Transitioning to an ESOP: Six tips to smooth the plan

By Elizabeth Di Cola, Managing Director, ESOP Finance Group

By addressing these six issues up front, you can avoid some potential pitfalls when transitioning to an ESOP.

As discussed in a previous article, there are a number of reasons an employee stock ownership plan (ESOP) might be right for your business. Ensuring a successful transition to ESOP ownership, as with any complex business endeavor, requires the ability to anticipate challenges and take steps to prevent them. Some of those challenges need to be considered prior to setting up an ESOP; others are likely to arise after the transaction is complete. Being aware of these challenges will give you an advantage in overcoming them and preventing future problems.

1. Depth of management
It is extremely important that the owner/seller carefully consider the question of post-transaction management when evaluating the sale of the business to its employees. Does the business owner/seller intend to remain actively involved in managing and growing the business? If this is the case, the trustee and any third party lender likely will require that the selling shareholder enter into an employment agreement that establishes the continuing relationship between the company and the seller as a member of management for a specified number of years. Who else will be involved in managing and leading the business during the transition period? Do the future leaders and managers of the business need to be hired, or are there long-time employees who can be trained and mentored to assume greater responsibilities?

  • If the owner/seller has been the primary driver of business development due to his or her industry contacts, can those relationships be effectively transitioned to someone else? Has that process begun? How long will it take?
  • Has the owner/seller previously shared responsibility for leading and managing the business so others understand the ins and outs of running the business? How well do they know the business? Do they understand how to grow the business?
  • If the company needs to hire outsiders, how difficult will it be to find the “right” people, and how long does the transition period need to be to accommodate that process?

If, however, the owner/seller is intending to disengage from the business after the sale, the issues raised above take on even greater urgency. Prior to the sale to the ESOP, there needs to be a senior management team in place that knows how to move the business forward. It’s important to be honest in judging the capabilities of that team. If they need more experience or there are holes to fill, it’s better to know in advance and work toward an eventual sale. The company’s ability to thrive — or even pay off third party or seller debt — may be compromised with a too hasty sale. Alternatively, the seller may find that banks are unwilling to provide financing for the sale to the ESOP until an appropriate management team is in place.

2. Operating the business in a different financial environment
Oftentimes, privately held businesses carry little or no debt other than a line of credit used to finance working capital and perhaps a real estate mortgage or a limited amount of debt that has been used to finance capital expenditures.

The transfer of ownership to the ESOP must be financed, whether by the seller alone or by the combination of external debt financing (from a bank, for example) and seller-provided financing. In either case, the sale to the ESOP will be financed by the company borrowing money to lend to the employee share ownership trust (ESOT) in order to purchase company shares. Once the buyout takes place, the company will be operating with significant debt. Dealing with a bank partner may require management to work within a budget to achieve profitability goals set by the bank. The management team and the finance team will need to have the expertise and the tools in place to run a company carrying debt. 

Does the company have a chief financial officer or controller who has the experience and knowledge to guide the financial affairs of a company with significant debt obligations? Running a business with term debt obligations — whether to a bank or other outside lender or to the seller — is very different than running a business without these obligations. After the transaction, the cash flow generated by the business will be needed for a new purpose, namely, to meet debt service requirements.

Prior to entering into the ESOP transaction, the management team (along with a financial advisor with expertise in ESOPs and the company’s accounting firm) will need to develop a three- to five-year business plan and financial projections. They will need to evaluate the company’s ability to meet projected debt service obligations and future ESOP share repurchase obligations, while at the same time having enough cash to grow the business. This analysis should include “stress-testing” the business’s ability to meet its debt service obligations even if things don’t turn out as planned. The analysis should also test the company’s ability to meet any financial covenants that might be imposed on the company by an outside lender. Finally, the seller and management team need to determine whether the company has the internal systems in place to generate the type of monthly financial reporting that will be required by a bank or other lender.

3. Impact on cash flow after the transaction
If the company transitioning to an ESOP is in a capital-intensive business — or if the company will need to expend a significant amount of capital to meet its growth projections — the business owner and the management team need to structure the ESOP transaction so the company will be able to support the new ESOP-related debt obligations and still have enough cash (or borrowing capability) to finance operations and growth. This means being realistic about how much capital the business needs to function and to keep growing. Underestimating future capital needs can seriously hamper the future success of the ESOP-owned company. While projecting future capital expenditure needs is far from an exact science, seasoned ESOP financial advisors can help management structure an ESOP transaction that integrates and balances the company’s future needs with the seller’s desire for liquidity at closing.

4. A new layer of reporting and regulatory obligations
The transition to an ESOP provides the owner/seller with many financial benefits. Those benefits go hand in hand with a number of obligations dictated by the Department of Labor and the Internal Revenue Code. These affect human resources, executive compensation, employee benefits and recruiting, and need to be integrated with the company’s needs and strategic objectives. Prior to entering into an ESOP transaction, the owner and the management team will want to consult with experienced ESOP professionals — especially an experienced ESOP attorney — to make sure they understand these obligations and are prepared to operate within these rules and regulations. After the transaction, company management will want to stay abreast of ESOP-related tax and regulatory obligations to ensure the company remains in compliance. 

ESOPs present additional record keeping and reporting requirements. This translates into additional administrative costs, the need for new internal expertise (or outside service providers) and additional time burdens. For example, because the company will need to file regular reports with the Department of Labor, management needs to think through who will be responsible for these new tasks and potentially what outside advisors the company will hire to assist in these tasks. 

In addition, there are tax regulations the company needs to be aware of and with which the company needs to comply. The best plan for dealing with these is to engage an attorney, auditor or accountant who is knowledgeable about ESOPs and can help the company set up the systems needed to track compliance.

Finally, the company’s board of directors or ESOP committee will need to hire an ESOP trustee who will be the fiduciary responsible for administering the ESOP for the benefit of the participants. In almost all cases, the initial trustee hired in connection with the sale of the business to the ESOT should be an outside trustee. After the transaction, some companies switch to an internal trustee, but this generally is not preferred by bank lenders. The cost of hiring and retaining an ESOP trustee should be taken into account when the business is developing its projections and evaluating the feasibility of the transaction.

5. Preparing for repurchase obligations
When an ESOP participant leaves the company (whether by death, disability, retirement or termination), the participant is entitled to “put” his or her vested shares to the company. The company is required to buy back those shares at a price and time set by law and regulation. This is called share repurchase. The company's obligation to buy back shares is called ”repurchase obligation” or ”repurchase liability”. 

Repurchase obligations generally do not represent a significant cash cost during the initial five to seven years after the sale to the ESOP. However, after 10 years, they can significantly impact the business’ cash resources — especially a successful business. In the case of a capital-intensive business, these obligations compete for cash with the need to invest in the business. Again, a knowledgeable ESOP professional (particularly one well-versed in repurchase liability issues) can help with critical front-end decisions regarding creating the ESOP’s design (matters such as structuring the internal ESOP loan, eligibility, vesting and distribution provisions that can affect repurchase obligations).

6. Creating a new culture
Transitioning to an ESOP also provides the owner/seller with the means and opportunity to transform the internal dynamics of the business. As previously discussed, there is much research showing ESOP-owned companies outperform non-employee-owned peers. That said, the degree to which ESOP ownership affects a business’s performance depends significantly on the desires of the selling shareholder and management team, and the intention with which the management team addresses employee ownership.

The first decision the business owner and management team need to make is whether the ESOP structure is being used because the business owner supports the value of employee ownership, or because the ESOP is a tax-advantaged corporate finance tool (or a combination of both). If the driver is the latter, the management team may not choose to devote time and resources to developing an “ownership culture.” If the driver is the former, management will want to work with professionals skilled at the development of communication plans and employee training to maximize the cultural and performance benefits of ESOP ownership.

Regardless of the underlying motivation management will need to decide how much information about the business will be shared with the employee owners. Legally there is no obligation to disclose anything beyond the annual share value. Many companies opt to share a great deal more because they believe it will increase the employees’ sense of ownership and buy-in. For companies that choose to share more information about the company’s financial performance, the question becomes: How do you provide the information to employees without overwhelming them? Oftentimes many employees will have had little or no opportunity to develop a high level of business or financial literacy. Fortunately, this is exactly the kind of challenge addressed by ESOP communications experts, as well as by the various ESOP organizations that sponsor national and local conferences, webinars and publications designed to help educate employees and management of ESOP-owned companies.

In conclusion
There’s an old saying, “an ounce of prevention is worth a pound of cure.” By anticipating and preparing for these issues, enlisting the advice of seasoned ESOP professionals and utilizing the kinds of resources identified above, the business owner and the management team can exercise that ounce of prevention. The result will likely be a successful transition to an ESOP, benefiting both the owner/seller and the employees.