What you need to know about an ESOP
Since setting up its Employee Stock Ownership Plan (ESOP) in 1998, Harrisburg, Pa.-based D&H Distributing has seen annual sales grow from $430 million to $3.4 billion. D&H’s third-generation co-presidents, brothers Michael and Dan Schwab, say their ESOP has motivated employees and helped them buy out their relatives. (D&H was the subject of the cover story in the July/August 2016 issue of Family Business Magazine.) Would an ESOP also be a good option for you?
That depends, according to Rob Schatz, a partner in ESOP Plus: Schatz Brown Glassman LLP. Schatz’s firm helps companies set up ESOPs—and advises distressed companies seeking to unwind their ESOPs. Schatz says several factors determine whether an ESOP will help a business family achieve its goals:
• The ESOP transaction must not overvalue the company, and the organization must be able to service the debt. The deal must not be structured solely for the benefit of the exiting owner(s); the well-being of the company and the employee-owners must also be taken into account. “In an economic downturn, a company that has been overvalued will have insufficient cash flow to support the debt that was incurred in the transaction,” Schatz says. “A reasonably valued company should be able to repay the acquisition debt out of cash flow within about 10 years.”
• The business leaders must plan for the repurchase of departing employees’ shares. Without proper planning, repurchase liability can reduce cash flow that the company may need for other purposes, Schatz says. Repurchase liability should be offset by the tax savings achieved through the ESOP, he notes. “A high payout due to employees is typically not a reason for failure of an ESOP,” he says. “We see a lot of companies that have multimillion-dollar ESOP payouts, and yet they’re generating sufficient cash flow to be able to [meet the obligation]. If you’ve done a repurchase liability study and understand what your obligations are, and you have a good management team in place that can prepare and plan for that, the repurchase liability should not be a reason for a company to fail.”
• ESOPs do not work well in companies that shelter their taxable income through depreciation of assets; these businesses will not be able to take full advantage of the ESOP's tax benefits. The plans are also not a good option for high-value companies with low cash flow, such as a marina whose real estate is more valuable than its operating entities (restaurant, repair shop, etc.).
• The family and the management team must buy into the ESOP concept. The family must understand that they are co-owners along with all the employees, and understand the planning that must be done in order for the ESOP to function as intended, Schatz says. A board that includes independent directors can help the family leaders make good business decisions and help protect employee-owners from family members’ missteps. “We’ve seen situations where succession management has structured incentive compensation to bleed off all the benefits and all the increase in the share value to themselves, rather than to the employees as a whole,” Schatz says.
• The business leaders must effectively educate employees about ESOPs. Employees must buy into the concept that they are owners. They also must understand the risks of business ownership; if the business loses value or the company fails, their retirement payouts will be negatively affected. While employees need to recognize the investment risk, Schatz says, they should also understand that “in large part, the success of the company is in their control.”
• An ESOP won't shield a company from the effects of an economic downturn. Just like any other business, an ESOP company must offer products and services that are in demand in the marketplace, and must be led by a talented management team. An ESOP company that struggles in a downturn will not be able to service its debt and will see its value reduced.
However, Schatz notes, ESOP companies tend to be better able to work through a downturn because the employee-owners are highly motivated.
“A properly structured ESOP transaction takes into account fair valuation, takes into account cash flow to service the debt, and has management buy-in,” Schatz says. “And the employees generally understand what the ESOP is, how it works and what they need to do to realize their benefit.”