Ask the ESOP Experts: Installing an ESOP

What are the typical processes of installing an ESOP?

Apologies granted – but it depends.  Using Mercer Capital’s own ESOP installation and process as a rough guide, let’s define who the players typically are.  The extent of the process and who is employed in that process depends on a number of assessments that ESOP sponsors and their initial advisor must decide.  In some cases, many of the necessities of financing and plan design can be handled by an experienced attorney.  Other functions may be best left in the hands of a focused specialist.  Ultimately, valuation services are a core element in the ESOP process with the results of the valuation are determinative of the transaction size and the financing requirements.  The typical professionals employed are:

• Legal – compliance and advisory services to formulate the ESOP process and attend to the required details; in some instances there may be multiple attorneys involved as each stakeholder may require or desire counsel (i.e. sellers, ESOP trustees, corporate);
• Appraisal – financial valuation and opinion services (initial valuation feasibility, transaction fairness, annual plan year valuations);
• Plan Design and Administration – assists in plan design and documentation, communication with employees, and annual plan administration;
• ESOP Trustee – as with other qualified retirement plans, ESOPs require a trustee whose fiduciary responsibility extends to the plan participants.  This trustee can be an independent trustee or an appointed internal trustee.  In many cases, the consummation of an ESOP transaction is overseen by an independent trustee while recurring plan administration duties are overseen by an internal trustee.  The degree to which an ESOP sponsor seeks to promote an independent and arm’s length process is often a contributing factor as to whether an independent trustee is used. 

By way of example, Mercer Capital installed its ESOP on January 1, 2006.  In that transaction, shareholders of the firm sold a portion of their stock to a newly formed ESOP in a leveraged transaction.  The firm borrowed money and then loaned those funds to the plan which, in turn, used the funds to purchase the stock.  Despite our collective professional familiarity with ESOPs, we retained an outside facilitator to assist in plan design and an independent trustee to oversee the process.  An independent appraiser was retained by the outside trustee to develop a valuation for the transaction and a fairness opinion was issued to document all aspects of the process and the valuation.  All parties had legal advisors.  Administration for the ESOP is handled by the same vendor overseeing the other retirement plans of the firm.  For purposes of recurring plan needs and supervision, two internal co-trustees (neither of whom were shareholders prior to the ESOP) were appointed.  While many ESOP formations may not mirror this transaction, each component is required in some form or another for a successful process.

The main theme for prospective ESOP companies and stakeholders is that an ESOP is not an event, it is an ongoing process. Companies with newly installed plans have the task of settling the acquisition debt while maturing plans have requirements to satisfy the needs of retiring or terminating employees.  ESOP feasibility assessment is perhaps the most critical phase of contemplating an ESOP.  A lack of investment in time and outside expertise can create unrealistic expectations and confusion among shareholders, directors, and management. 

Reprinted from Mercer Capital's Value Added (TM), Vol. 21, No. 1, 2009.