ESOPs are one of America’s best-kept secrets. Despite their tax advantages, despite their record of outperformance, despite the network of specialists, advocacy groups, and trade associations that promote them, despite periodic (and almost always favorable) articles in the press about ESOP companies, the number of ESOPs has plateaued in recent years. Why so?
Most ESOPs today are created when a company owner decides to sell the business, or in anticipation of that time. But plenty of company owners don’t want to sell to an ESOP. Some can’t get their mind around the idea, or have heard that ESOPs “don’t work.” Some want to pass the business on to their children, or else sell to a group of managers. Many business advisors–lawyers, accountants, and the like–remain poorly informed about ESOPs, so they recommend these more conventional options.
Advisors may also encourage owners to seek out a so-called strategic buyer, typically a large company in the same industry that can capitalize on the acquired company’s capabilities or customers, in hopes of realizing a higher price. The tax advantages of selling to an ESOP aren’t negligible—an owner selling at least 30% of the business to an ESOP can defer capital-gains levies—but the ESOP must pay a price determined by a third-party appraiser. (The Department of Labor watches pretty carefully to be sure that price it isn’t inflated.) In a few cases, the strategic buyer’s price is more than enough to make up for the tax differential.
All that said, of course, the potential for creating ESOPs by this route has hardly been exhausted. Advocates continue to educate business advisors about the benefits of sale to an ESOP. They point to the “silver tsunami” of baby-boom company owners who are soon to retire, some of whom presumably will be interested in such a sale. On that front, time will tell.
But ESOPs also suffer from an incentive problem. Individual owners do have an incentive to consider an ESOP because of the tax advantages, and because it may offer the best chance for the company they have built to survive intact, perhaps with the founder’s name on the door. But think of all the other sellers of businesses. Large corporations divest themselves of thousands of smaller companies every year, typically selling them to strategic buyers, management groups, or private equity firms. Private equity firms themselves do the same, selling their portfolio companies or taking them public. These sellers may ensure that the buyer’s management team—the people at the top—own shares, because such an arrangement is thought to produce better corporate performance. But none has an incentive to consider an ESOP, and virtually none does.
The situation is similar with publicly traded companies. Any company’s management is free to set up an ESOP as a retirement plan if it so chooses. An estimated 700 public companies have done so, for a variety of historical reasons. But what’s the incentive for a company to set one up today? If it assigns new shares to the ESOP, it dilutes existing stockholders. If the ESOP borrows money to buy shares, the company must divert some of its revenue to repay the loan. To be sure, the ESOP might contribute to greater commitment and loyalty on the part of employees, and thus to better business performance. But conventional bonus or profit sharing plans might have the same effect, and would be a good deal easier to establish. Spreading the ownership of capital is not high on most corporate executives’ agendas.
Perhaps the incentive problem can be addressed through tax law. We hope to report on some relevant proposals in the near future.