A company’s prosperity depends on many crucial factors: maximizing growth and profitability, ensuring sound financial management, maintaining robust operations and processes, and paying attention to customer service, among others. If your company is organized as an employee stock ownership plan (ESOP), however, long-term success requires something more: the ability to shift your strategy throughout the company’s life cycle.
Successful strategies for a newly installed ESOP differ from those for a thriving five-year-old ESOP or a maturing 10-year-old ESOP. Of course, hundreds of ESOPs have been in place for over 40 years, as employee ownership offers remarkable benefits to both the company and employees—including greater prosperity during market downturns and less employee turnover. ESOP-owned companies also typically outperform peers in sales growth, employment growth, and productivity growth (according to studies by the National Center for Employee Ownership). But a flourishing ESOP must continually analyze its sustainability throughout the stages of its life cycle. Here’s how.
Setting Up for Success: The ESOP’s First Five Years
Many privately owned companies that install an ESOP are not accustomed to seeing large bank debt on the balance sheet. But now that you’ve taken a loan to fund the ESOP transaction, your bank will likely require regular covenant and compliance reporting packages—something your company previously may not have had to prepare. Your bank may also insist on an independent review or audit of the financial statements by accountants outside of the company. Prepare for these steps early on to ensure that the requisite company resources are available post-closing to meet these requirements.
Prior to the ESOP transaction, your company’s board may have been entirely made up of internal board members (or even family members of the owners). Now, however, the ESOP trustee may strongly suggest (or even require) that the board include at least one outside independent director. When selecting outside board members, it is important to seek those who have qualifications that will be additive to the company. For continuity purposes, the majority of board seats may still be held internally—a five-member board could be comprised of, for example, three internal members and two outside members.
Perhaps the most critical post-ESOP implementation strategy involves fueling excitement early on by communicating with and educating your employees. What exactly is an ESOP? How is it going to affect employees personally? Open the communication lines with a companywide meeting to summarize why the ESOP was chosen as an ownership succession solution. Be clear about the facts: Employees are now beneficial owners in the company, and unlike with a 401(k), they need not contribute any cash to the ESOP to receive benefits. Also explain how company performance will impact them personally—for example, improved employee productivity and efficiency often leads to increased share price (which increases the value of each participant’s ESOP account). Hold regular meetings like this one throughout the ESOP’s life cycle stages. By learning to think like owners (instead of just clocking in and out every day), employees will contribute to the ESOP’s future success.
Time to Reflect: ESOPs at Five to 10 Years
The five-year mark is a good time to look back and reflect as you may need to reassess certain ESOP policies, such as the use of excess cash. Is the company using ESOP dividends or contributions to pay down debt—releasing allocated shares too quickly? Or are those dividends or contributions building up excess cash in the ESOP instead of on the company’s balance sheet? Cash in the ESOP can’t be withdrawn in response to company cash flow demands. Weigh the practice of rewarding employees (managing benefit levels) against your strategy for maintaining the financial health and sustainability of both the ESOP and the company.
If your initial transaction was for less than a 100% ESOP, examine your debt after five years of paying down the external ESOP loan. Is the company in a position to consider a second-stage transaction, where the shareholders sell additional shares of company stock to the ESOP? This presents a huge tax savings opportunity: When the ESOP owns 100% of an S corporation, the company’s income is generally not subject to income tax. The company can then use some of this additional cash to continue to pay down transaction debt and accumulate the rest on the balance sheet for future reinvestment purposes.
A five-year-old ESOP with reduced debt may also wish to pursue a strategy of growth through acquisition, using a combination of excess cash on the balance sheet and additional bank financing. Just as for non-ESOP companies, acquisitions can accelerate growth through expansion of both market territory and customer base and can create more efficient operations through combined synergies. An ESOP also tends to have certain advantages over other buyers where, for example, the seller is seeking to create benefits for employees, wants to preserve company culture and legacy, or is looking to defer capital gains on the sale.
An ESOP as a succession solution often results in the key owner (or owners) of the company exiting after several years. Having a management succession plan in place is vital for a smooth transition to the next generation of leaders. Analyze your “bench strength,” and recruit prospects for any key management positions from outside the company early enough for exiting management to train and develop them. Promote the ESOP—and highlight its five or 10-year milestones—to not only retain employees but also attract new management and other valuable employees to the company.
Looking Ahead: 10-Plus-Year ESOPs
After 10 years, an ESOP is beginning to mature: a good portion of shares have been allocated, share value may have increased significantly, and likely there are retired (or nearly retired) participant accounts with large balances. The repurchase obligation—the increasing liability to repurchase shares from retired and terminated plan participants—is probably what initially comes to mind when you think about ESOP sustainability. In order to pay for future share repurchases, the company must be able to quantify the liability and develop a strategy for funding it. To be sustainable, the company has to manage its cash flow to both fund the repurchase obligation and invest in the growth of the company. This is especially critical to maturing ESOPs, but it is never too early for younger ESOPs to start planning for and managing the repurchase obligation.
Evaluating the company’s sustainability may bring to light potential policy modifications for your maturing ESOP. For example, a sizable percentage of allocated shares in the accounts of retired or terminated participants may inspire the company to consider segregation, which “reshuffles” the share balances of terminated participants into cash. This strategy allows the shares to remain in active participant accounts, where share price increases ensure the employees who currently drive company growth are receiving the benefits of future gains.
Deciding how shares are repurchased or segregated—through either redemption or recycling—is important for a maturing ESOP. The current tax status of the corporation, the impact on the repurchase obligation liability and the impact on the ESOP participants are among important factors to carefully analyze prior to making a redeem vs. recycle decision.
The board of an ESOP company has a fiduciary responsibility to do what is best for the company and the shareholders (ultimately, the ESOP participants). Maturing ESOPs should consider performing a sell-versus-hold analysis, which confidentially evaluates alternatives without publicly testing the market. Depending on whether the analysis determines that there may be interested buyers willing to pay a premium over the current ESOP valuation, the company can decide to either go to market or remain an ESOP for the foreseeable future.
Conclusion
Ensuring your ESOP’s sustainability is about much more than preparing financial forecasts and determining your repurchase obligation, but the right strategy for success often depends on the stage of your ESOP’s life cycle. Performing a sustainability analysis can offer valuable insight on how your strategy should evolve as the ESOP matures.
As experts in all areas that affect sustainability, including ESOP installation and advisory, M&A, and valuation, the PCE team can design the scope of a cost-effective sustainability study that addresses the objectives of your ESOP at any stage. We deliver actionable insights and recommendations—from corporate governance and ESOP plan design/policies to second-stage/acquisition transactions and repurchase obligation studies—that your ESOP’s management, board, and trustees can trust. Please contact us if you have any questions about sustainability.
