Think Twice Before Making an ESOP Part of Your Exit Plan

ESOPS are touted as “allowing business owners to cash out at fair market value, pay no taxes on the sale, and transfer the company to their employees.” Sounds tempting, doesn’t it? But, have you looked at all aspects of it to actually determine if it fits your business and personal needs? If not, I strongly suggest you consider the following before deciding that an ESOP is the way to go.

ESOPS are qualified retirement plans that must invest primarily in the stock of the sponsoring employer. The stock of a construction company is typically thought of as high risk. The industry is, by its very nature, high risk (especially now). In addition, one of the guiding principles used in investing retirement assets is that prudent retirement asset planning is to be well diversified in relatively safe investments. We all learned this in 2008 when the stock market fell apart and people began calling their 401K’s, 201K’s. Do you really want your employees’ retirement assets concentrated in a very high risk investment? I see a real problem regarding employee moral and motivation when the stock in the construction company decreases in value as a result of the times. Not only are the employees’ jobs at stake, but their retirement funds as well. This is when you need your people to pull together and help you return the company to prosperity; instead this whole strategy backfires at the worst possible time. Further, as people leave your company, whether they are laid off or for any other reason, they may request payment of their retirement assets either to take with them or roll over into another qualified retirement plan. Do you think either the ESOP Trust or the company can afford to make good on this commitment when the company is fighting to survive and working capital and resources are stressed?

Some of the characteristics of companies where ESOP’s work well are:

• Strong, consistent cash flow.
• Good management team to carry on after the owner has left.
• Little to no permanent debt.
• Relatively large payroll base.
• Alignment of shareholder and employees’ interests.
• Adequate capitalization in place to sustain future company growth.

Think about these and then objectively apply them to the typical family owned construction company.  Do most family owned construction companies meet these tests? In my experience, they don’t. Also consider the cyclical nature of the construction industry and, therefore, the impact this has always had on earnings of construction companies. It is common in the industry for construction companies to experience erratic earnings. In years when the company doesn’t make a lot or incurs a loss, where are the funds going to come from to fund the ESOP? 

Further, if the company borrows money and lends it to the ESOP to enable the ESOP to make a leveraged purchase of the company stock, accounting regulations require that the bank loan be recorded as a liability on the company’s balance sheet and a like amount charged to equity. The net effect is to reduce the company’s equity by the amount of the bank debt. This could have a severe impact on the company’s ability to get both bank and surety credit to be able to bid future work. Even if the bank doesn’t require the company to borrow the funds and lends the money directly to the ESOP, in almost all cases the bank will require the company to guarantee the debt. This will create a required disclosure in the financial statements which will have the same effect on both banking and bonding.

Another consideration is, if the value of the stock appreciates substantially, the ESOP and or the company may not have sufficient funds to repurchase stock upon a shareholder’s retirement. If the stock of the company does appreciate, the liquidity needs of the ESOP will increase accordingly. Conversely, if the value of the company does not increase, the employees may feel that the ESOP is less attractive than other forms of retirement plans. Therefore, the incentive that was intended is gone and it becomes a disincentive. All full-time employees eventually participate in the plan. This is an ERISA plan and you cannot discriminate. Also, most companies prefund the ESOP to get equity into the ESOP before making the purchase from the shareholder because even if they get bank financing, most banks will usually only lend up to 60 or 70% of the deal. This further depletes the contractor’s cash and working capital, which is probably money that might have otherwise been paid directly to the owner or other key people in the form of bonuses.

Additionally, ESOP’s are quite costly both to set up and to maintain. Fees for the initial set up could be anywhere from $25,000 to $100,000. You are also required to obtain at least one arms-length, third party appraisal of the company’s stock, performed by a qualified business appraiser. The fee for an appraisal of this nature usually runs an additional $10,000 to $20,000. An annual update to the appraisal is also required at a cost of several thousand dollars each year. There are also annual government imposed filing requirements that also create additional costs, as well as consumption of valuable time that could be deployed elsewhere.

A final word of caution! If you are considering using an ESOP as part of your succession plan from your closely held construction company, remember that the sale of an owner’s stock to an ESOP must be an arms-length transaction between the selling owner and the independently directed and administrated ESOP. This is not the environment most closely-held, family owned construction companies and their owners are used to. Further, if an owner makes decisions for the ESOP regarding the purchase or financing of his stock, he exposes himself to allegations and lawsuits claiming a breach of fiduciary obligation or duty to the ESOP and its participants. No departing owner wants the specter of future litigation looming over him.  Because of this, this type of ownership structure could place a lot of unneeded stress on the whole organization.

Do you really want to do this? Again, think twice and look at all the facts before you make such an important decision.