September 01, 2014

Partially owned ESOP companies have a multitude of available alternatives when it comes to future ownership. Increasing or decreasing employee ownership can be achieved in a number of different ways, each of which needs to be considered carefully.

Since 1974, the year in which the Employee Retirement Income Security Act was enacted into law, the benefits of employee ownership have been enjoyed by thousands of companies and millions of employees. With the creation of Employee Stock Ownership Plans (ESOPs), successful business owners have been enabled and incentivized to transition their ownership in a company to its employees. This transition has been achieved by selling all or a majority of the company’s stock to the ESOP in a single transaction, or by selling much smaller blocks of stock to the ESOP whereby the remaining non-ESOP shareholders maintain their majority ownership. In fact, this flexibility in designing ownership transition through an ESOP is one of many benefits that ESOPs can provide to existing business owners.

Because the dynamics of each ESOP-owned company and its shareholders are unique, employee ownership can have varying levels of success within a company. Accordingly, the company should frequently evaluate the role of the ESOP in relation to its near- and long-term strategic objectives. Depending on the desired objectives, the company’s available alternatives can include: 1) maintaining the status quo, 2) increasing the ESOP’s ownership, or 3) decreasing (or terminating) the ESOP. Ultimately, it’s in the hands of the company’s board of directors, along with the ESOP trustee and their advisors, to shepherd the ESOP in the right direction and properly assess each path.

Stay the Course

When it comes to employee ownership, the first and simplest path for most companies is to maintain the status quo. If the current level of employee ownership works for a company and its shareholders, the company may determine that undergoing another ESOP transaction is currently not in everyone’s best interest. The remaining non-ESOP shareholders may not be ready to sell yet and still desire to continue their direct ownership in the company. Perhaps the company does not currently have enough debt capacity to finance another ESOP transaction, or it needs to utilize its debt capacity for other growth opportunities. Alternatively, in the case of more mature ESOPs where the majority of ESOP shares have been allocated, the company may already be funding significant ESOP repurchase obligations that, if not properly monitored, could have a detrimental impact on a company’s ability to finance future strategic alternatives involving the ESOP.

In order to prevent a partially-owned ESOP’s ownership interest from being diluted, shares repurchased from ESOP participants can be recycled within the plan. Recycling shares is typically achieved by repurchasing shares with cash already held within the plan or through tax-deductible contributions made by the company to the ESOP. Alternatively, the repurchased shares can be redeemed by the company and sold back to the ESOP in exchange for a loan. This alternative is often referred to as releveraging, and allows the company to allocate the repurchased shares over a longer time period as compared to simply recycling all of the repurchased ESOP shares in one year. As a result, the company is able to more easily manage its targeted benefit levels for ESOP participants. Releveraging is frequently utilized when companies need to address large ESOP repurchases in a given year. Another purpose of releveraging is not only to maintain ESOP ownership, but also to address the “haves” and “have nots” issue that occurs when most of the ESOP shares have been allocated and there may not be a sufficient amount of remaining ESOP shares to allocate to existing and future employees.

While maintaining the status quo may seem like the simplest path for partially owned ESOP companies, there are several factors that need to be frequently monitored in order to properly stay the course while achieving the company’s anticipated objectives through the ESOP.

Increase the Stakes

There comes a time in every company’s lifecycle where change is inevitable. When employee ownership has been advantageous for a company and its employees, increasing the ESOP’s ownership interest could be an enticing opportunity for the company, the employees, and the selling shareholders. Whether this additional ESOP ownership is obtained through gradual steps or one larger step, there are several alternatives available to achieve such desired ownership structure.

If the objective is for the ESOP to slowly accumulate additional ownership, the company can choose to contribute shares to the ESOP over a period of time, which would allow the company to manage its targeted benefit levels for the ESOP. This alternative would ultimately increase the ESOP’s ownership interest while simultaneously diluting other shareholders. This option is particularly attractive to companies since these contributions are typically tax-deducible and non-cash in nature, thus allowing cash to be used for company operations rather than retirement contributions.

Rather than gradually increasing employee ownership through contributions, ESOPs more commonly acquire additional shares by purchasing them directly from existing non-ESOP shareholders, perhaps in a similar fashion as the original ESOP transaction. Such transactions are typically structured with the ESOP borrowing funds from the company or the selling shareholders to finance the transaction. In addition, the selling shareholders may qualify to defer and possibly eliminate their capital gains through Section 1042 election if certain prerequisites are met when selling their shares directly to the ESOP. Alternatively, the company could also redeem the stock from non-ESOP shareholders, which would effectively increase the ownership interest of all remaining shareholders, including the ESOP. Finally, it may be advantageous for the company to redeem the non-ESOP shares and sell some or all of such shares to the ESOP as part of an integrated ESOP transaction. This structure would allow the company to have additional shares to allocate to existing and future ESOP participants, while mitigating potential legal and fiduciary complexities associated with the non-ESOP shareholders selling their stock directly to the ESOP.

Many partially-owned ESOP companies are enticed to structure a transaction that results in the ESOP owning all of the common shares outstanding and the company electing S corporation tax status. Such a structure would typically result in the company being exempt from federal income taxes since the tax obligation would only exist at the shareholder level and the company’s only shareholder would be a tax-exempt entity. These tax savings could be used to: 1) pay down debt quicker, 2) reinvest back into the company for organic growth, 3) make acquisitions, or 4) build up cash to strengthen the company’s balance sheet and be more prepared to fund future repurchase obligations.

While the tax benefits associated with being a 100 percent ESOP-owned S corporation are tempting to many partially ESOP-owned companies, proper due diligence needs to be performed in advance to ensure such an ownership structure fits the company’s desired culture and benefit levels. If not, it may be hard to sustain this ESOP ownership structure.

There are also a number of issues the company and ESOP trustee should consider when contemplating to increase the ESOP’s ownership interest, especially if the ESOP is transitioning from minority ownership to majority ownership. These issues can range from analyzing the company’s financial stability both pre- and post-transaction, determining the appropriate level of value reflected within the purchase price, and assessing whether or not price protection should be provided to existing ESOP participants.

Prior to undergoing any transaction, the company should first analyze whether it has the financial wherewithal to support the post-transaction impact on its balance sheet. In doing so, the company should consider the future repurchase obligations related to the original ESOP transaction as well as the additional repurchase obligations resulting from a potential second stage ESOP transaction. Accordingly, it is recommended that a repurchase obligation study be performed to fully understand the impact of a potential second stage ESOP transaction. Although the benefits of employee ownership can be rewarding, such benefits are less likely to be realized in a company that is not able to sufficiently amortize its debt obligations post-transaction.

When an ESOP transitions from a minority ownership to majority ownership, one of the first items to resolve is whether to value the company on a controlling-interest basis. All else constant, a buyer would typically be more willing to pay for a controlling block of stock in a company than a non-controlling block of stock. As a majority owner, the buyer would also likely have certain control rights, which may warrant a controlling interest valuation.

One additional issue that the company and ESOP trustee must address when increasing the ESOP’s ownership interest is how it impacts existing ESOP participants. The immediate impact of a leveraged transaction is an increase in debt, which could ultimately result in a lower equity value of the company and corresponding lower ESOP stock price. Accordingly, in order to offset the dilutive impact of the leveraged transaction, certain provisions can be implemented within the plan documents to protect existing ESOP participants who leave the company for a defined purpose prior to fully amortizing the debt incurred to finance the most recent ESOP transaction. This is often referred to as price protection. One method to implement price protection is to have the appraiser perform an additional valuation each year that would value the company without regard to the incremental debt incurred to finance the most recent ESOP transaction. Deciding how and whether to implement price protection can depend on several factors, including employee demographics, the number of allocated shares in the ESOP, the future growth prospects of the company, and the size of the contemplated transaction.

Decrease ESOP Ownership

ESOPs can be incredible ownership vehicles providing numerous benefits to employees, companies, and selling shareholders. However, ESOPs are not a right fit for every company. Perhaps there is lack of management support; and, therefore, the company’s culture does not support the ESOP. Although in order to maintain a successful ESOP, the company itself must also be successful. Companies that do not generate sufficient Cash Flow to satisfy its repurchase obligations or those that participate in rapidly declining industries may no longer be appropriate for an ESOP. Accordingly, the company may decide to shrink the ESOP’s ownership interest or maybe even terminate the ESOP altogether.

The process of decreasing an ESOP’s ownership interest can be performed gradually by retiring repurchased shares in the normal course of business. However, if the process of retiring shares is too protracted, decreasing the ESOP’s ownership interest can be achieved more quickly through a corporate redemption transaction. Alternatively, if a willing buyer exists, the ESOP may choose to sell its shares to another shareholder or even an outside buyer. In such transactions, the ESOP trustee has the fiduciary responsibility, with guidance from its advisors, to ensure the consideration to be received by the ESOP is not less than the Fair Market Value of the shares being sold.

Conclusion

Although the story behind each and every ESOP is unique, the various paths of employee ownership are somewhat familiar. In the case of partially owned ESOP companies, the future ownership possibilities seem relatively straightforward: keep the status quo, increase employee ownership, or decrease employee ownership. But when it comes to achieving such desired ownership and benefit levels, the complexities of each path are revealed. Whether a partially owned ESOP company chooses to undergo a releveraging transaction to maintain current ownership levels or an additional leveraged transaction to increase the ESOP’s ownership interest, or any other transaction, strong consideration should be given to all the available alternatives and any consequences of a particular decision. By doing so, those involved in the formation and maintenance of the ESOP can maximize the chances the transaction results in a positive and lasting legacy for the ESOP, benefiting existing and future ESOP participants.