Question

What are the problems with an ESOP?

Answer 1

Problems with ESOP:

1) It is complicated:

ESOPs have complex operating rules and require significant oversight. Although outside advisors and ESOP Third Party Administration (TPA) firms can manage the details of the plan, the ESOP company needs an internal agent to champion the program and serve as an onsite resource. If the company does not staff the ESOP properly, they risk problems and potential violations. Small companies and those with unsophisticated accounting processes are particularly ill-suited to ESOPs because they lack the infrastructure to follow the protocols and provide the required support and information to employees.

2) It’s got its ups and downs.

ESOPs are best suited to companies that have stable, predictable, secure patterns of revenue. Most ESOPs are leveraged, using some borrowed money to finance the exit transaction for the selling shareholder. Highly cyclical companies prone to volatility are poor candidates for deeply leveraged transactions and can be harmed by lender demands in a downturn. Moreover, cyclical companies tend to shed people rapidly in the down part of the cycle and the ESOP can be seen as a poor employee benefit when the stock price drops rapidly.

3) It is lacking a successor:

If the current owner/executive wants to reduce his or her role significantly and there is no qualified replacement, then an ESOP is not the right fit. ESOPs effect an internal liquidity transaction with no third party buyer–which means there is no infusion of new entrepreneurship and management. If the owner/key executive wants to retire soon, he or she will need a qualified successor to operate the company, handle the ESOP and manage the related transaction debt. If there is no successor immediately on the horizon, then an ESOP is an unsuitable strategy.

4) It is under capitalised:

If the company requires significant additional capital to endure, they should avoid an ESOP. ESOPs use company cash flow to fund the purchase of shares from shareholders. If the company needs to use its cash flow for capital expenditures or additional working capital, the ESOP transaction can compete for this necessary capital, creating a diminished ESOP company.

5) It is incompatible with shareholder wishes:

There may be another liquidity transaction that meets shareholder goals more effectively. Shareholders wanting to maximize cash at closing may find a third party buyer such as a private equity fund or strategic buyer that offers a primarily cash deal. Such a buyer may be willing to pay a significant premium over the fair market value of the company on a financial basis. Companies and shareholders considering ESOPs should always examine whether there are other transactions that achieve their goals more effectively.

If any item in this quintet describes your company, then an ESOP is probably not the right option for your succession and liquidity.