AE Valuation & Ownership Transition Advisor: Volume 8 Issue 1

valuation 101

ESOP Pitfalls and How to Avoid Them

Don’t let your ESOP become a Trojan Horse

Employee stock ownership plans (ESOPs) are popular succession planning tools for closely held AE firms, particularly in cases where the concentration of ownership and financial wherewithal of next-generation owners precludes a fair-market internal transition. 

But while ESOPs may offer a siren song of tax advantages and value for sellers, they can create major headaches down the line if not structured thoughtfully. It’s important to remember that an ESOP is a retirement plan just like a 401(k)—just with a different investment.

1. Complexity and Cost

Setting up an ESOP is expensive and time-consuming. And even once it’s set up, maintaining it requires significant annual costs as well as new fiduciary duties.  

Mitigation strategy: You can’t do much about the cost, but ESOPs are subject to complex rules and non-compliance penalties, so only work with seasoned ESOP consultants and administrators who can guide you through the labyrinth of regulations. 

2. Staff Reluctance 

Employees need to be invested—both figuratively and literally—in a firm’s ESOP. Convincing employees of the value of establishing an ESOP can sometimes be challenging, particularly if they don’t understand what they own and why it’s growing. Many would prefer a 401(k) contribution that is easier to understand, or better yet, a cash bonus.  

Mitigation strategy: Commit to educating staff about what an ESOP is, how it works, and what its advantages are. Transparency about the stock price and what drives it is critical. Show them why this is a competitive investment with a 401(k). Even so, staff typically don’t see the cash benefit until they depart the firm, so they may discount it as part of their compensation.  

3. Cash Flow Strains

ESOPs usually require a significant percentage of operating profit to repurchase shares when employees leave or retire. This can strain a firm’s cash flow and hamper investment in acquisitive or organic growth, especially if turnover is high. Firms unable to meet repurchase obligations could be forced to sell. 

Mitigation strategy: It’s critical to maintain a long-term model of ESOP redemptions, including redemptions of grants that haven’t taken place yet. ESOP cash-flow strains can be baked in the cake 10 to 15 years in advance if an ESOP isn’t carefully designed. 

So set up your initial ESOP to control contributions as a percentage of payroll. ESOP contributions are real cash expenses that take money OUT of the pockets of existing shareholders to put it in the pockets of new shareholders. You wouldn’t put 10% of employees’ salaries into a 401(k). Don’t do it with an ESOP either. ESOP contributions should be determined by the level of benefits you want to provide to employees, not by repurchase obligations. A leveraged ESOP structure can help bridge that gap in the short term, but it’s not a long-term solution.

4. Odd Executive Compensation Schemes

While some ESOP firms may see operating cash flow tapped out to meet repurchase obligations, others will have excess cash flow. Since ESOP firms typically don’t pay cash dividends or distributions to shareholders, they often pay large bonuses to executives or employees, meaning that shareholders don’t get the benefit of the firm’s profits! That saps value from the firm, especially if employees become used to high levels of bonuses that are hard to roll back.

Mitigation strategy: Make sure you have a strategy for operating cash flow, with an appropriate amount going to bonuses, sufficient incentives for executives, and (if appropriate) an acquisition strategy to ensure the shareholders reap the benefits of the firm’s cash flow.

If you have questions about understanding options for your ESOP, Morrissey Goodale’s ownership transition and AE firm valuation experts can help. To connect with Morrissey Goodale Principal Advisor Alexander Tepper, email him at [email protected] or text him at (917) 291-1410.