Over the years, there have been a number of creative mechanisms developed to enhance executive compensation in a highly efficient manner (meaning, at a manageable cost to the company). One such structure allows executives to acquire significant ownership stakes in a business for limited consideration, without requiring the company to incur a significant up-front cost. The core of our proposal applies this financial engineering concept for the benefit of rank-and-file workers -- but, rather than workers paying for their ownership stakes, these stakes would be awarded for no consideration (akin to a gift). The “cost” of that gift would be subsidized by tax incentives.

The proposed structure would require that the shareholders of the company invest the vast majority (90%) of their money in a non-convertible preferred stock that acts more like a loan because it has limited upside and its sole return is fixed at a relatively low rate -- say, 5%. The preferred stock could never earn a return higher than 5% no matter how well the company performs. The remaining 10% of the shareholders’ investment would be in traditional common equity that has unlimited upside. It is this common equity which would be shared with the workers in the form of a 10% stake awarded to the ESOP for no consideration.

What does this structure accomplish? It “forces” virtually all of the upside (both dividends and capital appreciation) to be received by small portion of the capital structure, the common equity.  The common equity gets all of the appreciation of the company’s value in excess of the 5% per year which is owed to the preferred stock. And because only 10% of the shareholders’ capital is in common stock, the structure conveys a substantial amount of upside without too great of an up-front cost.

The structure is complicated for those not steeped in finance, so we have included a detailed illustration of how it works here for those who are interested.

The rank-and-file worker is at the center of this proposal – as such, we envision mandating several important protections for these workers. Seven key components of this structure that protect and favor the worker are as follows:

1. The stock must be free to employees. Concurrent with the creation of the Partial C-Corp ESOP, the company would contribute to an ESOP trust 10% of its common stock at no cost to the employees or the ESOP trust.
2. There can only be one class of common stock. The common stock contributed to workers (via the ESOP trust) must be the same as that held by outside shareholders and management (except for the liquidation preference for workers, explained below under “Protecting the Spirit of the ESOP”).
3. The ESOP cannot be employees’ only retirement plan. The company must provide a minimum 401k benefit alongside the ESOP. This is important because, although the stock gifted in this program is free, it obviously comes with risk that the company may not perform up to expectations.
4. Workers would be provided with early access to funds. As many employees may have significant needs for their ESOP funds well before retirement, we contemplate adding a provision that some amount of vested ESOP shares (e.g., 10% per year) can be sold back to the company for cash, and can be withdrawn from the employee’s ESOP account without being subject to IRS penalties for early withdrawal. This would be subject to an annual election by the company’s board of directors to ensure that they have the financial means / liquidity to fund such repurchases.
5. There must be “proof” that the price of the common stock awarded to workers is fair. Here again, even though the stock is free to workers, we need to ensure that the price at which the stock is granted at fair market value (see “Avoiding Undue Litigation” for more on this)
6. The shares set aside for workers must be allocated in all circumstances. The company would establish a mechanism to allocate the 10% of the common equity to workers over time, subject to a maximum allocation window of 10 years. And if the company were to be sold within this time frame, the stock would need to be fully allocated before or at the time the sale is complete.
7. This program must disproportionately benefit rank-and-file workers, not executives: Allocations to employees must be done on a pro rata basis, which means that annual allocations to employees must apply the same percentage to wages for all employees, irrespective of their title or salary level. For purposes of this calculation there will be a compensation cap of $150,000, so any compensation beyond that would be disregarded. This would force the benefit to be applied disproportionately to lower income employees. A mathematical illustration of this can be found here.

For a period of 5 years from the date of the stock grant to the ESOP trust, the company will be able to “double deduct” its U.S. domestic payroll (i.e., deduct it twice). Thus, if the aggregate annual U.S. payroll expense for a company were $10 million, for 5 years from the date of the stock grant to the ESOP trust, the company could deduct $20 million per year (a mathematical illustration of this can be found here). We have done an extensive amount of financial modeling and we believe that, for a reasonably large number of companies, this limited tax benefit would come close to offsetting the cost of the ESOP equity award. If the company is successful in improving employee engagement, reducing the quit rate, etc., the business could, in fact, be much better off. An incremental benefit of this form of tax incentive is that it would encourage U.S. employment and U.S. wage levels. It would form as a significant disincentive for outsourcing or offshoring. It would also disincentivize layoffs as employment would be partially subsidized.

The only difference between the ESOP’s common equity and that held by the investor would be that the ESOP will benefit from a liquidation preference equal to the aggregate tax savings realized by the company for the “double deduction” of its labor expense over this 5-year period of time. Therefore, employees will directly benefit at least dollar-for-dollar with the ESOP tax incentives (and in most instances will benefit much more).

This serves the dual purpose of:

1. Aligning the incentives of the ESOP and outside shareholders (as the vast majority of the outside shareholders’ returns will come from the same security owned by the ESOP)
2. Ensuring that any better-than-expected return earned by shareholders is coming from fundamental operational improvement of the Company – not from the tax incentive (which is intended to flow in its entirety to the employees)

The creation of the ESOP must be concurrent with a transaction where an unrelated third party is investing money in the company on arms’ length terms. By having the market determine an appropriate valuation for the business (known as a “market check”), we have removed the issue of fair market value and confirmed that the transaction is “fair”. We would envision a specific safe harbor which, assuming certain preconditions are met, and the prescribed transaction structure is appropriately followed, would protect the company and its shareholders from litigation. This would remove a major impediment to partial C-Corp ESOP formations.