as the ESOP is a very flexible tool. No more control has to be given away than the minimum required by the Internal Revenue Code and ERISA. However, there is a broad range of options for sharing control or management participation with employees. By law, the shares are owned by the trustee of the trust who votes the shares. The employees are beneficial participants in the trust just as they are in a profit-sharing plan. Employees may or may not be included on the board of trustees, depending on what is appropriate for the particular company and situation. Although there are a few instances where the ESOP requires that ESOP participants be allowed to direct the vote of the shares in their accounts (“pass-through voting”), these instances are very limited. Furthermore, these issues rarely come up in the day-to-day operation of the company. Add to that the fact that most ESOP companies start out as minority ESOP-owned long before the ESOP becomes a majority owner of the company. The transition of real and complete control to an ESOP (if desired) is gradual or planned, for all companies that become majority ESOP-owned. Furthermore, employee owners, through ESOPs, have proven to be very conservative shareholders, and more often than not vote with management on key issues.

Financial-statement disclosure is not required just because you have an ESOP. Neither is it required that you give out a copy of the ESOP’s independent appraisal. However, most sponsors of successful ESOPs find that sharing financial information with employees or explaining how stock gets its value is a very powerful management and motivational tool. In fact, strategic sharing of a company’s financial performance in well-designed management/productivity programs happens to be all the rage for management gurus, including those who espouse philosophies such as “total quality management,” “open-book management,” and the “great game of business.”

Ironically, most company owners who think their employees are not capable of paying them what their companies are worth will find that the ESOP provides them a value that is not only favorable, but perhaps the maximum they can obtain by law. As with pride of ownership in a home, business owners often have an inflated or emotional value tied to their companies that must be dealt with in the business-planning process. For example, from an estate-planning perspective, it is not in the business owner’s best interest to place a high value on his or her shares. In fact, business owners and their estate planners will bend over backward to establish how low the value of the stock is.

As for employee interest in owning a piece of the company, a survey published by the Bureau of National Affairs several years ago indicated that more than 58 percent of employees it surveyed were interested in owning a part of their company through a program such as an ESOP.

As far as rescuing failing companies is concerned, according to the National Center for Employee Ownership, only about 2 percent of all ESOPs ever formed in the United States were formed for the sake of saving a failing company. Therefore, overwhelmingly, ESOPs are for successful, profitable companies.

Neither do ESOPs have to remain in place forever. They are not an impediment to a future sale of a company. Ironically, they happen to make companies very attractive to prospective purchasers. ESOPs can also be wound down or terminated immediately or gradually, depending upon the long term needs of the business.

Regarding appraisal of the shares owned by an ESOP, this legal requirement is often misunderstood. Both the Code and ERISA require a qualified independent appraiser to set the value of ESOP shares. Not only is it a violation of the law that a related party or an inexperienced or unqualified appraiser perform the work, it is also shortsighted. The ESOP appraisal, if done properly by a qualified financial analyst, can be a powerful tool for shareholders, and in turn management, to understand what makes a company valuable. We have seen time and time again that an ESOP armed with a top-quality financial advisory firm can help the company avoid blunders and refine its skills at projecting performance for the future. The appraisal fee is not an added cost. It is a great value-added feature of having an ESOP.

We would like to thank Robert W. Smiley, Jr. for his inspiration and comments. It is adapted from an article written by Mr. Smiley and published in the Spring, 1991 issue of the Valuation Consultant. Mr. Smiley is the Chairman and Chief Executive Officer of the Benefit Capital Companies, Inc., an ESOP investment banking and consulting firm. He is the founder, a lifetime Honorary Director and past President of the ESOP Association.

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Kevin Long

Written by Kevin Long