Archive for January 2014

Common Pitfalls of Being an ESOP Trustee

If you have spent time around the ESOP world, you know that, in addition to all of the wonderful benefits an ESOP brings to a sponsor company, there are complexities and various pitfalls to be aware of as well.  In this blog, I thought I would discuss some of the pitfalls of being an ESOP trustee.  In one of my past lives, I acted as an ESOP trustee for plans which ranged from ones as small as 20 participants to ones with nearly 1,000 participants.

Before discussing the pitfalls, I would like to say that ESOP trustees are held to the highest fiduciary standard under the law and are responsible for what they know or should have known.  The “should have known” component of that sentence is the tricky part.  What it means is that an ESOP trustee must be very well versed in the nuances of plan documents and ERISA rules as they apply to the ESOP in question.  In addition, an ESOP trustee must be able to anticipate where the various “ESOP pitfalls” might be located and then take action to correct or, better yet, avoid the missteps.  Of course, a competent ERISA attorney is indispensable to an ESOP trustee’s team of experts.  From my experience, it is clearly worth the added expense of retaining an attorney who is well versed in ERISA law and who has actual real world experience with ESOPs, as opposed to hoping (and wishing) that the local attorney whom you have known and trusted for years will be up to the challenge.  ERISA law is a different breed and requires a real specialist.  In my opinion, you do not want to take shortcuts when it comes to ESOPs.  An ERISA attorney acts as the trustee’s counsel but is actually paid by the plan sponsor or by the trust itself. It is also important to hire a good business appraiser.

One of the most important functions performed by an ESOP trustee of a closely held company is to set the fair market value of the plan sponsor’s stock.  On this issue the reader might assume that the business appraiser retained by the trustee sets the price of the stock.  That assumption is both right and wrong.  The trustee will typically rely on the appraiser’s expertise, but the ultimate responsibility for setting the stock price remains with the trustee.  The biggest pitfall of being an ESOP trustee is undoubtedly the scenario wherein the trustee is held liable for claims (frequently by current or former employees) that the stock price was either over- or undervalued.

The best way to mitigate this risk is for the trustee to have a good understanding of the valuation discipline, play an active role in the valuation process, and thoroughly document the process used to arrive at fair market value.  It is a fact that the determination of the fair market value of a closely held entity is highly subjective.  As is often said of the valuation profession, “It is more art than science.”  Therefore, it is important to show that a reasonable process is followed in arriving at the value conclusion.  In other words, clearly demonstrate that you, as trustee, put some serious work into coming up with the new stock price.  In fact, case law has established that ESOP trustees will not be shielded from liability for overvaluing or undervaluing employer stock when it has been determined that the trustee passively accepted a valuation report.

Other than the perils surrounding the ever-important task of setting the new annual stock price, the following are potential pitfalls an ESOP trustee faces in his or her goal to, as a judge in a 1982 U.S. Second Circuit Court ERISA case stated, make decisions “with an eye single to the interests of the ESOP participants and beneficiaries”:

•    Failing to allow employees to vote their shares on required issues
•    Failing to give employees appropriate information on which to base a decision when they vote
•    Failing to distribute benefits according to plan rules
•    Acting in a discriminatory manner in honoring the put option
•    Failing to ensure the filing of reports when such failure could result in the plan losing its qualified status

There certainly are pitfalls to watch out for as an ESOP trustee.  However, there is help!  Based on statements contained within numerous judicial opinions published over the years, the common theme in these statements appears to be that the best defense a trustee has in the face of legal and/or regulatory scrutiny is the existence of a well-documented process.  Much like the real estate profession’s mantra of “Location, location, location,” professional ESOP trustees have a favorite mantra of their own, “Process, process, process.”  A sound, thorough, and well-documented process will go a long way toward demonstrating that an ESOP trustee has indeed made a good-faith effort to look out for the exclusive benefit of the plan participants and beneficiaries involved.

For more information on how to avoid the common pitfalls of being an ESOP trustee, read So, You’re an ESOP Trustee, an article I co-authored with Tracy Woolsey of Horizon Trust & Investment Management.


The Independent Review of an ESOP Valuation Report

When is it wise to have an independent review of a business valuation report?  This blog will consider one common reason for requesting an independent review of a business valuation report.

Under the Employee Retirement Income Security Act (ERISA), an ESOP’s named fiduciary is charged with the responsibility of determining whether the consideration paid in a transaction represents adequate consideration.  The named fiduciary also has this same responsibility with respect to the annual update valuation.  In the case of a private company, adequate consideration is fair market value as determined in good faith by the named fiduciary in accordance with the provisions of the plan and the regulations of the Department of Labor.

Fiduciaries can fulfill this responsibility by undertaking the valuation themselves.  However, if the independent fiduciary does not have the experience or expertise to make the type of valuation, they may use an independent financial advisor or business appraiser to help them meet these responsibilities.  However, even if an independent financial advisor or business appraiser is used, the fiduciary is still responsible for determining adequate consideration by critically reviewing and evaluating the appraiser’s valuation report and approving it.

In Donovan v. Cunningham (716 F.2d 1455 (1983)), the Court commented that:

An independent appraisal is not a magic wand that fiduciaries may simply wave over a transaction to ensure that their responsibilities are fulfilled. It is a tool and, like all tools, is useful if used properly.  To use an independent appraisal properly, ERISA fiduciaries need not become experts in the valuation of closely held stock – they are entitled to rely on the expertise of others.  [italics and bolding added here and below]

The Court recognized that ERISA fiduciaries may not be experts in business valuations nor are they required to become an expert in business valuations.

In Howard v. Shay, the Court commented:

The fiduciary is required to make an honest, objective effort to read the valuation, understand it, and question the methods and assumptions that do not make sense.  If after a careful review of the valuation and a discussion with the expert, there are still uncertainties, the fiduciary should have a second firm review the valuation.

In the Couterier settlement (the Settlement), the Department of Labor (DOL) commented on the standards expected of fiduciaries in connection with an ESOP valuation.

The Settlement requires the Attorney in the Couterier matter to spell out, in a written communication, the ESOP fiduciaries’ duties in reviewing the independent valuation report.  One of these duties is to:

Determine that the appraiser’s opinion letter is justified by reading, and understanding the opinion and any supporting documents in the independent appraiser’s opinion letter, including identifying, questioning, and testing assumptions that underlie the opinion, verify that conclusions in the opinion a, the Court commented that the data, analysis, and conclusions are internally consistent, and if necessary, retain additional expert support to aid understanding and addressing any problems with the valuation report and other deemed necessary reports and/or advice and supporting documents.

Although the settlement in Couterier does not establish precedent for other legal disputes, it is important to take notice of the standards expected of fiduciaries with respect to ESOP valuation reports – an ESOP fiduciary is held to a standard of care applicable to all ERISA plan fiduciaries known as a “prudent expert”, the highest fiduciary standard under the law.

Most third-party trustees have a working knowledge of valuation theory and application and are capable to competently review the valuation report.

However, many internal trustees do not have a working knowledge of valuation theory and application and are not able to discern whether or not an ESOP valuation report is credible and can be relied upon.  They just simply do not have the requisite training and background to review an ESOP valuation report.

As a result of the DOL’s requirement to retain an expert to assist in reviewing the valuation report, some trustees are hiring an independent valuation firm to review the valuation report


Statistics Indicate that ESOPs Provide a Higher Rate of Return

In another blog post by Acclaro, we looked at why ESOPs (employee stock ownership plans) make very good business sense.  Today’s post provides an addendum and explores why ESOPs provide a higher rate of return to employees than do other retirement plans.

There has been much written lately about how ESOP companies have fared better during the latest recessionary period than their comparable non-ESOP counterparts.  A recent study published by Douglas Kruse and Joseph Blasi of Rutgers University found that ESOPs increase sales, employment, and sales per employee by approximately 2.3% to 2.4% per year over what would have been expected absent an ESOP.  In addition, Kruse and Blasi found that ESOP companies were somewhat more likely to still be in business several years later and were much more likely to offer other kinds of retirement plans.  This last finding flies in the face of conventional wisdom held by economists through the years that ESOPs must be a tradeoff for other wages or benefits.  That is, it is commonly assumed that they must be a substitution for other retirement plans or employee benefits.  Kruse and Blasi found that the introduction of an ESOP into a company was an overall net addition, not a substitution, to the company’s employee benefits offerings.

Another recent study also highlighted the attractiveness of an ESOP as a retirement plan.  The U.S. Department of Labor’s Employee Benefits Security Administration (EBSA) compiled statistics in 2012 on 401(k)s and other retirement plans and found that ESOPs provided higher aggregate rates of return than 401(k) plans.  EBSA took a look at retirement plans with 100 or more participants from 1996 to 2010 and found that ESOPs provided, on average, a 12.9% higher return to an employee’s overall retirement plan than 401(k) plans.

As good as the results are in the various studies conducted in the last 10 years which point to the “ESOP advantage,” the performance metrics gleaned from the studies really get a bounce when an ESOP company puts particular stress on participative management.  In other words, performance results for ESOP companies which actively encourage management participation by its employee-owners are superior to the operating results of those ESOP companies where management participation is not encouraged.   Specifically, employee influences on new products, work design, and marketing were strongly correlated to performance outcomes such as total sales and earnings.  In other words, as employees became more directly involved with decisions regarding the details of work design, the design and implementation of new products and marketing campaigns, company performance improved.

This point is corroborated by another study, published by the Great Place to Work Institute which conducts the annual “100 Best Companies to Work For in America” competition, which showed that an ESOP alone has a very limited impact on the sponsor company’s financial performance (as measured by the Return on Assets ratio) but, when combined with high employee engagement (participative management) scores, an ESOP has a significant impact on a Company’s total sales and earnings.

The research by the Department of Labor shows that ESOPs have provided a higher rate of return to employee-owners than have 401(k) plans.  Not only do ESOPs make great business sense, but they can prove to be a great retirement investment, as well.

Information contained in this blog came from the NCEO and the DOL (table E23).


ESOPs Make Very Good Business Sense

It has been common knowledge for quite some time that ESOPs (Employee Stock Ownership Plans) make very good business sense. This statement is backed up by research.  Study after study has shown that businesses which are employee owned usually have a definite advantage over those that are not.

ESOPs are essentially retirement plans in which a trust that forms the legal structure of an ESOP purchases employer stock of the company sponsoring the ESOP. Most ESOPs are leveraged, which means that the ESOP is allowed to borrow money to finance its purchase of employer stock.  Loan payments made by the ESOP are funded through employer contributions to the ESOP, much like a company would contribute to a 401(k) or profit-sharing plan.

Let’s took a quick look at recent major research on ESOPs since they first were conceptualized and implemented by Louis Kelso in 1956:

National Center for Employee Ownership (NCEO) Study, 1986

A first look at how employee ownership impacts corporate performance, this study by Michael Quarrey and Corey Rosen of the NCEO tracked company performance for a period five years before and five years after the creation of an ESOP.  The key findings:

  • ESOP companies had annual sales growth rates that were 3.4% higher and annual employment growth rates 3.8% higher in their post-ESOP periods than would have been expected based on pre-ESOP performances.

U.S. General Accounting Office (GAO) Study, 1987

Another “before and after” look at employee-owned firms, the GAO survey was a bit controversial because of an assumption in its research methodology.  However, its conclusions again pointed favorably towards the net benefits of ESOPs:

  • An ownership culture is key to increased productivity in an ESOP company.  Participatively managed employee-owned firms increased their annual productivity growth rate by 52%.  For example, what would have been a 10% annual growth rate became a 15% growth rate in an ESOP company in which there existed a strong ownership culture, i.e. one in which a broad base of employees feel empowered as co-owners.

Washington State Department of Community, Trade, and Economic Development/University of Washington Study, 1998

Peter Kardas, Jim Keogh, and Adria Scharf found that substituting stock for wages or benefits can have a very positive impact.  Their study found that employees are significantly better compensated in ESOP companies than are employees in comparable non-ESOP companies.  The key findings:

  • The median hourly wage in the ESOP firms was 5% to 12% higher than the median hourly wage in the comparison companies.
  • The average value of all retirement benefits in ESOP companies was equal to $32,213, with an average value in the comparison companies of only about $12,735.
  • The average corporate contribution per employee per year was between 9.6% and 10.8% of annual pay, depending on how it is measured. In non-ESOP companies, this measure was only between 2.8% and 3.0%.

Rutgers University Study, 2000

One of the most significant studies to date on ESOPs, the Rutgers study looked at the performance of ESOPs in closely held companies.  The researchers, Douglas Kruse and Joseph Blasi, looked at sales, employment, and sales per employee for ESOP firms and comparable non-ESOP firms.  The key findings:

  • ESOPs increase sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected without an ESOP.
  • ESOP companies were also somewhat more likely to be in business several years later.

Brent Kramer Study, 2008

Brent Kramer’s study, “Employee Ownership and Participation Effects on Firm Outcomes,” pointed again to the positive impact of employee ownership.  Matching 328 majority ESOP-owned companies to 328 non-ESOP companies of similar sizes and from similar industries, Kramer found that:

  • ESOPs had sales per employee that were 8.8% greater than in the comparable non-ESOP companies.

Alex Brill Study, 2012

A former advisor to the Simpson-Bowles deficit reduction commission, Alex Brill analyzed the ten-year performance of S-Corporation ESOP companies.  His assessment indicates that ESOPs clearly increase employment opportunities.  The key findings:

  • S-ESOP companies showed substantially more employment growth in the pre-2008 recession period than non-ESOP businesses.
  • S-ESOP companies regained momentum faster than other private firms after the recession.
  • S-ESOP companies in the manufacturing sector particularly benefited from the S-ESOP business structure, which buffered manufacturers through the recent, especially challenging economic times.

These studies provide a drum beat of evidence that ESOPs make very good business sense.  Most well-managed employee-owned companies, those which allow their employees an active role in the firm, realize higher sales and profit levels, are more productive, and create more widespread wealth than comparable non-employee-owned companies.

Information contained in this blog came from the NCEO, ESCA, and The ESOP Association.


How to Identify Prospective ESOP Situations for Ownership Transition


In today’s corporate and tax environment, successful ownership transition can sometimes be perplexing.  While many alternatives are available to accomplish this ownership transition objective, only a few alternatives are appropriate for any given set of circumstances.  The options typically include an initial public offering, a management buyout, a recapitalization, a sale to a third party, a sale to an employee stock ownership plan (ESOP), a joint venture, and others.

This blog post will discuss in detail one option, the leveraged ESOP, which is a powerful tool for accomplishing a successful transfer of ownership.  The benefits of an ESOP ownership transition include deferring capital gains taxes to the selling stockholder, the tax deductibility of principal payments on ESOP debt, low interest financing on certain transactions, possible improved employee productivity, and the opportunity to maintain operational control through employee ownership.

The following discussion summarizes the attributes a prospective ESOP company should have in order to best utilize the advantages of an ESOP for succession planning.

Diversification Desired by Owner

Diversification is important for all investors, but is particularly crucial for stockholders nearing retirement age.  For business owners whose major personal asset is their stock in a closely held company, an ESOP provides a valuable diversification vehicle.  The proceeds from the sale of stock to an ESOP can be reinvested in a diversified portfolio of securities with favorable tax benefits (discussed later), providing lower risk for an equivalent expected return on the owner’s investment in the current business.

Continuity of Business Ownership

ESOPs can provide continuity of ownership and control since the ESOP trustee is typically a passive, financial stockholder whose objective is closely aligned with the success of the business.  Therefore, if the stockholder sells less than a 50% ownership interest, then effective operational control remains with those best qualified to manage the business.  Also, owners can reward past and future employee efforts through employee ownership.

Alignment of Employee/Stockholder Interests

Because an ESOP provides for the allocation of stock.  Employees who are owners are more likely to be concerned with the business’s profitability and productivity, which are typically stockholder concerns, than are employees who are not owners.  Research has shown that ESOP companies are more efficient, productive, and profitable than their non-ESOP competitors.

Consistent Management

A strong management team should be in place to handle succession if the owner/manager is leaving.  Some financial institutions may require employment contracts or non-compete agreements with key executives in leveraged ESOP transactions.

Size of the Business

Businesses with larger revenues and/or substantial assets are often better candidates for leveraged ESOPs because larger businesses can attract more favorable financing and typically have a lower cost of debt.  In addition, transaction costs as a percentage of proceeds are relatively lower for larger businesses.

Manufacturing companies have a larger investment in fixed assets that can be used to collateralize loans.  Service businesses should have earnings and cash flows that are strong enough to support an ESOP loan.  To enhance the ESOP debt collateral, selling stockholders may have to pledge a portion of the transaction proceeds to the bank, although the pledge can be limited in both amount and duration.

The most efficient minimum size of an ESOP loan is typically $2 to $5 million, with a $1 million transaction generally considered the smallest transaction size for an ESOP.  For smaller transactions to be successfully completed, the transaction structure should remain simple in order to reduce transaction costs.

Debt-Carrying Capacity

The business must be capable of generating adequate cash flow to satisfy the debt service requirements of the ESOP and any other interest-bearing debt.  Businesses with lower debt-to-equity ratios can take on more leverage in the form of ESOP financing.  Therefore, it is generally more difficult to finance an ESOP in capital-intensive businesses that typically have larger debt loads.  The business with low debt-to-equity ratios should have established a significant banking relationship with a financial institution in order to facilitate the ESOP financing.  While the existing debt level may be a constraint in the leverage of the ESOP, this drawback may be minimized because the ESOP-related income tax benefits and possible improved employee productivity can enhance the business’s debt-carrying capacity.

Seller’s Low Tax Basis in Company Stock

Individual owners that sell to an ESOP and reinvest the proceeds in qualified replacement securities (i.e., any domestic corporate stocks or bonds) can defer recognition of a capital gain if the ESOP owns at least 30% of the employer company immediately after the sale.  The deferred capital gains tax benefits are especially valuable to owners who would otherwise recognize a significant capital gain because of to a low tax basis in their stock.

Large Payroll Base

In cases where a significant percentage of a business is sold to an ESOP, a large payroll base allows the business to repay the principal on the ESOP debt with tax-deductible contributions.  However, there is a limit on the amount of employer contributions that are tax deductible.  If this limit is expected to be exceeded, the preferred securities can be sold to the ESOP.  Because of the tax deductibility of dividends on ESOP-owned preferred stock, the ESOP debt principal payments remain fully deductible.


This blog post is designed to assist those considering a leveraged ESOP acquisition with the appropriate strategy to pursue, based on all of the facts and circumstances surrounding each specific ownership transaction situation.  While there are many circumstances when an ESOP fits the financial and cultural aspects of a business’s operations, it is important for business owners to keep in mind all the implications of becoming an ESOP-owned company.

Please contact Acclaro if you have any questions regarding the valuation of employer securities for ESOP purposes.