ESOP – The Fable and the Fraud

ESOP is a fanciful fairytale of sharing spun amidst the props of smoke and mirrors.

I have always been a believer in the motivational power of parallel interests that are created when employees share an ownership interest in the company they work for. It puts everyone on the same page and allows those who create value to share in the reward of success. And I know it really works.

After all, I helped create a very successful company – LifeUSA – that was founded on the premise that success is more likely to be achieved using a business model of direct employee ownership. But at the same time, I have also harbored the opinion that the employee stock ownership plan known as ESOP is not the best way to achieve that objective; it may, in fact, do more harm than good. The truth is that in many cases ESOP is an acronym for Employees See Only Promises.

My concerns about ESOPs emanate from the fact that they are a very complicated way to create parallel interests: they promise employee ESOPownership but fail to include rights of ownership. Plus, there is the potential for conflict of interest, which run counter to true parallel interests.

What ESOPs do is create a synthetic form of “group ownership” for employees as opposed to true, individual ownership that is enjoyed by company founders and management. Sure, using  ESOP “ownership” as a way to motivate employees  is better than no plan at all. But these plans are often more effective at demonstrating management’s desire to have their cake and eat it too, since they engender a feeling of false promises among the rank and file.

A Growing Concern

As ESOPs have grown to include almost 12,000 companies, the federal government has become concerned with the potential for abuse – if not fraud – that can occur in the structure and management of these plans. The Wall Street Journal recently reported that the federal government is currently the plaintiff in 15 lawsuits related to ESOPs. Virtually all of this litigation revolves around the potential abuse in the valuation of company shares (often sold by company founders or senior management) purchased by the ESOP “for the benefit of employees.” The Journal reported that since 2010 the Labor Department has recovered over $240 million from companies that had abused ESOP plans, all of which involved stock valuation.

The Nuts and Bolts of ESOPs

Technically, ESOPs are defined-contribution pension plans, regulated under the 1974 Employment Retirement Security Act (ERISA). As a qualified retirement plan, ESOPs offer favorable tax benefits for the company and employees. For example, contributions made by the company into the ESOP to purchase shares of the company are deductible and these contributions are not taxable income to the employee until they actually receive the benefits, usually at retirement.


Even though ESOPs are considered a retirement plan for the benefit of employees, the assets of these plans can be – and often are – used to enrich the management of the company, create liquidity for existing shareholders and serve as a lucrative “exit strategy” for company founders. This can result in a significant potential conflict of interest between existing shareholders and the employees who are “buying” the shares via an ESOP.

The vast majority of companies that have adopted ESOP plans are private; meaning there is no existing “market” for its stock. The result? Not only is there is no sure-fire way to determine the value of the stock, existing shareholders have little or no liquidity, that is, a ready-made market to sell shares. An ESOP remedies these problems for existing shareholders by creating a “captive” market for their shares and the liquidity they desire.

But, you ask, if there is no real “market” for shares, how can fair value for shares be determined? Simple. Outside consultants are be brought in (paid for by the company) to place a valuation on the stock, the price at which the employees (the ESOP trust) will purchase the stock from selling shareholders.

Now comes the tug-of-war. Existing shareholders seek the highest value possible, while employees seek share price as low as possible. This creates the potential for conflict of interest that ultimately has triggered the government lawsuits over valuation. And it raises an even more important question: If the stated idea of the ESOP is to motivate the employees with a feeling of ownership, just how much motivation and incentive will be engendered in employees who feel they are being forced to buy the stock at inflated prices?

The next important question is: Regardless of the price that is determined, where is the money going to come from for the ESOP trust to buy the stock from current owners? The company is obligated to make annual contributions to the ESOP and these funds are used to purchase the stock, but from the viewpoint of existing owners it could take years for them to receive the value for selling their shares. Not something they are likely to want to do.

To solve this problem (it is really only a problem for existing shareholders) about 70 percent of all established ESOPs “leverage” the purchase of the stock by taking a loan against the stock. This works well for existing shareholders because they can put cash in their pocket now, while the ESOP must use future contributions to re-pay the loan. There is nothing inherently wrong or immoral with this approach, but it does Pay-Daycreate a potential conflict of interest and the actual interests of the selling shareholders and employees participating in the ESOP are not truly in parallel going forward. One side has received their reward, while the other side has the promise of reward in the future.

Another potential conflict of interest arises when it comes to voting the shares of stock. Even though current shareholders have been paid for their stock, management of the company often controls the voting power of shares held by the ESOP but not yet allocated to participants, and that action that could take years. Again, there is nothing illegal in this type of structure, but when thinking of parallel interests and the motivation that real ownership provides, it leaves a lot to be desired.

If the existing owners of a company are seeking a way to cash out or create liquidity in the most tax-advantaged way, then an ESOP is the answer. But if management really believes that the way to enhance the total value of the company is by putting the interests of the employees in parallel with the interests of the company, then there are simpler, easier and more effective ways to accomplish that objective than using an ESOP.

So what are some of the ways to build real parallel interests between company founders, the company and employees?

First off, at LifeUSA, all employees and sales representatives as a condition of employment were required to use 10 percent of their gross pay to purchase new stock issued by the company. If someone was making $25,000 they were required to buy $2,500 of LifeUSA stock. Since the stock of LifeUSA was not publicly traded, the cost of this new stock was pegged at the same price the founders of the company paid for their stock.

Second, there was only one class of stock – common voting stock – for all shareholders. This meant the CEO of the company and the newest employee both owned the same class of voting stock, purchased at the same price. The CEO could not benefit from his stock unless everyone in the company could also benefit from owning their stock.

Thirdly, the happy outcome was that everyone working at LifeUSA was a real, direct, individual owner of the company. This may not have been the most tax-efficient way to spread ownership in the company, but it was simple, easy to understand and in pure parallel.

Just in case you might wonder, LifeUSA moved from being a start-up company in the life insurance industry to one of the fastest growing and most successful companies of the 1990s—a vivid testament that true employee ownership does, in fact, motivate employees to work harder and produce stunning results. In 1999 — 12 years after its founding — Allianz SE purchased LifeUSA for a value of $540 million and every single one of the 800 employees working at LifeUSA received a share of that purchase price. l

More times than I would like to count, I have been told that the LifeUSA model would not work for other companies. I agree that it would not work if you did not really believe in the concept of true shared parallel interests and didn’t want to work at it. But for the most part those comments come from the non-believers, the greedy and the lazy.

There are other ways a company can gain the benefits of parallel interests created by employee ownership without taking on the complexities, complications and potential problems of an ESOP. From my perspective and experience, the best way to motivate employees to work hard for the success of the company is to develop a plan that gives the employee both the feeling and the benefits of being an owner. And the best way to do that is make them real owners.

And the Moral of the Story …

I recognize that reading the ins-an-outs of an ESOP plan can be tedious and boring, but that’s the point. If you are an owner of a company and, deep in your heart, you really want to find a way to create liquidity for yourself and even create an exit strategy, then the path for you is to pretend that your motive is altruistic and that you want every employee to enjoy the benefits of ownership. And the best way to do that is to create an ESOP.

On the other hand, if you really believe that you will gain more value by sharing value; if you believe that building true parallel interests means creating a plan under which no one benefits unless all benefit, then you will eschew any thoughts of the fable called ESOP.

 

 

 

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