Sustainable ESOPs Start with Realistic Projections

Project Expected Future Cash Flows Not Best or Worst Case

We have just returned from NCEO’s conference in Denver. It was an excellent opportunity to meet new ESOP companies, talk to persons interested in ESOP transactions, and chat with many of our favorite professionals in the business of providing services to ESOP companies. The NCEO conference was a great opportunity for anyone at any level to learn something new about ESOPs. One of the consistent buzzwords or buzzphrases we heard at the conference was “sustainable ESOP.” We engaged in several conversations discussing what exactly is a sustainable ESOP and how you establish one.

We believe that four aspects of an ESOP should be considered at the outset in order to develop a sustainable ESOP – some of these can be implemented as the ESOP matures, but before you start an ESOP, consider all four of these. Over the next several weeks, we will present three more posts outlining various considerations when designing an ESOP for the long-term. Today, we address the initial transaction and the search for Fair Market Value. What the sellers receive and the impact on future cash flow are one of the greatest factors in long-term success of a new ESOP. If the value is too high, it can cripple the company going forward and if the value is too low, the sellers isn’t selling to an ESOP. For a good ESOP transaction to occur, the selling owners must walk away feeling that they have been appropriately compensated for the work they put in and for the risk they had taken to build their business. The buying ESOP in turn wants to see that business carry on and perform better than ever. To ensure that both occur, the sellers must receive fair market value for the stock sold to the ESOP and the company must have the wherewithal to service the necessary debt associated with any stock purchase. The two are inextricably linked.

Even if the sellers walk away with what is perceived to be fair market value at the time of the transaction, it does little good to a seller taking a promissory note as part of the purchase price if the sponsor company (the “Sponsor”) cannot service that note going forward. Because of the importance of the Sponsor Company’s ability to fund a good ESOP transaction that satisfies all parties, projections of expected future cash flow must be realistic. As the name suggests, “expected” does not equate to “best case” cash flows. By the same token, it also does not mean “worst case” cash flows either. One way to ensure realistic expectations of future cash flow is to make such projections with debt capacity of the Sponsor Company in mind. The parties should ask: Are the “expected” future cash flows achievable and necessary to meet transaction indebtedness? If the Sponsor does not meet the projections, what cash flow would be needed to repay transaction indebtedness? It is important to ask these questions for legal as well as practical reasons.

Under ERISA, the ESOP can pay no more than adequate consideration for the company stock. With respect to any transaction involving stock that is not readily tradable on an established market, adequate consideration is the “fair market value of the [stock] determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary.” Unfortunately, the Department of Labor (“DOL”) has never finalized regulations to assist fiduciaries in determining fair market value. Rather, the DOL merely proposed regulations in the late 1980s with respect to “adequate consideration”. Most practitioners nevertheless refer to those regulations as guidance as to how the DOL will enforce the provisions relating to adequate consideration and fair market value. The proposed regulations require that the fair market value be determined “as of the date of the transaction” and be reflected “in written documentation of valuation.”

In addition to the requirements of ERISA, the Internal Revenue Code (the “Code”) provides additional requirements. Under the Code, the trustee (or named fiduciary) of the ESOP must have the stock appraised by an “independent appraiser.” Combining the requirements of ERISA and the Code, the trustee has the independent appraiser provide a written valuation setting forth an opinion of the fair market value of the stock– i.e., “the price at which [the stock] would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell….” Then the ESOP trustee determines, in good faith, whether the price to be paid in the transaction is “not more than fair market value.”

In practice, the independent appraiser typically provides a range of value and the trustee negotiates the transaction price with the sellers (and often the Sponsor as well). Upon consummation of the transaction, the Trustee must ensure that the transaction price is within the range provided by the independent appraiser – assuming, of course, that the range adequately reflects fair market value. Recent litigation by the DOL indicates that it perceives a problem with that process or that problems have occurred in the process more frequently as of late. The allegations in the complaints filed by the DOL and the recent provisions of a settlement (the “Settlement”) with GreatBanc Trust Company (“GreatBanc”) indicates that the DOL not only wants the trustee to determine FMV, but also wants the trustee to consider precisely what we suggest should be considered for a sustainable ESOP – i.e., the debt capacity of the company. In that settlement agreement, the DOL has specifically insisted that when GreatBanc makes its adequate consideration determination, it must “analyze and document in writing [] whether the ESOP sponsor will be able to service the debt taken in connection with the transaction (including the ability to service the debt in the event that the ESOP sponsor fails to meet the projections relied upon in valuing the stock)”.

While the Settlement only applies to GreatBanc as a matter of law, the DOL has repeatedly stated that the Settlement provides guidance to all trustees and others considering ESOP transactions. At a minimum, the Settlement outlines steps that the DOL believes are appropriate steps in the context of determining whether the price paid by an ESOP for shares of the Sponsor’s stock in an ESOP transaction exceeds the fair market value of such purchased shares and the terms of the transaction, taken as a whole, are fair to the ESOP from a financial point of view.

Such consideration of debt capacity, however, is not merely prudent from a legal point of view (as noted in the Settlement), but has great practical value as well. . What good is a “high” fair market value if the Sponsor is not able to repay the debt associated with that fair market value determination? For example, what good is a $90m fair market value when after five years the sponsor is worth only a few million and the selling shareholders have received only $15m because the sponsor couldn’t service the high debt associated with the transaction? On a smaller scale, what good is an $18m valuation where after 10 years the sponsor only pays a total of $5m? In each of those instances, the ESOP related debt was an excessive drain on the Sponsor. The participants saw little value in the ESOP, and not surprisingly, a culture of employee ownership was never developed.

So how does one consider debt capacity in the context of determining fair market value? The first place to consider debt capacity is when providing the valuator with projections of future free cash flow. The most used valuation method is the discounted cash flow method. Under that method, the valuator estimates a future period’s expected cash flow and calculates its net present value by discounting it at a market rate of interest. Reasonable and supportable projections of future revenue growth demonstrate the value of the Sponsor and should, therefore, indicate the amount of debt the Sponsor is able to service. Inflated projections, on the other hand, may drive a higher fair market value, but such unsustainable projections of future revenue growth will lead to an unrealistic view of the debt capacity of the Sponsor. Considering growth in the context of loans that must be paid back to a lender, it is likely that such projections of future cash flows will fall in line with “expected” levels of income as opposed to “best case” levels of income. Whether or not the projected cash flows are “conservative,” it is also prudent to structure the purchase price and debt repayment in a manner that only a conservative portion of the projected free cash flow is required to service the debt. Then, if the projections are not achieved, a sufficient “cushion” remains for servicing the debt.

If you consider the debt capacity of the company at the outset, this will help protect the business held by the ESOP going forward and assist it in addressing the large debt burden that can arise in a 100% ESOP transaction. In the next entry, we will discuss how the structure of the transaction can be adjusted to also protect the cash flow of the going concern. Tune in next week.

As always, if you have any questions, please drop us a note or contact one of our attorneys here at ESOP Plus.

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Join ESOP Plus in Denver with NCEO

2015 Employee Ownership Conference in Denver This Spring

The growing community of employee-owned companies will gather April 20-23, 2015 in downtown Denver for the 2015 Employee Ownership Conference. Hosted by the National Center for Employee Ownership (NCEO), more than 1,200 attendees representing businesses from across the U.S. will learn about emerging trends, legal issues, best management practices, and much more. The events will all be held at the Sheraton Downtown Denver conference hotel.

The United States presently has close to 9,000 employee ownership companies. These businesses employ over 14 million people and outperform other business in job creation and productivity, while more broadly sharing the wealth they create. Driven by the demographic wave of baby boomers entering retirement age, the number of businesses for sale is sharply increasing, and many of those owners are choosing to exit their businesses by selling to employees.

ESOP Plus®: Schatz Brown Glassman Kossow LLP is proud to be sponsoring this conference. We will be actively involved with exhibiting, speaking, and sponsoring the book provided to each participant, which will provide insight into current trends in employee ownership. Our partner Peter Jones will be presenting on Tuesday, April 21, 2015 at 10:30 a.m. on “ESOP Committee Roles: Are WE responsible for that?”

As a special sponsor benefit, we are happy to be able to offer our clients and contacts the following discount codes for registration.  Simply enter the following discount codes on the registration page, when asked and you will receive $35 discount per attendee for the main conference, and a $20 discount per attendee for any preconference session.

Main Conference: Save35

Any of 3 preconference sessions: Save20

For more information and to register, go to / or call the NCEO at 510-208-1300. We urge interested companies to register soon, as this conference often sells out in advance!

Highlights of the conference include:

  • Morning Keynote Address on Wednesday, April 22, Mary W. Tilley from W.L. Gore & Associates speaks about Cultural Practices That Drive Business Results: What Ownership Inspires
  • Over 90 sessions in five learning tracks: employee stock ownership plan (ESOP) basics, ESOPs beyond the basics, compensation and benefits, communications and culture, and leadership and governance.
  • On the afternoon of Monday, April 20, three half day preconference sessions, Compensation Issues for Privately Held Companies, Building a Culture of Ownership in an Employee-Owned Company and Corporate Governance at ESOP Companies.
  • The Tuesday April 21 Welcome Luncheon and Opening General Session with the address, the State of Employee Ownership, by executive director Loren Rodgers.
  • Numerous opportunities to network, to discuss, participate, learn, and share
  • Exhibit hall with a wide representation of firms doing business in the employee ownership and equity compensation field

What Past Participants Say About This Conference:

“Networking opportunities were fantastic, especially the industry roundtables. And the energy of the group was palpable, positive, and infectious.”

“I was a first-time attendee to this conference and loved it. I hope to talk my company into sending me to this every year, no matter where it is located”

“For me, this was the most useful conference ever since I was able to find a breakout in each time slot that dealing with matters I face each business day.”

“I was amazed at how well run, informative, and professional this conference was. The quality of most of the speakers was so high that the whole event just flew by.”

The NCEO ( is a nonprofit research and education organization established in 1981. It is widely recognized as the main source for accurate, unbiased information on ESOPs, other forms of equity compensation, and ownership culture. Learn more about employee ownership from the NCEO ( or our informational Web site


ESOPs Take the Oxymoron Out of Inclusive Capitalism

ESOPs Take the Oxymoron Out of “Inclusive Capitalism”


In a January 20, 2015, op-Ed piece in the New York Times, “Can Capitalists Save Capitalism”, Thomas Edsall reports that key Democrats have reached agreement on a set of policies known as “inclusive capitalism” that would reduce wealth and income inequality.  According to Edsall the inclusive capitalism concept has expanded worldwide over the past 13 years to apply to those at the bottom and the middle of the ladder in developed nations, including the United States. Edsall reports that Republican leaders in Congress have already “stiff-armed” these proposals.


On May 27, 2014, more than 220 leaders met for the “Conference of Inclusive Capitalism” in London to discuss the future of capitalism and “how we can act to make our economic system more equitable, more sustainable and more inclusive.” Carol Hanish, writing in CounterPunch, a magazine that touts itself as “America’s Best Political Newsletter”, dismisses “inclusive capitalism” as an oxymoron and posits that in economics our thoughts and actions must be constrained within a discussion of “capitalism” versus “communism”.


Is there a way to bring these shrill views together?  Is there a vehicle to help mitigate the media-fanned tension between the evil, exploitive others and the virtuous rest of us?


There is such a vehicle in the United States, and it is already a vibrant part of federal law.  It has continuing broad-based, bi-partisan support.  It helps business owners, and it rewards employees by turning them into capitalists. It distributes capitalism into smaller employee teams who can compete effectively in the global marketplace.  It supports the fundamental American idea that reward follows hard work and strategic collaboration.


The vehicle is the Employee Stock Ownership Plan (the ”ESOP”).  It is a special kind of qualified retirement plan that can borrow money to buy businesses from owners who wish to sell. The ESOP buys the seller’s business for the benefit of all the employees of the business.  These employees in turn reap the rewards of their success (and, much less often, suffer from their failures), as did the prior owner.  In most cases, other common retirement plans, like 401(k) plans, continue to exist in the employee owned business along side the ESOP so that the risk to employees of business failure is minimized.


ESOPs have been around for many years.  Since 1974 they have been defined and regulated by the Internal Revenue Service and by the US Department of Labor for the protection of the employee owners.  They offer tax benefits to selling owners as well as tax benefits to employee owners. Because ESOPs benefit both owners and ordinary employees, both US political parties have consistently supported them.


Over 50% of the US workforce works for small businesses with fewer than 500 employees.  About 15 million of these employees already work for the approximately 9000 companies that have ESOPs or ESOP-like profit sharing plans.  Employees of ESOP companies regularly accumulate and ultimately receive substantial cash benefits from their ownership in ESOP companies.


In the United States, it is not necessary to create dozens of new, convoluted tax and fiscal policies to produce inclusive capitalism.  It is not necessary to create more bureaucratic structures to deliver fiscal benefits or to administer new taxes.  It is not necessary to increase the level of sharp partisan disagreement about policy.  All we need to do is increase the use of a well-defined tool that we have had in place for over 40 years.


ESOPs are the ideal synthesis between traditional capitalism and inclusive capitalism.  They represent capitalism.  They do not represent communism or socialism. They encourage employee owners to pool their front line knowledge competitively in the global economy.  They spread the wealth among those who compete successfully, and they have the potential to reinvigorate global American business with a tool already at hand.