By Brad Eriksen
Congratulations, you are now a part owner of your company/employer as a participant in the newly formed and funded Employee Stock Ownership Plan (ESOP). The original owners of the company have sold their stock to the ESOP and have retired to sunnier climates. The remaining employees are left behind to continue to operate the business for the benefit of its new sole shareholder, the ESOP.
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While ESOPs provide many advantages and benefits to employees and their companies, there comes a time in the life cycle of all companies when it becomes necessary to move past ESOP ownership in order to allow the company to grow, to take advantage of new opportunities, and to address new challenges facing the business. ESOP-owned companies can find themselves with limited access to additional capital to pursue new markets and products, limited ability to attract top managerial talent due to the inability to offer equity as part of the compensation package, and limited flexibility to adapt to changing business conditions due to the fiduciary obligations placed on the ESOP trustee, the defacto owner of the company.
When that happens, or more appropriately, before that happens, the company needs to look for exit strategies.
Simply terminating the ESOP and distributing each participant's stock account balance may be the easiest, most cost-effective exit strategy. ESOP termination is not, however, without its complicating factors. Upon plan termination, all participant account balances become 100 percent vested. Thus, short-term employees may receive a windfall benefit that was not anticipated by the initial design of the ESOP.
Upon distribution of the stock account balances to the participants, the distributions are taxable to each employee. If the distribution is solely in the form of company stock, the participants may find that they have a stock certificate suitable for framing but no cash to pay the taxes generated by the stock distribution. Some participants may want to roll over the stock distribution into an IRA. But locating an IRA custodian willing to hold closely held company stock is often difficult, and when one can be located, it tends to be significantly more expensive than a custodian of a conventional IRA.
For the company, having a large number of minority shareholders may be as cumbersome as the fiduciary restrictions on the ESOP trustee. At the very least, a large number of minority shareholders is an administrative burden on the company. At its worst, it may paralyze the decision-making process of the company to the extent that it has no ability to react to opportunities and challenges.
From the standpoint of the Internal Revenue Code, an ESOP is not much more than a qualified retirement plan that is specifically authorized to own the stock of its sponsoring employer. Accordingly, another exit strategy is to convert the ESOP to another type of qualified retirement plan, such as a Money Purchase Pension Plan or a Profit Sharing Plan. This may avoid some of the negative consequences of simply terminating the ESOP. For example, upon conversion, there is no 100 percent vesting requirement. Additionally, since there is no terminating distribution, the adverse tax consequences to participants are avoided, and the company avoids creating a large number of minority shareholders.
As noted, however, these other types of qualified retirement plans are generally not permitted to own significant amounts of employer stock. Accordingly, it is necessary for the company to replace the stock in the ESOPs with a corresponding amount of cash. This essentially requires the company to buy itself back from the ESOP, which can put a significant financial burden on the company. Although there are a number of methods available to finance the buyout obligation, the financial burden on the company of purchasing its stock with after-tax dollars may be more than the business is able to afford.
Another ESOP exit strategy is the buyout of the ESOP-owned company stock by a third party. The third-party buyer could be an outside buyer, unrelated to the company, or a management lead group. The source of funding for the purchase can come from new equity that the buyer brings to the table or debt acquired by the third party. Outside debt financing has the benefit of removing the obligation of funding the buyout from the company's financial statements. Ultimately, however, the profitability of the company is the source of funds necessary to repay the borrowing.
The Tax Code also places certain restraints on an ESOP buyout. The purchase price for the stock must not be less than the fair market value of the stock, as determined by an independent appraisal. The selling ESOP trustee is constrained by its fiduciary obligations to the ESOP and its participants to ensure that the sale of stock is in the best interests of the participants and is ultimately a fair transaction. These fiduciary, due diligence, and fairness obligations may well push the purchase price higher and will certainly slow down the closing of the deal and add to the cost of the transaction.
Any ESOP exit strategy is a long-term process. From beginning the process by performing the analysis necessary to determine whether it is appropriate to exit the ESOP, to the final closing on any exit strategy, the process can be expected to take several years. Given the complexity of the law involved and the significant impact on the company and its employees, this is not a process that can be rushed. Planning must be conducted, IRS approvals obtained, due diligence performed, and valuations made. Each of these steps requires a significant investment of time and resources by the company and its professional advisers. But the effort can be worth it if the company becomes better positioned to take advantage of the opportunities and respond to the challenges that lie ahead.