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ESOPs Turn Workers into Owners

The switch requires careful financial management and clear communication to employees

The idea of giving employees “skin in the game” through ownership of company stock is a compelling one to many businesses. Yet, few employers follow that idea to its fullest conclusion by establishing an employee stock ownership plan (ESOP)—a retirement plan in which employees are granted stock in the organization that they can hold as long as they remain employed with the organization.

In the U.S., only about 10 percent of the private-sector workforce has an ESOP available to them, according to The ESOP Association, a Washington, D.C.-based nonprofit that advocates for and provides education on behalf of companies with ESOPs. Among publicly traded companies, the numbers are even smaller, according to the association: Only about 300 public companies have ESOPs out of the approximately 10,000 ESOPs currently in place.

Common Misperceptions

An ESOP is fundamentally different from a company that allows its employees to buy stock shares out-of-pocket through a stock purchase plan, or a company in which workers can acquire stock options as an employee performance incentive. Under those strategies, which are common at publically traded firms, employees typically own a much smaller piece of the business.

Under an ESOP, however, the ESOP owns part or all of the company, and only employees can participate in the ESOP, which is why anyone who leaves the company cashes out.

Private or closely held companies may be interested in ESOPs as a way to provide their business with financial liquidity without selling their company to a third party, such as a private equity group. An ESOP can allow the existing company owners or shareholders to cash out their holdings by essentially selling the company to its employees.

For workers who become owners, an ESOP can serve as an employee retirement plan, and the stock holdings within an ESOP can grow into a valuable retirement benefit if the company continues to prosper.

However, before a company moves forward with an ESOP, it needs to think through several important issues. Without careful financial management and clear communication to employees, an ESOP is unlikely to be effective or successful.

ESOPs and 401(k) Plans

ESOPs differ from employee stock held as an investment within a 401(k) or similar retirement plan, although the two types of stock-ownership vehicles can face similar issues, such as so-called “stock drop” litigation.

ESOPs and 401(k) plans with an array of investment options can complement one another, and ESOP companies are far more likely to offer another employer-sponsored retirement plan than similar non-ESOP companies are to offer any retirement plan at all, according to an October 2015 report from the Center for American Progress, a Washington, D.C.-based progressive policy institute.

Plan for Post-ESOP Management

Before establishing an ESOP, companies need to consider both the finances of the transaction and the ongoing management of the company once the ESOP deal closes and employees have an ownership stake in, or outright ownership of, the company.

“It’s important to understand the financial impact of an ESOP transaction,” said Bruce Ashton, a partner with law firm Drinker Biddle & Reath in Los Angeles. “If the ESOP takes out a loan to buy out the owners, the company must have enough cash flow to repay that loan. Therefore, management must understand the company’s debt service capacity.”

The transaction itself can also be expensive, with costs associated with the company valuation, legal advice, and accounting and investment banking support.

Who will manage the company post-ESOP is also a key question. If the original owners or shareholders plan to remain with the company in some role after the transaction, they must understand that employees are now owners of the company and that they need to be treated as such. If there will be new management, then that team must be in place when the deal closes. Whoever runs the company “must be prepared to do so at a time when the business needs to generate a fair amount of money to pay down any loans that are incurred in connection with the purchase of stock,” said Ashton.

Prepare Employees for Ownership

Employees who act like owners are made, not born. When Point B Inc., a Seattle-based management consulting and venture investment firm, became 100 percent owned by its ESOP in 2014, the firm carefully prepared its 570 employees for the change.

After popping the champagne corks, the company provided employees with an “ownership basics” video the next day. “It explains the basics of how an ESOP works, the potential impact to employees financially, how dollars are transitioned, what tax implications there would be, etc.,” said E.J. Blanchfield, the firm’s chief operating officer.

The company’s leadership also holds “ownership” classes for eight to 10 employees at a time, which cover various parts of operations and how employees can impact results. These efforts are working. In a follow-up survey about the transition, 92 percent of Point B employees felt they understood what impact the transition had on them personally.

Operational changes may also be necessary to help employees see how they can impact company performance—and, by extension, their own financial position.

“We developed more-rigorous planning and financial analysis processes so that we feel confident we are doing all we can to increase the value of our ESOP,” said Blanchfield. “We have also worked to share this planning and financial information on a more-consistent basis.”

Look for the Payback

Once an ESOP is in place, employee-owned firms can measure the ESOP’s impact in a number of ways. Some companies do a simple before-and-after snapshot of high-level performance and changes to the company’s annual (and required) valuation to see if things have gotten better with employees as owners. Beyond that high level, companies can measure employee engagement levels, turnover levels and other metrics to see if there has been a post-ESOP change.

For West Monroe Partners LLC, a management consulting firm based in Chicago, employee retention and overall financial performance have been key metrics to gauge its ESOP’s success so far. For example, despite working in an industry with traditionally high turnover in a strong economy, the firm’s retention levels have been “unusually high,” according to Susan Stelter, West Monroe’s chief administrative officer. “Our people tell us that recruiting calls are up and normally we would see attrition tick upward.” So far, that has not happened, something that she attributes to the existence of the ESOP.

Communicating company results to employees is also key. West Monroe gives each employee an annual total reward statement to reinforce key messages about the ESOP and how it is helping employees build long-term wealth.

“It is important that everyone from our junior to our most senior employees understands how the ESOP benefits them and benefits our firm,” said Stelter. “It takes time; there are no easy shortcuts, but we are beginning to see that investment pay off.”

Asset Diversification Protection

The Tax Reform Act of 1986 includes a requirement that allows employees participating in an ESOP to diversify assets out of company stock under certain conditions. As interpreted by IRS rules, those who have participated in an ESOP for 10 years and have reached age 55 are allowed to diversify as much as 25 percent of their holdings over the subsequent five years. Workers can then diversify as much as a total of 50 percent of stock, minus any previously diversified shares, beginning in the sixth year. The company must offer at least three alternative investment options under the ESOP or another retirement plan in which participants can invest the proceeds from the sale of their company stock, or else issue the company shares or cash equivalent directly to the participants, if requested.

Joanne Sammer is a New Jersey-based business and financial writer.

Related SHRM Articles:

High Court Makes It Harder to Bring Stock-Drop Cases, SHRM Online Legal Issues, January 2016

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

Related Resource:

ESOPs: Naturally Built for Innovation?, The ESOP Association Blog, February 2016

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