ESOP Hazards
Very Real and Very Dangerous
The ESOP is an extremely valuable business tool. It's also a dangerous one and an important issue with us. Full disclosure motivates us to reveal ESOP hazards that can flat take your company down — hazards that should be avoided at all cost.
Choosing the Wrong Consultants
Easily 90% of all financial consultants never suggest you consider an ESOP. Why? They don't know how to implement it, or they don’t fully understand how it benefits you. Those who may consider an ESOP tend to follow "off-the-shelf" concepts. Most lack the deal structuring sophistication required for design and execution. Accordingly, you must vet any transition consultant, including us.
The Sub-s Transaction Pitfall.
The popular 100% ESOP sub-s transaction can burden your company with debt of 6-8 times EBITDA. This debt is crippling. Most banks will not lend more than 2-3 times. The addition of subordinated debt carries very high interest rates. Therefore, to accommodate the ESOP, some companies will use various strategies that take all stock growth value out of the ESOP Trust. This move often alerts the DOL which forces them to forgive the subordinated debt. The seller (you) never gets full value of the transaction. In addition, the company and Trustee are fined. The allure of the 100% sub-s transaction is this — the company is 100% tax free. However, there are other, better strategies that have tax advantages without the risk. For instance, a company can run 100% tax free with a smaller ESOP transaction.
Recycling Stock the Wrong Way
Many ESOP transactions recycle stock in the ESOP Trust. A company makes a tax-deductible, cash contribution to the Trust. It buys stock of retiring employees and reallocates that stock to all other ESOP participants. This move forces the company to buy 100% of the value of the same stock 2.4 times over 15-20 years. For example, the retirement benefit of a $50,000,000 ESOP transaction over 20 years costs the company, after-tax, $90,000,000 — a disaster. If the company used "redeeming” as a distribution policy, the cost is only $50,000,000.
Designing a rudderless ship
Many ESOPs do not include management succession. Without a motivated top management, companies don't survive. This oversight, combined with recycling ESOP stock, creates a rudderless ship that is generally doomed.
The Wrong ESOP is a Business Handcuff
Many ESOP designs attempt to let companies operate on autopilot. As owners of a thriving company, you must know that business environments during a 5-10-year period can't survive in the real world when any transaction, especially an ESOP, restricts the company from having the ability to change direction with emerging markets.