Improving Shareholder Liquidity, Employee Performance through ESOPs

Written by


ESOP-6-18-19.pngMost banks face challenges to find, incentivize and retain their best employees in an increasing competitive market for talent. Often, smaller banks and banks structured as Subchapter S corporations have the added challenge of providing liquidity for their shareholders and founders. An employee stock ownership plan can be an excellent tool for addressing those issues.

An ESOP creates a buyer for the bank’s stock, generating liquidity for shareholders of private or thinly traded banks and providing market support for publicly traded ones. An ESOP’s buying activity can reduce shares outstanding and increase a bank’s earnings per share. It can also increase employee benefits and gives them a sense of ownership that can improve recruitment, retention and performance.

ESOPs are tax-qualified defined contribution retirement plans for employees that primarily invest in employer securities. ESOPs offer accounts to employees, similar to 401(k) retirement plans. But unlike a 401(k), employees do not contribute anything to the plan; instead, the bank makes the contribution on their behalf.

ESOPs are an excellent employee benefit and a recruitment, retention and performance tool. ESOPs do not pay taxes on an annual basis, so taxes are deferred while the stock remains in a plan. When the employee retires or takes a distribution from the plan, the value of the distribution is taxed as ordinary income. Employees also have the ability to roll over the distribution to an individual retirement account.

Employees at companies that offer an ESOP have, on average, 2.6 times more in retirement assets than employees working at companies that do not have an ESOP, according to the National Center for Employee Ownership. Additionally, companies with broad-based stock option plans experienced an increase in productivity of 20 percent to 33 percent above comparable firms after plans were implemented. Medium-sized companies saw gains at the higher end of the scale. Employee ownership is also associated with higher rates of employee retention. According to a survey by the Rutgers University’s NJ/NY Center for Employee Ownership, workers at employee-owned companies are less likely to look for other jobs and more likely to take action when co-workers are not working well.

There are a couple of different ways that banks can establish ESOPs. The simplest and most efficient is called a non-leveraged ESOP, where the bank or holding company makes a tax-deductible cash contribution. The contribution can be in stock or cash and is recorded as compensation expense. If the bank contributes cash, those funds can be used to purchase stock directly from shareholders and create liquidity and demand in the stock. However, it can take years for a non-leveraged ESOP to accumulate a significant enough position to make a meaningful difference to a bank.

The other method, called a leveraged ESOP, uses a bank’s holding company to lend money directly to the ownership plan. The holding company is required because banks are not permitted to lend directly to the ESOP or guarantee a loan made to the ESOP. The holding company can use cash on its balance sheet, borrow it from a third-party lender or guarantee a third-party loan made directly to the ESOP. The ESOP uses the funds to purchase a large block of non-issued shares from the holding company or directly from shareholders. Although leveraged ESOPs have higher costs and complexity, they can make an immediate, meaningful difference in liquidity and employee benefits. This approach also has the benefit of increasing earnings per share upfront, since the shares underlying the ESOP loan to make the purchase are not considered outstanding. However, the repurchased shares negatively impact tangible common equity and tangible book value.

An ESOP can help the right bank accomplish many of its goals and objectives. Banks should carefully review their goals and objectives with qualified professionals that know and understand both the ESOP and commercial bank industries.

Employee Stock Ownership Plans: Another Tool for Family-Owned Banks

Written by


ESOP-06-19-15.pngToday’s economy presents numerous challenges to community bank profitability—compressed net interest margins, increased regulation, and management teams fatigued by the crisis. In response to these obstacles, many boards of directors are exploring new ways to reduce expenses, retain qualified management teams, and offer opportunities for liquidity to current shareholders short of a sale or merger of the institution.

For many family-owned banks, their deep roots in the community and a desire to see their banks thrive under continued family ownership into future generations can cause these challenges to be felt even more acutely. In particular, recruiting and retaining the “next generation” of management can be difficult. Cash compensation is often not competitive with the compensatory packages offered by publicly-traded institutions, and equity awards for management officials are unattractive given the limited liquidity of the underlying stock. All the while, these institutions should ensure that their owners have reasonable assurances of liquidity as needs arise or as investment preferences change. In combination, these challenges can often overwhelm a family-owned bank’s desire to remain independent.

Depending on the condition of the institution, implementing an employee stock ownership plan, or ESOP, may help a board address many of these challenges. While the ESOP is first a means of extending stock ownership to the institution’s employees, an ESOP can have other applications for family-owned banks.

Recruitment and Retention
An obvious benefit of an ESOP is to provide management and employees the ability to participate in an increase in the value of the bank, aligning their interests with those of shareholders. An equity interest provides economic incentives to join or stay with the bank and the ownership interest provided by ESOPs to employees has been shown to improve workforce productivity and morale.

Source of Liquidity for Shareholders
Without significant trading activity in their stock, shareholders of a closely-held institution may seek a liquidity event, which can include the sale of their shares to a third party or a merger with another bank. For these institutions, using the ESOP as part of a stock repurchase plan or to buy out selected shareholders can provide a buyer for large blocks of stock at a reasonable price.

For family-owned institutions, the tax benefits associated with a sale of a family’s interest in the institution to management via an ESOP are considerable. Most individual sellers of stock to an ESOP (and some trusts) qualify for a tax-free rollover of the proceeds of that sale into domestic stocks and bonds of U.S. corporations which meet certain limits on passive income. Under certain circumstances, this tax-free rollover opportunity avoids all federal income and capital gain taxes on the sale of shares to an ESOP.

In order to fund large purchases, the ESOP can take on a limited amount of leverage in order to acquire more shares in a particular year than can otherwise be allocated to plan participants. Before taking on this leverage, the bank should carefully consider how much leverage it can actually handle relative to the contributions that are expected to be made to the ESOP.

Special Benefits for S Corporations
ESOPs can also reduce shareholder numbers to facilitate a company’s conversion to an S corporation, which can help significant shareholders avoid the double taxation of dividends that apply to C corporations. Under the Internal Revenue Code, an ESOP counts as only a single shareholder for purposes of S corporation limitations, no matter how many employees have shares allocated to their accounts in the ESOP. Upon a plan participant’s separation from service from the institution, the participant may be entitled to only the cash value of the shares, rather than the shares themselves.

ESOPs also benefit from the S corporation status given their exemption from federal and most state income taxes. Since ESOPs are tax-exempt entities, they do not pay income taxes on their share of the institutions’ income like other shareholders do. When S corporations make distributions to their shareholders, ESOPs can retain that distribution, giving a better return to the ESOP participants. Additionally the cash reserves held in the ESOP from these distributions can be used to pay down ESOP debt incurred to buy shares for the ESOP, fund additional stock purchases by the ESOP, or to fund employee withdrawals from the ESOP.

For a variety of reasons, ESOPs can help family-owned financial institutions better manage the challenges of today’s market by providing a more liquid market for the institution’s shares and an exit strategy for some significant investors short of a sale or merger. ESOPs can also improve employee and senior management engagement and retention at a relatively low cost, which can improve the institution’s bottom line. With careful implementation and board oversight of compliance efforts, ESOPs can be a powerful tool for many community banks.

Should our 401(k) Get Married?

Written by


CCR_2-8-13.pngRetirement plans are viewed by many bank boards as necessary to retain employees and keep up with the competition. Costs are weighed against benefits, real and perceived. How should private banks and holding companies view their 401(k) while looking to minimize costs and maximize benefits?  One way is to marry the 401(k) provisions with employee stock ownership provisions in a single plan: a 401(k) + Employee Stock Ownership Plan or KSOP.

Should a Retirement Plan Own Closely-Held Shares?

The ability to purchase shares in a closely-held bank or bank holding company using the company’s tax-deductible contributions and dividends does not mean that it is universally the right thing to do.  First, no employee money should be used to purchase stock—funding will be entirely with employer-directed dollars. Efforts to structure programs using employee money to buy private stock are fraught with fiduciary and legal concerns (remember Enron?). Four major strategic considerations in using a qualified plan to purchase shares are:

  1. Is there a need to buy shares back?
  2. Will the required independent valuation of the shares reflect a fair market value acceptable to sellers?
  3. Will the tax favors and incentives of employees having beneficial ownership in some shares in the company warrant the costs?
  4. Does the company have the discretionary earnings to make such purchases, even on an untaxed basis, given the need for capital?

If the conclusion is that the tax-exempt private stock market is appealing, how does the KSOP work?

Key KSOP Operational Features 

A KSOP is a single plan document defining the two major components: 1) The employee savings deferrals making up the employee-directed accounts, and 2) The company contributions and dividends comprising the employer-directed accounts.

All the customary 401(k) features for employees can be retained—i.e. vesting, distribution rules, hardship loans, array of investment choices, daily valuation etc. for the employee directed money. The employer money can now be used to make contributions in cash or stock to the plan, with features of the company stock accounts now reflecting ESOP rules.

For example, if the employer match is made in the form of stock, the matching shares are allocated to all plan participants who participate in the deferral program. This is often done by employers wanting high employee participation. Rules restrict benefits that skew heavily to highly compensated individuals, and this broad participation can allow the more highly-compensated employees to defer more because it allows the firm to pass non-discrimination tests required for these plans.

The usual mechanism of a safe harbor 401(k) plan requires immediate 100 percent vesting of all contributions and employer matching contributions. Contributions can be matched at 3 percent of pay, or dollar for dollar up to 3 percent and then 50 percent on the next 2 percent of pay. The match goes to even non-participating employees.  

We have seen non-safe-harbor matches made with stock to avoid these rules and still provide sufficient incentives for broad participation.

Four Basic Pros:

  1. The company sponsors a single plan, which for companies with more than 100 employees requiring plan audits, reduces the cost to a single audit.
  2. The company can make matching non-cash contributions in the form of stock.
  3. The company can use cash accumulated in the employer-directed accounts to buy shares from any source—even newly-issued stock for capitalization purposes.
  4. As opposed to separate administration of two plans (often by different vendors), the consolidation of the process in a single plan can simplify management of the retirement plan.

Three Basic Cons:

  1. With often different rules for the ESOP and 401(k) components of one plan, care must be taken to avoid participant confusion.
  2. An independent valuation of the employer stock is required—something done annually, as opposed to the typical 401(k) daily valuation platform, which can also be a source of misunderstanding.
  3. The stock will incur an obligation for the company to repurchase shares for cash in the future.

Conclusion

Banks and bank holding companies needing a controlled market for their shares and reduced retirement plan costs, while retaining or improving employee retirement benefits, should consider a marriage allowed in the tax code between 401(k)s and ESOPs. Yes, there are complications, but the IRS will get its pound of flesh, either in complexity or dollars. Choose wisely.

Stock Bonus Plans for Community Banks

Written by


nest-egg.jpgCompanies are cutting employee benefits to conserve cash. There is another approach. Banks can sponsor retirement plans which provide deductible employee benefits in the form of stock, not cash, and reward the folks who build value over time.

How Does a Stock Bonus Plan Work?

It is a retirement program that works much like a profit-sharing plan, permitting the sponsoring company to make tax-deductible contributions in cash or stock to participant accounts. The limit is 25 percent of eligible compensation aggregated for all qualified plans.  

So, if a community bank with a payroll of $2 million makes a $50,000 match on the 401(k) plan, the deduction limit for an additional stock bonus contribution would be $50,000 less than 25 percent of $2 million, or $450,000. While most banks would typically contribute a much smaller percentage of compensation, the key is to understand the limits. 

Who Benefits from a Stock Bonus Plan?

In the above example, the bank had 49 employees with seven employees making more than $100,000 annually; these seven received 47 percent of the total compensation.  Since the allocations to participant accounts were made in proportion to pay, the 10 percent of payroll ($200,000) contributed meant that the key group received $94,000 in stock. The non-discriminatory plan meant that the non-highly compensated group received the balance of the shares in the plan.

Curiously, these plans sometimes better suit smaller banks specifically because of the need to reward key players and the ability of some stock bonus designs to skew benefits to them. Large plans with hundreds of participants can spread ownership more broadly.

The bank holding company sponsoring the plan received a tax deduction for the $200,000 non-cash expense and a resulting cash flow improvement (analogous to the tax effect of depreciation). This would not be possible if you contributed cash instead of stock to a retirement plan. The end result is more cash saved on the balance sheet. The table below illustrates this in a hypothetical example.

Three retirement plan options were considered: A) cash contribution; B) no contribution; C) stock contribution.  

ccrv-stock-chart.png

What Are Five Must Dos for Stock Bonus Plans? 

  1. Use an independent stock valuation for the share value, if the corporation is closely held or thinly traded.
  2. Coordinate the capitalization and shareholder (dilution) effects with a comprehensive benefit strategy for both the highly and non-highly compensated employees.
  3. Base the cost/benefit analysis on the ongoing plan operating costs, cash savings and the long-term obligation to repurchase shares from former plan participants when they retire. 
  4. Maximize the benefit of employee ownership by communicating the plan clearly to the participants.
  5. Consider using the more versatile Employee Stock Ownership Plan (a sub-class of stock bonus plans), if the intent is for the plan to purchase shares rather than operate as a simple contributory plan. A stock bonus plan cannot purchase stock from shareholders, while an ESOP can; the ESOP can even borrow money to buy the shares; both types of plans hold the majority of their assets in company stock.

What Are Three Things Not to Do?

  1. Implement a stock plan where the organization’s operating profits (<$500K) or numbers of employees (<30) do not warrant the cost.
  2. Convert the 401(k) plan of a closely-held sponsor to any of the forms of stock bonus arrangements and use employee money to purchase shares or otherwise have stock in employee-directed accounts.
  3. Consider stock compensation in troubled banks with problematic “going concern” valuations or questions about viability. 

Conclusion

Successful banks may be tempted to curtail employee benefits in a difficult economic environment, but may in fact be better served in terms of employee motivation and operating results by a restructuring of the benefit program. There are many other rules and variations on the stock bonus theme; a decision should be narrowed to the main pros and cons through a review with skilled designers.

What Offers Capital Creation, Employee Benefits and Untaxed Profits?

Written by


money-gift.jpgAn ESOP is a retirement plan designed to purchase the highest and best class of stock of a corporate plan sponsor with tax-deductible contributions and/or tax-deductible dividends from the company. The ESOP is indifferent to the source of the shares (i.e. shareholders or a new issuance). There are limits to how much a company can contribute to an ESOP annually and the shares must be independently established at fair market value. An S or C corporation bank or bank holding company can sponsor an ESOP.

Who Should and Who Should Not Create an ESOP?

The bank must have sufficient number of employees, adequate ongoing earnings and sound capital/leverage ratios. The bank must:

  • have at least 30 employees and sustainable annual pre-tax profits of $500,000 or more
  • be a viable, long-term going concern
  • make a market for shares (either new issues for capital or from outside shareholders) of $500,000 or more at some point, and be well capitalized, both for valuation and regulatory purposes (e.g. Tier 1 capital ratio of 10 percent or better)
  • be willing to support the complexity and cost of the plan (small stock plans can cost $20,000 annually to maintain due to requirements for annual independent valuations, record keeping and additional accounting)
  • have the ability to make annual plan contributions in stock or cash averaging $200,000 or more; some variability downward (even zero) in bad years is possible, but good years should offset that

One Example: An ESOP Benefits a Bank or Thrift

A single-bank holding company which had taken TARP is now profitable, making $2 million in pre-tax earnings as a C corporation with 200 shareholders and capitalization of $400 million. The board wants to improve key executive benefits, hopefully increase capital (to help with the retirement of the TARP obligation) and mitigate taxes.

By establishing an ESOP and pre-funding it with cash for two years ($500,000 annually) at a level which did not degrade capital ratios, there is $1 million in cash available to purchase new shares in a capital stock transaction.  The resulting $1 million  tax-free cash arrives on the balance sheet at the price of some shareholder dilution, but represents Tier 1 capital and a possible source of a partial TARP repayment. The effects are:

  • The company has $1 million of tax-deductions spread over two years.
  • The tax arbitrage (taking dollars to the balance sheet at dollar-for-dollar vs. 60 cents per dollar of taxable income) results in better capitalization.
  • The non-ESOP shareholders have some minor dilution with the purchase of newly issued shares.
  • The 57 employees eligible to participate in the plan do so irrespective of TARP—key executives with compensation above $100,000 received 43 percent of the allocations in the ESOP. (A non-qualified discriminatory key executive plan was out of the question with TARP, and even without TARP, would be non-deductible.)
  • The 8 percent ESOP is controlled by the trustees, appointed by the board.

Here are Five Key Do’s and Don’ts

1. Don’t install an ESOP just for a near-term tactical tax advantage—implement a coordinated strategy tying the ESOP market/benefits to key executive programs, capitalization, shareholder market needs and all the regulatory requirements.

2. When considering an ESOP, get a competent feasibility study done (at a cost of $10,000 to $25,000), even if the threshold criteria are all met – there may be something lurking in the weeds.

3. Be prepared to deal with complexity in the coordination of employee benefit law with the management of both cash and stock flows between the bank, shareholders and ESOP, with clear definitions of the roles of the board, trustees and supporting professionals.

4. Don’t consider the ESOP stock repurchase obligations something to be dealt with in a few years as the plan matures: analyze and understand the strategy for the funding and management early on.

5. Do engage and educate your ESOP participants in the benefits of the plan to loyal, long term employees.

Some Resources:

1. The National Center for Employee Ownership (www.nceo.org) is an excellent source of educational materials.

2. The ESOP Association in Washington, D.C., is an ESOP advocacy organization and has helpful publications (www.esopassociation.org).

3. A booklet expressly for bank boards considering the ESOP alternative is: “The ESOP Handbook for Banks: Exploring an Alternative for Liquidity and Capital While Maintaining Independence”, 83 pp, Peabody Publishing, 2011 (ISBN 978-0-9825364-4-5).

Using an ESOP to Raise Capital

Written by


Privately held community banks have had a tough time raising capital during the financial crisis and its aftermath. Investors are cautious and community banks have been especially challenged due to the economy’s troubles and investors’ desire for liquidity. One option for those banks is an Employee Stock Ownership Plan, or ESOP. Basically, an ESOP is a tax-qualified retirement plan that benefits all employees who meet certain criteria, such as 1,000 hours of service. An ESOP can use the tax deductible contributions made by a bank or bank holding company to purchase newly issued stock, thereby returning the cash to the balance sheet of the bank or holding company. These funds improve capital strength and could also be used to repay funds to the federal government’s Troubled Asset Relief Program. W. William Gust, J.D., L.L.M. of Corporate Capital Resources and Andrew Gibbs of Mercer Capital discuss some of the benefits of ESOPs and how they might help a bank raise capital.

How does it work?

The bank or bank holding company makes contributions to an ESOP, either in stock or cash, subject to certain limits. These contributions are allocated among participants in proportion to compensation or compensation plus length of service. An ESOP may use its cash to purchase newly issued shares or existing shares held by non-ESOP shareholders, as well as to purchase shares from participants exiting the plan.

What are the benefits of ESOPs for a bank?

Unlike retirement plans such as 401(k)s, ESOPs can purchase shares of the sponsoring S or C corporation. An ESOP can borrow money to purchase stock. Principal payments on the acquisition loan are tax-deductible. The ESOP is treated as a single, tax-exempt shareholder. S corporation ESOPs do not face the tax liability that otherwise would pass through to shareholders. As a hypothetical example, if the bank contributes $100 to the ESOP, it could save $40 in taxes and use the savings to purchase more bank stock, either to repay TARP or meet other capital raising goals. Because contributions are tax-deductible, purchasing newly issued shares is accretive to total equity, although the transaction would dilute the ownership interest of non-ESOP shareholders. While TARP requirements preclude key executives from non-qualified and discriminatory plans, they do not apply to ESOPs.

Why do banks make more use of ESOPs than companies in any other industrial classification?

Closely held banks often need a mechanism to acquire shares efficiently. An ESOP permits containment of the number of stockholders through an untaxed mechanism ultimately under the governance of the board. Most bank ESOPs are minority-interest owners.

What benefits do they have for participants?

The participants receive a retirement benefit as an equity interest in the sponsor at no cost to themselves. ESOPs typically reward loyal, long-term employees through vesting schedules, eligibility rules and the like, which cause the bulk of the plan assets to accumulate in their accounts.

In what instances would an ESOP not be appropriate?

ESOPs require a profitable sponsor, the ability to create value over time and a sufficient number of employees to meet the various compliance tests. Companies with fewer than about 25 employees or profits below about $500,000 (pre-tax, pre-ESOP) are not suitable, though there are exceptions. Since they have a market, widely traded public corporations do not often use ESOPs. Highly leveraged ESOPs often are inadvisable.

Who controls the stock?

The trustees are the legal owners who vote the stock for private corporations, except for major transactions. Participants in public company ESOPs vote all shares allocated to their accounts.

How is value established?

The trustee establishes value. For privately held banks, the trustee engages an independent appraiser to value the stock. Valuing banks in the current regulatory and economic environment is challenging; banking industry and ESOP expertise should be key considerations for the trustee in appraiser selection. Appraisers will consider numerous factors and apply specific valuation methods considered most appropriate. Draft regulations from the U.S. Department of Labor provide guidance specific to shares held by ESOPs.