Using an ESOP To Raise Capital

An employee stock ownership plan (ESOP) has long been used for succession planning and to reward and incentivize employees for their dedication and hard work. This article provides a brief overview of ESOPs and general information about how an ESOP might be used as an alternative for raising capital.

General Overview of an ESOP

An ESOP is a type of qualified defined contribution plan, like a profit sharing plan, that is designed to invest primarily in “qualifying employer securities,” which generally means shares of common stock issued by the bank holding company. As a qualified plan, the ESOP must comply with numerous requirements imposed by the Internal Revenue Code of 1986 and the Employee Retirement Income Security Act of 1974 (ERISA). For example, the investment of employees’ retirement accounts in company stock must satisfy ERISA’s fiduciary standards, which require that the investment is prudent and for the exclusive benefit of employees and their beneficiaries. The ESOP also must comply with many of the same eligibility, vesting, and nondiscrimination requirements and compensation and deduction limits that apply to other qualified retirement plans. The shares held by the ESOP must be valued at least annually by an independent appraiser.

Special rules apply to an ESOP. For example, employees approaching retirement have the right to diversify the investment of their accounts in the ESOP. An employee who is age 55 and who has 10 years of participation in the ESOP may diversify 25 percent of his or her account into other investment options, with that percentage increasing to 50 percent at age 60. In some cases, employees have the right to receive distributions from the ESOP in the form of stock, which they can then require the company to repurchase. Distributions of employees’ accounts usually occur over a five-year period; however, some ESOPs permit a lump sum distribution if the account is under a specified dollar amount.

In most cases, the trustee of the ESOP votes the shares held by the ESOP, such as for the annual election of the board of directors. But, for major corporate events such as a merger or a sale of the company’s assets, the employees have the right to vote the shares held in their accounts.

When setting up the ESOP, the bank holding company will need to carefully consider and project the ESOP’s cash flow needs. The ESOP will need cash to repay any debt incurred for the purchase of shares and to fund employees’ distributions and diversification elections. That cash must come from either contributions or dividends made by the bank holding company to the ESOP.

How an ESOP Can Be Used to Raise Capital

An ESOP can provide a tax-efficient source of capital that can be used to finance expansion projects, acquire a target company, refinance debt, or purchase stock held by minority owners. For example, the ESOP can purchase stock from the bank holding company using tax-deductible cash contributions made by the bank holding company to the ESOP.

Alternatively, the ESOP can purchase shares through a leveraged transaction. Under this approach, the ESOP purchases stock from the bank holding company with a loan, which is secured by a pledge of the stock purchased with the loan proceeds. To repay the loan, the bank holding company makes tax-deductible contributions to the ESOP, which the ESOP uses to make the loan payments. As the loan is repaid, the stock is released from the pledge and allocated to employees.

In either case, the ESOP cannot pay more than current fair market value for the stock, and that value must be determined by an independent appraiser hired by the trustee. Because ESOPs are heavily regulated by the IRS and the Department of Labor, it is critical to have experienced financial and legal advisors involved in the design of the ESOP and the structure of the ESOP transaction.

Bank Regulatory Considerations

The Federal Reserve has determined that an ESOP that owns or controls 25 percent or more of the voting shares of a bank or bank holding company is a “company” under the Bank Holding Company Act of 1956, as amended. Further, any ESOP owning or controlling less than 25 percent may be required to provide passivity-type commitments to the Federal Reserve and/or provide other notices or filings with the Federal Reserve and other applicable bank regulatory agencies.

In summary, with thoughtful planning, an ESOP can provide a great alternative for raising capital. At the same time, the ESOP can reward employees for their contributions and efforts in the bank holding company’s success and, at the same time, enhance employees’ retirement benefits.