How Data Can Benefit Colleges & Universities: Part 1

SUSAN MOSER: This is Susan Moser with Cherry Bekaert, along with my partner John Carpenter. We thought we'd spend a few minutes talking about ESOPs for government contractors. We often get many 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, the top five reasons, some of the challenges with ESOPs, and some common myths. We'll be debunking myths today.

JOHN CARPENTER: I'll start with a couple of basics about ESOPs to provide the framework. ESOPs are governed by ERISA and are subject to Department of Labor oversight, similar to 401(k) plans. ESOP trusts are established for the benefit of employees.

JOHN CARPENTER: The stock price is established at the beginning of an ESOP by an independent valuation and must be independently valued each year thereafter. Employees who participate in an ESOP receive company shares allocated to their ESOP accounts without making out-of-pocket contributions.

JOHN CARPENTER: Shares 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 specific timing of a sale.

JOHN CARPENTER: Now I'll cover some of the main reasons companies implement ESOPs. First, ESOPs give owners of closely held businesses a chance to obtain liquidity. They can serve as an exit strategy or a way to take money off the table while continuing in the business.

JOHN CARPENTER: Second, if an ESOP is done and communicated properly, it can increase productivity and employee engagement. Employees become full or partial owners of the company and can be encouraged to act like owners and help grow the business.

JOHN CARPENTER: Third, there are significant tax advantages for current owners who sell their stock if structured correctly, and for the company after closing. We won't cover all the tax details here, but the benefits can be substantial.

JOHN CARPENTER: Fourth, and key for government contractors, contributions to the ESOP plan—whether used to allocate shares to employee accounts or to retire debt—are generally allowable under the FAR. These contributions are treated like a fringe benefit and can be included in the fringe pool, providing a way for cost-reimbursable contractors to obtain government reimbursement for ESOP-related costs.

JOHN CARPENTER: Finally, ESOPs are flexible in structure. They can be financed with outside debt, seller notes, or a combination of bank debt and seller notes. There is no requirement regarding how many or what percentage of stock must be sold to the ESOP.

SUSAN MOSER: Over the years we've had clients become ESOP-owned companies, either partially or fully. Some start with an ESOP owning 30% of the company and later transition to 100% ESOP ownership. There have been notable large ESOP government contractors, including SAIC, which was a successful example long before ESOPs became widely discussed.

SUSAN MOSER: Now let's discuss challenges with becoming an ESOP. My top five list starts with communication. The ESOP structure needs to be clearly communicated to employees so they see the value and embrace it. This requires more than a quick email; it requires thorough communication and discussion.

SUSAN MOSER: Second, ESOPs are not a mechanism to selectively exclude employees. While you can design vesting criteria and set eligibility parameters, once the plan is in place eligible employees cannot be excluded simply because they had a poor performance year. Similar to a 401(k), the plan must be available to eligible employees based on the plan's criteria.

SUSAN MOSER: Third, ESOPs require careful planning, both upfront and ongoing. Planning is needed for the plan design, annual valuation, and long-term repurchase obligations when employee owners retire, leave, become disabled, or die. The company must plan and account for the repurchase obligation over time.

SUSAN MOSER: Fourth, ESOPs are not free to implement or administer. Valuations must be performed annually by an outside third party. If the plan has 100 or more participants, the ESOP must be audited, similar to a 401(k). There are plan administration expenses, so ESOPs are often not appropriate for very small companies. Determining a cutoff is difficult, but companies under $10 million should carefully consider whether an ESOP is appropriate.

SUSAN MOSER: Fifth, because an ESOP is essentially a retirement plan, the Department of Labor has specific rules and a trust structure to protect employees. The ESOP trust is responsible for overseeing the plan on behalf of employees, which is why external valuations and compliance are important.

JOHN CARPENTER: As a general observation, ESOPs typically work well for growing companies. However, for highly cyclical companies or those that experience serious downturns, valuation declines can cause employee dissatisfaction. Planning upfront is key to addressing these risks.

JOHN CARPENTER: Next, we'll cover some common myths we hear from clients. Myth number one: You can't sell an ESOP company. Not true. You can sell an ESOP-owned company. The plan generally must be terminated upon sale unless you're selling to another ESOP company, but a sale can proceed and often is not impeded by ESOP ownership.

JOHN CARPENTER: Myth number two: You can't fire employees after implementing an ESOP. Not true. You can hire and fire employees as before, following applicable employment laws and policies.

JOHN CARPENTER: Myth number three: ESOPs are all or nothing—either 100% or 0%. Not true. You can structure ESOP ownership anywhere from a small percentage up to 100%.

JOHN CARPENTER: Myth number four: If you go ESOP, you can never attract outside investors or private equity capital. Not true. It can be a bit trickier, but it is not prohibitive.

JOHN CARPENTER: Myth number five: Employees run the company like "the inmates running the asylum." Not true. An active board of directors is still required, and management can largely remain the same depending on the ESOP structure. The board and management are responsible for running the company.

SUSAN MOSER: ESOPs can also be an effective employee retention and engagement strategy. We recently worked with a client evaluating two paths: selling the company or becoming an ESOP. They pursued both options in parallel, conducted research, and sought counsel.

SUSAN MOSER: With many transactions, initial information is limited to a few people, but word often leaks out. This client carefully planned the communication and ultimately decided an ESOP was the best route for the shareholders and employees.

SUSAN MOSER: They announced a 100% ESOP, and the employees, who expected a sale, were very excited when told they would become participants in a 100% ESOP. The reaction from employees was very positive, and it was a great outcome for the owners, management, and staff.

SUSAN MOSER: ESOPs are not for everyone, but this introductory session should be helpful for those considering an ESOP or wondering how they work. There are many tax and structural considerations that go into an ESOP.

SUSAN MOSER: For more information, follow up with Susan Moser, John Carpenter, or other members of our government contracts practice.