October 28, 2021 •Patrick Trask, CPA
According to the US Bureau of Labor Statistics (BLS), 4.3 million Americans quit their jobs in August 2021. That’s 2.9% of the total non-farm workforce, the highest rate ever recorded by the BLS. For closely held companies in search of retention solutions, employee stock ownership plans (ESOPs) could play a key role.
What’s Driving the Great Resignation?
This trend began in early 2021 and has accelerated since then. Delayed departures could be one explanation. Economic uncertainty prompted many to hold on to their jobs through the height of the coronavirus pandemic. With an end in sight, some workers may now be seeking greener pastures.
But many economists and labor experts believe the current wave of resignations reflects deeper societal shifts. Remote working trends have broadened opportunities for experienced, mid-career job-switchers. Other employees, especially those in the service and healthcare industries, are burning out. While COVID-19 put unprecedented work-life pressures on essential workers, many also faced stagnant wages and benefit reductions long before the pandemic.
The Cost of Employee Turnover
According to a 2019 Gallup analysis, a company can expect to spend 50% to 200% of a departing employee’s salary to find and train their replacement. That represents a $1 trillion annual inefficiency for U.S. businesses. The impact of unplanned departures on small and mid-market businesses can be especially profound. Many of these firms lack robust human resources and talent acquisition capabilities.
Targeted incentives can take on outsized importance during an attrition crisis. When it comes to rewarding performance, cultivating belonging, and encouraging tenure, private businesses have several options.
401(k)s and Medical Benefits
These benefits have value but lack differentiation. In a volatile labor market, companies in direct competition for talent will likely strive for parity across standard health and retirement benefits.
Cash Bonuses, Phantom Equity, and Profit Interest
Although these individual and company-wide performance awards can be lucrative, they lack long-term staying power. After an annual incentive is paid, an employee is under no obligation to stick around. In addition, the earnings are subject to taxes, creating inefficiencies for companies and employees alike.
These programs reward longevity and performance, but the pool of grantees is generally limited to upper management and high performers. Most closely held middle market companies are ill-equipped or unwilling to roll out broad-based option plans.
The ESOP Alternative
Employee stock ownership plans have been part of the benefits toolkit since Congress passed ERISA, the Employee Retirement Income Security Act of 1974. Primarily conceived as a vehicle to build workers’ wealth, ESOPs are often framed solely as a retirement benefit.
Studies have long demonstrated the positive effect of ESOPs on employees’ economic well-being. But significant research also illustrates the value of employee ownership to a broader set of stakeholders. Selling shareholders receive fair market value for their equity, and plan sponsors perform better than their non-employee-owned peers. Tax incentives are certainly a catalyst in these instances, but there’s another known driver of ESOP-oriented prosperity: employee retention.
Employee Ownership and Retention
The median tenure of an ESOP participant is 46% greater than a non-employee owner (5.1 years vs. 3.5 years), according to a 2018 analysis of National Longitudinal Survey data of workers aged 28-34. This trend transcends racial, gender and income lines. The study’s author, the National Center for Employee Ownership, ultimately concluded that “employee ownership is strongly predictive of longer job tenure.”
Plan participants often cite a sense of belonging, pride of ownership, and skin in the game when describing allegiance to employee-owned companies. These soft benefits are all valid and important. Nonetheless, plan mechanics also encourage retention in several ways.
ESOP Shares are Allocated Over Time
Even in a leveraged ESOP – where some or all of a company’s equity is sold to an employee trust – those shares are allocated to employees over a multi-year period. That time frame is often 10 years or greater. This helps reward employees with longer tenures and extends the ESOP benefit to employees who join the company after plan formation.
ESOP Allocations Have a Vesting Period
Similar to a 401(k), annual share allocations vest over a three- to six-year period. Specifics, including vesting schedules (cliff or graduated) and accelerated vesting for long-tenured employees, are determined on a plan-by-plan basis.
As Tenure Increases, so Does an Employee’s Potential Upside
By virtue of the allocation and vesting mechanisms, an employee owner has more to gain by remaining with their company. Longer tenures lead to more vested stock. And, hopefully, over time the business will grow and increase its valuation. When an employee leaves an ESOP company, their vested shares are sold back to the plan sponsor at a current valuation. As a result, when long-time workers leave prosperous, employee-owned companies, their hard work is tangibly rewarded.
Transitioning to an Employee-Owned Company
The pivot to an ESOP does not happen overnight. Companies seeking to immediately address an attrition problem cannot turn to employee ownership as a cure all. ESOPs are Department of Labor-regulated defined benefit plans, and leveraged plans are complex financial transactions.
So, knowledgeable partners and a multi-month runway are essential to getting a well-designed employee stock ownership plan off the ground. A strong plan rollout is also critical. It’s important to properly convey the benefits and unique dynamics of an ESOP to employees. A poorly understood incentive is rarely effective.
But when an ESOP makes practical and financial sense, it can be a game-changer for closely held companies – especially in competitive labor markets.