Many companies that sponsor an employee stock ownership plan (ESOP) implement it with certain policies or procedures—and then essentially put it on autopilot.
The ESOP’s initial design remains in effect despite changes in the business, employee demographics and the economic environment. Often, leaders of those companies don’t realize they can change plan provisions within some limits, or they may not fully understand how changes may benefit the company or its employees.
The result? An ESOP that fails to meet the company’s goals after the initial ownership transition.
However, with occasional attention and some manual overrides, the company can help drive beneficial results from the ESOP instead of allowing the ESOP to drive the company.
The decision to pursue an ESOP in the first place is about more than just financial performance. It’s about building on the company’s cultural foundation to create a legacy of growth, stability and shared success.
As the ESOP ages, though, certain designs that seemed sensible at the outset may become less favorable. This erosion may stem from numerous issues, including:
Consider the following illustrations and note that multiple variables are commonly at play:
Share price: If your share price is increasing rapidly, and your distribution policy says that distributions will not begin until the latest possible starting date, the repurchase obligation will be larger than if you started distributions sooner. Conversely, your operating capital needs might dictate that an early distribution policy might not be sustainable.
Workforce: If your workforce increases significantly, but you are contributing the same amount to the ESOP every year, the benefit level may shrink. Also, there may not be many new shares available for allocation to new workers unless you make some changes to how your plan operates.
Tax deduction planning: Your tax profile changes along with your business. For example, you may find that tax deductions lose value for you if you have converted to S corporation status and the ESOP owns 100%. You may have based some of your plan contribution, repurchase and distribution policies on an assumption of deductibility that no longer applies.
By reviewing your plan periodically with your advisors, you can identify optimal strategies for the current situation and modify your plan without violating applicable laws and regulations.
As your ESOP matures, its benefit level may differ from what the company desires according to its total rewards philosophy. This may be a result of adding more employees faster than planned, or the share price changing more or less than planned.
The good news, though, is that ESOP rules are not immutable.
In fact, a written distribution policy can live outside the plan document and allow for discretion within certain parameters. For example, a company might have a policy to pay people out more quickly than legally required, as long as it has the cash flow to do so without threatening the stability of the firm.
Companies can add provisions, such as account rebalancing and segregation, to get shares to newer employees faster. In rebalancing, ESOP accounts are adjusted to have a relatively even mix of cash and shares in each employee’s account. In segregation, terminated employees who have not elected to take their distribution are given other investments in lieu of their company stock so that company stock can go into the accounts of active employees.
Another major area of ESOP upkeep is repurchase planning. Careful studies allow a company to estimate the number of shares that it will need to repurchase in future years. Your distribution policy, as well as participant demographic profiles and turnover patterns, will dictate a large portion of that repurchase timing. By modeling multiple scenarios to evaluate what you can manage, you can better decide the timing of distributions and the form in which people receive them.
You also need to know how your repurchase strategy drives share value. Incorporate scenarios of potential changes in future share value.
For example, rising stock values can lead to increased nonproductive costs because the company must spend more money to repurchase shares from departing employees. The nonproductive cost in that case is the expense associated with repurchasing shares from employees who leave the company. That cost does not directly contribute to the company's productivity or growth but is necessary to fulfill the obligations of the ESOP.
Debt repayment, benefit expenses, the number of shares outstanding, funding methodology and cash flows related to operating expenses all need to be considered. The result is an iterative, dynamic planning process.
In addition to applying those concepts, your company can guard against dulled benefits by regularly revisiting its ESOP and addressing the following operational issues:
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Employee benefit levels |
In ESOPs, the employee benefit level is heavily dependent upon the share price, which can be hard to predict. In leveraged ESOPs, benefit levels are also affected by the loan amortization schedule that governs the number of shares released to employee accounts. If desired, companies can target specific benefit levels; however, this requires thorough planning. |
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Share allocations |
The form of distributions (shares or cash) and the loan amortization for leveraged ESOPs dictate how and when shares are allocated. These policies may result in an undesirable allocation within the plan, which may lead to issues with business sustainability. It is important to monitor allocations so that policies can be amended proactively if repurchase obligation issues begin to form. |
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Distribution rules |
Distribution provisions dictate what happens to the accounts of terminated participants. If those accounts are not segregated or cashed out, terminated participants may retain a significant claim on the company’s equity. |
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Repurchase obligations |
The method, timing and financing decisions with respect to repurchasing shares from terminated participants will all affect who ends up with shares in the ESOP and how well the company can manage its commitments to buy back those shares. |
Without occasional reevaluation, your ESOP may eventually seem to work against you rather than for you. As your business circumstances change, updating your ESOP accordingly can help ensure it continues to serve your employees and meet your company’s objectives. By reviewing your plan periodically with your advisors, you can identify optimal strategies for the current situation and modify your plan without violating applicable laws and regulations.
It is important to remember that while an ESOP is often implemented as an ownership transition vehicle, it functions as a retirement plan that benefits employees. Employers would be prudent to use that benefit as part of an overall compensation package that supports the company’s goals.
