There are a variety of ownership models that may be put in place by architecture and engineering firms. For instance, the firm may be structured as an S Corporation. Alternatively, it may be owned by a single individual, by a group of senior managers or by an employee stock ownership plan (“ESOP”). If the company is ESOP-owned, preserving the ESOP while at the same time maintaining the health of the business may become challenging. However, a sustainability study reviews different scenarios that will allow the company to see how it can achieve its goals and still provide ESOP benefits on an ongoing basis without being forced to sell the business or terminate the ESOP.
Every company and every ESOP is unique. Therefore, there is no one-size-fits-all approach to sustainability. In our experience, we have found that there are several interrelated variables that an ESOP company can work on to position both the firm and the ESOP to achieve long-term success.
For instance, when the ESOP is initially established, a plan document is drafted. Among other things, it outlines the administrative policies and procedures related to the ESOP. One of these policies addresses repurchase obligation, which is the responsibility of the company—not the ESOP Trustee—to fund any departing participant’s stock repurchase at its current fair market value. The participant may be leaving the company for a variety of reasons—retirement, termination, disability or death.
To build a sustainable ESOP, the planning process must be more comprehensive than simply putting together a forecast of the number of shares of stock that will become eligible for repurchase each year. For example, another variable central to sustainability is the interrelationship between repurchase obligation and the company’s share price trajectory. As part of this analysis, there are multiple considerations that will need to be reviewed with regard to the repurchase of ESOP shares. Not only does a company need to make decisions about the timing of distributions to participants and whether or not they will be paid in a lump sum or in installments, but the repurchase method (redeem, recycle, rebalance, reshuffle or re-leverage) for future redemptions also needs to be established. Additionally, a determination will need to be made as to what the company is worth currently as well as what it will be worth in the future, taking into account whether there is a way to optimize the trajectory of value while simultaneously maintaining balance between the company’s corporate objectives and repurchase obligation.
Another way to boost the value trajectory—and manage the sustainability of both the company and the ESOP—is to manage to a certain benefit level. The benefit level—which is typically communicated as a percentage of qualified payroll—is the rate at which contributions are made by the company to employee retirement plans. These contributions can take a variety of forms such as safe-harbor contributions made to a 401(k), ESOP loan amortization payments or contributions directly to the ESOP. Benefit levels are set by the Board. One advantage of managing to the benefit level is that it may help improve communications with ESOP participants as it can set their expectations around what type of benefit the ESOP is expected to deliver. We have found, however, that many firms are inadvertently providing a much higher benefit level than they realize as a result of their ESOP policies and/or the way they fund their repurchase obligation. Not only can a sustainability study help find these types of issues, but it also can run numerous scenario tests that utilize different ESOP policies in order to determine which policies work best.
A sustainability study will also review the company’s future cash flow requirements. The company must be able to fund repurchase obligation, as well as investments and future growth, from its cash flow. The company should approach these and other capital allocation decisions from a very holistic standpoint so that the company is also able to allow for downturns in the business. In terms of the ESOP, a sustainability study examines whether the benefits are being concentrated with certain individuals or whether they are more broad-based. It is important to verify that there are no “have/have not” issues; typically, regular contributions result in a broad allocation of stock, whereas S corporations earning distributions and dividends concentrate the benefit allocated to participants who hold more stock (which can compound over time, resulting in a “have/have not” dilemma).
Management succession is another important aspect of the sustainability of ESOP companies. Part of ensuring the continuing prosperity of any company is putting a clear management succession plan in place. This is especially important in an ESOP company, as ESOPs have particular requirements that need to be well understood by the company’s management team. It is prudent, then, to develop a strategy for identifying and grooming future management candidates so that leadership transitions are smooth, not disruptive. If no internal candidates exist, it may be necessary to look outside for successor management, which may pose additional challenges. In such a case, it will be especially important to provide the new member of the management team with training so that they have a clear understanding of ESOPs. Otherwise, if there is a significant change, the ESOP may not continue to succeed.
Much of the work that we have been doing with employee-owned architecture and engineering firms focuses on the long-term sustainability of those businesses and the interrelatedness of the factors outlined in this article. Given that each of these choices impacts the others, it is critical to balance each of these elements collectively rather than treat them as independent decisions.
In closing, it is important to remember that sustainability is not stagnant. Therefore, if your company does a sustainability study this year, that does not mean your obligations regarding sustainability are complete. Instead, reviewing the concept of sustainability is something an ESOP company must do consistently as the competitive landscape changes. The various dynamics that impact a company—for example, the census of the employees, the company’s capital needs and even the company’s repurchase obligation—can change and evolve, so it is important for company management and the ESOP trustee to think about sustainability every two to three years, at a minimum, in order to perpetuate the ESOP and preserve the business’s well-being. That will provide an opportunity to develop and refine a sustainability strategy on an ongoing basis.
Henry Ventura is a Director at Prairie Capital Advisors, Inc. He can be contacted at 404.809.2444 or by email: hventura@prairiecap.com
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