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Implementing the Strategy
One of the first activities to begin the implementation process is called Plan Design, Formation and Implementation. This, basically means drafting the necessary legal, corporate, shareholder and employee documents and agreements to tax qualify the plan with the IRS and make it effective in the eyes of the regulatory authorities.
The plan design is formalized in the plan and trust documents. These documents will formalize rules and procedures relating to:
- Eligibility and participation rules
- Contribution amounts and allocation rules
- Leveraged vs. non-leveraged design issues
- Procedures relating to dividend payments
- Vesting and forfeiture provisions
- Distribution and repurchase provisions
Documents and agreements drafted during this process include various stock purchase agreements, loan agreements and various board resolutions to implement the plan, approve plan contributions and adopt the trust. The necessary filings must be made to tax qualify the plan with the IRS. And, the required disclosure documents must be drafted including a summary plan description for the participants.
The ESOP Trustee
The next area to address involves the ESOP trustee. Basically the ESOP trustee ensures that the creation and maintenance of the plan adheres to fiduciary standards. The trustee is required to prudently act in the best interest of the plan participants and their beneficiaries.
More specifically, the ESOP trustee ensures that the shares are purchased for adequate consideration. The trustee will vote the stock in the ESOP plan on behalf of the ESOP participants and in their best interests. The trustee ensures that the employee accounts are properly accounted for and properly maintained. And the trustee ensures that appropriate professionals and advisors are involved to ensure that the ESOP regulations are being followed.
The ESOP trustee could be an officer or group of employees from within the company, it could be someone from outside the company - possibly a local attorney, or the company could choose a corporate trustee such as an independent bank or trust company.
What is Your Business Worth?
Most qualified plans are prohibited from engaging in certain “prohibited transactions” with the company, its shareholders, officers, directors and fiduciaries. ESOPs are exempted from provisions that would otherwise prohibit it from purchasing company stock from its shareholders as long as it pays “adequate consideration” or fair market value for the stock. Therefore, a critical activity involved in the implementation of an ESOP is establishing the current value of the business. A business valuation must be conducted annually by an independent, third-party, qualified appraiser to establish a fair market value of the business. The ESOP trustee must ensure that the ESOP pay fair market value or less for a shareholder’s stock. The ESOP can never pay more than fair market value.
ERISA requires that, where no market or exchange exists for the shares, the plan trustee must determine and pay “adequate consideration” for the shares. While there is little regulatory guidance regarding valuation, the DOL provides five components of value to help determine “adequate consideration.”
Business enterprise value is an accounting driven measure that includes the sum total of all the business assets, commonly referred to as invested capital in the business, which includes working capital, tangible and intangible assets like good will.
Market value, on the other hand, is basically an exchange between a willing buyer and a willing seller. It’s what a ready, willing and able buyer is prepared to pay for a company. It assumes that
- both the buyer and seller have a reasonable knowledge of all the relevant facts
- neither the buyer nor seller is forced into the transaction
- and the buyer has the means to make the purchase.
When any number of shares purchased is less than a controlling interest in a company, which is usually less than 50%, the purchaser is purchasing a minority interest in the company. The concept of minority interest is typically applied in the form of a discount to the market value in the range of 15% - 25%.
Closely held company stock must be valued on a non-marketable basis because a market or established stock exchange is not readily available to trade the stock. Discounts for marketability can range from 25% to 50%. For this reason, some companies establish a formal stock repurchase program that creates an internal market for the ESOP shares. Such a repurchase program can significantly reduce or eliminate the discount for marketability.
In our example the market value of the company was established at $15 million dollars. The ESOP transaction was designed to purchase a 33% minority interest in the company from the owner. A 20% minority interest discount was applied to the appraised market value.
Independence
The trustee or administrative committee hires the appraiser. The appraiser should have no conflicts of interest with the company whose shares they are appraising. While no regulatory guidance exists, court cases have found conflicts when prior business dealings, including auditing relationships, have existed between the company and the appraiser.
ESOP Financing
Now let’s discuss ESOP financing alternatives. First the company must decide whether it prefers to use a leveraged vs. non-leveraged approach. As we discussed, a non-leveraged transaction is a type of stock bonus plan. The corporation makes a contribution of treasury stock or newly issued stock to the plan. Or the company could contribute the required cash to purchase the stock.
A leveraged ESOP uses internally or externally financed funds to purchase the stock from a shareholder. Or a leveraged transaction could occur with owner financing. Under such an arrangement, the owner would hold a note issued by the ESOP. Each year the ESOP would make payments of principal and interest to the owner instead of to a bank until the note is paid off.
It’s common for a leveraged ESOP transaction to occur in a two-step process. The bank makes a loan to the corporation often referred to as the external loan. The bank will underwrite the loan and conduct due diligence on the company in a similar manner to any commercial loan opportunity. The corporation in turn makes a loan to the ESOP often referred to as the internal loan. The terms of these loans may be the same often referred to as a “mirror loan.” Or they can be different. This is particularly helpful in situations where the maximum term that a bank is willing to lend is too short resulting payment that is too high based on your ESOP contribution limits. Under such a situation, the term of the internal loan could be lengthened to accommodate a payment that fits the limits.
The ESOP trustee will maintain custody of the ESOP shares in a suspense account as collateral for the loan. As the bank receives its loan payments, it will authorize the trustee to release shares from the suspense account to the ESOP where they will be allocated to the participant accounts.
To repay the debt, the corporation makes annual, tax-deductible contributions to the ESOP. The ESOP trustee makes annual loan payments back to the company and the company makes annual loan payments to the bank. Financing the ESOP in such a way creates a tax deduction for not only the interest on the loan but the principal as well, which is one the most appealing features of a leveraged ESOP.
It’s not unusual to finance a transaction with a combination of owner, bank, and internal or private financing.
ESOP Administration
The ESOP Trustee or the Administrative Committee must ensure that the ESOP is properly administered in a compliant manner. The Administrator must collect and maintain all required participant data; prepare the management and participant reports and ensure that the plan complies with government reporting and disclosure requirements. While the administration of an ESOP is similar in some ways to other defined contribution and profit-sharing plans, there are significant differences that require specialized administrative expertise.
Employee Communications
Our final topic of this presentation concerns employee communications. The breadth and depth of the communications plan will depend on the original goals and objectives of the ESOP. For example, if the company relies on other strategies to attract, reward and retain productive workers and the ESOP is to be implemented solely as an exit strategy for a shareholder, the employee communications plan may be minimal - possibly an initial meeting to explain the mechanics of the plan and written updates annually.
However, if the purpose of the ESOP is to motivate employees to higher levels of loyalty and productivity, then a carefully planned strategy of employee communication combined with participative management practices will increase the probability that the company will actually create the internal “ownership culture” required to achieve the desired results.
For example, according to the National Center for Employee Ownership, over 10 years of research consistently concluded that merely implementing an ESOP alone was not likely to significantly move the typical performance metrics such as growth in sales, profits or cash flow. However, companies that combined employee ownership with participative management practices performed better than they did before implementing the ESOP and performed better than similar non-ESOP companies.
A carefully planned and executed employee communications plan combined with modified management practices while not required will increase the probability of success.
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