Why aren't there more?

Today, ESOP activity is somewhat limited.

While we are seeing incredible examples of success across the ~250 Employee Stock Ownership Plans (ESOPs) formed each year (particularly amongst the 100% S-Corp ESOPs), we are going to need greater levels of ESOP activity if we are seeking a more inclusive and sustainable economy. This will require both a great number of ESOP formations, as well as a larger average company size for new ESOPs (particularly given the highly effective 100% S-Corp ESOP is most frequently utilized by small businesses).

New ESOP formations per year are relatively flat. There is limited accurate long-term historical data, but we do have reliable data back to 2016 such that we can look back a number of years with confidence. As shown in the data below, new ESOP formations per year are steady at 250, but are not growing, and these new formations are concentrated in a few industries.

Source: National Center For Employee Ownership

C-Corp ESOPs, which are applicable to larger businesses, are in decline. It is only a slight over-generalization to say that most ESOP activity comes in one of two forms, 100% S-Corp ESOPs and partial C-Corp ESOPs. The specific details get fairly technical but, as noted earlier, 100% S-Corp ESOPs are most commonly used by smaller businesses with simpler ownership structures, whereas partial C-Corp ESOPs can be used more easily by much larger companies with broadly distributed shareholder bases.

As shown above, the “flat” trendline of total new ESOP formations obscures the fact that partial C-Corp ESOPs have been declining.

Source: National Center For Employee Ownership, Department Of Labor

Why has this happened?

There are five primary reasons for the decline in partial C-Corp ESOP activity, particularly among larger companies.

Some of the challenges related to statutory and regulatory complexity, and the associated litigation risks, are things larger companies are just not willing to tolerate. This has been compounded by unclear rules established for ESOPs, which dissuaded employers from offering such benefit plans (despite Congress’s clear desire to avoid such a situation when ESOPs were created in 1974).

For a Partial C-Corp ESOP, the key corporate tax benefit comes in the form of deductions for ESOP contributions. But given the corporate tax rate is only ~25%, that means the company will only realize $25 of tax savings for every $100 given to the employees. For large companies with institutional investors, this is inherently a very dilutive action which reduces the return to investors, and this dissuades many larger companies from pursuing partial C-Corp ESOPs. Even many well-intentioned institutions have their hands tied, because their fiduciary obligations to their own investors – which include pension plans that are also subject to ERISA – prevents them from taking such below market returns.

(1) Assumes an effective tax rate of 25%

There are certain tax benefits for selling shareholders who establish a partial C-Corp ESOP, but these are only relevant to small businesses with a handful of individual owners (not larger companies with more distributed shareholder bases which frequently include institutional capital).

The timeline for establishing an ESOP is often not compatible with the timelines on which large companies are being bought/sold. Large businesses typically are sold in highly competitive auction processes on tight timelines, sometimes in as little as a few weeks. It currently takes a minimum of several months to put a new ESOP in place.

For most ESOPs, the amount of liquidity a seller can receive at closing is limited by the available debt capacity of the company -- as employees do not bring capital to the table, debt financing tends to be the key source of cash to sellers. For a small business pursuing a 100% S-Corp ESOP, a single founder-owner may be willing to take less cash at close to facilitate a transaction. But for a scaled business with a more complicated set of shareholders, only a partial C-Corp might be viable. And for them, it becomes significantly more difficult to convince multiple parties to take such consideration at the point of sale.

How can we reverse this trend?

We need to find a compelling way to reinvigorate partial C-Corp ESOP activity.

This will make ESOPs more relevant to larger companies and more sectors of the economy, including software, media, financial institutions, consumer products, pharmaceuticals, and medical devices, to name a few. There are a number of issues we’ll need to address as they relate to partial C-Corp ESOPs, including litigation risk and the need to balance the tax benefit with the cost of sharing ownership with workers.