One of the management team members let out a gasp. Two others shook their heads in disbelief and angst. The senior leader on their team had just informed them that the company they had been strategically targeting over the last several months was employee-owned, or at least partially employee-owned, through an Employee Stock Ownership Plan (ESOP).
Several people on the team had heard stories of the ESOP at Enron, as well as ESOPs that have been the subject of contentious government investigations. But, the real cause for their concern was fear of the unknown: how to proceed with the acquisition, what will involvement by the ESOP look like, and what are the real concerns and how should they be addressed.
The purpose of this column is to address some of the key considerations and important steps in purchasing a company that is owned, at least partially, by an ESOP. Before addressing the above questions, however, it is important to point out that ESOPs have been, and in many cases continue to be, successful retirement savings vehicles for employees, a near unparalleled way to give employees a direct stake in the financial future of their companies, and an efficient mechanism for legacy owners to exit the business.
For every negative story that those management team members had heard about ESOPs, there are a dozen success stories that they hadn’t heard. That being said, any company purchasing an entity with an ESOP should proceed with caution and consider the following:
1. The nature of an ESOP
First, it is important to remember what makes an ESOP unique. An ESOP, unlike all other types of defined contribution plans, is designed to invest primarily in securities of the sponsoring company. Instead of participants having retirement accounts invested in a variety of marketable securities and mutual funds, ESOP participants have accounts invested primarily in their employer’s stock.
For a company that is owned, in part, by an ESOP, the trustee of the ESOP is essentially a shareholder of the company, entitled to participate in the sale or transaction just as other shareholders would. The trustee represents ESOP participants as the beneficial owners of the company stock.
Second, while there are many legal requirements unique to ESOPs, perhaps the most important rule is that anytime the ESOP is involved in the purchase or sale of company stock, the purchase or sale must be for “adequate consideration,” and the trustee’s decision to buy or sell must be in the best interest of the ESOP participants from a financial point of view.
As discussed below, this point is critical when discussing the involvement of an independent trustee or during any review by the U.S. Department of Labor (DOL).
2. Stock or asset purchase
The form of the transaction, whether a stock or asset purchase, is the first issue to consider in determining the ESOP’s involvement in the impending transaction, as well as what type of liability the buyer may be assuming relative to the ESOP.
If the transaction is structured as an asset purchase and such purchase involves substantially all of the company’s assets, then the selling company’s ESOP is required by applicable provisions of the Internal Revenue Code to pass-through the voting rights on the transaction to the individual participants in the ESOP.
If voting rights are passed through, then the fate of the transaction may lie with how participants decide to vote (depending upon the number of shares owned by the ESOP). Therefore, communication to ESOP participants is key.
Regarding liability, although the buyer in an asset deal typically does not have successor liability related to the seller’s ESOP, it is in the best interest of the buyer to ensure that all applicable rules related to the ESOP’s involvement in the deal are followed.
The reasons are that the buyer may be taking on some or all of seller’s employees and therefore has an interest in ensuring these employees were treated fairly in the deal; and, if the transaction is ever scrutinized by the DOL, the buyer will likely be involved in any investigation.
If the transaction is structured as a stock sale and seller is a private company, then (unless the ESOP document provides otherwise) the ESOP trustee (not the participants) retains the voting rights and will decide whether the ESOP votes for or against the proposal.
In terms of liability, the buyer will likely have some exposure related to the ESOP in the case of a stock sale, irrespective of whether the ESOP is terminated concurrently with the closing or whether it continues to exist post-close for a period of time. Often times, the selling company has agreed to indemnify ESOP fiduciaries for any liability they may incur related to the ESOP, and that indemnification obligation flows to the buyer in a stock deal.
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