ESOP Risks

As great as ESOPs are, they aren’t perfect and they aren’t right for every company. There are several risk factors that a business owner who is looking at an ESOP needs to understand.

First, ESOPs are qualified retirement plans, so they’re subject to regulation by the IRS and the Department of Labor. Because ESOPs have occasionally been used in the past by business owners to engage in abusive transactions in which the ESOP overpaid for the stock, the Department of Labor in particular pays close attention to ESOP transactions. Therefore, it’s extremely important to work with qualified professionals when implementing and maintaining an ESOP. This includes using an independent, outside ESOP trustee for any purchase of stock from the owner. This does add to the cost of an ESOP, but it greatly reduces the risk to the company and the selling shareholders of much more expensive problems down the road. After the transaction, the company should continue to engage qualified advisors to make sure that the ESOP is being administered in accordance with its documents and applicable laws – the regulation from the IRS and DOL doesn’t end after the transaction is complete.

Second, because most companies borrow money to fund an ESOP transaction, there will be additional leverage on the company when transaction takes place. That debt service, obviously, can have a big impact on the company’s cash flow, which is why it’s important to have a feasibility study done early in the process to make sure that the company can sustain itself and grow as that outside debt is paid off.

Another risk factor is what’s called the repurchase obligation. While it’s great to see employees accumulating large account balances, it’s inevitable that at some point, they’re going to leave the company. After that happens, either the company or the plan has to buy out their shares (since most non-public ESOP companies don’t want to distribute stock to former employees). This is another cash obligation of the company, so the company has to plan for it – fortunately, there are plenty of qualified service providers who can help an ESOP company with this. If the company doesn’t adequately plan for the repurchase obligation, it can have major liquidity concerns, even to the point where a sale to an outside buyer becomes the only way out.