Enterprise Services, Inc. Business Transitions and Valuations
ESOP Articles

Written by Scott D. Miller, CPA/ABV, CVA

Originally published in The Valuation Examiner by the National Association of Certified Valuation Analysts, First Issue 1995.

During the last two decades there has been a trend in the United States for employers to formally adopt a legal entity that permits their employees to participate in the ownership of the company. Assuming that all of the proper steps and approvals are completed, significant financial advantages exist for both the employees and the employer. The legal entity that is referenced is called an Employee Stock Ownership Trust, which most people commonly call an "ESOP". There are significant opportunities for business valuers regarding ESOPs in closely held companies because they typically require an annual appraisal.

The purpose of this article is to provide a short narrative regarding both the legislative history of ESOPs and the philosophy backing their creation. Establishing a historical perspective will help set the stage for an understanding of key valuation issues relating to ESOP companies. While it is beyond the scope of this article to address many of the ESOP valuation issues, we will examine those issues in detail in later months.

The Employee Stock Ownership Trust is the legal entity that actually owns the stock of the company for the beneficial interest of the plan participants, the employees. The Employee Stock Ownership Plan is the document that provides the rules for administering the Trust. Every time you have a Trust, you also have a Plan. Most people familiar with the concept of employee ownership think of an ESOP. For the purposes of this article and all succeeding articles, I will use the term "ESOP" interchangeably for both the trust and the plan.

Philosophy of Employee Ownership

There is general agreement that the one person instrumental in developing the concept of the ESOP is Louis Kelso. Mr. Kelso is an economist who studied what he perceived to be a fundamental problem with capitalism. The problem as he defined it is capitalism's propensity to concentrate both capital and the benefits of capital ownership into the hands of a small minority. According to a 1986 report by the United States General Accounting Office, except for the corporate stock held in pension plans, 90 percent of equities are owned by just 10 percent of households. What is more alarming is the fact that almost 60 percent of all stock is owned by just 1 percent of households. The majority of households do not own any equities.

Mr. Kelso notes that while the United States is a capitalistic country, we are first a consumer based economy. The concentration of wealth into the hands of a few does very little to support a consumer driven economy. The great challenge from his perspective is to fashion a practical approach to broaden the ownership of capital in this country without taking property from others.

One great barrier to broad equity ownership in our economy is that it most frequently takes existing capital resources to earn more capital. Virtually all financial institutions require collateral before you can borrow money or "capital". Most people are effectively shut out from amassing capital because they currently have no capital, and they cannot obtain the credit to acquire capital assets. Our puritan heritage suggests that the individual must work hard to save, and that those savings are the wellspring of capital formation. The problem according to Mr., Kelso is that most people working for a salary are just barely able to purchase life's necessities. They are often unable to save and thereby build capital resources.

The way to broaden equity participation is to enhance the individual's access to credit markets for the purpose of acquiring private capital resources. Mr. Kelso was sensitive to allowing market forces to work in favor of the individual. He did not propose to socialize private capital, rather he championed democratizing access to the credit needed to acquire private capital.

The solution to the barriers in our economy preventing broader equity participation is the ESOP. The ESOP was envisioned as a vehicle whereby employees in a company could acquire the company's stock using credit, and repaying the debt from the earnings of the company. Widespread application of the ESOP principal would promote broader ownership of capital. This would be accomplished through the use of free enterprise incentives. Redistribution efforts of the government by the use of taxation polices is avoided. The full reasoning of Mr. Kelso is far more intricate and complex than this brief overview. His philosophy is more clearly outlined in several books he has written including The Capitalist Manifesto (1958), The New Capitalist (1961) and Extending the ESOP Revolution Through Binary Economics (1990).

Legislative History and Impact

Mr. Kelso was particularly influential in gaining Congressional interest in his ideas for employee ownership. A critical early Congressional supporter was Senator Russell Long. Senator Long was the Chairman of the Senate Finance Committee in the early 1970s, and he witnessed first hand some very difficult problems in capitalistic countries. Some of those problems included such things as the Penn Central Railroad bankruptcy, banks rationing credit, high interest rates, and scarce venture capital. Senator Long was one of the first political leaders to grasp the significant benefits of employee ownership and he personally campaigned for their formal existence..

ESOPs were first specifically mentioned in the Regional Rail Reorganization Act of 1973. This bill required the feasibility study for using an ESOP in the reorganization of the Northeast rail system. The rail system was being reorganized into the government owned Conrail. Conrail eventually included an ESOP.

The ESOP came into the forefront with the passage of the Employee Retirement Income Security Act of 1974 (ERISA). This law is the first specific statutory provision for the framework of ESOPs. The Act included ESOPs in the definition of a qualified employee benefit plan, meaning contributions to them are tax deductible. ERISA generally standardized the rules governing pension and retirement plans, but it permitted certain exceptions to ESOPs in recognition of their special mission. The Act permitted the ESOP to borrow money in the interest of acquiring employer securities, and ESOPs had to be primarily invested in employer securities. These provisions are significant because most other qualified retirement plans contain specific restrictions against the inclusion of more than 10% in employer securities.

The next significant legislation was the Revenue Act of 1978. This Act required stock that was not publicly traded and in a leveraged ESOP to offer participating employees a put option back to the employer. Full pass through voting rights on allocated shares in publicly traded securities was required. Closely held companies were required to extend voting rights to plan participants on major issues.

The Chrysler Loan Guarantee Act of 1980 required Chrysler to establish an ESOP and insure the employees a significant stake in the Company by 1984. With this legislation and the Regional Rail Act of 1973, the federal government officially encouraged employee ownership of their companies.

The Economic Recovery Tax Act of 1981 contained two significant ESOP provisions. First, the Act increased the covered payroll contribution limit from 15% to 25% in leveraged ESOPs for principal payments, and it allowed unlimited interest. Second, it permitted companies substantially owned by the employees to require that departing employees accept cash for the fair market value of their stock rather than the stock itself.

Tremendous financial incentives were extended to ESOPs in the Deficit Reduction Act of 1984. The legislation is noteworthy because it occurred at a time when the federal government was concerned about reducing the spending deficits, and yet ESOPs were further encouraged by extending tax oriented incentives to them. Those incentives included such things as a deferral of taxes on the gains of a selling owner to an ESOP if the ESOP owns at least 30% of the company (and the proceeds are reinvested in domestically qualifying securities within 12 months), and a tax deduction for cash dividends paid to ESOP participants.

The Tax Reform Act of 1986 revised many rules for qualified employee pension and retirement plans in such areas as contribution limits, employee benefit distributions, vesting and coverage requirements. Several additional revisions were made to ESOPs. The significant provisions provide for the following: expansion of the deduction for dividends for the repayment of an ESOP loan, modification of the put option so that employees would be paid entirely in cash over a period not to exceed five years, imposition of new rules on the payments to ESOP participants following a break in service, clarification of pass through voting rights in closely held companies and requiring the use of an independent appraiser for the valuation of closely held securities.

Over the twenty years that ESOPs have been mentioned in federal legislation, there has been a steady increase in the financial incentives officially extended to encourage employee ownership of their companies. Employee ownership had its first best legislative friend in Senator Long, and since that time many other representatives have agreed that encouraging ESOPs is good social policy.

It is appropriate to specifically mention two tireless champions that have actively worked to promote favorable legislation and the expansion of ESOPs. The ESOP Association, with headquarters in Washington, DC, is the largest and most organized sponsor of employee ownership. The Association is active in Washington promoting pertinent legislation, and it hosts a large annual convention specifically geared to ESOP issues. The National Center for Employee Ownership (NCEO), with offices in Oakland, California, has been instrumental in communicating the advantages of employee ownership and delineating the characteristics of successful installations of ESOPs. I have a personal debt to both organizations since they helped educate me on ESOP related issues and their materials have been instrumental in the preparation of this article.


We have completed a brief overview of ESOP philosophy and legislative development. Clearly, by the actions of our elected federal representatives, encouraging employee ownership of their companies is social policy. This policy simply makes compelling practical sense in a consumer oriented capitalistic economy. The benefits of capital ownership need to be spread among greater numbers of citizens if we are to avoid the trap of increasing concentration of wealth into fewer hands.

As ESOP legislation has expanded the incentives to encourage employee ownership, the "rules of the game" have become increasingly more complex. ESOPs are almost infinitely flexible in their ability to custom tailor a plan to meet the needs of a particular company. This flexibility is often perceived as an unwelcome encumbrance because of the myriad rules and regulations that demand compliance. The Internal Revenue Service (IRS), the Department of Labor (DOL) and the American Institute of Certified Public Accountants (AICPA) have all promulgated detailed regulations and instructions governing ESOPs and how we account for them.

The number of active ESOPs has grown from a mere handful in 1973 to over 10,000 today. It seems that the ESOP legislation has worked, and that ESOPs are here for the long term. There are now so many successful applications of employee owned companies, that ESOPs have earned their way into the social fabric of our society.

One key observation in relation to the historical perspective is that ESOPs are by nature long term in their orientation. This is a critical distinction. When employees have a direct capital interest in their companies, they are additionally guided by a concern to keep the company financially healthy. The company is both a source of capital appreciation and a steady job. In the valuation process, it is appropriate to adopt a long term approach to assessing value and not merely a temporary moment in time.

The above insights have a pronounced impact for business valuers. There is a well established market for business valuation services. In the case of closely held companies with ESOPs, typically an annual valuation of the stock is required. The repetitive requirement for valuation services is an attractive consideration. The rules surrounding ESOPs are very complex, and multiple entities have issued rules and regulations regarding them. Due to the federal statutes impacting ESOPs and the requirement for independent appraisals, professionals are advised to approach ESOP valuations with caution until they have gained appropriate experience dealing with pertinent issues.

The intention of this article is to provide a foundation for further consideration of ESOP valuation issues. Upcoming issues will address many of the considerations pertinent and often unique to ESOP valuations.

Enterprise Services, Inc. Business Transitions and Valuations
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