How to Choose Employee Ownership Consultants

Hiring the experts to help you manage the creation of an employee ownership plan will cost money, but the right experts will save you the hassle, time, and unwarranted risk of trying to figure this out yourself.

Contents

Overview
Gauging Someone's Qualifications
Choosing a Lawyer or Plan Design Expert
Choosing an Appraiser
Choosing an Administrator
Other Parties

1. Overview

Where to Find Experts

Our Service Provider Directory lists hundreds of NCEO members who provider services in this field. (NCEO members also have access to our ESOP Lender Directory in the members-only area of our site.) Although these are all NCEO members, we do not vouch for their qualifications or approaches. For that you need to probe further, as described below.

Who You Need for ESOPs

When setting up an employee stock ownership plan (ESOP), you need at a minimum:

A law firm with experience setting up ESOPs.
A qualified business appraiser with ESOP experience who is independent, having no contractual relationship with the company or the other advisors involved in the transaction. (However, there is no appraisal requirement if your company's stock is readily tradable on an established securities market.)
Due to the administrative complexity inherent in ESOPs, a qualified third-party administration firm is a must.

Other parties are frequently hired as well:

As discussed in the section of this article on choosing the lawyer, it is best if the same law firm does not represent more than one party to the transaction. So if the company hires and is represented by the law firm that drafts the ESOP, the plan itself should have its own counsel, and the selling shareholder(s) may in turn hire their own counsel.
Companies may want to hire an expert in feasibility assessment to help determine whether and how a deal can be structured.
Depending on the company and the situation, the company may hire an investment banker, a financial advisor, an outside trustee, and so on.
Selling shareholders who elect the tax-deferred Section 1042 "rollover" often hire investment advisors with specialized expertise in 1042 rollovers.
Aside from the technical aspects of running the plan, companies often find it a very good idea to hire ownership culture consultants to help communicate what the plan is about and create employee participation structures.

This may seem like a lot. However, if you are using an ESOP to buy out an owner, many of these same people would be needed if you chose some route other than an ESOP, plus you might need a business broker, who would charge a percentage of the transaction. Be sure to read our article on Red Flags in ESOP Transactions, which provides a list of key issues to watch out for and ways to avoid them.

Who You Need for Equity Compensation Plans

The guidelines for stock option plans, stock purchase plans, and the like are not as strict as for ESOPs, but you will still need qualified people:

The plan should be prepared by (or at a bare minimum, carefully reviewed by) a law firm with experience setting up equity compensation plans, preferably not only executive plans but broad-based ones as well. The company may be advised by compensation and human resource consulting firms as well at this stage.
Closely held companies often hire a business appraiser to determine (1) the value of the options for accounting purposes and/or (2) the fair market value of the stock itself for purposes of setting the price for option grants (especially in the pre-IPO period) and buying shares back from employees.
Public companies usually hire a brokerage firm to handle option trades.
The company may outsource administration. However, unlike the case with ESOPs, there are software packages designed for in-house administration of stock option and stock purchase plans.
As with ESOP companies, an ownership culture consultant can help communicate the plan and build a feeling of ownership among the employees.

With a broad-based equity plan, some companies understand the technical issues sufficiently enough to effectively design, implement, and administer their stock option plan mostly in-house. In fact, many companies have had equity plans for executives in place for a long time and are, therefore, familiar with the operation of the plan. Although setting up and maintaining a plan does not necessarily require the same degree of technical assistance as an ESOP, the advice of experienced, knowledgeable professionals is often necessary and desirable to design a plan that maximizes benefits and best meets corporate objectives. Most commonly, assistance is needed in designing, administering, and communicating a stock option plan.

Outside the U.S.

The above comments apply to U.S. plans. If you are setting up a plan outside the U.S., then the very type of plan you have will depend on what is possible in that country; for example, the U.S. ESOP is largely unique to the U.S. However, stock options, for example, are more alike from country to country. A multinational corporation wishing to set up a stock plan or plans covering employees in multiple countries must be careful to comply with the host of tax and regulatory issues that will arise; working with experienced legal counsel is crucial here.

Interview Several Firms and Check References

In picking a professional advisor, we recommend that you interview several different firms, checking references for each, before hiring one.

Don't Limit Yourself to Local Firms

Remember that you need not hire someone in your state, let alone your city. This is a specialized field, and it is common to hire firms located hundreds of miles away, especially if you are not in a major metropolitan area (New York, Chicago, Dallas, Los Angeles, San Francisco, etc.). What matters is hiring an expert. It is not at all like hiring a local personal injury attorney after you get in a car accident, or hiring a local CPA to keep your books in order.

2. Gauging Someone's Qualifications

Once you have gotten over the natural instinct to find a way to do it for less money and with less complexity, it is time to get down to the serious business of finding the right team to set up your plan. There are some general considerations to keep in mind for everyone:

Some Key Indicators to Look For

Insist on demonstrated experience and expertise. First, it will save you money down the road. It makes no sense to hire inexperienced people and pay them to learn how to set up an employee ownership plan. Second, you will be much more likely to avoid the much larger cost of a bungled plan. Your experts should be members of one or more of the relevant professional organizations, such as ours (the National Center for Employee Ownership), the ESOP Association, and the National Association of Stock Plan Professionals. They should be willing to give you lists of clients (many more people claim experience than have it). It is a plus if they have written or spoken on the subject in various professional forums; that likely means an outside source has reviewed their qualifications and their professional reputation. Interview more than one person for each area of needed expertise and find people who are not just qualified but whose philosophy toward the employee ownership plan matches yours. You don't need to argue with a lawyer about why you want, or don't want, employees to have full pass-through voting, for instance, or with your options plan design expert over whether you should give options to part-timers, or with your valuation consultant about why you want to be cautious about giving the ESOP too much credit (or not enough) for the impact of the put option on value, or your options consultant about whether the options value formula should be on the conservative side, or with your administrator about why you want reports sent in a computer-readable format or just on paper. In the case of an ESOP, ask for recommendations from ESOP trustees: Ask ESOP providers to provide recommendations from institutional trustees (unless, of course, you are interviewing trustees; in that case, ask for recommendations from other service providers they work with). At least two references should be provided. These trustees work closely with ESOP experts and may be able to provide useful feedback. Question pricing structures that are unusually low or high. Some consultants will give low initial estimates to get the contract, but costs escalate later on. Check with references to see how much prior clients actually paid rather than relying solely on the estimates of the providers. If proposed transaction fees are unusually high, get a detailed explanation of why the fees are so much higher than those for other reputable providers.

Look for Red Flags

Ask whether the firm has been involved in litigation or audits that were resolved unfavorably for its clients.
Make sure your appraiser is independent. If your main provider wants you to use only its appraisal firm, this may raise independence issues. Make sure that the appraiser has no stake in providing a appraisal that moves the deal forward.
Be careful about aggressive deal structures, especially those that promise substantial executive equity on a post-deal basis. This can trigger a Department of Labor investigation and/or a lawsuit.
Along the same lines, be careful about proposals to make a buyout work by transferring employee retirement funds from diversified accounts in another plan to employer stock in the ESOP; too large a percentage can both put employees at risk and invite litigation in the event the company experiences a downturn or fails.
If an appraiser promises you will get a good price in advance, find another appraiser.
Be skeptical about percentage-of-transaction fees, investment banking fees for seller notes or bank loans you can get on your own, or for bringing the deal idea to you.

If in Doubt, Call Us at the NCEO If You Are a Member

We cannot make specific endorsements, but if you are an NCEO member (if not, you can join here) we can tell you whether someone is a member and for how long, and, if we know it, any specifics about areas of specialization. Our main phone number is 510-208-1300.

3. Choosing a Lawyer or Plan Design Expert

In most cases, the attorney will draft your plan documents, keep you apprised of changes in the law that require plan amendments, provide legal advice about plan design and operation, and coordinate the transaction (you can, however, also choose a financial advisor to coordinate matters). A company creating an ESOP should always use a law firm for plan drafting, etc.; a company creating a broad-based equity option plan might use a specialist in designing these plans who is not an attorney, but have an attorney review the plan. (For simplicity, we will assume here you are using a law firm, but if not, you can make a mental substitution for "plan design expert.") The most important initial task of the law firm will be to draft plan documents. This should be a participative process. Most attorneys will have a standard plan they will apply to your situation, so writing the document is itself not time-consuming. Instead, time will be spent working with you to establish the attributes of the plan, such as allocation, vesting, voting, distribution, equity award exercise, and governance rules. The more you know in advance about these issues, the more the plan will conform to what you really want and the less expensive the attorney's fee will be.

ESOP Issues

The plan document and transaction documents are usually drafted by counsel hired by and working for the company, not the ESOP. In any case, however, the ESOP trustee should have its own counsel, representing the interests of the plan itself and thus the plan participants, even though the company will actually pay the counsel's bill. Additionally, the company's existing corporate counsel may be involved to a greater or lesser extent, and the selling shareholder(s) may be represented by their own counsel. The degree to which separate counsel are needed depends on the complexity of the transaction, who the parties are, their degree of sophistication, and which lawyer(s) can cover multiple bases while adequately representing the parties. Most of the time, the transaction is between the ESOP and the selling shareholder(s), so the company is not negotiating, but the sellers may well need to be represented by counsel, which, due to conflicts of interest, may need to be independent from the company's corporate counsel.
Loan documentation is an area that varies considerably in ESOPs. Some lenders are willing to forego or pay themselves for any of the legal opinions that accompany business loans of this type. These lenders tend either to already have done a lot of ESOP loans and be comfortable with them and/or are simply being aggressive in pursuing the loan. Most of the time, however, loan documentation will be required as part of any leveraged ESOP, much as it would be in any other highly leveraged transaction.
Sometimes a company's main point of contact when setting up the ESOP is a general consultant (who is not an attorney) acting as a "quarterback." If you do this, be sure you know who the law firm is and that you have direct access to the attorney or attorneys working on your ESOP.

Equity Compensation Issues

Some companies have staff members who can develop the basic plan document in-house. At a minimum, however, companies will need an experienced in-house or hired attorney to review or help design the plan. Often, an accountant and/or a compensation specialist also will review the plan. Generally, the bigger the company and more complex the plan, the more people will be involved in its design. Less experienced companies may wish to hire any or all of the above professionals to play a more active role in plan design. Also, because equity compensation plans raise important accounting issues, you want to make sure your accounting firm is very knowledgeable about this area; if not, it makes sense to hire additional expertise, at least to set up a workable approach.
Many companies giving broad-based equity awards will have overseas operations and may want to include these employees in a global stock plan. Because of the complexity of international laws on this subject, it is important to hire an expert in the field of global plans to help navigate through this.

4. Choosing an Appraiser

If your company is closely held, and for some purposes even if it is public, you should have an appraisal to determine the share value. Outside appraisals are required for ESOPs and sensible for equity compensation plans. This may be the most complex and important part of your task in putting a team together. Note that in the ESOP context, the appraiser is hired by and reports to the trustee of the plan, not the seller or the board, although the seller or company may hire an appraiser for a preliminary valuation when evaluating the feasibility of an ESOP. Thus, if an ESOP transaction is in question, the recommendations directed to "you" below about hiring an appraiser are addressed to the ESOP trustee, and in particular an internal trustee (i.e., a company employee or committee) as opposed to an external trustee whose business it is to know these matters. First, you want to make sure the appraiser is independent, a requirement of the law for ESOPs and desirable for broad stock option plans. There is no "bright line" definition of this term. At a minimum, the appraiser should have no other business relationship with your company. Clearly, your company's CPA is not independent, nor is your CFO. But what if your CPA is a member of a major accounting firm that has a separate appraisal division? Or your appraiser is a member of a brokerage firm that also has a lending division making you an ESOP loan or is handling the sale of exercised stock options in a broad stock option plan? Most people think that large firms like these can create sufficient separation between the units to provide independence, but you should have a compelling reason for taking this approach when there are lots of truly independent appraisers available. Some legal consultants also have affiliated appraisers who are technically not part of their firm but who get referrals from them. This is not clearly improper, but our advice at the NCEO is that it is a risk that is not worth taking and that it creates a clear conflict of interest. The point of having an independent appraisal is to avoid putting the appraiser in a situation where he or she knows that coming up with an acceptable price will win business for a related firm. Second, you want to check qualifications, as outlined above. Appraisers have particular professional designations granted by either the American Society of Appraisers or Institute of Business Appraisers. Various designations offered by these groups indicate professionals have reviewed materials and taken tests to demonstrate their competence. You should ask if an appraiser has any such designations and what they entail. Industry-specific expertise is generally not an issue. Appraisers all have access to various databases indicating the relevant ratios and other information that are used to make appraisals for particular business areas. ESOP-specific or options-specific expertise is another matter, since both plans raise special valuation issues. In order to become familiar with these issues, appraisers should have participated extensively in professional organizations. Third, you want to evaluate the cost of an appraisal. Fees will vary widely. In part, the variation is a function of the size and reputation of the firm. In a larger firm, your appraisal will be reviewed by one or more other people. Some firms also have proprietary databases tracking such things as how much closely held business have sold for in various industries. Naturally, you will pay more for this additional infrastructure and time. Will this result in a better or different number than using a smaller firm? There are costs and benefits either way. Finally, you should find an appraiser whose approach is one that fits your definition of what is in the best interests of the plan. This is a complex issue. The general methods used to assess the value of a company overall do not vary dramatically from one qualified appraiser to another, but some appraisers are more aggressive in their assumptions than others. More important, the philosophy about ESOP-specific or options-specific issues varies widely.

ESOP Issues

As noted above, the appraiser is hired by and reports to the trustee of the plan, not the seller or the board, although the company normally pays the appraisal fees.
Often, the selling shareholder or company hires an appraiser to do a preliminary valuation when deciding whether to adopt an ESOP. In the past, the same appraiser has often been hired to perform the full-blown valuation for the transaction, but in recent years this has come under fire. The Department of Labor has severely criticized this practice, arguing that the seller or company is "road testing" an appraiser to see whether they will arrive at a high price and then turning that same appraiser over to their counterparty in the transaction (the ESOP), for which the appraiser will tend to arrive at the same valuation conclusion, compromising their independence. The most prudent approach is to use a different firm for the preliminary appraisal than for the transaction.
There are two other ESOP issues of particular concern: the impact of the repurchase obligation on marketability and whether it makes sense to apply a control premium. Closely held company stock is not as marketable as the stock of a publicly traded company, and hence is worth less, often 25% or more. The ESOP, however, provides a market for the shares of a closely held company. Some appraisers argue this should reduce the marketability discount to zero; some say it should only reduce it if and when the company shows its has the specific capacity to buy the shares; some say the discount should only be reduced to the extent that the cost of repurchase does not exceed what the company would otherwise put into employee benefit plans; others argue that it should have no effect. An aggressive approach will result in a higher price for sellers, but problems for the ESOP down the road when it tries to buy the shares back. Too aggressive an approach can also land you in court. There is not a right or wrong answer on this issue, but its importance indicates that you and the ESOP trustee should at least know which philosophy is being used and be comfortable with it.
Similarly, if the ESOP is not buying a controlling interest, it cannot pay a control premium. This too can be 25% or more. In some cases, the ESOP is not buying control now, but will in the future. Should this allow a current control premium and, if so, under what conditions? Some valuation consultants even argue that an ESOP can never pay control prices because each employee interest is a minority interest. Again, there is not a right or wrong approach, but you and the plan trustee need to understand what is going on and find an appraiser whose approach makes sense given the fiduciary interests of the plan and the plans of the company.

Equity Compensation Issues

In valuing equity compensation awards, the guidelines are less rigid than for ESOPs. In fact, an independent appraiser is not a legal requirement. Determining the value of the options correctly, however, is important in a number of ways. First, under accounting rules effective in 1997, companies must include the present value of their options either as a compensation cost on their income statement (an alternative few companies select) or as an entry into their footnote disclosures. So companies, at the least, must figure out what this number should be. Figuring it out is a complex task that involves not just understanding the current value of the business, but the value of options that will be exercised at current or historic prices some time in the future. A formula such as the Black-Scholes model must be used to determine this. Even if the company is publicly traded, an appraiser may be desirable to help with this calculation. Second, unless the company is publicly traded, the share price must be determined for any stock buyback arrangement. An improper valuation can cost the company or the recipient a great deal of money, so it pays to get it right. Some closely held companies may choose just to use a formula to determine value (an almost certain guarantee that the price will be inaccurate). The company may be willing to trade off accuracy for simplicity, but, at the very least, it makes sense to hire an appraiser to help establish the formula and to review it periodically.

5. Choosing an Administrator

ESOP Issues

Here the task in selecting a service provider is relatively simple. Find an administrator with a good reputation, demonstrated expertise, and acceptable fees. The administrator will keep all the records, make sure forms are filed with the government, work with you to make sure participants get the information and distributions they need, and help integrate your plan into other plans you may have. The administrator should also be capable of helping you assess your repurchase obligation and plot strategies to deal with it. An accomplished administrator should also be a participant in the plan design phase, helping you to structure the plan so that you can actually live with it. It is advisable that your administrator be able to administer all your retirement plans. ESOP plan administration firms can do this, but many firms that focus on 401(k) or other plans may not have the right skills and systems for ESOPs.

Equity Compensation Issues

Many companies administer their equity plans in-house, especially smaller companies. In fact, there are software programs on the market specifically designed for this. Companies can also outsource plan administration. This is common with larger companies who find it more cost-effective to have someone else administer a complex plan. The choice depends on the complexity of the plan, the company's knowledge and experience, as well as the company's desire to devote staff time resources to this process. At companies with broad-based equity plans, there can be thousands of employees with awards 'in the money," and at any time they can exercise those shares. If a company has little experience with administration, this can become difficult, confusing, and time-consuming.
An outside administrator can also be useful for companies with few employees or infrequent transactions. From the perspective of employees, probably the most important consideration is access to their administrator. Most employees, however, have very little contact with their stock options administrator as the majority of employees appear to exercise and sell all their options in one day.
If you have a broad-based equity compensation plan that delivers actual shares, and you are publicly traded, you probably will want to hire a brokerage firm to handle trades. These companies can help you set up and maintain a program to allow employees to exercise their awars through cashless exercises, stock trades, or other approaches. Most large brokerage companies now have special departments to handle this area. Fees and services vary widely, so comparison shopping makes sense. In some cases, brokerage firms also handle plan administration.

6. Other Parties

Aside from the necessary parties such as attorneys, there are other experts you may need or want, such as feasibility study experts, investment bankers, and organizational development experts.

Ownership Culture Consultants

To help create an ownership culture, you may want to hire people to help you with plan communications and employee participation structures. There is a growing number of people with specific organizational development experience in employee ownership companies, although people from conventional management consulting organizations may be able to provide useful advice as well. The key to hiring these people is to avoid those with a prepackaged program or those who will come in and impose programs from above. The best ownership culture consultants work with you and an employee team to help the company's employee owners develop and implement their own programs. The consultants serve as coaches and advisors. There is something very unsettling to employees to be told their company will now become more participative by having a participation structure imposed on them by an outsider.

Financial Advisors and Trustees for ESOPs

Financial advisors. In assessing an ESOP, you will want to do a feasibility study. This will help determine whether the amount you plan to put into the ESOP is affordable and fits within the legal limits for these plans. Working with your administrator, you may be able to do this internally, but you can also hire financial advisors to help you. ESOP expertise is helpful here, but not always necessary. In large and complex transactions, especially where there are multiple investors of which the ESOP is one or equity capital is needed, you will probably want an investment banker. These advisors will help structure the transaction so that the various investors will agree to it and help locate sources of capital (and sometimes provide it themselves). They usually charge a percentage of the transaction, often in the five to ten percent range. The percentage declines with the size of the deal.
Trustees Strictly speaking, the trustee of an ESOP is not a consultant and often will not even be an outsider. Because the trustee is so integral to the operation of the plan, however, deciding how this person will be selected and what the role of the trustee will be is an essential part of putting together the ESOP team. An outside trustee provides more of an assurance that decisions made for the ESOP will be independent and thus may provide some protection should legal battles arise. Outside trustees may also have special expertise that can be useful in operating the plan. Trustee services are expensive, however. You will pay for more than their time; in fact, most of what you pay will, in effect, be insurance costs. One compromise approach is to hire an independent fiduciary when a complex or conflicted situation comes up where the inside trustee is not comfortable with or appropriate for the decision. If an inside trustee is chosen, it can be anyone, but usually is either an officer, such as a CFO, or a committee of management and/or non-management employees. The board usually appoints the trustee, but, in some cases, some or all trustees may be elected by employees. Whoever is the trustee should be indemnified and insured by the company and must act exclusively to protect the interests of plan participants. Because of this fiduciary requirement, it is not advisable for sellers to an ESOP to act as trustees.

Equity Compensation Issues

Companies with broad-based equity compensation often develop a strategy to communicate the plan when it is rolled out, at the time of grant, and for other key events. An experienced consultant can be very useful in designing this type of program, providing advice on the nature and content of these communications.