Spinnaker Trust
Jeannine Pendergast, Spinnaker Trust
September 14, 2022
How businesses can avoid common ESOP pitfalls
By Jeannine Pendergast and Laura Pfeiffenberger
Employee Stock Ownership Plans, or ESOPs, have become a popular tool for succession planning, and with good reason: they give the owner an exit strategy that provides liquidity, while keeping the operations, management, and culture intact. They give employees a vested interest in the company's continued success, and an incentive to commit for the long term.
What’s more, studies have shown that ESOPs pay off for all involved. When comparing household net worth, income from wages, and job tenure, ESOP participants’ medians outperformed those who worked at privately held companies.
After helping more than 50 organizations in a wide variety of industries convert to ESOPs over the last decade, and going through an ESOP conversion ourselves here at Spinnaker Trust, we have observed both best practices that spell success, and common pitfalls that trip ESOPs up.
Here’s how to avoid a few common ESOP mistakes and ensure that your organization thrives and rewards employee owners.
Don't try to DIY. By law, an ESOP must appoint a trustee to oversee the company plan and handle the vast array of duties involved with ESOP administration, including determining the value of the stock, trust accounting, and coordination with attorneys, accountants, and the third-party administrator. In a bid to save money, many ESOPs tap a member of the management team for this role, piling it on to the myriad of other full-time duties that individual already has running the company. But anytime a task is just part of someone’s job, it often gets put on the backburner. Long term, it pays off to have an independent third party who is solely focused on ensuring the success of the company and value for ESOP participants. An independent external trustee is better equipped to track troubling trends and keep them from tripping up the company. What’s more, an outside trustee brings a big-picture perspective on best practices, and changes in regulations and tax laws that an internal trustee could not possibly bring to the table.
Spinnaker Trust
Laura Pfeiffenberger, Spinnaker Trust
Don't underestimate the power of perception. The success of ESOPs hinges on the buy-in of participants, in both a literal sense, and on an emotional level. Participants draw a great deal of confidence from knowing that there is an independent professional who has a fiduciary duty to ensure the Board of Directors and management team are driving the financial health of the company, and the value of participants’ shares. The ESOP can represent a huge proportion of participants’ retirement savings. Though guidelines to prevent internal conflict of interest may be established, even a perceived conflict of interest can gnaw at ESOP participants, and ultimately their commitment to the company. When you have an independent, third-party professional serving in the trustee role, doing things like determining the value of the company stock, and ensuring compliance with all laws and regulations, it gives employee shareholders a certain amount of trust in the organization.
Plan for your payouts. After converting to an ESOP, it’s critical to have a plan to repurchase the shares when your employees leave or retire. ESOPs that fail to plan often end up running into trouble. The company may not have the funds to meet the repurchase obligations and could end up having to sell to a third party, file for bankruptcy, or find some other alternative. An external trustee can help you get a realistic view on what your payout obligations will be, by evaluating factors like your payroll, projected future growth, share price and current allocations. The external trustee can offer guidance on how to plan for those obligations, while also maintaining the level of capital you need to run operations on a day-to-day basis and invest in the business’ long-term growth.
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