The Smith Report - Operational Playbooks

ESOPs – Issues to Consider for Owners

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The WSJ ran an interesting piece this week, on the issues surrounding employee stock-ownership plans. I’ve extracted some points worth considering from the article and added some issues from my own experience.

Background

As of 2011 approximately 10,900 ESOPs existed, up 12% from 2007. Nearly all of these firms have less than 500 workers. Prominent academics have spoken out against ESOPs – Andrew Stumpff, University of Michigan Law states, it’s bad enough to risk your retirement savings in a single company, but it’s even worse if that company is your employer, because your lose your job and your savings. Norman Stein, Drexel University says the ESOP model cause more harm than good. Many of the plans he claims are based on a bloated assessment of the value of the businesses. It’s the linkage to retirement plans that troubles him, not ESOPs as a concept. Research by Harvard, Rutgers and the National Bureau of Economic Research suggest businesses with shared-ownership plans performed better in the recession than more traditionally structured firms.

Owners who have taken the plunge claim a series of benefits; workers are more engaged, better team spirit, driving factor for long term success, values and culture remain intact for a longer period, and it helps employees think like entrepreneurs.

Issues To Consider
  1. If the CEO is staying on but diluting down her equity stake you need to consider how that might affect the ability to lead. Senior members of the team might feel more empowered to challenge fundamental strategy decisions, creating a business paralyzed by decision making.
  2. Depending on the structure of the ESOP be careful that junior employees with family money don’t have a chance to own a significant equity stake. I’ve seen this cause massive HR issues.
  3. The only valuation of a private company that is real is the value a buyer places on it. The value placed on an ESOP can be way above or below market value because it’s not necessarily what a buyer would pay.
  4. Communication from the leadership team to staff will often have to change dramatically after an ESOP. A brief town hall meeting once a year just won’t cut it.
  5. As communication increases across a much broader shareholder base you need to be careful that competitive information doesn’t leak out. Rules of disclosure need to be put in place.
  6. Disciplinary rules have to be made clear and holding equity doesn’t give you a “get of jail free” card.
  7. An ESOP company can be a turn off to a future acquirer because of the shareholder approvals a seller needs to go through. Compare that to the private company owner who owns all of the shares.
  8. Motivating staff can be achieved many simpler ways than the complexity of an ESOP structure, e.g. Long Term Incentive Plans, shadow options, profits with interests structures, change of control bonuses.
  9. Owners are selling to a buyer in an ESOP where valuation is dominated by affordability.
  10. The desire to pass the business on to the staff is often quoted as an objective. One owner quoted in the article with sales of $150m, stated that selling to a competitor or a Private Equity house could lead to layoffs or cost cutting. I’m not sure the ESOP wouldn’t cut costs if it were necessary!
  11. Remember when selling a business a simple alternative might be to allow the management team to launch a management buy out. Give the team 10 weeks to produce an acceptable offer but if they fail, tell them you will be running a covert controlled auction.
  12. Tax is a complex issue in ESOPs from a seller and a staff perspective. The owner should ensure all sides are well advised to avoid pain later.
  13. If you are considering an ESOP, as an owner, you need to consider the development of your team. Are they ready to run the business? Have you considered how the business will scale over the next 5 years under their leadership? After all if you don’t care why use an ESOP? Just sell it.
  14. Clearly with only 6000 companies selling out for $10m or more per year out of 27.3m enterprises you may feel an ESOP is your only option to safely crystallize cash, tax efficiently.
Problems like these require a consolidation of private owner objectives and company objectives. Whatever you do please reach out to an objective adviser who can help you talk through the issues.
The Portfolio Partnership advise and execute on all aspects of scaling and exiting private companies.
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About the Author

Ian founded The Portfolio Partnership (TPP) in 2010. TPP is an operational consultancy focused on scaling private businesses safely. He believes his resume of building 4 previous businesses from publishing, investment banking to software in Europe and the States gives him a unique set of skills and a sense of humor. He remains a competitive masters track & field athlete and in 2012 was ranked #2 indoors in the world for his age at 400m.

Discussion

  1. Paul Cronin  April 22, 2013

    Fine post Ian. ESOPs need to be careful that not become a crutch by weak companies, those with little value outside of the stakeholders. At Successful Transition Planning Institute, we counsel owners and their advisors, that the owner must consider a life beyond the business to reach their true personal potential. If an owner uses an ESOP to “hang on”, because he can’t imagine life not being an “owner”, then he is only delaying the inevitable, and possibly damaging the value of his company

    (reply)
    • Ian Smith  April 23, 2013

      Agreed Paul, I’d need convincing that an ESOP was the best strategy. However there is no doubt for the right situation they are a clever, effective solution.

      (reply)

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