Bring Employee Ownership to Life at your Business

October is Employee Ownership Month. Are you ready? Celebrate your employee owners and the company’s success by hosting some of these fun company-wide events:

  • Volunteer for a Cause
    Find a local service project that aligns with the company’s values and spend a day volunteering. Group service is a great teambuilding exercise and provides an opportunity for employees to connect outside of a work setting. Note: Make sure to call the charity ahead of time to let them know the size of your group so they can accommodate your team.
  • Host a Lunch ‘n Learn with a Leadership Speaker
    Ask employees to vote on a topic they would like to learn about, but give them some ideas like retirement, health, and wellness or personal development. Hire an external speaker or create a panel of employees to talk about the topic most voted. Serve lunch and people are sure to show up hungry and eager to learn.
  • Create and Compete in an Old Fashioned Field Day
    A little healthy competition never hurt anyone. Divide into teams and create reasonable obstacles and races to compete in. Everyone will enjoy the fresh air and the light competition is a great way for employees to blow off steam and bond.
  • Throw a Theme Party
    What better way to celebrate than with a party? Choose a theme like the ’80s or Hollywood, and have everyone come into work dressed in costume. Business as usual in the morning, then take the afternoon off and throw a party; provide food, games, and maybe even host a costume contest.

Employee Ownership Month provides you with the perfect opportunity to promote employee ownership. Make it fun. Be sure to acknowledge and recognize the positive contributions of your employee owners.

If you need more ideas, visit our website to view our Employee Ownership toolkit:


What Do Employees Get Out of an ESOP?

Are your employees financially prepared for retirement? Many are not, as a result, they outlive their savings and have to depend on others in their old age.

In recognition of this reality, many owners of privately held companies choose to move toward an ESOP transaction as an exit strategy from their business instead of selling out, going public, or shutting down.

These thoughtful owners choose an ESOP because, among other reasons, it allows their valued employees to keep their jobs and over time, earn beneficial value in the company.

Looking to learn more about ESOPs? Thinking about moving your company toward the ESOP model? Contact an ESOP Lawyer, Advisor, or Consultant today at

But the benefits of an ESOP to the employees does not begin with retirement. There is something to be said for pride of ownership. Historically, companies that have taken the ESOP route have had better employee retention and satisfaction. Why? Simply put – the employee now has “skin in the game”.

Having worked over the years with ESOP companies and having examined the statistics surrounding companies that have adopted an ESOP model, I have discovered the following to be true.

  • Employees feel more in control of their own destiny because they have a stake in how their job impacts company value.
  • Employees (on average) make more money than their counterparts in publicly or privately-owned companies within the same vertical.
  • Employees bring a more trusting attitude with them to work in relation to management.
  • Employees tend to stay longer in their position because of the ESOP financial incentives.
  • Employees band together to work through the difficult times instead of abandoning the company and each other. This builds community and preserves their sweat-equity investment in the company.
  • Employees enjoy greater job satisfaction than their counterparts in other systems of corporate ownership.

Want better for your employees as you transition to a new phase in your business? Contact the ESOP professionals today at


ESOP in Practice: How Does it Really Work?

If you didn’t read my last article, you may want to check the September/October issue of BoxScore to get the background on the pros and cons of establishing an employee stock ownership plan (ESOP). If you did, you have a good sense for the concepts but are probably a little fuzzy on how it actually works. The goal of this article is to give you a sense of what is involved in actually putting an ESOP into place.

A good way to think about an ESOP is using a red light/green light analogy. You’ve thought about it, are open to the concept, and now you want to take the next step (the lights are still green). What should you do next?

The best way to proceed is to engage with a sell-side ESOP adviser. This person will perform what is known as a feasibility analysis, which will take into account valuation, cash flows, debt repayment, compensation levels, and other factors to see if a deal even makes

sense. This feasibility analysis will help you as a seller understand what you will get from the sale of your stock, as well as the impact on the company and the employees. Assuming that the lights are still green, this preliminary study will roll into plan design, transaction structure, and implementation.

Plan design will involve your goals and objectives with respect to such things as benefit levels, vesting, eligibility, whether credit for prior service will be given, and other factors. It will also consider other benefit plans that might exist, what will happen to those plans,

and whether there are any other administrative or regulatory issues to consider. While the plan can be amended at a later date, some of the decisions that are made in the design phase can have a significant impact on the transaction structure, as well as the implications of

the post-transaction implementation.

Transaction structure will involve such things as the proposed sale price to the ESOP, the amount of bank financing that will be sought, the terms of any seller financing, and other factors. This stage also involves modeling of the expected benefit levels of the ESOP based on the contributions to be made post- (and sometimes pre-) transaction. Your sell-side adviser will generally model all of these factors into a proposed structure, and assuming the overall proposal meets with your approval, you can move to the implementation phase.


Making the Transaction

Mechanically, an ESOP transaction is like any other sale transaction, in that there is an offer, an acceptance, a due diligence

period, and the execution of transaction documents. These documents often consist of a stock purchase agreement, employment agreements, seller notes, and the like. The primary difference between an ESOP transaction and a non-ESOP transaction is that an ESOP deal involves the sale of stock to a trust. Therefore, in order to proceed with a sale of stock to an ESOP, a trust must be formed and a trustee appointed. The trustee can be anyone who is independent of the transaction. Most sellers opt to hire a third-party

transactional trustee for the sole purpose of representing the interests of the ESOP in the transaction. That trustee will then

retain the services of a financial adviser to perform an appraisal of the company and report a range of value to the trustee.

Once the trust is formed and the trustee is retained, an offer to sell the stock is tendered to the trustee. The trustee, in consultation with his financial adviser, will respond to the offer, and a negotiation will occur. When both parties are satisfied with the material terms of the transaction, a letter of intent will be signed, and the transaction will move to the due diligence phase.


Due Diligence

During due diligence, the trustee team will request a significant number of corporate documents to facilitate legal, accounting, and operational due diligence. While this due diligence will generally be less onerous than it would be with a public company or private equity buyer, response to due diligence requires patience and thought. During this process, transaction documents are drafted,

bank financing is coordinated, and final negotiations and transaction structuring occur. At closing, signed documents are

exchanged, monies are transferred, and the ESOP officially becomes a shareholder of the company.

Post-closing, the company will make debt service payments to the bank and the selling shareholder. Typically, if there is bank financing involved, the bank will allow for interest-only payments on the seller notes until the term debt to the bank is repaid. Following this repayment, the seller notes can begin to be amortized. After the seller notes have been repaid, the company will typically cash out any warrants that have been issued as a yield enhancement to the seller notes.


Time for Growth

From the ESOP’s perspective, it will begin to repay its obligations through contributions made by the company. When this occurs, shares are released to the participants, and their account balances grow. The concept is similar to how equity grows in your home as you make your mortgage payments and a portion is used to repay the principal. The participants get an allocation based on their W-2 and subject to vesting and eligibility requirements.

For example, a person who makes $100,000 per year receives twice as much of an allocation as a person who earns $50,000. Thus, the participants’ accounts grow in the following two ways: 1) by allocation of shares as the debt is repaid, and 2) by the increase in the value of the stock. These contributions are tax-deductible to the corporation, and it is through these contributions that the repayment of debt ends up happening on a pretax basis.

The debt to the bank and the shareholders will generally be repaid over the shortest possible period of time without putting an undue burden on the company. The allocation of shares to the participants, on the other hand, will generally be over a longer period than the repayment of the bank debt or seller note. There are three primary reasons for this: 1) As the ESOP is a retirement plan, the goal is

typically to provide a long-term benefit to the employees, not a short-term benefit; 2) the longer allocation period encourages longevity and tenure of the workforce (i.e., they have to be there longer to get more); and 3) a longer allocation ensures that shares will be available for allocation to new employees in the future. Furthermore, this enhances the ability to sell the ESOP as an additional employee benefit when recruiting.


Enhanced Performance

While the tax benefits to both the sellers and the company can be substantial, what really makes an ESOP work to maximum effect is the enhanced performance that often occurs when the employees have a vested interest in the company’s performance. Numerous studies have confirmed that companies in which ownership is shared with the employees outperform those that do not. Many ESOP

companies end up branding themselves as employee-owned, and they effectively communicate the benefits of employee ownership to all of their stakeholders. This has resulted in numerous examples of companies where performance has improved and the workforce has ended up with a far greater economic benefit than they would have achieved elsewhere.

Other than an ESOP, no transition vehicle or strategy currently available affords the combination of flexibility, tax benefits,

employee engagement, and preservation of corporate culture. From the seller’s perspective, the taxes on the sale of stock can be deferred or avoided altogether. In exchange for financing the transaction over time, the seller can receive a substantial rate of return on this financing, often in excess of the expected rate of return were cash proceeds to be invested in a bond or stock portfolio. From the company’s perspective, the transaction can be paid for with pretax dollars, and if the ESOP ends up owning 100 percent of the stock, the company will never again have to pay corporate tax or make a tax distribution.

From the employee’s perspective, they receive a meaningful financial incentive to help the company grow and prosper in the future, and they get to work for a company whose culture is intact. With more than 7,000 ESOP-owned companies in existence in the United States today, it is a strategy that should be considered by most closely held companies seeking an ownership transition.

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ESOP: Let Them Eat Cake and Have It Too!

Let’s face it, you’ve been running the company a long time. Maybe you started or bought into it, or were lucky enough to inherit it. Maybe you’ve been the person most responsible for its success.

Do you ever lie awake at night and wonder why no one cares as much about your business as you do? You may have tried to motivate some of your key people by promising them bonuses, with little impact to the business in the end. You may be thinking what life could be like if you could just take some chips off the table.

Perhaps you have thought about selling the company, or have even been down that road. You may have concerns-the process, taxes, your corporate culture, and what will happen to your people if you sell to a big public or, God forbid, private equity fund. Maybe your concern is about your legacy and the reputation you have built over the last 30 years. Or it may be more about what people will say about you if you “sell out.”

Well, what if I told you there was a way to sell your company, possibly tax-free, and not disrupt the corporate culture one bit? What if I told you that you could sell your company to a “friendly” buyer, one who would not steal your sensitive information if the deal goes south, who would keep everything intact and actually push for a generous benefit program? A buyer who would encourage and even require employee engagement.

There is a way to accomplish all of this, and the way to do it is through an employee stock ownership plan, or ESOP. In short, an ESOP is a vehicle to sell your company on a tax-advantaged (tax-free) basis to your employees. You end up with many of the benefits of a sale to a third party—and if you structure it right, a whole lot more. Your employees end up with a long-term benefit that will usually far exceed any other retirement savings they could possibly accumulate on their own, and the opportunity to impact their own financial future each and every day.

Before I get into the details, let’s quickly review a partial list of the pros and cons of other ways in which you can try to exit your business:



  • You will generally get most of your money upfront.
  • You will generally be free to do what you want in a short period of time.
  • You may get a premium price, depend­ing on your niche.


  • Potentially risky and protracted process (i.e., exposing your deepest, darkest secrets to a buyer that may back out).
  • Payment of capital gains tax at least, and potentially higher rates if you are a C corporation or the buyer shifts the purchase price that results in ordinary income.
  • No control over what happens post-transaction.
  • Usually results in disruption to corporate culture or displacement of employees.



  • None I can think of.
  • OK, maybe you preserve your home life.


  • Offspring will rarely take company to the next level.
  • Kids generally don’t have your skill set, so getting paid is risky.
  • Talented executives may resent you for it and separate from the business.
  • No tax advantage unless you gift some or all of the company to them—and gifting the business doesn’t get you any cash.



  • They are familiar with the business and see its potential.
  • Streamlined, less risky due diligence.
  • They are motivated to make the deal work.


  • Management teams generally don’t have any money.
  • No tax advantages.
  • Could sour relationship if deal craters.
  • The decision-making process (which ones and how much?).

In many cases, one of the above strategies will be the best alternative for you to exit. But in many other cases, these strategies leave something to be desired. In some cases, they can be disastrous. So what, then, is this ESOP alternative, and how does it work?

Succinctly put, an ESOP is a tax-advantaged vehicle to exit your business. At its most basic level, it is a structure, vehicle, trust, or legal entity that is memorialized in a document. When put into practice and used to full advantage, an ESOP is a living, breathing retention-, motivation-, and wealth-building tool that can literally transform an organization.

From the seller’s or owner’s perspective, the ESOP provides maximum flexibility. The ESOP can purchase all or part of the equity of the owner, either now or in the future. As such, an ESOP can be an incredibly effective way to buy out a partner or shareholder when there are dif­ferent goals and objectives. Some owners sell a minority interest to the ESOP, use it to motivate employees, and sell the rest later when the value has gone up. Other owners sell 100 percent to the ESOP in one transaction to maximize the full effect of the tax advantages. Before we illustrate what is possible with an ESOP through a few examples, let’s review the primary advantages—and disadvantages—of using an ESOP as an exit vehicle.


  1. The transaction can be structured as completely tax-free to the seller. Yes, you can sell your stock to an ESOP, and never pay any tax on the gain. Now, of course, there are a number of strings attached to this, but it’s perfectly legal and has been vetted and approved by the IRS over the last 42 years.

The first requirement is that your company has to be organized as a C corporation. (If you are an S corporation, you can always revoke the S election to facilitate the transaction). Next, the ESOP has to buy at least 30 percent of the company. Lastly—and here’s where it gets a little tricky—you have to reinvest the proceeds into “qualified replacement property.” QRP is basically stocks or bonds of U.S.-based companies—i.e., no mutual funds, international, or real estate holding companies.

If you are satisfied with a deferral of tax, you can simply reinvest the proceeds into your favorite stocks or bonds and ride off into the sunset. As long as you hold the stocks or bonds, you will preserve the deferral, and if your investments outlive you, you will never pay the tax. Pretty nifty, right? But what if you don’t want to hold the stock you bought for another 30 years? Well, when you go to sell it, or “rebalance” your portfolio, you will trigger the gain and have to pay the tax. So, what’s the solution?

If you want the transaction to be tax-free, buy what’s known as a floating-rate note—the ultimate form of qualified replacement property. Basically, it’s a 40- or 50-year bond, so it is almost guaranteed to outlive you—unless you are a 30-something, in which case, why are you selling the company? The rate on the note “floats,” which means it usually sells at or near face value, as opposed to most bonds, whose value rises or falls as interest rates change. Since it sells at about face value, you can use it as collateral and borrow up to 90 percent of the face amount. You’ll receive interest on the bond but owe interest on your loan—they are usually structured for these amounts to offset one another. Thus, you can “monetize” upward of 90 percent of the value of your company and never pay tax on the sale. Assuming the bond outlives you, your estate will get a stepped-up basis to the face amount of the note, and thus gain is eliminated.

  1. The company gets to deduct inter­est payments and principal payments on funds used to effect the purchase. The mechanism for this to be true is that most ESOPs are structured whereby the company loans money to the ESOP— either from funds on hand or money borrowed from a bank. These funds are then used by the ESOP to buy the stock from the selling shareholder. Alternatively, the seller “loans” funds directly to the ESOP by agreeing to sell stock to the ESOP in the form of seller notes. The ESOP obtains cash from the company in the form of contributions that it then uses to repay the borrowed funds. Since these contributions, subject to certain payroll limitations, are tax-deductible by the corporation, any debt used to fund an ESOP purchase is effectively repaid with pre-tax dollars (i.e., fully deductible).
  1. After the company is 100 percent owned by the ESOP, the company becomes 100 percent tax-free. That’s right, 100 percent tax-free. In other words, the company can use the 40 percent corporate tax it used to pay—or distribute to the shareholders in the case of an S corporation—and use it to reinvest in the company. Alternatively, it can pay down debt faster, make bigger contributions to the ESOP, make acquisitions, or do just about anything it wants that enhances value. In other words, 100 percent ESOP-owned companies have a huge advantage over their competitors, thanks to Uncle Sam—and when was the last time the government gave you any help, much less an advantage?
  1. Employee motivation and behav­ior improves when they have a stake in the outcome. As if the advantages referenced above weren’t enough, consider that a number of studies show that ESOP companies outperform their non-ESOP counterparts in just about every measure. The main reason for this relates to tying employee behavior to performance. When you show employ­ees how they make a difference and back it up with real economic benefits that they can see, the results can be incredi­ble. The ESOP world is full of examples of rank-and-file employees retiring from their ESOP companies with much greater account balances that they would have had from a 401(k) match or other retirement plan.


Like the old economics adage says, “There is no such thing as a free lunch.” So, what’s the catch? Well, first and foremost, you can’t easily sell your stock to an ESOP and simply walk away. Why? Because the ESOP itself does not start out with any money of its own, which means that you as the seller, or potentially the company, or both, will generally have to borrow money to get a deal done. Thus, you will generally get repaid over a period of time. While you will get a fair rate of inter­est—or in some cases a very substantial rate of return if the transaction is highly leveraged—you are going to have to be willing to stomach some amount of debt.

Second, all employees will participate in the ESOP according to their W-2. Thus, an employee making $100,000 will get twice as many shares allocated to their account as a person making $50,000. So, if your goal is to get a disproportionate incentive into the hands of a few key people, a supplemental plan (like phan­tom stock or stock appreciation rights) will have to be implemented.

Third, you will have third-party oversight in the form of the IRS and Department of Labor, as an ESOP is a qualified retirement plan under the Employee Retirement Income Security Act (ERISA). If done correctly, this is not an overly burdensome issue, but it cannot be ignored. Similar to the rules that gov­ern your 401(k) plan, an ESOP will have eligibility requirements, vesting, etc., and you can’t discriminate or exclude specific people in an ESOP in favor of others.

In closing, approximately 9,000 compa­nies across the United States have adopted ESOPs. Many have been in existence since ERISA was passed in 1974. If you are thinking about exiting your business and you haven’t considered an ESOP, it might be a good idea to learn more about it. As it relates to your employees, you can “let them eat cake.” Or, if you are open-minded, don’t like to pay taxes, and are willing to stick around for a few years after a transaction, you really can have your cake and eat it, too, through an ESOP. Check next month’s issue for a more detailed dive into how an ESOP actually works in practice.

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Employee Engagement Boosts the Bottom Line

Here’s a quick test. Crumble a piece of paper and toss it in the hallway. Then watch and wait. How many people walk by it before someone picks it up? That’s your ownership culture barometer.

When consultants speak of “building an ownership culture” in ESOP companies, what they really mean is employee engagement.

Do your employees care about the place they work? Employee engagement is the commitment that individuals have to their company. It’s the belief that the company is on the right track, that it values my contributions, and that my work makes a difference.

Whether you call it ownership or engagement, the result is the same: employees who care go the extra mile. They create tangible value for the business. Take a look at the research data:

  • Fully engaged employees return 135% of their salary in value–Center for Talent Retention
  • Moving from low to high engagement can result in a 21% increase in performance—Corporate Executive Board
  • Business units in top quartile of engagement outperform those in bottom quartile:
    • 50% higher in productivity
    • 44% higher in profitability
    • 50% higher in customer satisfaction —Gallup

I think this quote from Simon Sinek underlines the opportunity for ESOP companies: “When people are financially invested, they want a return. When people are emotionally invested, they want to contribute.”

For more, visit the Nest Egg Communications blog


Survey Says – What Employees Really Want at Work

Over the last year, the business community has been abuzz about Gallup’s latest study on employee engagement which revealed the awful truth that only 3 in 10 American workers are truly engaged. Since then, articles about keeping employees “happy” with free perks and bonuses have abounded. Perks are nice, but maybe there’s a better way to inspire team members to take initiative, commit to the culture, and be more productive.

According to Gallup CEO, Jim Clifton, decades-long studies on engagement has shown that employees are engaged when their deeper needs to feel valued, grow and develop, maximize their strengths and make a meaningful contribution are fulfilled.

The results of Gallup’s studies point to three specific things employees need to feel good about their jobs and be fully engaged. Here are suggestions you can use to make these three elements work for your company:

Employees want to know you care about them and their development – When you truly believe employees are the company’s most valuable asset, it shines through in the frequency and manner in which you communicate with them. Let them know specifically how the company is working. Show them how business success boosts their personal success. Share information about important changes and initiatives as freely as possible and think “collaboration” not “command and control.”

Employees want a job that matches their strengths – Every role presents interpersonal and character growth opportunities. Help employees understand their strengths and how that builds the business. When employees deliver their roles with skill, it builds confidence and engagement.

Employees want a sense of purpose in their jobs – Chances are, your employees believe – or used to believe – in your company’s mission or purpose – what you contribute to the world at large. Keep this purpose at the core of your communications. Be sure you regularly articulate the relationship of the work done every day to deliver your mission.

Let us know how you are able to engage your employees, and what challenges we can help you with. We can help you capture your employees connect the dots between their jobs, and their needs and ownership culture.

For more, visit the Nest Egg Communications blog


Empower Your Communications Committee

The single most important characteristic of a successful ESOP is ownership culture. Profitability and growth are assured when employees are invested and involved. Your Communications Committee can play a significant role in building employee engagement, yet in discussions with ESOP leaders, some say it’s difficult to even get volunteers for the Communications Committee.

What can you do? Start small and build on success. Empower your Communications Committee and position them for success by doing these things:

Set clear goals

The Communications Committee should have a clear mission statement and bylaws to outline members’ duties and responsibilities. Put guidelines in place to address issues like how the committee works representation, term limits, and the member election process. Make it part of the committee’s responsibilities to set goals and develop strategies to improve communications within the company. Measure the results to determine what worked.

Ask employees what you should stop/start/continue

Most communication committees are tasked with educating and explaining the ESOP and acting as the bridge between the employees and company leadership. One of the best ways to do this is to ask frontline employees what they think about the ESOP. There are many free online survey programs, like Survey Monkey, Zoho and Typeform that you can use to check in with employees. Get specific about your current communications and education and find out if it’s working or how it can improve. And remember, when you ask for feedback, act on it. Otherwise, you may create dis-engagement.

Be representative

Be sure to involve team members from all employment levels. This means that you’ll need to encourage some people who don’t want to be involved. But here’s a secret: the naysayers bring perspectives that may not have been considered previously. Once they are involved, they are fantastic emissaries for your ESOP.

Interested in creating a Communications Committee for your company? Need ideas on what to communicate? We’ve got that covered. Visit our website to view our 12-month communications toolkit.

For more, visit the Nest Egg Communications blog


Chris Kramer is speaking at the 2015 Vegas ESOP Conference

Chris Kramer will join Philip J. Carstens, Jr. of K&L Gates LLP and Ted M. Becker of Drinker, Biddle & Reath LLP, in a Panel discussion of “Surviving a DOL InvestigationFriday, November 13, 2015 @ 3p PST.

What if you receive a letter that says “The Department of Labor has commenced an investigation of [your] ESOP.” Typical responses by the recipient are “Why are they investigating us? What do we do now? How long will it take? What can happen? How does it end?”  Mr. Kramer’s program will address the investigation process from commencement through closing, and provide insight into the DOL’s goals and priorities, as revealed by the positions the Department has taken as a party in litigation, in amicus briefs, in settlements, in its Fiduciary Process Agreement, and in press releases and other public statements.


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