What I Know Now that I Wish I Knew Then About My Company's ESOP



There are about 6,200 companies in the United States that are owned by employee stock ownership plans (ESOPs).

About 5,700 of these companies are privately held, about 2,300 of those are 100% ESOP-owned, and more than 1.5 million workers are employee-owners in ESOP-held companies. These companies hold more than $1.6 trillion of total retirement savings.

Chad Rock, Kansas City market executive and managing director of BMO Commercial Bank, shared these statistics to open ACG’s monthly meeting Oct. 21.

Robert Grossman of the Polsinelli law firm then moderated a panel discussion titled “What I Know Now that I Wish I Knew Then About My Company’s ESOP.”

The panelists were:

  • Dana Kettle, CFO of Henderson Engineers
  • Andrew Peck, CFO of PBI Gordon
  • Jeff Placek, CFO of McCownGordon

Grossman said that, with an ESOP, employees take an equity stake in the company and thereby directly or indirectly become owners of the company. Grossman leads Posinelli’s national ESOP practice. He likened ESOPs to 401(k) and profit-sharing plans, calling them “at core the same kind of plan.” An ESOP is a type of qualified retirement plan defined by the Internal Revenue Code.

An ESOP must hold its assets in trust, meaning a trust owns the plan’s assets. The company makes annual contributions to the plan’s trust. Unlike a 401(k), ESOP employees typically don’t put their own money into the plan, but some ESOPs have a 401(k) component. Tax incentives support ESOPs based on the idea that ESOPs narrow the wealth gap and strengthen companies.

Virtually all full-time employees are covered in an ESOP. Employees have their own accounts. Contributions are typically used to buy stock or pay off loans. Shares are allocated over time to the plan participants’ accounts.

Contributions typically are used to buy stock or pay off a loan. Shares get allocated over time to plan participants’ accounts. Vesting typically occurs at 20% after 2 years and 100% after six years. Usually, the account balance at retirement is paid in cash and is taxable at ordinary tax rates. Participants also can choose to roll their accounts into IRAs.

ESOPs have two important characteristics that are different from other plans, Grossman said. First, unlike profit-sharing and 401(k) plans, in which participants direct their asset investments, ESOPs are designed to invest mainly in the employer’s stock. It’s not uncommon to see an ESOP with 100% investment in the company. Second, an ESOP can borrow money to finance its front-end purchase of stock, and it’s the only type that can.

Grossman asked the panelists why an ESOP made sense for their companies, how they went about pursuing one and what they learned in their first year.

Kettle’s ESOP has been in place for about a year.

“We had a fairly good succession plan,” she said. “We were selling down our shares. We knew an ESOP might be good. We had become an S corp (which the IRS defines as “corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes”). We started a deep dive two years ago. I was one of the shareholders. I had to convince myself it was right thing to do and persuade other shareholders.”

ESOPs bring tax savings to the company and help shareholders with liquidation and growing equity, Kettle said.

Placek said his company established its ESOP on Dec. 31, 2014. Earlier in the year, they were trying to formulate a succession plan and an exit strategy for two primary shareholders and one minority shareholder. The process “was tough” because of contention with the trustee, but “a 100% ESOP made sense” and they came to an agreement.

“The shareholders got a fair market value for their sells, and we did seller financing,” Placek said. “In return, the plan did warrants, which have upside potential for exiting shareholders. It has worked out well. The tax exemption accelerates excess cash and working capital, and it maintains the surety relationship and bonding capacity.”

An S corp’s benefit is that it “saves the tax obligation and therefore drives cash flow,” Grossman said. “It’s not a tax shelter, not a gimmick. It was knowingly created by Congress to extend the ESOP concept to S corps with a full social purpose, and they set up anti-abuse protections.”

Peck said his company was probably the “most mature ESOP in Kansas City,” established as a partial ESOP in 1994 and a full one in 1997.

“I probably came into this not truly appreciating what an ESOP was,” Peck said. “I had some years in public accounting and tax, four years at Cerner and two CFO roles at a private equity bank. An ESOP is more of a long-term model. … For me, it’s been more of a cash management challenge” to manage payouts while ensuring the ESOP’s future.

Grossman asked the panelists what other things they considered while thinking about forming an ESOP.

Placek said one of the most important things for his company was a succession plan. An ESOP smooths that path.

“They come in and get their total compensation with no buying and selling shares,” he said.

Kettle said her company got a good external buyout offer, “but we wanted to be a legacy firm. We liked our culture. An external sale will get you more money. An internal sale, a little bit lower.”

Grossman said the Employee Retirement Income Security Act of 1974 (ERISA) requires that an ESOP can’t pay more than what’s called “adequate consideration,” which essentially means fair market value “determined in good faith by an independent appraiser.”

Peck said that his company’s ESOP has a “responsibility to all shareholders to consider any offer” and that “we have our annual evaluation of our stock price. A 10-year forecast is not easy; we’re moving to a five-year forecast.”

“We battle with, as a management team, (ensuring) the valuation matches the business’ value today, ensuring that our stock price is fair to those retiring taking payouts and to those staying with the company and having their balances accrue.”

In a Q&A session following the panel discussion, an audience member asked how transitions affect a company’s culture. Grossman said the National Center for Employee Ownership had data on employee ownership’s effects on companies’ cultures.

“Most ESOP companies keep their 401(k),” he said. “The average account balance in an ESOP is 2.3 times a 401(k) account balance. Whether or not it translates into better efficiency, better performance, is a question.

“I’ve lived it, I’ve seen it, and I believe 100% that if it’s properly communicated and if the company is performing, that it does translate through this ownership into ‘Everybody has a stake, everybody can affect the ultimate value.’ … It underscores the importance of communication (that) we’re all owners.”