By Thomas H. Mug
Maybe it’s the preservation of a legacy, perhaps it’s the conclusion of thoughtful succession planning, or it might be a desire to motivate employees and enhance corporate performance … for whatever reason, the construction and real estate industry is increasingly embracing employee stock ownership plans (ESOP).
Indeed, this publication documented the trend three years ago, noting transfers to some form of employee ownership at Brinkmann Constructors, McCarthy Building Companies, CH2M Hill, Parsons, Black & Veatch, HDR, HNTB, Burns & McDonnell and Terracon. Last year, Lawrence Fabric & Metal Structures Inc. and Balke Brown Transwestern, Inc. joined the ranks of employee-owned companies with the help of our law firm, Greensfelder, Hemker & Gale. However, ESOPs are not for every situation and require considerable forethought and planning.
Many businesses begin considering ESOPs as they approach a transition in leadership and want to preserve the distinctive qualities that define the company and its culture and ensure the company’s long-term success. That has been accelerating with a wave of baby boomers entering retirement.
An ESOP is an intense planning process. Business owners should consider the following:
- Is the firm suited for an ESOP? Business owners should conduct a feasibility study as a first step to determine whether the company is a suitable candidate for an ESOP. This will consider the motivating factors for establishing an ESOP, the financial capability of the company to finance ESOP debt and suitability of the company as an ESOP candidate. The feasibility study will also identify any issues or obstacles in the establishment of an ESOP.
- Before entering into an ESOP, a business owner needs to know the value of the company. It is likely that the owner will have an expectation of the amount that will be paid for his or her stock. One of the first steps in examining the ESOP as an exit strategy is for the owner to obtain an independent valuation of the company stock. If the result is not to the owner’s satisfaction, the owner may elect to forgo the ESOP and consider other alternatives. Valuation typically involves projecting the future earnings of the company and will rely on those projections of company income. Industry outlook is also a major consideration, as well as the general economic forecast. If appropriate, the valuation may also consider book value and sales of comparable businesses.
- Federal regulations. ESOPs are heavily regulated by both the U.S. Department of Labor and the Internal Revenue Service. As an ESOP is a retirement plan designed to invest in company stock, the interest of the Department of Labor is to see that plan participants and their retirement savings are adequately protected. Consequently, the Department of Labor will scrutinize an ESOP transaction to assure that the terms of the transaction, including the price paid for company stock, are fair. One way to assure compliance in this regard is to engage a well-qualified independent trustee to represent the interests of ESOP in the transaction.
- Repurchase obligations. One major consideration for any ESOP, new or mature, is an understanding of the company’s repurchase obligation with respect to its ESOP shares. As employees approach retirement, they will seek to cash out the company stock in their ESOP accounts. In addition to retirement, a repurchase obligation can also occur due to termination of employment, death of an employee or a participant’s exercise of diversification rights. In order to prepare for this eventuality, a company will want to have a repurchase liability study performed and develop a plan to have adequate resources available when the need arises. Failure to plan for this eventuality can result in a crisis in future years.
- Creating a culture of employee ownership. Critical to the success of any ESOP is the presence of an ownership culture. Some companies have a workplace culture that will give them a head start on this. Others will need to work harder at the developing the ownership mentality. What is important is to have a culture in which employees are engaged as owners and are aware of the responsibilities that come with ownership. This is enhanced through the sharing of information on the financial health and outlook of the company and by developing a team approach to achieve success. An old saying is that there is no “I” in ESOP.
In a sense, a transition to an ESOP takes on the same attributes of a personal family decision. Business owners need to work with financial, legal, and accounting advisors who are familiar with the culture of the firm and its mission. It is a significant advantage when the team has an understanding of the challenges unique to the construction and real estate industry.
It can be more remunerative and sometimes easier to sell to an outside buyer than to embark on an ESOP. The decision depends on the motivation and goals of the owner, the desire for the future of the business, and the feasibility of an ESOP as a succession alternative. Many St. Louis construction and real estate firms have found that properly planned ESOPs are an effective way to develop the next generation of leadership who will continue to advance the legacy of excellence that has defined the company since its inception.
Thomas H. Mug is an attorney in the employee benefits and trust and estates practice groups at the St. Louis law firm Greensfelder, Hemker & Gale, P.C.