Should your company consider an employee stock ownership plan? Perhaps.
They're certainly popular. So much so that, according to the National Center for Employee Ownership, there are roughly 6,500 employee stock ownership plans (ESOPs) covering more than 14 million participants. The lion's share of these plans provide a great benefit for both owners and employees. It's all good...for the most part.
ESOPS make a lot of sense for a lot of reasons. For some business owners - particularly baby boomers and older persons that have a difficult time finding buyers because they're maybe located in rural geographic areas or are operating in industries that aren't the most...well...sexy, an ESOP may be a ticket out. Employees, not wanting to lose their jobs if things get shut down could be open to buying the company, particularly if there's financing. For sure, there are tax advantages to doing this.
"Given the demographic realties of baby boomers exiting their businesses, ESOPs should absolutely be considered and understood by all owners who don't plan to "die with their boots on."" says Chris Rhyme, a partner at The Business Transition Group based in Denver who consults on succession planning and exit plans.
An ESOP is a non-taxable trust. Employers can contribute shares or cash for employees to buy shares based on a formal plan. The non-tax part is very attractive: employees don't get taxed on the contributions and employers get a deduction. Plus, the ESOP pays no taxes on its share of the earnings of the company. Banks love these things because they can step in and arrange financing where the business owner gets paid off and the ESOP assumes the debt, which is then paid off by the employees over time.
And therein lies the potential problem. What kind of problem?
Just ask the 525 employees at Telligen, a healthcare company based in Des Moines Iowa. Or the employees at Sonnax Industries, a Vermont auto parts supplier. Or the workers at Cactus Feeders Inc. in Lubbock Texas. Or those at the Laser and Skin Surgery Center of New York. All of these companies - and a growing number of others on the Department of Labor's list - have been involved in ESOP plans gone bad, according to a recent report in the Des Moines Register.
Why bad? In each of those examples, the valuations of the companies were alleged to be overstated. In other words, the employees paid too much and the owners were accused of walking away with more than they should have. The bankers who arranged lucrative financing deals that - according to some lawsuits - were knowingly based on inflated valuations are also under the gun. Some of these cases are still active. Others have been settled.
"Accurate company valuations are critical when it comes to establishing an employee stock ownership plan," Jonathan Kay, a Department of Labor administrator told the Des Moines Register. "Too often, company owners seek to inflate the price to benefit themselves at the expense of workers."
In the case of Telligen, an employee representing the company's ESOP sued Bankers Trust Co. of South Dakota after the bank quickly arranged financing at a healthy six percent rate over twenty years for a deal that valued the company at $37.50 a share or $37.5 million. The lawsuit alleges that soon after this deal was done, another analysis put the company's valuation at just $6.25 per share. Telligen's former owners and the bank are accused of profiting "by saddling the plan and Telligen employees with millions of dollars in debt" according to the Des Moines Register report. Bankers Trust had previously decided to get out of the ESOP business after settling a pair of similar lawsuits that also alleged over-valuation of shares but the Telligen deal had already been struck.
The one big reason why ESOPS go bad is valuations. Valuations are the key to ESOPs. What happens is that employees - who may not be as well versed in high finance as the people putting the deals together - can be lead into deals that are weighted against them and find themselves unknowingly agreeing to share prices that are potentially much too high.
Smart employees who have successfully done ESOPs know the importance of having good representation, knowledgeable advisors and an objective approach towards valuing their company. They also try not to get too romanticized with the concept of "ownership. " Smart bankers and business owners selling out and arranging financing understand that not being greedy is the best strategy for completing a successful ESOP.
It's about a successful transition at a fair value. When that's done, both parties - and the company - thrives.
"We have a client in Washington that is fully ESOP owned and the moment you walk in the door the culture screams "employee ownership," says Rhyme. "These companies thrive particularly in educating their employees of the benefits of broad based employee ownership and how that value directly translates to them."