ESOPs Present Business Transition Planning Opportunity

Some ownership transitions are designed to wring every last dollar possible out of the business, but this is simply not what ESOPs are about.

Harvey Katz, partner at Fox Rothschild, is now in his 40th year practicing law, and he is proud of his long and distinguished career.

At an age where retirement is no longer an abstract idea, Katz says he has gained valuable insight into the various ambitions and concerns that stand at the heart of the way people think about retirement and retirement investments. He fits squarely in the camp of people that have reached the traditional retirement age and have no intention of hanging it up, regardless of his career success to this point.

“Like many people in my generation, I have enjoyed my share of business success, and I am proud of that. I have enjoyed what I do and I still enjoy serving clients and having a role to play in business,” Katz explains.  

He offers up the background less for the sake of autobiography and more as a way to begin to discuss the virtues of employee stock ownership plans (ESOPs)—and when they are an option that should be seriously considered by an employer. 

“In my experience the folks that make the best candidates for establishing ESOPs are people who are really facing a decision about what to do with, essentially, their life’s work,” Katz says. “In that respect ESOPs generally are thought of in terms of business succession planning, and they are most effective when there is a paternalism about the company, the employees and the legacy that is guiding the decisions that are being made.”

In this sense one can compare ESOPs against managed buyouts or other structures that turn to an independent third party to monetize a closely held business, which are more designed to wring every last dollar possible out of the business at the point of the transition of ownership. This is simply not what ESOPs are about, Katz warns.

“In most cases, the dollar amount is not going to be the primary motivating factor for creating an ESOP,” he says. “It has to be about caring about the employees and the legacy of the company. ESOP is a very powerful structure and one that I advocate more often than not, but I would say that it’s only about half of businesses that come to us where this is truly a good fit for what the ownership is trying to accomplish.”

NEXT: Ownership psychology matters

Katz observes that his basic approach to explaining ESOPs to current and potential clients has shifted a lot over the course of his career.

“I used to go in and talk very technically about how an ESOP works, going through the mechanics of it and describing all the steps,” Katz says. “I would explain how the company borrows money from a lender, and then loans it to the employees, who then buys the shares and create the ESOP. What we have realized over the years is that you really have look past the technical details and talk to people about the psychological issues.”

In essence, talking about creating an ESOP or pursing some other route is really just having a conversation about how a business owner wants to depart of their life’s work.  

“If you just sell your business to a third party, you are no longer in charge, you are no longer the important person in the company,” Katz says. “ESOPs offer a certain type of employer a path forward in this challenging time of transition, where they can turn their life’s work into something sustainable. When you sell to your employees the right way, you are going to be somebody who wants to take care of the employees. You are going to be the kind of business owner that has very open-book management and many long-term employees that are treated well. Business owners with a direct personal connection with the office. This is when an ESOP is probably in order.”

Also important, ESOPs are better for owners who want to transition out slowly.

“If you sell to a third party, a strategic buyer, you will generally have one or two years in which they take on your knowledge and then you’re made irrelevant to the business moving forward,” Katz notes. “But with the ESOP route, it can be a more gradual change operationally for the business, and the business owner can set the pace.”

Over the years one other pattern to emerge is that some industries and employer types simply are better suited for the ESOP route than others. For example, the same type of company that will be attractive to strategic buyers might not be great for spinning into an ESOP. As Katz explains, strategic buyers will generally be picturing the acquisition in terms of a wider book of business that will gain important synergies from the addition of a new company with specific capabilities that mesh well with existing holdings, in effect making the sum of the combined entity greater than its parts.

“An ESOP cannot take the strategic perspective and pay a premium for the strategic fit,” Katz says. “So companies that don’t have this type of strategic attractiveness actually make great ESOP candidates.”   

NEXT: Regulations on ESOPs could shift 

In mid-April, Republicans in the House of Representatives passed the “Encouraging Employee Ownership Act,” which broadly speaking would increase the cap on the amount of stock closely held companies can award employees before triggering certain SEC reporting requirements.

Katz has not yet reviewed the legislation in detail, but he feels this is likely a positive development. However, he also agrees that it could in theory create more space for bad actors to behave opportunistically and “not exactly in their employee’s best fiduciary interest” during the launch of new ESOPs. One does not have to dig deep into the compliance coverage on for myriad examples of lawsuits wherein business owners and ESOP service providers were sued for willfully permitting employees to grossly overpay for ESOP stock, among other breaches.  

For example, during the same week that the House voted on the Encouraging Employee Ownership Act, a federal district court judge ruled that First Bankers Trust Services Inc. breached clear duties of prudence and loyalty to participants of an employee stock ownership plan when it caused the plan to overpay for shares of the company’s stock. Subsequently the company has said it will suspend the offering of trust services for new ESOPs, but it is continuing to serve existing ESOP clients.

In a classic example of ESOP wrongdoing on the part of business owners, outlined in an October 2016 lawsuit, assets of employees of a Virginia-based company were used to purchase ESOP shares at $406 a pop, for a total sale price of $20,706,000. This price, the complaint details, “greatly exceeded that offered to other participants who had previously sold their shares back to the ESOP at prices ranging from $241 to $285 per share.” Immediately after the purchase of the stock, the price offered to participants dropped below $285 per share.

And so the question should be asked, is reducing reporting requirements around new ESOPs really a good idea? Overall Katz says these examples do not capture the real nature of the ESOP marketplace, which he says is staffed by honest and dedicated professionals working with, the vast majority of the time, honest and dedicated business owners who genuinely see a win-win opportunity in pursuing an employer stock spinoff.

“It is a problem that valuation firms can go overboard in their effort to please business owners,” Katz continues, “but that is the rare exception. Unfortunately the concern around litigation has actually dramatically increased some of the costs associated with working on an ESOP. What ends up happening is that it makes the transactions more expensive in the end for many employers, all the due diligence work you have to do, and it has reached the point that on the margins, its makes many ESOP transactions untenable.”

In other words, concern about potential wrongdoing is holding back ESOPs from doing a lot of potential social good, Katz says.