Is an ESOP a Good Exit Strategy?
At some point, all business owners begin planning for their retirement by examining the exit strategies available to them and settling on the one they feel is most appropriate. But what makes one strategy more appropriate than another? This largely comes down to the owner’s priorities (or goals) from exiting the business. While most settle on a simple transfer of ownership to a third-party, some go the route of an employee stock option plan (ESOP) that may preserve their legacy, provide employees with the opportunity to participate as employee-owners, and still afford the owner tremendous value. Let’s explore the components of an ESOP in greater detail in order to determine if this strategy is right for you.
Defining an ESOP ESOPs are a qualified, defined-contribution employee benefit plan designed to invest primarily in the sponsoring employer’s stock. Some consider it a “win-win” for owners and employees. Based on a report from The ESOP Association, the United States has over 7,000 ESOPs and 76% of those surveyed indicated that an ESOP positively affected productivity of employee-owners. A separate report from the National Center For Employee Ownership (NCEO) found that two-thirds of ESOPs are developed by owners looking to exit their business, which may suggest that the value to owners is comparable to alternatives.
Establishing an ESOP Typically, an ESOP goes through a multi-step process of valuing the business and conducting demographic studies in order to assess feasibility, creating an ESOP trust, and engaging in a leveraged buyout of the shareholder(s) through a bank loan. Easy peasy, right? Following the initial steps in the process, the company uses annual tax-deductible contributions, dividends, or distributions (depending on your business structure) to repay the loan. Shares from the selling shareholder(s) are held in a suspense account and allocated to employees over time and then redeemed upon separation from the company. The broad structure of a leveraged ESOP (most common, but unleveraged is an option) is detailed below:
Pros and Cons of an ESOP
As with all things in business and life, you need to take the pros and cons into consideration when determining if an ESOP is right for you and your business. The table below details some of the key areas for consideration, but shouldn’t be considered an all-inclusive list by any means.
The United Airlines ESOP Case Study United Airlines (UA) is famous for establishing the largest, at the time, ESOP in 1994 that purchased 55% of the company’s common shares with approximately 85,000 employees participating and conceding 15% – 24% of their respective wages in exchange for ownership in the company. The honeymoon phase was great and UA grew rapidly until 2000 – it’s amazing how growth can hide some underlying issues – when it faced contract negotiations with two of its largest unions that led to work slowdowns. Further complicating matters were other unions who didn’t participate in the ESOP, but leveraged the work slowdowns as an opportunity to push for increased wages. The combination of events led to poor financial performance that culminated in a significant drop in UA shareholder value, and brought an end to the UA ESOP that appeared so promising just six years earlier.
Many have wondered what went wrong with a company that appeared to be doing exceptionally well and rewarded its employees with an ownership stake. While pointing fingers at the ESOP is easy, a more objective analysis reveals that the airline industry suffers from an exceptional level of union control – especially with pilots – that resulted in deteriorating financial performance and an eventual loss of faith in the ESOP. Ultimately, the UA ESOP debacle is a case of poor planning on the part of the airline and its unions – neither of which truly got behind the ESOP and tried to make it a legitimate benefit as opposed to a tool for negotiations (by contrast, Southwest does very well with its ESOP and is a market leader in the airlines industry). More specifically, if the employees don’t perceive the ESOP as a benefit (many didn’t participate) then it holds less value.
Conclusion Once again, ESOPs can present owners with a terrific tool for motivating employees and exiting the business. Support is well-documented through numerous studies such as the one conducted by Dr. Joseph R. Blasi and Dr. Douglas L. Kruse, professors at the School of Management and Labor Relations at Rutgers University. The study found that over a 10-year period ESOP companies outperformed comparable non-ESOP companies in sales, sales per employee, employment, longevity of the business, and many other key business measures. That said, it’s fair to assume that, on average, these companies implemented their ESOPs correctly and, more importantly, for the right reasons. Please contact us at firstname.lastname@example.org if you’re interested in discussing ESOPs as a potential exit strategy.