An ESOP is an Employee Stock Ownership Plan used by companies with private equity as an exit strategy rather than sale or acquisition. Essentially, the idea behind an ESOP is to give employee company stock as part of their remuneration package or added benefits so that the company can remain within the control of the employees where a shareholder wants to exit. They are set up by establishing a trust fund into which the business entity puts in newly issued company shares or money to purchase existing company shares. In most cases, business entities borrow to finance this venture.
In the US, ESOPs are recognized as tax-qualified retirement plans and therefore governed by the Employee Retirement Income Security Act of 1974 (ERISA). Contributions to the ESOP kitty are deductible from a business’ annual tax bill.
For closely guarded private firms, ESOPs might be a better succession planning tool than acquisition or sale. However, the risks involved in managing and operating an ESOP far outweigh the benefits. These disadvantages include;
1. It is a complex process
Setting up an ESOP is complicated. It involves a lot of government agencies, paperwork and is subject to a ton of regulations. For starters, a company desirous of setting up an ESOP has to set up a trust. Contributions have to be made into the trust annually with keen oversight from the IRS and Department of Labor. The trust also has to conform to ERISA guidelines strictly. The contributions made into the trust are then appropriated into different employee accounts only after vesting. Besides, there is a lot of legal work to be done.
2. It is expensive
Generally, initial setup costs may set back the company at least $100,000 to $150,000. This is dependent on the size and complexity of the transaction. Remember that these amounts only relate to the annual contributions. Legal costs also add to the bulk of expenses required to make an ESOP fully functional. Moreover, the company also has to retain a financial advisor and an independent trustee.
3. It is not ideal for cyclical businesses
Cyclical businesses occasionally experience downturns. When this occurs, employees may be laid off. If there was an ESOP set up, the company would have to fork outwards of cash to buy back the laid-off employee’s stock. Moreover, since ESOPs are often leveraged against debt, the company may be in trouble when lenders demand satisfaction of debt during a a downturn.
4. Deals a blow to Cash Flow
The money used to set up and operate an ESOP reduces the operating capital of a business. This negatively affects cash flow leaving the business with little money for its day to day operations.
5. Succession may fail
The main reason why companies opt for ESOPs is for succession planning. However, where there is no suitable successor in place, the company then lacks the talent of management and entrepreneurship. This problem is amplified by the fact that the company has diluted liquidity as a result of the ESOP.
6. Decreased valuation
In case the ESOP trustees, that is, the employees, exercise their rights to redeem their stock, there is a potential risk of dilution of existing stock value. Moreover, the price of the stock in an ESOP is limited to fair market value.
7. Corporate governance issues
The initial set up of an ESOP takes time and is prone to delays due to bureaucratic hurdles. ESOP trustees may develop impatience and opt up of the scheme before set up is complete. In this case, it will be prudent to readjust the ESOP, causing more delay.
8. Fiduciary obligations
The scheme comes with a lot of fiduciary obligations that require utmost disclosure to all beneficiaries of the scheme. Breach of fiduciary duties may expose the business to legal claims that may cost the business money in damages or hefty taxes in the case of inflation of stock prices.
9. The terms of the ESOP may be incompatible with employee wishes
Where the scheme is packaged as part of the employee’s remuneration package, employees may be hesitant to take pay cuts and benefit rollbacks.
10. Implementing some of the ERISA guidelines may be difficult
Section 409(p) of the ERISA guidelines, for instance, prohibits a single individual or family from receiving too many share allocations in the scheme or any other equity issued by the company. This would not sit well with members of a family working in the same corporation.
11. The scheme is not a good fit for small businesses
With all the intensive investment to run an ESOP, the scheme may not be viable for a small business with 10 to 15 employees. In this case, the costs of maintaining the scheme will outweigh the benefits of tax deductions.
12. The ESOP is only good when the issued shares have value.
If an ESOP fails, employees may lose their jobs along with any benefits accruing from the scheme. In summary, an ESOP is a delicate process that can only be pulled off with intensive monitoring and huge operating capital. Anything short of that can result in total mayhem.