ESOP’s Venture Planning Week 10 Dowling Fall 2005

ESOP? ESOP - Employee Share Ownership Program ESOP - Employee Share Ownership Program Legally, it is set up as an employee trust established to hold shares in a company’s common stock on behalf of the employees. Legally, it is set up as an employee trust established to hold shares in a company’s common stock on behalf of the employees. Conceived in the 1950’s by Louis Kelso, a lawyer & investment banker in San Francisco Conceived in the 1950’s by Louis Kelso, a lawyer & investment banker in San Francisco

What is an ESOP? An ESOP is a retirement plan set up by a company for the benefit of its employees An ESOP is a retirement plan set up by a company for the benefit of its employees Similar to a 401K Similar to a 401K Instead of receiving cash in their retirement accounts each year, employees earn shares of the company’s common stock Instead of receiving cash in their retirement accounts each year, employees earn shares of the company’s common stock Over time, this stock vests and shares become attributed to individual employee retirement accounts Over time, this stock vests and shares become attributed to individual employee retirement accounts

ESOPs - A Brief History Kelso’s book The Capitalist Manifesto published in 1958 described the growing “income gap” between common laborers and the wealthy elite. Kelso’s book The Capitalist Manifesto published in 1958 described the growing “income gap” between common laborers and the wealthy elite. Kelso: ‘the impact of industrialization was marginalizing the importance of labor’ Kelso: ‘the impact of industrialization was marginalizing the importance of labor’ Kelso: ‘ employee ownership of companies would not only lead to a more equitable distribution of wealth but a more efficient economy’ Kelso: ‘ employee ownership of companies would not only lead to a more equitable distribution of wealth but a more efficient economy’

ESOPs - A Brief History The theory held that employees, now owners, would be motivated to work harder and implement operational improvements that would lead to higher productivity. The theory held that employees, now owners, would be motivated to work harder and implement operational improvements that would lead to higher productivity. Kelso sought federal tax legislation to encourage employee ownership in US corporations. ESOPs would get special tax treatment. Kelso sought federal tax legislation to encourage employee ownership in US corporations. ESOPs would get special tax treatment.

New Tax Law Initial tax law creating favorable tax treatment for ESOPs was passed on January 2, 1974 Initial tax law creating favorable tax treatment for ESOPs was passed on January 2, 1974 Amended several times in the 1970’s and 1980’s Amended several times in the 1970’s and 1980’s

ESOP Tax Incentives Deduction of ordinary pension contributions to an employee trust rather than a pension plan Deduction of ordinary pension contributions to an employee trust rather than a pension plan Interest deduction for bank loans that financed ESOPs Interest deduction for bank loans that financed ESOPs 50% tax reduction to commercial lenders on interest paid on loans to finance ESOPs 50% tax reduction to commercial lenders on interest paid on loans to finance ESOPs By selling the company to the employees, owners earned a deferral of capital gains (1984 tax law change) By selling the company to the employees, owners earned a deferral of capital gains (1984 tax law change)

ESOP Use In the 1970’s, 1980’s, and 1990’s ESOPs were used for 3 main purposes: In the 1970’s, 1980’s, and 1990’s ESOPs were used for 3 main purposes: To save struggling companies in unionized industries (Weirton Steel, TWA, United Airlines) To save struggling companies in unionized industries (Weirton Steel, TWA, United Airlines) As a defense against takeovers (not the intent of the original ESOP legislation) As a defense against takeovers (not the intent of the original ESOP legislation) And as a means of financing buyout transactions and a means of exiting private equity investments (think angels and VC’s here) And as a means of financing buyout transactions and a means of exiting private equity investments (think angels and VC’s here)

Harvest Strategies via ESOPs A private equity sale to an ESOP has significant tax advantages including the ability to defer capital gains taxes if reinvested in “approved securities”. A private equity sale to an ESOP has significant tax advantages including the ability to defer capital gains taxes if reinvested in “approved securities”. ‘Private Equity’ does qualify as an approved security (think VC’s here). ‘Private Equity’ does qualify as an approved security (think VC’s here). An ESOP valuation can often exceed that of other potential offers. An ESOP valuation can often exceed that of other potential offers.

Harvest Strategies via ESOPs ESOPs can provide a means of achieving liquidity in an investment for which there is no logical strategic/financial buyer and for which the public markets have limited interest. ESOPs can provide a means of achieving liquidity in an investment for which there is no logical strategic/financial buyer and for which the public markets have limited interest.

Harvest Strategies via ESOPs Downsides to an ESOP transaction are the costs of setting up & administering the trust, time delays, and ERISA law administered by the US Dept. of Labor. Downsides to an ESOP transaction are the costs of setting up & administering the trust, time delays, and ERISA law administered by the US Dept. of Labor. ERISA law: There are extreme conflict of interest issues related to management’s position as both a seller and a fiduciary of the buyer, the ESOP. There is no negotiation between management and the ESOP. A sale to an ESOP must meet the “prudence” test relative to the price paid by the ESOP and the level of debt incurred, a higher legal standard than “good faith”. ERISA law: There are extreme conflict of interest issues related to management’s position as both a seller and a fiduciary of the buyer, the ESOP. There is no negotiation between management and the ESOP. A sale to an ESOP must meet the “prudence” test relative to the price paid by the ESOP and the level of debt incurred, a higher legal standard than “good faith”.

Recent Decline in Use Since late 1980’s declining use of ESOPs: Since late 1980’s declining use of ESOPs: The Labor Dept. has become much more critical of ESOP-financed LBO’s The Labor Dept. has become much more critical of ESOP-financed LBO’s In 1996, bank interest on loans to ESOPs became fully taxable due to use of ESOPs as ‘poison pills’ -- nicknamed “MESOPs” -- short for “management entrenchment stock ownership plans”. In 1996, bank interest on loans to ESOPs became fully taxable due to use of ESOPs as ‘poison pills’ -- nicknamed “MESOPs” -- short for “management entrenchment stock ownership plans”.

Recent Decline in Use Since late 1980’s declining use of ESOPs: Since late 1980’s declining use of ESOPs: Questionable benefits re: worker incentives: GAO 1987 exhaustive study found no correlation between productivity/profitability and employee ownership. Only in situations where workers were given ownership in combination with increased participation in decision-making was there a significant difference in performance between ESOP and non-ESOP companies. Questionable benefits re: worker incentives: GAO 1987 exhaustive study found no correlation between productivity/profitability and employee ownership. Only in situations where workers were given ownership in combination with increased participation in decision-making was there a significant difference in performance between ESOP and non-ESOP companies.

Recent Decline in Use Since late 1980’s declining use of ESOPs: Since late 1980’s declining use of ESOPs: Skeptical Employees: unions and workers became more skeptical as large, high-profile ESOPs such as United Airlines have resulted in worse, not better, labor-management relations. Skeptical Employees: unions and workers became more skeptical as large, high-profile ESOPs such as United Airlines have resulted in worse, not better, labor-management relations.

Recent Decline in Use Since late 1980’s declining use of ESOPs: Since late 1980’s declining use of ESOPs: Enron Impact: Enron had both an ESOP and a 401K plan - commonly called a KSOP. ESOP was the “ownership” plan; the 401K was the “retirement” plan. Employee contributions to the 401K are matched by company stock from the ESOP. All stock in both plans are usually company shares, therefore little diversification. Enron Impact: Enron had both an ESOP and a 401K plan - commonly called a KSOP. ESOP was the “ownership” plan; the 401K was the “retirement” plan. Employee contributions to the 401K are matched by company stock from the ESOP. All stock in both plans are usually company shares, therefore little diversification.

Recent Decline in Use Since late 1980’s declining use of ESOPs: Since late 1980’s declining use of ESOPs: Enron Impact: New laws allowing/requiring pensions, 401K plans, and ESOPs to diversify the portfolio will be the end of widespread ESOP use in large and small firms. The firm would have to repurchase potentially illiquid company shares so that employees could diversify. Companies would need to borrow funds to do this thereby creating a host of potential financial and operating problems. Enron Impact: New laws allowing/requiring pensions, 401K plans, and ESOPs to diversify the portfolio will be the end of widespread ESOP use in large and small firms. The firm would have to repurchase potentially illiquid company shares so that employees could diversify. Companies would need to borrow funds to do this thereby creating a host of potential financial and operating problems.