Yesterday’s XPX event on ESOPs (Employee Stock Ownership Plan) was meaty. Jim Higgins and Rob Edwards of SES Advisors schooled all of us on the dark side and the upside of this exit option. It became clearer to me yesterday not only why ESOPs are a powerful exit option, but also why they are misunderstood. Rob explained that an ESOP, in essence, has a two-fold purpose: it is a tool for corporate finance (exit) and at the same time, it is a special qualified (buy the IRS under IRISA) plan. This is why so much focus is placed on fiduciary duties.

The light went on for me yesterday. The ESOP regulations give the owner “superpowers” to create his or her own market for the sale of his company. It’s like pulling a rabbit out of a hat. And because he or she is the creator/master of the rabbit, the potential for abuse is huge; hence a trustee to watch over the rabbit to make sure once created the ESOP (my rabbit in this example) has a guardian and is able to have a fair and arm’s length relationship with its master. After all, the shares of the corporation owned in the ESOP are funding the employees’ retirement. The ESOP is essentially a mirror of the 401k, but in this instance, it is funded with shares of the employers stock.Clearly there is both an opportunity to increase a real and meaningful sense of employee ownership and for the employer to be abusive.

I learned that there is study by Steven Freeman with 30 years of empirical data, which concludes that ESOPs, on average, tend to be more productive, grow faster and last longer than non-ESOP businesses. Apparently,in contrast to traditional businesses, ESOPs created jobs during the recession!

Businesses with less than $2 MM in gross revenues are not good candidates for ESOP. Generally companies with more than 1,000 employees are also unlikely ESOP candidates. ESOPs are viable for companies with strong,steady growth potential and owners who are more than maximizing their financial wealth on the way out. They must have some legacy values as well, such as ongoing concern for employees, customers and the community. The highest price and the most cash will generally come from a strategic buyer, not an ESOP.Companies that have aggressive growth potential are not good ESOP candidates.

I learned that ESOPs, as a creature of statute (IRS Regulations),are complex and tricky, as well as powerful in the right situations. Those business that qualify are fortunate, but need adult supervision (great advisors like those at XPX!) to make sure they don’t get burned.

Rob Edwards and Jim Higgins of SES are terrific teachers. I wish we had another two hours to finish ESOP 101 for the experienced advisor. I am grateful for the lesson.

Click here for the presentation.

By Daniel A. Guglielmo, J.D.