On the surface, November’s midterm elections appear to have had a negative impact on ESOPs (Employ Stock Ownership Plans), because ESOP supporters in both arms of Congress were either defeated or retired. However, many supporters still remain and the Indiana environment continues to be strong as evidenced by Gov. Holcomb’s recent declaration of October as “Employee Ownership Month”. This political change was one of the major focuses featured at the recent 2018 ESOP Association’s Annual Conference in Las Vegas.
Why is this important? Any political shift, including the 2017 leadership changes at the Department of Labor (DOL), creates uncertainly relating to how ESOPs will be treated. Even though the DOL supports ESOPs, all newly-elected leadership needs to be educated on the powers of employee ownership.
Employee-owned companies are consistently more profitable than their peer companies and 7.3 times less likely to lay off employees than conventionally-owned companies. Fewer layoffs save the government money in unemployment compensation – nearly $2 billion in 2014 alone. In addition, ESOP companies often contribute over 10 percent of employee compensation to their ESOP which is far above the national average for contributions to 401(k) plans of non-employee owned companies.
While the DOL and government officials acknowledge these facts, they continue to concentrate on one facet of ESOPs – their initial set-up. Protection of the individual employee is key to the DOL. They want to ensure that the initial value that the ESOP plan pays for the stock of the company is not in excess of its fair market value. In simple terms, making sure the employees are protected from overpaying and the previous owners are not receiving too much for their stock.
Accurately valuing an ESOP can be tricky. ESOPs cannot pay more than the fair market value for the stock of the company, per the DOL and IRS guidelines. This may sound like an easy step to overcome, but it is the DOL’s number one concern. First, the company is valued by an experienced valuation expert. Then, after the transaction is completed, the debt due to the previous stockholders is placed on the balance sheet causing the value of the company to decline. Consequently, the DOL then oftentimes takes the position that the company was not properly valued in the first place since its value declined immediately after the ESOP was initiated, causing the new shareholder employees to overpay for the company.
One of the keys to a successful employee-owned company lies at the very beginning of the process. Make sure the company is valued properly at the start of the plan. During the past several years, the DOL consistently contests the cost of the stock that the employees are paying to the previous owners. It is critical that an ESOP administrator secure a highly experienced team of professionals who know how ESOPs work, which goes beyond simply conducting a valuation. It should include a well-documented feasibility study, strong projections with well thought-out assumptions and a detailed process that includes a third party trustee.
Helping our new political leadership understand this complex issue is critical to gaining their support and assistance for ESOPs well into the future. The ESOP Association will be actively educating our federal legislators.