ESOPs Remain Attractive for Companies Seeking to Engage Workers

Employee stock ownership plans (ESOPs) can be a powerful tool for recruiting and retaining top talent in good times and bad. And there is ample research showing that ESOP companies weather economic crises better than non-ESOP businesses.

Those advantages helped drive peak interest in ESOP conversions just before the coronavirus that causes COVID-19 hit. Although dealing with the pandemic takes priority now, there are still strong reasons to consider an ESOP for long-term stability.

For instance, researchers from Rutgers University and the University of Massachusetts Amherst found that publicly traded ESOP companies were more likely to survive a recession and maintain steady employment levels in both boom and bust cycles.

Similarly, researchers at Georgetown University's McDonough School of Business who studied ESOPs formed as S corporations found that during the U.S. recession that began in December 2007, these ESOPs, on average, continued to hire when other firms laid off workers; invested in their businesses when other firms were in retreat; and expanded their contributions to employee retirement plans when other firms were doing the opposite.

ESOP Considerations During the Pandemic

The COVID-19 pandemic may have distinct impact on ESOP businesses, especially when they are downsizing.

"ESOP sponsors need to appreciate the extent of the financial strain imposed on their company by a simultaneous layoff of a sizable portion of their workforce," Harvey M. Katz, a partner at law firm Fox Rothschild in New York City, wrote recently. "Each one of these terminated employees will receive a distribution of shares from the plan at the same time and therefore will become eligible to 'cash-out' all or part of those shares concurrently."

That would result in "a spike of cash-out requests by a significant number of employees—at a time when the company is least able to afford to make these payments," Katz noted.

Like other businesses, however, the Coronavirus Aid, Relief, and Economic Security (CARES) Act offers ESOP-owned companies much-needed assistance.

ESOP companies can now apply for and take out a Small Business Administration loan under the new Paycheck Protection Program (PPP) to cover payroll costs and other approved expenses, explained Christopher McLean, an attorney with Kaufman & Canoles in Norfolk, Va. ESOP companies can then use PPP loans to cover both ESOP contributions and 401(k) plan contributions, he pointed out.

In calculating the ceiling on PPP loan amounts, attorneys at Morrison Cohen in New York City advised, "companies that have paid cash contributions into their ESOPs during the measuring period (calendar 2019 for most employers) should remember to include [these contributions] in the calculation of 'payroll costs' in their loan applications."

Two nonprofit organizations, the ESOP Association and the National Center for Employee Ownership, offer resources for ESOP companies on applying for PPP loans and can provide advice on issues such as managing ESOP contributions when cash flow is reduced.

[SHRM members-only HR Q&A: How Does the Families First Coronavirus Response Act (H.R. 6201) Impact Employers?]

How ESOPs Work

The appeal of ESOPs for both businesses and employees is in how ESOPs are structured, giving employees ownership of the company. This makes ESOPs distinct from employee stock purchase plans that allow employees to buy company shares through payroll deductions. ESOPs also differ from incentive pay plans that grant employees company equity, often as stock options or restricted shares, without giving employees a majority stake in the business.

When transitioning to employee ownership through an ESOP, a company creates a trust fund and then contributes new shares of its stock or cash into the fund. Each employee in the ESOP, depending on tenure, salary and vesting status, then receives a proportionate share of the company at regular intervals (usually annually), which can be paid out at retirement or on leaving the company, either in a lump sum or over no more than a period of six years in substantially equal payments.

Employer contributions to ESOPs are tax-deductible, and when credit is used to finance ESOPs, both the principal and the interest are tax-deductible, as well.

A Sweet Spot for ESOP Conversions

Privately held firms looking to assure stable succession should consider ESOP conversion, said Delcie Bean, founder and CEO of Hadley, Mass.-based Paragus Strategic IT. He navigated the ESOP transition at his firm from 2013 through 2016.

The Old Fort Banking Co., headquartered in Tiffin, Ohio, with 108 employees, began transitioning to an ESOP in 2015 when its majority shareholder, who was in her 60s, wanted to assure it remained independent. The ESOP began with a 47 percent share of the company, and by February 2020, it had increased employee ownership to 63 percent.

"If you're trying to buy a large percentage of the company, it works best if you have one owner willing to sell to an ESOP, whether it's all at once or over time," Old Fort Chief Financial Officer Mike Daniel said.

Chicago-based consultancy West Monroe Partners has been 100 percent employee owned since 2013. The firm opted for ESOP ownership to give its employees better return over its previous profit-sharing and ownership structure, said managing director Nate Ulery.

"Anyone who is an employee in a plan year with at least 1,000 hours of service receives shares," he explained. Share allocation is based on a combination of salary plus tenure with the company.

"We feel equity should go to those who have decided to spend a significant period of time at the organization," Ulery noted. "Employees get a stock grant for the full value of the shares, not an option."

West Monroe Partners uses this short video to explain its ESOP to employees.

In Tandem with 401(k)s

West Monroe still offers a match into employees' 401(k) accounts, as well as the ESOP to its 1,500 employee-owners.

"Most ESOP companies have a 401(k) plan, and the ESOP is in addition to it," Ulery said. "The vast majority continue to match 401(k) contributions in order to encourage employees to continue to diversify their retirement savings."

Along with the 401(k) plan, the ESOP provides "an extra-competitive benefit, because it costs the employee nothing. It gives us a distinct advantage in the talent marketplace," Ulery said.

Daniel said Old Fort Banking had contributed 6 percent of salary into employees' 401(k)s, whether the employees contributed or not, but now it puts all company contributions into the ESOP. "Banking is an industry that lends itself to a very steady stock price," he noted, and employees can use their 401(k)s to own diversified investment funds.

Promoting Employee Ownership

Joseph Blasi, professor of human resource management and director of Rutgers University's Institute for the Study of Employee Ownership and Profit Sharing, said that  before the pandemic he noticed a sharp uptick in interest in ESOPs among supporters of fairer pay "because there aren't many ways to address economic inequality other than equity sharing and profit sharing." And, he added, "ESOPs now have a 50-year track record."

Daniel said it may take a while for employees to grasp the intricacies of the ESOP, but converting to an ESOP is a mutually beneficial move. "When you talk about why certain decisions are made and how it's better for the bottom line, people understand it's also better for them."

Greg Goth is a freelance business and technology writer based in Oakville, Conn.

Related SHRM Articles:

Younger Employees Face Rewards, Risks in Stock Compensation Plans, SHRM Online, September 2019

Equity Compensation Plans Build Loyalty but Uncertainty Abounds, SHRM Online, February 2018

When Is a Privately Held Business ESOP-Ready?, SHRM Online, November 2015