ESOP Tune-Ups

By Alex Mumblat

Moments of adversity offer business owners an opportunity to step back and evaluate their operations and strategies.

It isn’t easy to find time for reflection when business continuity is the top priority, but owners who actively assess the changing economic environment, as well as their overall life objectives, often emerge from downturns more effective and focused on future growth. 

The same goes for leaders of employee stock ownership plan (ESOP) companies. Turbulent times should evoke a series of questions focused on the sustainability and performance of an employee trust.

  • Is the ESOP generating tax efficiencies?
  • Is administration of the ESOP reasonably manageable?
  • Is the company prepared to deal with the ESOP share repurchase liability?
  • Is the company’s bank facility optimized?
  • Has the ESOP provided an adequate incentive for employees?

With these in mind, an ESOP re-evaluation and potential tune-up should focus on three key areas.

1) ESOP Structure Optimization

Declining earnings are common during an economic downturn. This can reduce the benefit of ESOP-related tax savings, as the magnitude of those benefits is income driven. Companies may consider scaling down their ESOP contributions or deferring ESOP dividend payments during a downturn.

Conversely, certain businesses do well during the recessionary times. Such companies may want to consider additional liquidity transactions such as secondary ESOP sales (for minority ESOPs) or warrant redemptions (for the warrant holders).  Financial crises magnify the importance of an owner's personal liquidity and asset diversification. Secondary ESOP sales can also further contribute to corporate tax efficiencies.

2) Bank Loan Restructuring

Companies facing cash flow challenges should reassess their ability to meet bank covenants and service debt. Restructuring may offer ESOP companies an opportunity to extend their loan amortization periods and capitalize on prevailing low interest rates. Banks often anticipate these requests and are open to restructuring discussions in order to help avoid borrower defaults and enhance their client relationships.

On the other hand, banks are eager to extend new loans to counter-cyclical businesses. Recession-resistant ESOP companies with outstanding seller debt might consider increasing their bank loans to replace seller financing.

3) Employee Incentives & Obligations

In the years following an ESOP implementation, companies often undergo substantial workforce changes.  Turnover across employee populations may require realignment of benefits and incentives. For example, additional benefit plans could be adopted for certain members of the management team, subject to approval by the ESOP trustee.

A crisis can accelerate staffing changes, due to sudden layoffs. This may trigger repurchases of vested ESOP stock accounts. While the per-share value of the company’s stock would typically decline alongside a deterioration in performance, management must evaluate the potential impact of these obligations and budget in advance for such repurchases.  

Beyond Maintenance

ESOP companies may also engage in more extensive activities to address plan under-performance, new business realities, or changing shareholder needs. These include plan terminations, employee share redemptions, or plan expansions towards the goal of 100% employee ownership (with options for selling shareholders to hold warrants and participate in future upside). 

The best laid business plans are rarely set in stone. An ESOP is no exception. Employee benefit programs, in general, demand constant re-evaluation to keep up with internal (company) and external (market) trends. Doing so can mean the difference between a high performing ESOP that benefits all stakeholders and a potential operating risk.