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Home > ESOPs > Articles Online > ESOP Forum >
Many companies sponsoring an employee stock ownership plan and trust ("ESOP Companies") face a significant issue after either the debt incurred to purchase the ESOP's interest is repaid in full or the ESOP reaches its maximum ownership level (e.g., 100%) by some other means. At that point, it gets very difficult to provide broad-based equity incentives to new employees who were not employed during the time the debt was being repaid or the original contributions were made. Basically, this sometimes develops two classes of employees: those who are owners through the ESOP and those who are not because no shares are being allocated. Clearly, these new employees will not have the same "ownership" mentality as older ones who shared in substantial allocations of company stock during the period in which the ESOP was accumulating its ownership.
Obviously, repurchase and/or re-contribution of distributed company stock and reallocation of forfeitures offsets this problem to a certain extent, but these sources of shares within the ESOP are often not enough on their own to provide meaningful ownership to the next generation of employee-owners.
Before examining "solutions" to this problem, please recognize that this is another of those "ESOP problems" which actually have nothing to do with ESOPs per se. Assuming that ownership is motivational, and that motivating employees is good for a corporation, then the shareholders are going to have to share ownership with employees to get that benefit. This is in no way affected by the fact that one (or all) of the shareholders is an ESOP. Getting ownership in the hands of all employees will have to occur, and, as is true of any benefit or other discretionary expense of a corporation, the benefit of ownership can only come from the current owners. Where the current owners include an ESOP, there may be a few additional fiduciary concerns, but the decision to use equity as an incentive benefit is largely unchanged.
Given all the above, there are only two ways to provide ownership interests for these new employees; both methods involve diluting the percentage interest of the current shareholders, hopefully to generate the larger absolute value created by the incentive of broad ownership. The first method is to use newly issued shares of company stock either as a direct contribution medium or through additional leveraging to finance other corporate activities. The second method, which has been suggested by some in the ESOP community, is to adopt a method of profit-sharing accounting which basically re-shuffles the cash and the company stock components of participants' accounts each year so that all participants have the same ratio of company stock to cash in their ESOP account regardless of when they may have begun participating in the plan. A number of ESOP companies and professionals favor the first method, but several very respectable professionals have advised their ESOP clients to follow the second approach.
Using company stock as an ongoing contribution medium or using additional leveraging of the ESOP to finance corporate activity is fairly straightforward. On a non-leveraged basis, each year the ESOP company's board of directors determines a contribution amount in its discretion. Of course, this can be based on the profitability, the general economy, a commitment to employees, or other factors, and it can be an amount up to 15% of covered payroll. The contribution, once declared, is then made in the form of newly issued shares of company stock. Unless the total authorized shares needs to be increased in order to do so, or there is some other contractual restriction on issuing new shares of company stock, there is no special legal or corporate restriction on this process, and the result is that all employees each year have ongoing access to new or additional employee ownership. As is the case with all company stock contributions, the existing shareholders' interests are diluted by the newly issued shares of company stock, but, in general, it is believed that the ongoing contributions to all current employees and the gain in value which is the objective of shared ownership will offset the dilution.
Using a leveraged ESOP in the same situation gets to the same place with some additional advantages and disadvantages. On the plus side, an ESOP company can create pretax funding for any legitimate corporate activity (including acquisitions and/or other capital expansion) by funneling the financing through the ESOP. In this situation, an ESOP company borrows from an outside lender, loans the proceeds to the ESOP and, in turn, the ESOP uses the proceeds to buy newly issued shares of company stock from the company. Of course, this type of transaction is subject to the typical fiduciary, prohibited transaction exemption, and valuation issues associated with any transaction between and ESOP and a "party-in-interest." In this way, the cash returns to the company and the company uses the money to make the acquisition or investment in expansion or whatever, paying off the debt with fully tax-deductible dollars. From the participants' point of view, this gives ongoing access to shares for allocation, and, presuming the investment adds value to the enterprise at least equal to the investment, the absolute dollar dilution may be minimal or non-existent.
In either case, the "two classes of employees" problem doesn't exist, and, where company stock is appreciating in value, everyone wins. The primary class of people who can be negatively affected by this approach are those terminated employees who retain benefits in the form of company stock. Because terminees are not generally involved in the allocation of new shares, the dilutive effect on their accounts is the largest. An ESOP sponsor electing one of these options may want to consider converting terminees' accounts to cash at termination (whether they are distributed then or not) in order to offset the purely dilutive effect of these approaches.
The second alternative is to adopt a form of accounting commonly known as "profit-sharing" or "dollar" accounting. Typically, as the ESOP is developing its interest in the company, company stock is either contributed or purchased or released from the suspense account as contributions are made. Stock is then added to accounts either as a contribution or, in a leveraged ESOP, based upon one of two formulas (i.e., principal only or principal and interest). In either case, the company stock is generally allocated to ESOP participants' stock accounts based upon their pro rata compensation during the year of allocation. A participant thereby has a direct beneficial interest in specific shares of company stock and as it increases or decreases in value, this results in unrealized appreciation or depreciation for the participant based upon his or her ownership interest in the company. "Profit-sharing" or "dollar" accounting simply spreads this unrealized appreciation and/or depreciation among all participants, irrespective of whether a participant initially has company stock, cash, or other investments allocated to his or her ESOP account before the shift to "profit-sharing" or "dollar" accounting. Company stock simply becomes one investment in the ESOP's portfolio that is not allocated to any participant's specific account. With "profit-sharing" or "dollar" accounting, each participant's ESOP account is allocated a pro-rata share in the dollar value of all assets held by the ESOP.
For example, assume for simplicity's sake that an ESOP has two participants, one who was a participant during the time an ESOP loan was incurred and paid off and a second who only became a participant after the debt was repaid in full. Also assume that the first participant has 1,000 shares of company stock @ $10.00 per share allocated to her stock account and $10,000 allocated to her other investments account and that the second participant only has $10,000 of "other investments" allocated to his other investments accounts. Aggregate ESOP assets, therefore, amount to $10,000 of company stock and $20,000 of other investments (i.e., stock, bonds, mutual funds, etc.). Also assume that the company adopts a "profit-sharing" or "dollar" accounting approach to ESOP recordkeeping and that the company stock increases in value to $20,00 per share during such plan year and the other investments appreciate in value by $2,000 to $22,000 during the such plan year.
Under traditional ESOP accounting, the first participant would have $20,000 of company stock allocated to her stock account (1,000 shares @ $20.00 per share) and $11,000 of other investments allocated to her other investments account ($10,000 plus $1,000 of earnings and/or unrealized appreciation) for an aggregate of $31,000 of plan assets at the end of the plan year in which the ESOP switches to "profit-sharing" or "dollar" accounting. The second participant would have $11,000 of other investments allocated to his other investments account ($10,000 plus $1,000 of earnings and/or unrealized appreciation) at the end of such plan year.
With "profit-sharing" or "dollar" accounting, the first participant would have $13,340 in dollar value of company stock allocated to her ESOP account at the end of the plan year (two-thirds of 1,000 or 667 shares @$20.00 per share) and $14,667 in dollar value of the other investments (two-thirds of $22,000) allocated to her ESOP account at the end of the year for an aggregate of $28,007 of plan assets. The second participant, on the other hand, would have $6,660 in dollar value of company stock allocated to his ESOP account at the end of the year (one-third of 1,000, or 333 shares at $20.00 per share) and $7,333 in dollar value of the other investments (one-third of $22,000) allocated to his ESOP account for an aggregate of $13,993 of plan assets. As of the first day of the year in which an ESOP switches to "profit-sharing" or "dollar" accounting, therefore, such accounting essentially re-shuffles plan assets to create new ESOP account balances for participants based upon the total value of company stock and/or other investments originally allocated to a participant's accounts. This re-shuffling in the allocation process allows participants who do not originally have company stock allocated to their accounts to share in the appreciation (or depreciation) of company stock and thereby create a connection between their business efforts and the value of their ESOP account.
Of course, this is obviously done at the expense of longer-term participants, and where the value of the company is increasing faster than the return on other investments, the difference in the ultimate benefit to a long-term employee could be significantly less.
Although the Internal Revenue Service has approved ESOPs that include "profit-sharing" or "dollar" accounting provisions of the nature described above, there are a number of significant issues that are raised by such recordkeeping. For example, the Internal Revenue Code of 1986, as amended (the "Code"), requires an ESOP fiduciary to solicit voting instructions on certain issues from participants with regard to certain shares allocated to their ESOP accounts. There is a real question if the result of profit-sharing accounting, which essentially moves allocated shares among accounts, would allow the ESOP company to comply with such provision? Also, the Code provides participants with other specific rights related to company stock allocated to their accounts (e.g., put options, etc.), and it is clear that profit-sharing accounting would make it difficult for an ESOP to comply with those provisions? Third, given that the Code's diversification provisions are tied to the amount of company stock allocated to a participant's stock account, does profit-sharing accounting allow compliance with such requirements where stock accounts have been reshuffled as described above?
In any event, this matter of providing continuing opportunities for employee ownership to new employees is a real issue for established ESOP companies, and there are few definitive answers at this time. It seems that the first mechanism (i.e., continuing the stream of new shares) has the most value with the least exposure, but "profit-sharing" or "dollar" accounting is an idea that does have some merit for "mature" ESOP companies that want to continue their employee ownership culture after the ESOP's maximum ownership is achieved.
The author thanks Anthony Mathews, an ESOP administrator (and fellow contributor to this Web site) for his assistance in preparing this column.
Copyright © 2002 by The National Center for Employee Ownership (NCEO) (phone 510/208-1300; email nceo@nceo.org; WWW http://www.nceo.org/). All rights reserved.
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