ESOP Sustainability

How Having a Sustainable ESOP Became a Hot Topic

After ESOPs could own S corporations starting in the late 1990s, the idea of being ESOP-owned forever became more popular due to the S corporation tax shield. However, this massive financial incentive to keep the ESOP going was coupled with financial and other challenges: As ESOPs matured, more companies faced repurchase obligation pressures. Also, the idea of having a more satisfying and productive ownership culture spread, but this means incoming leaders should embrace new ideas. And once a mature ESOP allocates all the stock to participants, a "have/have-not" problem can arise in which new participants receive only cash except for reallocated forfeited shares, etc. Thus, ESOP sustainability emerged as a key issue and remains one today.

So how can a company be sustainably ESOP-owned? Some of this comes from managing the ESOP itself, such as managing the repurchase obligation. Some of it is external to the ESOP, like effective risk management and leadership succession plans.

Sustainable Distribution Policies

ESOPs often have boilerplate provisions that delay distributions as long as allowed, but where the stock price is rising, this can make the repurchase obligation larger than it needs to be. Hence, many companies pay out sooner than legally required so the ESOP is more sustainable (within limits, a distribution policy can allow some flexibility here); this also makes the ESOP more relevant to participants because they get paid out sooner.

Sustainable Repurchase Policies

The company can plan share repurchases with an eye to what will enhance sustainability in its case: Will the company buy them back, and if so, will it retire the shares or recontribute them? Or will it fund the ESOP to repurchase shares? It is important to regularly perform repurchase analyses. Failure to prepare for repurchases can lead to the company running out of cash, resulting in a forced sale or even bankruptcy.

Valuation Issues

There used to be some controversy on this, but it is now generally agreed that the ESOP appraisal should reflect the repurchase obligation. Without this, the stock price would be higher, resulting in a greater repurchase burden on the company, which in turn would make the ESOP less sustainable.

Creating and Growing an Ownership Culture

NCEO research has found that ESOP companies perform best when they have extensive employee involvement systems, such as open-book management. Employee ownership is more sustainable at these companies because they simply perform better.

Leadership Succession and Sustainability

As time goes on and new leaders must be hired, the company needs to hire leaders who will embrace the ESOP and any ownership culture the company has adopted.

The Have/Have-Not Problem in Mature ESOPs

What happens when all the shares have been allocated to existing participants and then new employees come on board? If something isn't done, the new employees will get only shares reallocated from forfeitures and recycled repurchased shares, creating a culture of "haves" (the original employees who now have almost all of the stock) and "have-nots" (the newer ones not sharing in the stock price appreciation). So what can you do?

• Account segregation (called "reshuffling" by the IRS, which issued guidelines on this and rebalancing in 2010): After employees terminate, their balances are converted to cash instead of remaining in stock until distributed. The resulting shares are now allocated to the accounts of the remaining participants.
• Rebalancing: Every year, the plan redistributes stock and cash in employee accounts (using cash in A's account to buy stock from B's account, etc.) so everyone has the same percentage of stock and cash.
• Profit sharing accounting: Here, participant accounts do not have literal allocations of stock or cash but instead have a percentage of the pool of assets in the ESOP trust, so everyone has the same percentage of stock and cash. This is best done from the plan's inception to avoid messy administrative issues.
• Adjusting forfeiture formulas: As long as they meet legal rules, forfeiture formulas can be set to favor new and/or lower-paid employees.
• Contributing newly issued shares to the ESOP: This dilutes the existing ownership but spreads shares among participants.
• Funding ESOP share purchases from remaining non-ESOP owners: If the ESOP doesn't own 100% already, this will provide shares for newer as well as long-time participants.
• Stretching out the inside loan: Where the ESOP is leveraged and the company borrows money (the "outside" loan) and reloans to the ESOP (the "inside" loan), the inside loan may be stretched out over a longer period than the outside loan so that benefits are distributed more evenly, with employees arriving later still being able to get shares instead of finding all the shares have already been paid off and allocated.
• Releveraging the ESOP: As described in our Repurchase Obligation Handbook, the company redeems shares from participants or the ESOP and sells them to the ESOP in return for a promissory note; the shares are allocated to employees over time as the note is repaid, thus ensuring everyone gets shares.
• Offering early diversification: If participants can diversify out of stock earlier than legally required, this provides more stock to reallocate to newer employees.

Strategy and Governance

ESOP companies need to plan for the effects of having the plan, from dealing with the repurchase obligation and its effect on strategy to planning how acquired companies will fit into an ownership culture. Governance plays a role in sustainability, too: for example, the company may formulate a written policy that it is employee-owned, plans to stay that way, and is not for sale, although it will consider serious offers.

The ESOP Sustainability Study

An ESOP sustainability study models the effect of the repurchase obligation and other factors, reviews elements such as the ESOP's current plan design, and recommends actions to maintain a thriving company and successful ESOP.

Resources on Sustainable ESOPs

These and other issues are discussed in our books Sustainable ESOPs and Creating a Sustainable ESOP Distribution Policy. If you're an NCEO member, watch our live and replay webinars on ESOP sustainability and related topics. If you're not a member, consider joining.