There is extensive research and experience on what makes an ESOP work well. Largely as a result, there is virtually universal consensus on the importance of the steps described below. A good feasibility study should help address many of these elements. The NCEO has a number of resources to help in the process, which are pictured and linked within each corresponding section.
Many closely held companies are highly reliant on their founder(s) or other owners. If the seller(s) are leaving, new leadership needs to be in place when the deal is completed. Often, however, sellers assume that they can continue to help during the transition. This can work well for everyone, but because sellers tend to be older, there are obvious risks that demand a succession plan with every key leader in place.
Everyone needs to know in advance what the seller(s) intends to do. Other people in the company may make assumptions about how the ESOP will change these roles, leading to potential conflicts down the road. Sellers also need to understand that this is not “their” company anymore. While they may retain a lot of day-to-day control, the ESOP trustee may require one or more outside board members—and a board that actually meets and functions like a genuine board. The trustee and the board also now have a duty to protect the interests of the new shareholder, the ESOP trust. Most commonly, this can lead to conflict if the seller still demands excessive pay or perquisites. There is a lot of flexibility in all of this, but it is not unlimited.
Having outsiders on boards can be a way to reduce the riskiness of a transaction. But just having outsiders does not make a board a productive addition to a company. Board members need to understand their duties under ERISA and state law and act with care and prudence. A good board seeks outsiders who can add skills and perspectives not already present at the company and who are willing, when necessary, to challenge management.
No ESOP will be effective if employees don’t understand it. The best companies create a communications committee charged with providing regular and varied communications about how the ESOP works and how the company is doing. Ideally, the committee will represent employees across the company, but you may need to start by just asking for volunteers.
A common—and incorrect—assumption is that just the act of creating a financially rewarding ESOP is enough to make people think and act like owners. It isn’t. The benefits of ownership are a long way off for employees and subject to some risk. Successful ESOP companies set up structures that incorporate being an owner into daily work. This includes sharing some company-level financial information and work-level metrics for employee teams and projects. These companies also create specific structures for employees to identify problems, share information, and generate ideas. Often, the company creates an ideas team to oversee this process.
Some companies already have this kind of culture when they become ESOP-owned, but most don’t. Creating this kind of culture will take considerable time and commitment, but it will be rewarded with much higher performance and employee retention. While some companies will be able to foster an ownership culture by learning from the considerable literature on this topic, going to conferences, and visiting other ESOP companies, many companies find that engaging consultants to help with the process is a wise investment.
Very often, the rules for the ESOP on issues such as vesting, allocation, and distribution follow default provisions from your attorney. They may be just right for your company, but understand that there is some flexibility, and it is worth having a discussion with all of your advisors about the various options and how they will impact the sustainability of the plan. The rules should be reviewed every few years to see if they need updating.
Similarly, do a careful analysis of how long the internal ESOP loan can should be. The repayment of this loan is what triggers allocations; longer loan terms spread this out more. Because there is a lot of flexibility, careful modeling is important.