Employee-Owned
Loren Rodgers, executive director of the National Center for Employee Ownership (NCEO) in San Francisco, says there are a few ways to look at the value of employee stock ownership plans (ESOPs). While there are different types of ESOPs—e.g., some are open to all employees—the general premise is that the employer sets up a mechanism to grant shares of equity ownership to workers as a form of compensation.
As Rodgers observes, several decades of academic and commercial research have clearly established, especially among privately held companies, a direct benefit to employee ownership in terms of better productivity, sales growth, and staff retention and loyalty.
“Of course, this is on average,” Rodgers notes. “Any company can have a bad patch, and employee ownership doesn’t bulletproof anyone against negative outcomes. Still, generally speaking, there is really good data showing the positive impact of ESOPs on employees and companies. At the very least, employees gain a deeper connection and loyalty to their company—a sense of stewardship over the company’s future.”
According to Rodgers, the NCEO has thousands of members, spanning all sectors of the economy. While some business sectors with relatively high employee turnover may not make great ESOP candidates, most other businesses will. These include financial services firms such as retirement-focused independent registered investment advisers (RIAs) and wealth managers.
A Case Study
One advisory firm that has leveraged the ESOP structure is Ellwood Associates, headquartered in Chicago. The firm was founded in 1977.
“The story of our ESOP goes back pretty far,” says Aaron Ward, a managing director and senior consultant with the firm. “In 1999, [our] founder, John Ellwood, sold part of the company to employees through the first ESOP transaction, but at that stage he actually remained the majority owner.”
Showing that ESOP transfers can occur in phases, it was not until 2004 that Ellwood sold the remainder of the firm to employees.
“The way it worked back at that time was that the shares acquired by the ESOP from John were actually unallocated,” Ward explains. “The shares had equity value at that point, but they were technically held by the ESOP trust. The company used some third-party financing to make this happen, which we were able to pay back over the following few years.”
ESOP financing can work in several different ways. According to the ESOP Association, the majority of the plans (70%) are leveraged in some way, utilizing either third-party financing or “seller financing.” A collateralized loan can be issued either to the employer or directly to the ESOP.
In Ellwood’s case, the ESOP’s “unallocated equity” structure means that, every year, all firm employees can be granted shares from the trust. Ward says shares are released from the trust annually based on a formula that is tied to eligible compensation.
“What this approach has resulted in, if you fast-forward to today, is that ownership of Ellwood Associates is very widely distributed among employees,” he says. “Out of over 60 advisers and staff, nobody owns more than 10% of the firm, and every single employee who has worked a full year has accrued an ESOP allocation.”
Ward says he understands that some firms may not be thrilled about the idea of turning to third-party financing to enable an ESOP transaction, but, in the advisory space, this may be necessary given the high value of such businesses relative to the generally small number of staff.
“For advisory firms, the tough part on the front end is figuring out how you can get the capital to allow the ESOP to buy the business,” Ward says. “Given the challenge, I think this type of effort to create an ESOP structure is oftentimes going to be led by a charismatic founder or a single majority shareholder. Once you navigate this step, it really becomes a great structure that can disperse the equity among everyone.”
Rodgers agrees with that assessment, adding that advisory firms and similarly structured professional services entities can work through this difficulty by finding the right partners and having the right strategic vision. In other words, the financing may be tricky to organize, but it is definitely not something that should hold advisers back from at least considering creating an ESOP.
Ellwood’s ESOP Success
“The pros for our organization as a whole have been amazing,” Ward says. “The ESOP has been a strong retention tool for employees, but especially our 25 lead consultants and other senior people in the organization. Over the last decade, out of those 25, we’ve had just three departures and one retirement. So it’s clearly helped us attract and retain talent.”
The ESOP also indirectly helps the firm hold onto clients, because they can see and feel the enthusiasm and commitment of Ellwood’s advisers and staff, Ward suggests. “Our client attrition rate has been in the low single digits for the last several years, and I think the staff’s ownership mentality has a lot to do with it.”
One clear benefit to the firm itself is the tax efficiency of the ESOP structure when it comes to sustaining earnings, year over year.
“In our case, the ESOP is organized to be a retirement benefit, and for that reason it sits inside a qualified retirement plan, which in turn creates significant tax advantages,” Ward says. “Our ESOP structure allows us to retain earnings without necessarily being taxed on them. Compared with a lot of competitors that aren’t structured this way, we have an advantage. Often, in professional services industries such as ours, more of the earnings are paid out on an annual basis and less is retained—in part because it can be detrimental to retain significant earnings as a fully taxable entity.”
More ESOP Challenges
While the ESOP has been a great success at Ellwood, Ward says, there are further challenges to consider. First and foremost, the ESOP requires careful maintenance and extensive ongoing education for staff.
“One potential con of the ESOP structure is that it can be complex, especially with the structure we have in place as an S-Corp ESOP,” Ward says. “Our structure means the ESOP is tied into our nondiscrimination testing, which is quite a complex process to manage, frankly. The rules for what happens when people leave the firm can also be very complex. We have low turnover, but it’s been a little higher among our newer hires in recent years. So, we need to make sure they understand what will happen with their benefits and what happens with the ESOP.”
Getting the governance structure correct is another important and challenging task. “You have to ask, what’s the appropriate level of separation of the ESOP board and company management? Considering things such as [having] an outside perspective on the board is important, as is communicating the governance goals and structures to the employee-owners,” Ward advises.
He cites one other “problem” for Ellwood’s ESOP—but one good to have. “The company has done well, and so the retirement benefit in the ESOP has compounded over the long run,” he says. “The ESOP’s success can lead to people having an outsized amount of their retirement wealth tied up in the company. There are positive reasons why this happened, but we proactively help make sure our employees understand the importance of diversification.”
Art by Doris Liou