I have spent a lot of time talking about the top benefits of implementing an ESOP for a company, the business owner(s), management and key employees, all employees, and the local community. These benefits include the tax and cash flow benefits and the many competitive benefits of building an ESOP ownership culture.
I talk to a lot of business owners and management that are considering implementing an ESOP and their #1 concern is control.
On one hand business owners appreciate the control premium that an ESOP can pay for a change in control.
On the other hand, they are very concerned about the unknown about what a change in control means and doesn’t mean.
Fast forward a few years and many business owners will tell you that moving to a more formal board with some outside board members was one of the top benefits of implementing an ESOP.
It is important to understand the corporate governance and ESOP stakeholders, what is an ERISA fiduciary, and the relationship between the ESOP Trustee, Board of Directors, and the ESOP Committee.
What is Corporate Governance?
Corporate governance is how corporations manage the business affairs of the company to achieve their corporate and shareholder objectives.
Who are the Corporate Governance Stakeholders?
- Shareholders– The shareholders are the owners of the company. The primary responsibility of shareholders is to elect the Board of Directors.
- Board of Directors– The Board of Directors are responsible for corporate governance and delegate authority to officers/management. The Board represents the Shareholders, is the highest level of management in a company, and is responsible for governing the company. The Board has a corporate fiduciary obligation under state law to the Shareholders. Advising the CEO and succession planning are other key responsibilities.
- Officers/Management– The officers/management are appointed by the Board to carry out the strategic direction of the company and are responsible for the day-to-day operations of the company. Management hires the employees for day-to-day operations and to carry out the operational plan.
Who are the ESOP Stakeholders?
- ESOP Plan Sponsor– The employer that establishes and maintains the ESOP.
- ESOP Plan Administrator– The individual(s) with authority and discretion over the management of the plan. Unless another individual or entity (e.g. ESOP Administrative Committee) is specifically assigned, the Plan Sponsor is the legal Plan Administrator and decisions are made by the Board of Directors. The Administrator(s) is an ERISA fiduciary.
- ESOP Administrative Committee– The ESOP Administrative Committee is usually appointed by the Board of Directors and serves as the Plan Administrator.
- ESOP Trustee- The ESOP assets, which primarily consist of the stock of the company, are held in a trust and managed by the ESOP Trustee. The ESOP Trustee is the individual(s) with authority and discretion over the plan assets. For most purposes the ESOP Trustee acts as the legal Shareholder of the ESOP. The ESOP Trustee is an ERISA fiduciary and has a fiduciary duty to act in the sole interest of ESOP Participants, maximizing the long-term value of the assets of the trust (the stock of the company). The ESOP Trustee will often vote according to the direction of the ESOP Administrative Committee. In addition to ERISA, the ESOP Trustee is governed by the Internal Revenue Code, the plan document, and trust document.
- ESOP Participants– The ESOP Participants are beneficial owners of the company and generally have limited legal authority. In most cases the ESOP participants as Shareholders are represented by the ESOP Trustee. The plan document specifies the voting rules. Unless provided by the plan document, the ESOP Trustee is not required to pass-through decisions such as voting for the Board of Directors, buying or selling stock, and exercising voting rights. In limited cases, such as a significant corporate event (e.g. liquidation, sale of all or substantially all the assets, recapitalization, merger), the ESOP Participants may have the right to have pass-through voting rights on all issues, including the election of the Board.
What is an ERISA Plan Fiduciary?
A plan fiduciary is a person that exercises discretionary authority or control over the management of the plan or plan assets. ERISA defines the four primary duties of an ERISA fiduciary:
- The Exclusive Benefit Rule – An ERISA fiduciary must act solely in the interest of the plan's participants and beneficiaries while defraying reasonable plan expenses.
- The Prudent Person Standard – An ERISA fiduciary must act with the care, skill, prudence, and diligence under the circumstances that a prudent man acting in a similar capacity...
- Diversification – An ERISA fiduciary must diversify the investments of the plan unless it is clearly prudent not to, knowing that by definition an ESOP is "Designed To Invest Primarily In Qualifying Employer Securities". You should also be aware of the ESOP diversification rules.
- Follow the Plan Documents – A fiduciary must act in accordance with the plan documents.
What is the Relationship between the ESOP Trustee, Board of Directors, and the ESOP Committee?
- The ESOP Trustee is selected by the Board of Directors.
- The ESOP Trustee generally votes the ESOP shares for the election of the Board of Directors. The ESOP Trustee will often vote according to the direction of the ESOP Administrative Committee.
- The ESOP Administrative Committee is usually selected by the Board of Directors and generally consists of members of management.
- This "circular" selection process often leaves the same people in charge of the company and the ESOP.
The IRS has announced the 2020 pension plan limits, including the following:
An ESOP is a Qualified Retirement Plan
ESOP stands for Employee Stock Ownership Plan. An ESOP is a qualified retirement plan that can be used as a business transition tool and as an employee ownership vehicle.
An employee stock ownership plan (ESOP) is an IRS qualified retirement plan, similar to a 401(K) Plan, that buys, holds, sells company stock, providing employees with an ownership stake in the company, as well as an additional form of compensation directly linked to success of the company.
- ESOPs and 401(k) plans are both tax deferred retirement plans that are funded by pre-tax contributions.
- While 401(k) Plans are funded with employer and employee contributions, most ESOPs are funded exclusively with company contributions. This means that most ESOPs are provided by the company at no cost to the employees.
- While 401(k) Plans are invested in stock and bonds and other investments, ESOPs are the only retirement plan that is allowed to be primarily invested in employer securities of the company.
- While 401(k) Plan account values are generally updated on a daily basis based on the results of the stock market, ESOP account values are generally updated once per year. This is because most ESOPs own privately held stock. Since there is not a stock market for privately held stock, the ESOP trustee has to obtain a valuation from an independent appraiser once per year.
- A leveraged ESOP is the only retirement plan that is allowed to borrow money. It is also the only retirement plan allowed to enter transactions with “parties-in-interest” (e.g. the company, owners). These special ESOP rules allow ESOPs to be able to purchase stock from the company or owners of the company.
Check out this brief animated video to learn more about ESOPs.
An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that can be used as a business transition tool and as an employee ownership vehicle.
The ESOP repurchase obligation or liability is the company’s obligation to buy back shares from ESOP participants according to the company’s ESOP plan document and ESOP Distribution Policy. The ESOP repurchase obligation helps with planning for cash requirements and how to meet bank (or seller) requirements for leveraged ESOPs.
Watch the video below to understand the importance of working with an Administration Provider that includes a repurchase obligation strategy as part of your ESOP road map and long-range planning.
During times of change, senior leaders play a key role as an executive sponsor. According to Prosci’s, Best Practices in Change Management – 2018 Edition, the greatest contributor to a successful change initiative is “active and visible executive sponsorship”.
An executive sponsor is typically a C-Suite leader who oversees a business unit and is responsible for meeting project deadlines. They oversee projects and keep them aligned with the organization's strategy and direction.
During an ESOP implementation and ongoing support and buy-in, the role of the executive sponsor sets the tone for how employee-ownership is embraced in the organization.