Incentivizing the Next Generation of Leadership with an ESOP

June 2020

Using an Employee Stock Ownership Plan (ESOP), businesses can incentivize the next generation of leaders and align the interests of these leaders with the interests of the company and exiting shareholders.

 
In addition to its well-known structural benefits, an ESOP can be an extremely attractive incentive plan for business owners who have a pool of strong managers willing to lead the company moving forward. Often, a sale to an ESOP can be more rewarding to the next generation of leadership than a sale to an outside party. Through an ESOP, the next generation of leaders can drive growth of the business while reaping the economic benefits of that growth through a management incentive plan (“MIP”), warrants, and ESOP share allocations.
 

Structuring an ESOP with a Management Incentive Plan

Many ESOPs are structured to include a separate MIP that is tied to share price to motivate and reward key employees. These MIPs are non-qualified plans that are over-and-above the annual ESOP share allocations provided to employees, offering key members of the leadership team further incentives to increase employee owner value via phantom stock or stock appreciation rights. The MIP can mirror existing bonus plans in terms of payout and possible performance metrics (though it does not need to replace bonus plans), but its value is tied directly to the value of the company, therefore aligning the interests of the leadership team with those of the company and employees. MIP units may include retention or performance vesting. Retention shares vest over the period of time that an employee remains employed by the company; the vesting of performance shares is typically tied to performance metrics, such as EBITDA, revenue or perhaps sales by department over a period of time. MIP pools can be intentionally designed to include a mixture of both retention and performance shares. While the structure and possible allocation of the MIP is negotiated with the trustee as part of the sale transaction, the compensation committee or other governing body has discretion and flexibility in the granting of MIP units, and those employees receiving MIP grants can change each year. Trustees are typically in favor of MIPs because it incentivizes the future leadership to continue to pursue growth strategies for the company, thereby aligning the interest of both parties. 
 

Detachable Warrants in ESOP Design

Another incentive for future leadership can be achieved through the use of warrants. Warrants are often included as part of the overall return of proceeds to selling shareholders participating in the resulting capital structure of the company through a subordinated seller note and, like the MIP, the value is tied to company share price. Former owners can elect to take detachable warrants as part of their overall junior subordinated note package in exchange for a lower cash pay interest rate. Warrants are often referred to as a “second bite of the apple,” and any increase in their value is taxed at capital gains rates upon exercise (whereas interest income from a seller note is taxed at ordinary income rates). Younger sellers to an ESOP are often more attracted to the structure of a warrant than to high interest rates as they move into more significant leadership roles, because the value of the warrant increases as the value of the company increases (with no upper limit), whereas interest payments are fixed. Furthermore, warrants can be transferred tax-efficiently from exiting owners to younger leadership to further incentivize growth of the company. ESOP trustees often agree to some level of warrants as part of the overall negotiation of sale structure, as it lowers the interest payment burden on the company in early years.
 

ESOP Share Allocations

Perhaps the most obvious benefit of an ESOP to the future leaders of the business is annual ESOP share allocations. While plan design is determined with input from the company and trustee and is relatively flexible (within the Employee Retirement Income Security Act and Department of Labor guidelines), most plans’ share allocation formulas are tied to compensation. In other words, employees receive a percentage of the annually allocated shares equal to the percentage of their compensation compared to total eligible compensation recorded by the company. Future leaders are usually among the highest-paid individuals in the company, so they should receive a higher percentage of the annual shares. Another option in the design of the ESOP plan would involve the inclusion of employee tenure in the share allocation formula, so that employees who have been with the company longer receive a higher percentage of the annual ESOP shares. Both options can be advantageous for management team members who will be leading the business going forward, as the value of their shares will grow when the value of the company grows.

The flexibility of an ESOP sale structure provides for the delivery of additional incentives to those who will lead the company post-transaction. Beyond the ownership stake provided to these key individuals by the ESOP, the creative use of incentive plans and warrants can further serve to align the interests of the exiting ownership group, the trustee, the employees, and the key leadership tasked with managing the business to a successful future. 
 

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