The Advantages and Disadvantages of ESOP's: A Long-Range Analysis (1991)

THE ADVANTAGES AND DISADVANTAGES OF ESOP'S: A LONG-RANGE ANALYSIS An ESOP, or Employee Stock Ownership Plan, is a qualified retirement plan which can be used to provide employee stock ownership and, at same time, advance a number of other objectives. While this article gives a thorough review of financial advantages of ESOP's, it also explores their disadvantages. Because advantages of ESOP's are so immediately obvious, it is important that management also be conversant with their hidden problems. It is reasonable to think that virtually every business in U.S. is a potential candidate for an ESOP structuring. ESOP's currently cover over 10 million workers, and participants range from small, privately held companies to Fortune 500 firms such as Polaroid and J. C. Penny. The basic idea behind any ESOP is that common stock (or convertible preferred stock) is distributed to accounts of employees and eventually passed on to them at retirement or departure from firm (assuming vesting has taken place). ESOP's represent ultimate approach to corporate democracy. Lewis Kelso, founder of modern ESOP, was quoted in August 1987 issue of Institutional Investor as saying, the ESOP is treated as simply an employee benefit, but is really a device to save human race (Rosenberg 1987). While these words are somewhat strong, they represent sentiments of some of truly fervent devotees to this movement (Mathews 1989). STRUCTURE OF ESOP'S ESOP's may be either unleveraged or leveraged in nature. With an unleveraged ESOP, firm merely makes periodic contributions of employer stock to ESOP or contributes cash which, in turn, is used to purchase stock. The contributions are tax deductible, and stock eventually passes on to employees. The real tax benefits flow to second form, leveraged ESOP. The initial step is once again to set up an ESOP (appropriately administered by a qualified trustee). However, with a leveraged ESOP, stock is not directly contributed to ESOP. The shares are acquired by ESOP's borrowing necessary funds from a financial institution to purchase stock from sponsoring company or from key stockholders of company. To ensure availability of lendable funds to ESOP, sponsoring company normally guarantees loan from financial institution and, furthermore, makes tax deductible contributions to ESOP to ensure that funds are available for orderly amortization of principal and payment of interest. The ESOP, upon receiving these funds, uses them to repay financial institution. The shares acquired by ESOP are, in turn, assigned to employee accounts and distributed to employees at an appropriate future time. Most of comments on ESOP's in this article will be directed to leveraged ESOP's because that is where primary tax and other financial advantages lie. Leveraged ESOP's allow sponsoring company to acquire cash for its shares, which can be used for capital investment or other corporate purposes. However, leveraged ESOP may also acquire shares from retiring owners of business in order to facilitate estate planning and to ensure continuity of business. In either case, borrowed funds are utilized and repaid with pretax dollars. Further, as pointed out in popular press, ESOP's also have been used as defensive measures against unwanted corporate takeovers, to facilitate financing of LBOs and divestitures, and as part of corporate rescue operations (Burr 1989). In next section, tax advantages of ESOP's are highlighted. Since most of these advantages are on front-end, we will then take a hard look at caveats and potential drawbacks that can come later. TAX RELATED BENEFITS The tax benefits associated with ESOP's may be broken down into three separate categories: those accruing to corporate sponsor, those provided to original selling stockholders, and finally those available to employee participants. …