Skip the ESOP

The intention behind ESOPs is noble, but the vehicle is flawed. That’s the overview.

The ESOP (employee stock ownership plan) movement started with some lofty goals, but underneath it all is a massive tax advantage for the seller (this is only true for the US, UK, and Ireland variants, which is why they are pushed so hard in the US, especially). And the unbalanced narrative is fueled by the stakeholders in the movement itself. While an ESOP can (but seldom) make sense in a large production or logistics or industrial environment, it never makes sense for a firm like yours, and that’s why we’ll refuse to help you do one. Here’s the “why” behind our stance.

Background

The “ESOP” movement is present in every developed country, and the academic premise is really alluring: “if the team actually owns the company, their work will be different because they are working for themselves. They’ll think like owners.” This makes perfect sense to me on its face, but there are two things missing from the equation:

• The role of entrepreneurial decision making, which often balances the short-term and the long-term. Employees (just like voters) tend to focus more on the “now” without making the short-term sacrifices that will serve the firm’s (or country’s) longer-term success.
• The structure of how an ESOP firm works—while the premise itself is good—violates many other important principles, and in the end it doesn’t deliver as promised.

So where do the heavenly glories of ESOPs come from? The trade associations, which are continually publishing stats about how much more engaged the workforce is and how the profits keep rolling. Please look to independent sources before you believe all that.

Eight Problems With ESOPs 

Rather than turn this into a short book, let me just summarize the problems with an ESOP. In some cases, even one of these reasons should talk you out of it. But there are actually eight.

1. Safe, Unremarkable Decision Making. First, please note that everyday workers have a voice, but no real vote. All the actual decisions are made by a committee of “administrator” types who try to please everyone and not fail. These folks are chosen primarily because of their tenure, but they are not entrepreneurs. ESOPs do not attract entrepreneurs but in fact spits them out. None of this will matter in the early days after the transaction, but it’ll eventually catch up to them. Predictability takes the place of innovation. 
2. Risk Concentration. Say your kid finds a job that she’s really excited about. It’s a publicly traded firm, and she has the option of investing all her 401(k) in company stock. That’s how much she believes in the firm’s future. What would your advice be? A smart advisor would say to not tie your jobto your retirement, because if it falters or even fails, you’ll lose on both fronts. But that’s what an ESOP does: concentrate an employee’s risk. Yes, an ESOP can also have a 401(k), but if they do (most don’t), it’s not seriously funded. What makes this a little bit worse is a common theme in job offers from ESOP-owned companies: “yes, your base salary is a little bit lower than you’d otherwise get, but the bonuses are more substantial…and within your control.” Think of the backlash, about a decade ago, to the idea of a trustee or some other designated person making investment decisions over your own retirement account. Now, every sensible firm allows “participant directed” retirement decisions. So I, as the principal, decide how we’ll fund the 401(k), but you decide how you want to invest that money that’s allocated to you. This is not happening in an ESOP. Your job and your retirement are both tied to the success of the same entity.
3. Eliminates Other Options. Yes, there is a very narrow possibility of reversing one or even selling the non-allocated shares, but it never happens. And you know why? Because an ESOP is a ship that’s setting sail and it’s never coming back to that port. This is not the case for an internal sale (because of a drag-along clause) or a merger or even a traditional sale. Once an ESOP is initiated, the company is going to be a mediocre performer: the only variable is time. Technically, you can sell 100% of the shares or just a portion (even a minority interest), but whatever transaction you choose, that will almost certainly be the last one. Or at least the last remarkable one.
4. Later Retirements Are Unfunded. In general, the ESOP itself is required to buy out departing employees, mainly because the intent of the ESOP is for owners to actually be working there. So if an employee moves on, their interests are repurchased by the ESOP. And there’s money for this at the beginning, but the money nearly always runs out. This crisis builds to a head, too, as employees who are considering retirement rush to the exits…and exacerbate the challenge. It looks like a fire at a theatre, and the ESOP can collapse on itself. Barkley’s ESOP was not set up that way, by the way, which just formed another problem: they couldn’t distribute shares to current employees like they wanted.
5. Better Than Walking Away; Worse Than An Acquisition. The departing (or soon to depart) principal always casts this as a principled decision to share the wealth and honor the contribution of the team. This same leader wants the sale price to be “fair”, as you would expect, and so in some cases, they are not maximizing the sale price to an outside buyer. This is not a fault of the ESOP ecosystem itself, of course, but rather just the truth: ESOP sales are financial transactions and not strategic sales that would yield any sort of premium. If you’re considering an ESOP and would never sell to an outside buyer anyway, then this doesn’t matter. The point is simple, really: the seller never gets a premium in the sale (though the tax advantages of an ESOP can come close to accounting for this). But this fact—that the ESOP cannot pay more than fair market value—is actually a legal requirement. What’s worse is that you, as the seller, will have to carry the note unless you find a bank willing to grant a loan.
6. Very Expensive To Establish and Maintain. An ESOP requires a very expensive valuation, onerous advisor fees, yearly valuations and legal filings, etc. The ongoing fees will leave you thinking that you’ve bought a timeshare that you can never visit. For the typical reader of this weekly missive, count on paying $175,000-300,000 the first year, and $20,000-30,000 in every subsequent year.
7. Leaves a Remaining Portion. Nearly every ESOP transaction leaves a retained portion, although you can legally sell 100% of your shares to the ESOP. There are tax advantages either way,  but it’s very rare for a seller to find any other buyer for his or her shares. This is a separate point from no. 3, above, because it highlights the fact that your payoff needs to come from that original transaction, without counting on any other portion of the firm to sell to the same ESOP.
8. Doesn’t Result In More Engaged Workforce. I don’t want to spend too much time on this, so I’ll just suggest something. If you’d like to explore this further, look for peer-reviewed research that’s not associated with the National Center for Employee Ownership or other similar organizations with a vested interest: banks, insurers, CPAs, valuation professionals, etc. What motivates employees is a great culture and great leaders, regardless of the ownership structure. And an ESOP doesn’t give them any singular control, anyway.

There you go. If you’re considering an ESOP, you’re almost certainly doing it for the right reasons. But essentially you’re giving a 16-year old a sports car, and 10 years from now…if it’s running at all…it’ll look like an Amazon delivery vehicle. As good as your intentions are, it’s not in the best interest of the people you want to honor. And the modern variant of this, the worker cooperative, is a slightly improved version of the same thing. I’ll spare you an article on that.

What drives culture and financial performance? It’s the leadership and not an ESOP. So to repeat the opening line, the intention behind ESOPs is noble, but the vehicle is flawed.