Sustaining Employee-Owned
Firms Over the Long-Term
Vermont Employee Ownership Center
2012 Conference
Burlington, Vermont
June 8, 2012
Alex Moss | Praxis Consulting Group
Judy Kornfeld | ESOP Economics
Peter Paquette | Tarndale
What is “Sustainability”?
Meeting present needs without compromising
the ability of future generations to meet their
needs
World Commission on Environment & Development
(Bruntland Commission), 1987
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VEOC Conference | ESOP Sustainability
June 8, 2012
Employee Ownership Sustainability
Being employee owned
(through an ESOP, coop, or other form)
in perpetuity.
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The Historical Record:
Something Interesting is Going on Out There
 Shared ownership in the US: predates the American
Revolution
 Coops
 Mutuals: e.g. Franklin’s fire insurance society
 Cooperatives: Rochdale, England, 1844
 ESOP
 Economist Lou Kelso & Senator Russell Long
 37 years: part of 1974 ERISA
 11,400 companies, 13.7 million participants, 10% of workforce
(NCEO)
 Wide range of industries, structures, & experience
 Shared ownership, ESOPs and beyond (GSS)
 45%+ of workforce
 Highly valued by workers
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ESOPs Are An Exception Under ERISA
 An ESOP is an ERISA retirement plan…
…that owns your company = shareholder
 ESOPs are an exception to key pension rules
and philosophy
 Technical: prohibited transactions
 Philosophical: diversification
 Likely source of current DoL discomfort: this isn’t
how “pensions” are supposed to work
 Why? Lou Kelso + Russell Long
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Different Models & Expectations
 For some, long-term aspirations, e.g. Silver
ESOP Awards and taking public position of
long term employee ownership
 For others, transitional aspirations: natural
life-cycle of ESOP, including sale of company
or termination of ESOP
 Overall # of ESOPs has been relatively flat for
many years; however, there continues to be
lots of activity, into and out of ESOP form
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Data: ESOP Formation & Termination
% of
ESOPs
# of
ESOPs
The company was performing well financially but could
not manage its repurchase obligation or expected not to
be able to do so in the future
13.2%
60
The company could handle its repurchase obligation,
but received an attractive offer it could not turn down
51.2%
233
The company was dissatisfied with the ESOP for
reasons other than repurchase Problems
15.6%
71
The company was in financial difficulty and needed to
cut costs
13.1%
60
The company never intended the plan to be permanent;
it was just used to buy out an owner with the intention
of terminating the ESOP at a later date
2.2%
9
Other
5.3%
22
Reason for Terminating ESOP (source: NCEO)
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More Often Than Not…
 Business *failure* is not our challenge
 The market is pretty good at handling this (!)
 How will we handle business *success*?
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Core Question
 Can you run your business better under
ESOP ownership?
 If yes
 Your company & ESOP will thrive
 Public policy & opinion will support employee
ownership
 If no, ESOPs will be a temporary ownership
vehicle
 until the operating burden outweighs the valueadded in your firm
 until Congress changes its mind
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VEOC Conference | ESOP Sustainability
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Should Your Company
Remain ESOP Owned?
 Does ESOP ownership generate return in excess
of costs?
 What’s your “Return On Ownership” (ROO)?
 Costs
 Direct $ expense + staff time + hassle + regulatory risk
 Benefits
 Tax savings + operational performance improvement +
intrinsic value of independence
 What’s your alternative?
 Repurchase obligation is universal, ESOPs give it a name
and shape
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VEOC Conference | ESOP Sustainability
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Two Inter-Dependent Discussions
 Can we manage the *ESOP*, as a benefit and
ownership plan, sustainably?
 Can we manage the *company* sustainably?
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VEOC Conference | ESOP Sustainability
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Judy Kornfeld
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Peter Paquette
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Challenges to ESOP Sustainability
1.
2.
3.
4.
5.
6.
7.
8.
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Hostile legislative / regulatory environment
Business model fails
Repurchase obligation is too great
No consensus view of shareholder value
Succession discontinuity
Business is not run like an ESOP
Plan design time bombs go off
Purchase offer is “too good to ignore”
VEOC Conference | ESOP Sustainability
June 8, 2012
1. Hostile Legislative / Regulatory
Environment
 ESOPs are creatures of the federal tax code
and ERISA
 Potential efforts to curtail ESOPs
 Tax reform
 DoL aggressive enforcement
 Advocacy efforts
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2a. Business model fails
 ESOPs can not overcome a flawed business
model, e.g., Polaroid
 ESOPs cannot overcome a poor
implementation, e.g., United Airlines
 ESOPs cannot overcome management fraud,
e.g., Enron
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2b. Business model fails
 Sustainability of the ESOP, as previously
defined, must be a strategic imperative
 If not, sustainability is a matter of luck rather than
design / purpose
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VEOC Conference | ESOP Sustainability
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3. Repurchase obligation is to great
 The problem is not repurchase obligation per se, but
repurchase obligation in excess of normal benefits levels
 Valuation issue: current valuation standards for ESOPs
incompatible with “ESOP in perpetuity”
 Current standard: willing buyer/willing seller from IRS Revenue
Ruling 59-60
• Written in 1959, before ERISA law of 1974
 This standard does not consider repurchase obligation in excess of
normal benefits levels as a claim against cash for valuation
purposes
 Management issue: may mean a fluctuating share price
 Communication, communication, communication
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4a. No consensus definition of
shareholder value
 Different views / lack of definitional alignment of
shareholder value among the following:
 Trustee(s) of the ESOP Trust
 Non-trust shareholders
 Board of Directors of the company
• Maybe influenced by state of incorporation






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Senior leadership
Middle/front line management
Non management employees
ESOP committee
Employees not in trust (seasonal, part time, foreign)
Terminated employees
VEOC Conference | ESOP Sustainability
June 8, 2012
4b. No consensus definition of
shareholder value
 What is shareholder value in an ESOP company?
 Proposition 1: Shareholder value in an employee owned
(ESOP) company is solely share price, and all the
organization’s energy should be directed towards maximizing
the share price.
 Proposition 2: Shareholder value in an employee owned
(ESOP) company is something other than solely share price,
and all the organization’s energy should be directed towards
maximizing that value proposition.
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4c. No consensus definition of
shareholder value
 Proposition 1
 Standard “wall street” definition
 Shareholder value = share price
 Proposition 2
 Terms shareholder value and share price are not identical –
must be careful when using these terms
 Each ESOP must spend time defining what is its shareholder
value proposition
• Must be buy in from the different stakeholders
• Must be buy in from the Board of Directors
 Each ESOP must communicate its definition of shareholder
value to the employees
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VEOC Conference | ESOP Sustainability
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4d. No consensus definition of
shareholder value
 The employment dividend
 Those cultural norms, work place rules, benefits,
etc. that your company implements only because it
is an ESOP. (Some examples.)
 The employment dividend generally
depresses the current share price
 But may support longevity of the company, and a
create a higher share price in the long run
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4e. No consensus definition of
shareholder value
 Is proposition 2. legal?
 Does it conform to the fiduciary duties of the
Trustee(s)?
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5a. Succession discontinuity
 3 levels
 Board of Directors
 Senior Leadership
 Employee selection / turnover
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5b. Succession discontinuity
 Board of Directors
 Challenge: implementing “best practice” of outside dominated
Board while getting real Board buy-in to the ESOP ownership form
(refer to the “Shareholder Value” discussion)
 Selection
• Define what your company wants
– Number of insiders versus outsiders
– Specific technical or industry knowledge
– Is ESOP knowledge a pre-requisite?
– How to filter for “ESOP-aligned values”?
 Recruitment
• How to find: not a large pool of ESOP-ready directors
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5c. Succession discontinuity
 Senior leadership
 Generally, many private company ESOPs are started by an
owner/CEO who believes in employee ownership, or who
does an ESOP to keep the company independent and comes
to believe in ESOPs more broadly through that experience.
 In most cases, the owner has a ready successor in either a
family member or a long term, trusted and proven employee,
who is the designated successor CEO.
 The problem generally comes with the third CEO.
or develop.)
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VEOC Conference | ESOP Sustainability
(Recruit
June 8, 2012
5d. Succession discontinuity
 Senior leadership continued
 Recruiting from outside—some problems
• Limited pool of talent to become a senior leader/manager
(CEO, CFO, etc.)
• Limited pool of philosophically oriented leaders outside of other
ESOP companies
– In addition, most senior managers at ESOP companies like
their company and are reluctant to move
• S Corps have almost no ability to give a recruited senior leader
capital gains treated gain sharing, i.e., 15% tax rate
– Rangel bill: Paragraph 3701
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VEOC Conference | ESOP Sustainability
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5e. Succession discontinuity
 Senior leadership continued
 Developing next generation of senior leadership from within
• In a bigger ESOP company, this should be a central focus of
the BoD and current senior leadership
• Issue: ESOP company maybe too small to have successors on
staff
– Now what?
 Are the required leadership competencies in a sustainable
ESOP different from other capital / cultural structures?
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5f. Succession discontinuity
 Employee selection
 New employees
• Selection / recruitment criteria consistent with ESOP in
perpetuity
 Current employees
• Retention criteria consistent with ESOP in perpetuity
– Why should the company retain philosophical cynics
or those that do not believe in shared equity?
• Training, development, & career advancement: build &
reinforce needed ownership behaviors & competencies
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VEOC Conference | ESOP Sustainability
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6a. Business is not run like an ESOP
 Is a mixed capital structure sustainable?
 ESOP and public company
• Which definition of shareholder value prevails
 ESOP and private company
• Minority ESOP
• Majority ESOP
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VEOC Conference | ESOP Sustainability
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6b. Business is not run like an ESOP
 Lack of conviction that ESOP should be sustainable (some examples)
 A financial ESOP where sustainability of the ESOP is unimportant; looking for the next
exit strategy
 Or, there is no perceived value in shared equity / ownership; selling shareholder
continues to run the business as before the ESOP transaction
 Or, a union buyout where the union does not want ownership, just want to own it long
enough to turn it around and sell, and then go back to being employees
 Failure of conviction that ESOP should be sustainable
 Senior leadership and/or the BoD losses its belief in ESOPs
•
•
•
•
•
Business model is failing
Repurchase obligation overwhelming
Definition of shareholder value defaults to share price
Successor leadership has no empathy with ESOPs
ESOP model is overwhelmed with cynics
 Failure to appropriately manage the inherent conflicts of interest
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VEOC Conference | ESOP Sustainability
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7. Plan design time bombs go off
 The bank run waiting to happen
 Plan design assumes a constantly increasing
share price
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VEOC Conference | ESOP Sustainability
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8a. Offer that is “too good to ignore”
 Evaluating the offer:
 Share price is merely the beginning
 The add backs
• The employment dividend
• The S Corp tax shield
• The repurchase obligation in excess of normal benefits
levels
• The potential salary/wage premium
– Above market salary / wage structure
– Disintermediation
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VEOC Conference | ESOP Sustainability
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8b. Offer that is “to good to pass ignore”
 Do I have to sell?
 Board of Directors – state law for BoD members
 Trustees
• DOL statement of 1989
 What can we do to slow down the need to sell
process
 Adopting a “not for sale unless” statement
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VEOC Conference | ESOP Sustainability
June 8, 2012
Back to the beginning:
Are ESOPs sustainable?
 Yes, subject to…
 Not entirely clear as to all the pieces but includes




Unshakable belief in employee ownership through ESOPs
Sustainability of the ESOP as a strategic imperative
Proper governance (balancing inherent conflicts of interest)
Appropriate level of repurchase obligation (and a plan to fund
it)
 ESOP philosophy is passed from generation to generation
 The ability to say no to the offer that appears “too good”
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VEOC Conference | ESOP Sustainability
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Emerging Trend:
What if ERISA Isn’t Enough?
 ESOP Trustee’s duty is to protect participants
retirement interests, i.e. long-term share
value
 What if that is not your sole objective?
 Approaches
 Board policy re independence
 B-Corporation status
 Coop models
 Other models
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Questions
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VEOC Conference | ESOP Sustainability
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ESOP Governance
Shareholders
ESOP
Fiduciary
Committee
Individual
Owners
ESOP Trustees
select
are
represented
by
ESOP
Participants
elect
Board of Directors
appoint and oversee
CEO / President
hire and oversee
Leadership Team
when meet
eligibility
requirements
hire and oversee
ESOP
Communications
Committee:
Promote
Ownership
Employees
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Contact Information
Alex Moss
Praxis Consulting Group, Inc.
215.753.0304
alex@praxiscg.com
Judy Kornfeld
ESOP Economics, Inc.
215.606.3591
judy@esopeconomics.com
Peter Paquette
Tarndale, LLC
603.643.8460
peter.paquette@tarndale.com
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