ESOP Growth Presents Market Opportunity for Retail Agents

Employee Stock Ownership Plans (ESOPs) are increasingly common across various business sectors and have become a popular tool for company perpetuation strategies. However, establishing an ESOP entails risks that need to be managed and insured, both for former company owners and the new employee ownership group. This scenario presents a significant opportunity for retail agents to expand their business by deepening their knowledge and collaborating with partners who offer the necessary markets and products for success.

ESOP History, Trends, and Risks

ESOPs support the perpetuation of private and family-owned businesses and are often part of a comprehensive compensation plan. As a qualified deferred compensation retirement plan, an ESOP provides employees with ownership through company shares. Employee ownership can enhance company culture, improve recruitment, and boost employee productivity.

The concept of employee ownership dates back to early U.S. history, but the first official ESOP was created in 1956. The Employee Retirement Income Security Act of 1974 (ERISA) set guidelines for employee benefit plans and facilitated the modern ESOP structure, increasing their popularity. Subsequent legislation, like the Economic Recovery Act of 1981 and the Small Business Job Protection Act of 1996, further fueled ESOP growth.

After a slight decline in the 2010s, the number of ESOPs has been rising steadily. Data from the National Center for Employee Ownership indicates that 2021 saw an increase in ESOPs driven by private company sale activity, a trend expected to continue as the U.S. workforce and company ownership age.

Despite their benefits, ESOPs carry risks, mainly related to company valuation or sale/loan terms. ESOP trustees and former business owners may be held liable for any issues. Over the past decade, settlements or judgments involving ESOPs have totaled $385.5 million.

There are also regulatory risks. ESOPs cannot pay more than “adequate consideration” for company shares. Between 2007 and 2017, the Department of Labor’s Employee Benefits Security Administration (EBSA) found ERISA violations, mainly valuation and loan term issues, in over 1,000 cases. The EBSA’s ESOP National Enforcement Project investigates ERISA violations in connection with ESOPs, and additional scrutiny can come from the IRS and the Pension Benefit Guaranty Corporation.

Risk Management

Retail agents can help clients manage ESOP-related risks by recommending best practices and appropriate insurance coverage.

An ESOP Trustee must obtain an independent valuation for ESOP purposes. While it may be tempting for companies to use C-suite members as Trustees due to their business familiarity, this can lead to conflicts of interest. Independent ESOP valuation firms have the expertise to objectively assess financial data, including financial statements, cash flow projections, customer and geographic concentration, and management depth.

Independent firms also bring the objectivity and independence that internal staff cannot, conducting in-depth interviews with management to establish credibility around projections and generate necessary transparency. These firms analyze not only value but also the entire transaction, considering interest rates, synthetic equity, and deal structure.

Insurance Coverage

Both the existing company and the acquiring ESOP need comprehensive liability insurance protection, primarily through Fiduciary Liability (FL) and Directors & Officers (D&O) insurance.

  • Fiduciary Liability Insurance (FL): This protects plan fiduciaries against claims of mismanagement, including improper management of plan assets, misrepresentation, or failure to provide required information to participants. It covers legal defense costs, settlements, and judgments. As per ERISA and court decisions, the ESOP plan itself cannot indemnify fiduciaries, putting their personal assets at risk without fiduciary liability insurance.
  • Directors & Officers (D&O) Insurance: This protects the personal assets of directors, board members, and other managing members if they are sued for mismanagement. In an ESOP transaction, directors may have fiduciary responsibilities to both existing/former shareholders and ESOP participants, complicating their role.

Other recommended coverages include:

  • Employment Practices Liability (EPL): Protects against claims from dissatisfied employees during ownership and cultural transitions.
  • Crime Insurance: Covers theft, including employee theft, which may increase during ownership changes.
  • Cyber Insurance: Addresses potential control vulnerabilities during systems and access changes in ownership transitions.

Potential Coverage Gaps

  • Coordination of Coverages: Fiduciary liability and D&O are claims-made forms requiring coordination between ESOP and former owner policies. This can involve Prior Acts Coverage, Extended Reporting Period endorsements, and Waiver of Change in Control clauses.
  • ESOP Coverage Language: Existing fiduciary liability and D&O policies must be evaluated for their treatment of newly formed ESOPs. Some policies cover them, while others exclude them, necessitating awareness of policy differences.

Partner with an Expert

ESOP liability coverage is complex, the market is specialized, and underwriting scrutiny is intense. Expect to provide detailed and company-specific ESOP applications, multiple financial statements, and thorough documentation of ESOP valuations. Underwriters will deeply analyze share price volatility, financial condition, reputation, ownership structure, and more.

Retail agents are best served by partnering with experts in the ESOP space. DOXA has extensive expertise, strong underwriter relationships, and access to specialized resources to help agents succeed. By aligning with a knowledgeable partner like DOXA, retail agents can effectively navigate the complexities of ESOP coverage and capitalize on the growing market opportunity.

ESOP Growth Presents Market Opportunity for Retail Agents