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An Employee Stock Ownership Plan (“ESOP”) is an ownership program where a company provides its employees with company stock, usually at no cost to the employees. Shareholders often create an ESOP by selling their shares of stock to the newly created ESOP as a form of an “exit strategy.” The ESOP may pay the shareholders for these shares of stock by taking out a loan (“leveraged ESOP”). As the company creates revenue, it repays the ESOP’s loan, and the ESOP releases shares of company stock to its employees.
When shareholders sell the company to its employees by selling all the stock to the ESOP, the company may tout this move as giving its employees the ability to grow the company and reap the benefits of their work. But often undisclosed are the risks to the employees, particularly in ESOPs that involve privately traded employee stock.
ESOPs in general carry inherent risks not present in other retirement plans—ESOPs don’t diversify investments, an employee’s retirement account value is tied to the performance of the company, and large amounts of employee layoffs can cause the ESOP to spiral. The risks become even more amplified in privately traded ESOPs.
An ESOP is privately traded when its stock is not available for public purchase and not valued by the stock market. The stock in the privately traded ESOP is valued by a third party who performs a yearly valuation. If the third party is biased, or trying to produce a valuation that pleases the shareholders, it may overvalue the stock, which allows the shareholders, when exiting the company, to receive more money for the privately traded stock than it may actually be worth.
Many ESOPs take on loans to purchase the privately traded stock from the shareholders (called a “leveraged ESOP”). The risk to employees’ ESOP accounts comes when the ESOP takes on too much debt. An ESOP that takes on significant debt has little room to survive financial downturn of the sponsoring company, which is now owned by the employees.
If you are a participant in an ESOP of a privately traded company and you believe that the ESOP may be subject to any of the risks described above, please contact us for more information.