Is an ESOP Transaction Right for Your Business?

Whether you’re a Baby Boomer seeking liquidity for your retirement or a younger business owner wanting tax incentives and increased benefits for employee engagement, an employee stock ownership plan (ESOP) may be an option for you.

According to the National Center for Employee Ownership (NCEO), there are more than 6,600 ESOP-owned companies, not including the 3,800 profit-sharing plans and stock bonus plans that are mostly invested in company stock. From 2014 to 2018, an average of 263 new ESOPs formed each year, and that rate is accelerating thanks to the favorable mergers and acquisitions (M&A) that began this year.

In February, Peter Stavros, a partner and co-head of private equity for the Americas at KKR, announced that he and his wife were launching the Center for Shared Ownership. The non-profit organization focuses on employee ownership by funding research and education, providing resources, and pushing for government support.

This article discusses what an ESOP transaction is and examines its benefits and its unique insurance needs.

What is an Employee Stock Ownership Plan (ESOP)?

As a flexible, tax-advantaged alternative to a third-party M&A transaction, an ESOP gives employees an ownership interest in the company. Shareholders can sell the entire company, or even just a minority percentage interest in it to an ESOP, to gain liquidity and transition ownership.

Companies often use ESOPs as a strategy to better align the interests of their employees with those of their shareholders. Companies of all sizes, including some large publicly traded corporations, have ESOPs. They often are a good fit for the following:

• Business owners wanting a gradual exit
• Family businesses hoping to continue their legacy
• Business owners who worry a third party will alter the established direction of their company

ESOPs are created as trust funds. Companies fund them by purchasing newly issued shares or existing company shares or borrowing money through the new entity to buy company shares.

However, since each ESOP transaction is uniquely structured, it is not a one-size-fits-all solution for every company. ESOPs have three primary risks associated with them.

ESOP Transactions are Not One-Size-Fits-All

First, they are highly regulated by both the Department of Labor and the IRS. Secondly, because ESOPs often are formed to provide a market for closely held stock, they can be highly leveraged, requiring significant cash flow to service the debt and increased annual costs to administer the plan.

And, third, ESOP litigation is costly due to the heightened fiduciary duties and the current regulated environment.

ESOPs also have management requirements. ESOPs are overseen by a trustee––an institutional trustee or professional trustee, or you may serve as your own trustee. A plan administrator will also have some oversight and administration duties.

Insurance Needs of an ESOP

The insurance needs of an ESOP are complicated by the interplay of: directors & officers (D&O) liability, which protects management decisions, yet there may be a dual responsibility to shareholders and ESOP participants; errors and omissions (E&O) insurance, which insures your relationship with customers and other non-employee stakeholders; fiduciary liability, which protects against plan fiduciary duties and in particular violations of ERISA; and trustee liability, which protects against carrying out duties as a trustee, such as voting and valuing the shares and acting in the sole interest of plan participants.

Here are three insurance solutions for ESOPs:

• D&O Liability insurance protects management decisions and your relationship with customers and other non-employee stakeholders.
• Fiduciary Liability protects plan sponsors against claims resulting from a breach in fiduciary duty and, in particular, violations of the Employee Retirement Income Security Act (ERISA).
• Trustee Liability protects against carrying out duties as a trustee, including voting and valuing the shares and acting in the sole interest of plan participants.

From a risk management and insurance perspective, let’s look at the risk characteristics of an ESOP during its three stages: Formation, Operation, and Exit.

Forming an ESOP

The first steps you’ll take to form an ESOP are a feasibility study and company valuation. If these studies prove to be positive, you may see increased administrative costs and funding requirements.

The liability at this formation stage tends to be based on stock valuation and fairness opinions, capital structure including loan documents and stock purchase agreements, and disclosures to the employees.

ESOP D&O, fiduciary liability and trustee liability policies should be structured according to that company’s needs. Pay close attention to exclusions such as regulatory, ERISA, and insured versus insured. Also, be sure to evaluate any additional conditions, such as change of control provisions and reporting requirements that the transaction may trigger.

Operating an ESOP

The relationship between ESOP administrators and company management can be tricky, and it is not uncommon for litigation issues to occur.

Companies also must navigate ERISA’s rules that prohibit ESOPs from transacting with the company, its officers and directors, and any significant shareholders unless the ESOP pays or receives “adequate consideration” for the stock. Keep in mind that trustee liability insurance construction is determined by whether the ESOP is self-trusteed or has a third-party trustee.

Exiting an ESOP

As the ESOP matures, the company will enter the redemption stage as employees begin to retire or leave employment for other reasons.

The pandemic has created some new decision-making opportunities for this stage. According to the Pew Research Center, the pace of Baby Boomer retirements has accelerated over the past year. This higher rate creates increased liquidity requirements for ESOPs. In some cases, management may have to sell if cash flow is not enough to meet redemption requirements.

The acquisition of a company also creates additional risks. The trustee, who has fiduciary responsibilities to the plan participants, must hire independent financial advisors to value the stock and ensure the acquisition will result in a fair deal for all stakeholders.

Escrows are another potential problem area for ESOPs. Although escrows are common M&A transactions in favor of buyers for possible breaches of representations and warranties, escrow funds in ESOP transactions cannot be guaranteed to be paid out to the ESOP participants.

In lieu of escrows, representations and warranties insurance may be a better option for ESOPs.

A Word About ESOP and Family Trusts

A topic that doesn’t get much attention is the relationship between an ESOP and a family trust. If your company is a multigenerational family business, there may be an established family trust.

If you are considering an ESOP transaction, you’ll want to learn more about your trustee’s fiduciary responsibilities to the trust beneficiaries as opposed to the grantor or other corporate stakeholder. There is a separate trustee liability policy available to the trustee of wealth transfer vehicles (trusts) for breaches of fiduciary duties outlined in the family trust documents.

Before transitioning to an ESOP, make sure you understand the risks and the benefits as they apply to your company. Please contact us at Woodruff Sawyer to learn more about ESOP insurance needs.