Are you thinking about an Employee Stock Ownership Plan (ESOP) or wondering how they work? Susan Moser, Partner, and John Carpenter, Principal, in Cherry Bekaert’s Government Contractor Services Group discuss ESOPs, including the top 5 reasons an ESOP makes sense, the challenges in becoming an ESOP and common myths and questions asked from government contractors considering an ESOP.
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SUSAN MOSER: Hi, this is Susan Moser with Cherry Bekaert along with my partner John Carpenter. We thought we'd spend a few minutes today talking about ESOPs for government contractors.
SUSAN MOSER: We often get asked a lot of questions from clients about ESOPs, and there is a lot of misunderstanding. ESOPs can be a great option for certain companies in certain situations, so we thought we'd spend a few minutes discussing them.
SUSAN MOSER: John is going to cover some good reasons why ESOPs make sense, including the top five reasons. We'll discuss some of the challenges with ESOPs and address common myths.
JOHN CARPENTER: We'll be debunking myths today, Susan.
SUSAN MOSER: Before we do that, a couple of basics about ESOPs so you know the framework. Here's ESOPs 101.
SUSAN MOSER: ESOPs are governed by ERISA, which is under the Department of Labor. Like a 401(k) plan, the Department of Labor has oversight, and there are eligibility requirements that generally make plans available to most employees.
SUSAN MOSER: ESOPs are essentially retirement plans. ESOP trusts are established for the benefit of employees. The stock price is established at the beginning of an ESOP by an independent valuation, and the company's stock must be independently valued every year thereafter.
SUSAN MOSER: Employees who participate in ESOPs receive company shares allocated to their ESOP accounts without making out-of-pocket contributions. Unlike a 401(k), where you select mutual funds, with an ESOP your contributions are allocated into company shares.
SUSAN MOSER: Shares in ESOPs are normally allocated to employee accounts based on W-2 compensation, similar to a 401(k) plan. Currently, shareholders can sell all or part of their shares to an ESOP; there is no requirement for a minimum number of shares or timing of a sale.
SUSAN MOSER: Now I'll ask John to talk about some of the top reasons an ESOP might make sense for some companies.
JOHN CARPENTER: Over the years, we've had a number of clients implement ESOP plans, and we have several clients today that are ESOP-owned companies, either fully or partially.
JOHN CARPENTER: The primary reason companies establish an ESOP is that it gives owners of closely held businesses an opportunity to obtain liquidity. It can be an exit strategy, or a way for owners to take money off the table and continue their careers with the company.
JOHN CARPENTER: Second, if an ESOP is implemented and communicated correctly, it can increase productivity and employee engagement. Employees become full or partial owners and, ideally, act like owners who help grow the company with similar vigor.
JOHN CARPENTER: Third, there are significant tax advantages. We could spend a lot of time on this, but there are tremendous benefits potentially available to current owners who sell their stock if structured correctly, and benefits for the company after closing.
JOHN CARPENTER: Fourth, and key to government contractors, contributions to the ESOP plan—whether used to allocate shares to employee accounts or for debt retirement—are fully allowable under the FAR. These contributions are treated like a fringe and are part of the fringe pool, so on cost-reimbursable contracts the government can reimburse you for the cost of the ESOP.
JOHN CARPENTER: Lastly, ESOPs are flexible in structure. They can be funded with outside debt, without outside debt, or a combination of bank debt and seller notes. There is no requirement for how many or what percentage of the stock must be sold to the ESOP.
SUSAN MOSER: Over the years, some clients initially made 30 percent of the company ESOP-owned and then became 100 percent ESOP-owned over time. There have been some very large ESOP employee-owned government contractors, including SAIC, which was one of the earliest and most successful ESOP companies.
JOHN CARPENTER: One of the first to go ESOP.
SUSAN MOSER: Before it went public.
JOHN CARPENTER: Right. Before it was widely adopted.
SUSAN MOSER: Now let's discuss some of the issues and challenges with becoming an ESOP.
JOHN CARPENTER: There are some. My top five concerns start with communication. The ESOP structure needs to be communicated to employees, and they need to see the value and embrace it. That requires more than a quick email; it requires substantial communication and discussion.
JOHN CARPENTER: Second, some clients express concern that an ESOP is a socialistic plan and that they can't exclude poor performers. You can design vesting criteria and there is flexibility, but once the plan is in place, eligible employees generally cannot be excluded solely because they had a poor year.
SUSAN MOSER: Similar to a 401(k), ESOPs are generally available to all eligible employees based on criteria you set, such as full-time status and service. There is a common misconception that you can pick and choose participants; you can have an employee stock plan that is not an ESOP where selection is possible, but those are different arrangements.
JOHN CARPENTER: Third, ESOPs need careful planning up front and ongoing planning. Design considerations include annual valuation and planning for repurchase obligations when employee owners retire, leave, die, or become disabled. The company must plan for long-term repurchase obligations.
JOHN CARPENTER: Fourth, ESOPs are not free to establish or administer. Valuations must be performed annually by an outside third party. If you have 100 or more participants, like a 401(k), the plan requires an audit. There are plan administration expenses, so ESOPs are often not appropriate for very small companies.
JOHN CARPENTER: As a rough guideline, companies under $10 million in revenue should carefully consider whether an ESOP is appropriate, and the threshold may be higher depending on circumstances.
SUSAN MOSER: The ESOP trust is established to protect employees because an ESOP is essentially a retirement plan. The Department of Labor's interest and the trust's oversight are designed to protect employees, which is why there are rules and requirements that must be followed.
JOHN CARPENTER: Lastly, ESOPs typically work well for growing companies. Highly cyclical companies or companies that experience serious downturns can face issues because valuations fall and employees may become disgruntled and question the decision. Up-front planning is key.
SUSAN MOSER: John, let's discuss some myths. There is a lot of misunderstanding about what an ESOP is and is not, so we'll cover common questions we hear from clients.
JOHN CARPENTER: Myth number one: you can't sell an ESOP company. Not true. You can sell an ESOP-owned company. Unless you are selling to another ESOP company, the plan typically must be terminated upon sale, but that is usually manageable with a reasonable sale price.
SUSAN MOSER: We had a very large client in the past year that was partially ESOP-owned and completed a successful sale of the company, and the ESOP ownership was not a barrier.
JOHN CARPENTER: Myth number two: you can't fire any employees. Not true. You hire and fire the same way you always have.
JOHN CARPENTER: Myth number three: it's all or nothing—either 100 percent ESOP or 0 percent. Not the case; you can be anywhere from 1 percent to 100 percent ESOP.
JOHN CARPENTER: Some say that going ESOP means you can never attract outside investors or private equity. Not true. It may be a little trickier, but it is not prohibitive.
JOHN CARPENTER: Another myth is that employees will run the company. No. An active board of directors is required, and management can largely remain the same depending on the ESOP structure. The board is responsible for running the company, and management is designed as appropriate for the organization.
SUSAN MOSER: ESOPs can be an effective solution for employee retention and engagement. One client evaluated two paths—selling the company and establishing an ESOP—and pursued both in parallel. With careful research and counsel, they ultimately decided an ESOP was the best route for the shareholders and employees.
SUSAN MOSER: That company planned communications carefully and announced that it would become 100 percent ESOP-owned on day one. Employees, who expected a sale, reacted with excitement when they learned they would become participants in a 100 percent ESOP.
SUSAN MOSER: ESOPs are not for everyone, but we hope this introductory session was helpful for those considering an ESOP or wondering how they work. There are many tax considerations and other factors to evaluate.
SUSAN MOSER: Be sure to follow up with Susan Moser, John Carpenter, or any of our other colleagues in our government contracts practice for more information.
JOHN CARPENTER: Exactly.
HOST: Thank you. Thanks, everybody.
