November 26, 2007
Beware the ESOP? | A conversation with Verrill Dana attorney Eric Altholz on the payoffs and pitfalls of employee stock ownership plans
By Kerry Elson
For some companies, an employee stock ownership plan, also known as an ESOP, is ideal. Business owners who don't want to sell the company to an outside buyer can instead sell shares to employees. Some would say partial employee ownership allows business owners to maintain control over the business, but also boosts employee satisfaction, increasing productivity.
Those benefits have prompted ESOPs to grow in popularity since Congress approved them in 1974. That year, there were about 200 companies with ESOPs. In 2007, about 10,000 companies have ESOPs, according to The ESOP Association in Washington, D.C. ESOPs got nationwide recognition earlier this year, when real estate magnate Sam Zell said he would purchase The Chicago Tribune Co. using an ESOP.
Most ESOPs function like this: A company decides how much stock it would like to sell to its employees, whether it's five percent or 75%. Then it borrows the equivalent amount of money from a bank and, in turn, lends that money to a trust fund. The trust then pays that money back to the company over time, in exchange for the company stock. When employees leave the company, they can receive their stock, and the company must buy back the shares at market value.
But an ESOP isn't right for every company. For some, the expense and complexity of setting one up can outweigh the benefits. Maine business owners approaching retirement age should consider them carefully, warns Eric Altholz, an employee benefits attorney at Verrill Dana in Portland.
Altholz is one of just a few attorneys in Maine who've worked on ESOPs, primarily to write companies' plans and make sure they meet federal guidelines. He says he's received frequent calls from small-business owners interested in setting up an ESOP. But once he lays out the requirements ˆ including annual valuations and fees for the trustee who manages the money companies use to purchase stock ˆ many businesses ditch the ESOP in favor of other options.
The expense alone may be one reason ESOPs are relatively rare in Maine, reasons Altholz. Of The ESOP Association's 1,400 member companies, just seven are from Maine. At most, there may be 30 Maine companies that use the plans, Altholz estimates. (For a selection of Maine companies with ESOPs, see sidebar, page 23.)
Mainebiz recently spoke with Altholz about the ups and downs of ESOPs, from boosting employee productivity to draining a company's coffers. The following is an edited transcript.
Mainebiz: What kind of ESOPs have you worked on?
Eric Altholz: Most of the ESOPs I've worked on were ESOPs that were established as a financing device. An ESOP is certainly a type of retirement plan but it's almost better to think of it as a financing device. That is to say, a mechanism by which the owners of a small or mid-size business can sell their stock and realize on their investment without necessarily identifying a third party buyer. And that's very much at the heart of what ESOPs do.
So my experience has been with ESOPs that were designed and established for the purpose of buying stock from the owners of the company. And that has ranged from ESOPs that have bought a minority interest in the company ˆ 30%, sometimes less than that ˆ to ESOPs that have bought a majority of interest in the company.
Are you the first contact for someone interested in an ESOP?
Well, when I get a call from a client who's interested in an ESOP, I have a conversation with them and I direct them to a consultant. You need to have a threshold analysis done to determine whether your company can support an ESOP. And if it can, is the ESOP something that can help you meet your financial goals? And that's really not the role of the lawyer. That's the consultant's role.
Now, once [the ESOP] is up and running, my role is to continue to consult with the company when questions arise about what the plan says. Like other retirement plans, ESOPs are regulated both under the Internal Revenue Code, and under ERISA, the Employee Retirement and Income Security Act of 1974, as amended. The lawyer's role is to make sure that at every point ˆ not just in the document but in the actual structuring of the transaction ˆ the way they're administering the plan is always complying with those two sets of laws.
There aren't that many ESOPs that you know of in Maine, right?
Right. I mean, I've worked with about half a dozen over a period of 15 years. I don't know how many there are in Maine. If you were to tell me there were 25 to 30 in Maine, I guess I would believe that but it's not based on any direct experience.
But when I think about how many clients I deal with all the time on all kinds of retirement plans and the tiny fraction that have ESOPs, that's probably [a] pretty fair [estimate].
Why do you suppose more people aren't interested in ESOPs?
At least two reasons: One, they're just very complicated, and that's a turn off. There are high barriers to entry, you might say. This is by no means a firm estimate, but it would not be surprising if the total cost to establish an ESOP from scratch were somewhere between $30,000 and $50,000. Now, that's not a ridiculous amount of money, but for a mid-size business in Maine, that's a lot of money.
And then there are ongoing expenses, because you have to have the company valued every year ˆ a formal, written appraisal ˆ and that's required under ERISA. You use that appraisal to determine how much stock goes into the accounts of the employees every year. If there are subsequent purchases of stock by the ESOP, the appraisal is critical ˆ you've got to do it every year. A typical privately-held company isn't appraised every year. You might be appraised if the company is borrowing money from the bank, or if the shareholder is being bought out or if they're considering selling the company. But you wouldn't do it every year. When you have an ESOP, you've got to do it every year.
So when people call you, they don't realize that there are all those expenses?
Right. I have turned away many more ESOPs than I have worked with over the years. I typically will explain all this stuff, but I'll say, "You know, you really ought to talk to a consultant."
[For] the few that have heard all that and then proceeded, it works out great because they know what to expect. In some cases, there are some business owners that are quite happy to pay $50,000 to set up an ESOP, [but] it literally can't work for them because of the limitations on the amount of money that a company can contribute to an ESOP.
The amount of money that can be contributed by the company to the ESOP every year is limited by federal law to 25% of the payroll. And the reason for that is that the Department of Treasury doesn't want companies to be able to shelter all of their income through these plans.
If your total payroll was $1 million, you know right away that the maximum amount of money that you can put into that ESOP for any given year and deduct for corporate tax purposes is $250,000. Then the maximum amount of money that the ESOP can afford to pay off the debt for any year is $250,000.
If you take that and project it out, at $250,000 a year, if your stock were worth $10 million, then you know that would be, like, 40 years. That's not a very good example, but it would take forever.
The key is this: The total amount that the ESOP can afford to pay out to the selling shareholders will be limited by what the company can afford to pay in to the ESOP.
And in terms of what the company can afford, that's just determined by what will keep it operating, basically?
Yeah, exactly. And then lurking out there is that no matter what happens, even if the company is awash in cash, cash coming out of its ears, you've got the 25% maximum contribution limit.
So what kind of company does it work for?
It's a company that has a total payroll that's big enough to support significant contributions to the ESOP, such that the ESOP can borrow enough money to buy the stock. There's no magic number. If you were to ask me what would be a typical size for that kind of company in Maine, I would say that you're more likely to see companies that meet that kind of a requirement that are upwards of 100 employees. But if you have a highly paid workforce, if you've got a small company [of] 20, 50 employees, and they're really highly paid and with sophisticated owners, I think that could potentially work. But it isn't guess work. It's science. The consultant can put it all in a spreadsheet and will tell you.
Could you share an example of a company that it did work well for?
There are lots of them in lots of different industries. I worked with one company ˆ a professional services company, so accounting, engineering, consulting ˆ that had a small number of owners, about 125 employees or so, right here in Maine. It was a very sophisticated business, [and the] owners really didn't want to sell the company to some other giant consulting firm. But the demographics were that there were a couple of owners, they were relatively older, starting to approach retirement and then a couple of owners that were younger, maybe 15 or 20 years from retirement. But they really wanted to have an opportunity to sell their stock and maintain some measure of control over their company.
And because of the demographics of their workforce, the size of their payroll, and their sophistication in handling challenging problems, the ESOP was a perfect situation for them. They used an ESOP consultant out of Minneapolis and the consultant came in and was able to offer them a few alternative structures. Basically, one of the owners was tasked with really owning this project and making it go and we worked on it for about a year and they ultimately closed this year on the sale of their stock and it's been great. They're very happy with it.
Did that make the employees more productive?
That's an excellent point. If you believe what ESOP consultants tell you, they'll say that an ESOP will increase the productivity of your employees by at least 10%. Now I'm not sure how that measure is [calculated], but yes, that's one of the benefits that ESOP consultants sell. Just knowing that they are going to participate in the financial success of the company, and giving them a sense of investment ˆ literally, actual investment and ownership in the company ˆ makes them want to work harder. I certainly buy into the idea that there are intangible factors that affect someone's attitude towards work. I know it affects my attitude towards work.
Those benefits have prompted ESOPs to grow in popularity since Congress approved them in 1974. That year, there were about 200 companies with ESOPs. In 2007, about 10,000 companies have ESOPs, according to The ESOP Association in Washington, D.C. ESOPs got nationwide recognition earlier this year, when real estate magnate Sam Zell said he would purchase The Chicago Tribune Co. using an ESOP.
Most ESOPs function like this: A company decides how much stock it would like to sell to its employees, whether it's five percent or 75%. Then it borrows the equivalent amount of money from a bank and, in turn, lends that money to a trust fund. The trust then pays that money back to the company over time, in exchange for the company stock. When employees leave the company, they can receive their stock, and the company must buy back the shares at market value.
But an ESOP isn't right for every company. For some, the expense and complexity of setting one up can outweigh the benefits. Maine business owners approaching retirement age should consider them carefully, warns Eric Altholz, an employee benefits attorney at Verrill Dana in Portland.
Altholz is one of just a few attorneys in Maine who've worked on ESOPs, primarily to write companies' plans and make sure they meet federal guidelines. He says he's received frequent calls from small-business owners interested in setting up an ESOP. But once he lays out the requirements ˆ including annual valuations and fees for the trustee who manages the money companies use to purchase stock ˆ many businesses ditch the ESOP in favor of other options.
The expense alone may be one reason ESOPs are relatively rare in Maine, reasons Altholz. Of The ESOP Association's 1,400 member companies, just seven are from Maine. At most, there may be 30 Maine companies that use the plans, Altholz estimates. (For a selection of Maine companies with ESOPs, see sidebar, page 23.)
Mainebiz recently spoke with Altholz about the ups and downs of ESOPs, from boosting employee productivity to draining a company's coffers. The following is an edited transcript.
Mainebiz: What kind of ESOPs have you worked on?
Eric Altholz: Most of the ESOPs I've worked on were ESOPs that were established as a financing device. An ESOP is certainly a type of retirement plan but it's almost better to think of it as a financing device. That is to say, a mechanism by which the owners of a small or mid-size business can sell their stock and realize on their investment without necessarily identifying a third party buyer. And that's very much at the heart of what ESOPs do.
So my experience has been with ESOPs that were designed and established for the purpose of buying stock from the owners of the company. And that has ranged from ESOPs that have bought a minority interest in the company ˆ 30%, sometimes less than that ˆ to ESOPs that have bought a majority of interest in the company.
Are you the first contact for someone interested in an ESOP?
Well, when I get a call from a client who's interested in an ESOP, I have a conversation with them and I direct them to a consultant. You need to have a threshold analysis done to determine whether your company can support an ESOP. And if it can, is the ESOP something that can help you meet your financial goals? And that's really not the role of the lawyer. That's the consultant's role.
Now, once [the ESOP] is up and running, my role is to continue to consult with the company when questions arise about what the plan says. Like other retirement plans, ESOPs are regulated both under the Internal Revenue Code, and under ERISA, the Employee Retirement and Income Security Act of 1974, as amended. The lawyer's role is to make sure that at every point ˆ not just in the document but in the actual structuring of the transaction ˆ the way they're administering the plan is always complying with those two sets of laws.
There aren't that many ESOPs that you know of in Maine, right?
Right. I mean, I've worked with about half a dozen over a period of 15 years. I don't know how many there are in Maine. If you were to tell me there were 25 to 30 in Maine, I guess I would believe that but it's not based on any direct experience.
But when I think about how many clients I deal with all the time on all kinds of retirement plans and the tiny fraction that have ESOPs, that's probably [a] pretty fair [estimate].
Why do you suppose more people aren't interested in ESOPs?
At least two reasons: One, they're just very complicated, and that's a turn off. There are high barriers to entry, you might say. This is by no means a firm estimate, but it would not be surprising if the total cost to establish an ESOP from scratch were somewhere between $30,000 and $50,000. Now, that's not a ridiculous amount of money, but for a mid-size business in Maine, that's a lot of money.
And then there are ongoing expenses, because you have to have the company valued every year ˆ a formal, written appraisal ˆ and that's required under ERISA. You use that appraisal to determine how much stock goes into the accounts of the employees every year. If there are subsequent purchases of stock by the ESOP, the appraisal is critical ˆ you've got to do it every year. A typical privately-held company isn't appraised every year. You might be appraised if the company is borrowing money from the bank, or if the shareholder is being bought out or if they're considering selling the company. But you wouldn't do it every year. When you have an ESOP, you've got to do it every year.
So when people call you, they don't realize that there are all those expenses?
Right. I have turned away many more ESOPs than I have worked with over the years. I typically will explain all this stuff, but I'll say, "You know, you really ought to talk to a consultant."
[For] the few that have heard all that and then proceeded, it works out great because they know what to expect. In some cases, there are some business owners that are quite happy to pay $50,000 to set up an ESOP, [but] it literally can't work for them because of the limitations on the amount of money that a company can contribute to an ESOP.
The amount of money that can be contributed by the company to the ESOP every year is limited by federal law to 25% of the payroll. And the reason for that is that the Department of Treasury doesn't want companies to be able to shelter all of their income through these plans.
If your total payroll was $1 million, you know right away that the maximum amount of money that you can put into that ESOP for any given year and deduct for corporate tax purposes is $250,000. Then the maximum amount of money that the ESOP can afford to pay off the debt for any year is $250,000.
If you take that and project it out, at $250,000 a year, if your stock were worth $10 million, then you know that would be, like, 40 years. That's not a very good example, but it would take forever.
The key is this: The total amount that the ESOP can afford to pay out to the selling shareholders will be limited by what the company can afford to pay in to the ESOP.
And in terms of what the company can afford, that's just determined by what will keep it operating, basically?
Yeah, exactly. And then lurking out there is that no matter what happens, even if the company is awash in cash, cash coming out of its ears, you've got the 25% maximum contribution limit.
So what kind of company does it work for?
It's a company that has a total payroll that's big enough to support significant contributions to the ESOP, such that the ESOP can borrow enough money to buy the stock. There's no magic number. If you were to ask me what would be a typical size for that kind of company in Maine, I would say that you're more likely to see companies that meet that kind of a requirement that are upwards of 100 employees. But if you have a highly paid workforce, if you've got a small company [of] 20, 50 employees, and they're really highly paid and with sophisticated owners, I think that could potentially work. But it isn't guess work. It's science. The consultant can put it all in a spreadsheet and will tell you.
Could you share an example of a company that it did work well for?
There are lots of them in lots of different industries. I worked with one company ˆ a professional services company, so accounting, engineering, consulting ˆ that had a small number of owners, about 125 employees or so, right here in Maine. It was a very sophisticated business, [and the] owners really didn't want to sell the company to some other giant consulting firm. But the demographics were that there were a couple of owners, they were relatively older, starting to approach retirement and then a couple of owners that were younger, maybe 15 or 20 years from retirement. But they really wanted to have an opportunity to sell their stock and maintain some measure of control over their company.
And because of the demographics of their workforce, the size of their payroll, and their sophistication in handling challenging problems, the ESOP was a perfect situation for them. They used an ESOP consultant out of Minneapolis and the consultant came in and was able to offer them a few alternative structures. Basically, one of the owners was tasked with really owning this project and making it go and we worked on it for about a year and they ultimately closed this year on the sale of their stock and it's been great. They're very happy with it.
Did that make the employees more productive?
That's an excellent point. If you believe what ESOP consultants tell you, they'll say that an ESOP will increase the productivity of your employees by at least 10%. Now I'm not sure how that measure is [calculated], but yes, that's one of the benefits that ESOP consultants sell. Just knowing that they are going to participate in the financial success of the company, and giving them a sense of investment ˆ literally, actual investment and ownership in the company ˆ makes them want to work harder. I certainly buy into the idea that there are intangible factors that affect someone's attitude towards work. I know it affects my attitude towards work.
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