Expertise Beyond the Numbers

How to Give Your Business an ESOP Check-Up

Your financial statement audit has been completed. Tax season is over. You have been able to leave the office at a decent time, maybe even enjoyed a vacation or two (we hope). Business is typically slower in the summer, so before jumping into full swing this fall, now is a great time to check in on the health of your ESOP.

Plan sponsors and fiduciaries have an obligation to continually monitor ESOP operations to make sure the plan is being operated for the exclusive benefit of the plan participants and meeting all regulations and corporate strategic objectives. There is no better time than the present to check up on your ESOP to confirm that the plan document is in compliance with ERISA, ensure that the Board and plan fiduciaries have reviewed and understand the annual ESOP valuation, confirm that the plan sponsor has completed all ESOP administration tasks as required by ERISA, and review longer term implications of the plan sponsor’s repurchase obligation. Use your remaining summer months to tackle some of these ESOP related items (that may have crept lower on your to-do list) before your plate gets filled up again this fall.

Have you addressed all ESOP transaction elements?
As an ESOP appraiser, we often speak with clients who have completed an ESOP transaction months or even years ago and still have not addressed all of the ESOP transaction elements.

  • Management Incentive Plans: Many ESOP transactions provide for the ability for the Board of Directors to issue retention stock appreciation rights (SARs) or performance SARs. These are great benefits that key members of the management team can receive as incentives for strong performance. If a SAR plan has already been approved, be sure to check that the Board of Directors has implemented the plan. It is a good idea to start a tracking sheet that includes the SAR recipient, number of SARs, date issued, strike price, and vesting information for administrative and annual ESOP valuation purposes.
  • Earn-Outs and Performance Bonuses: Be sure you understand how earn-outs and bonuses are achieved based on the purchase agreement and/or the relevant employment contracts. It would be helpful to create a sample calculation that can be easily updated with the company’s actual financial results after each performance period to ensure timely and accurate payments.

Actual vs. Projection Comparison
Most plan sponsors will be asked by their appraiser to prepare financial projections for purposes of the annual ESOP valuation. An ESOP appraiser should compare your company’s actual performance to what was projected by management for the year to understand 1) how the company performed against the budget, 2) understand the reasons for deviation of performance against the budget, and 3) assess management’s track record of providing reliable projections. Projections should be as realistic as possible – not overly conservative or aggressive. The best projections are based on the firm’s backlog and sales reports and also include detailed expense projections. Take advantage of staff who have some down time to create a projection template that can be used each year.

Repurchase Obligation
Companies with mature ESOPs should periodically revisit their repurchase obligation strategy/cash requirements to remain sustainable. Required distributions to participants begin to grow as the ESOP ages – whether by result of terminations or diversification requirements. Take time to analyze the cash needs of the ESOP. A repurchase liability study may need to be completed or updated. These studies can be performed by a specialized ESOP repurchase consultant or your third party administrator (TPA). Alternatively, you can purchase modeling software and complete the analysis in-house.

Employee Communication
An ESOP is a great retirement benefit that can be an employee recruiting and retention tool if effectively communicated to employees. Within the same firm, some employees may have a detailed understanding of employee efforts can directly correlate to improved financial performance and increasing stock values, while other employees have no idea what ESOP even stands for. Are the benefits of the ESOP really being maximized if some employees still don’t get it? Regardless if your firm wants to fully embrace an employee-owned culture, it is important that your team is educated on ESOPs in general, as well as the specific features of your company’s plan.

All companies are required to distribute three ESOP communication documents to plan participants: Summary Plan Description, Annual benefit statement, and Summary Annual Report. Take time to meet with your Board of Directors, Human Resources team, and/or ESOP committee to determine if the required documents are enough to effectively communicate employee ownership and serve as an incentive for enhanced performance. Consider hiring an outside consultant to assist with employee meetings or ask your ESOP trustee to assist you with developing an effective ESOP communication program.

Rather than forget about the ESOP until it is time for your annual ESOP update, take advantage of these last few weeks of summer to check up on your plan. You’ll be happy you did!

As you are reviewing your ESOP checklist, if you have any questions contact Greg Hogan, Director, SC&H Capital to guide you through the process.