The first two parts of this series have explored the concept of the Employee Stock Ownership Plan (ESOP) and the potential advantages of establishing one for your contracting business. This month, we will discuss some of the possible pitfalls.

The costs associated with designing and maintaining an ESOP include professional fees and ongoing clerical expenses as well as filing fees. Legal fees for small company ESOPs begin at about $10,000, mostly for time spent designing individualized requirements and document preparation.

You will pay a professional valuation expert an equivalent fee to establish the initial stock value, plus half of that (about $5,000) for required annual repeat valuations. You also need an accountant to set up the recordkeeping structure and handle government filings.

Plan administration costs vary with the number of participating employees. For the smallest (20 employee minimum), the fixed costs may run about $2,000, plus $30 to $60 for each employee. Leveraging adds loan fees, attorney and accountant fees, and the internal cost of preparing documents; plan to spend another $10,000 or more.

Of course, if the primary purpose of setting up an ESOP is to buy out the owner of your company, compare the total ($40,000 or more) against the fees charged by a business broker (often the same or greater). Finding a ready buyer for a closely held contracting firm is difficult, and many owners have sentimental reasons for transferring ownership to loyal employees.

One measure of the costs’ reasonability is to make sure your annual costs (including startup cost amortization) don’t exceed your annual stock or cash contribution multiplied by your tax rate.

For example, if your costs total $10,000 per year, and your tax rate (federal and state) is 30 percent, then you can contribute at least $33,333 per year to the ESOP ($33,333 × .30 = approximately $10,000).

To estimate your maximum leverage, multiply the eligible payroll—excluding those who don’t qualify plus any individual salary amounts greater than the maximum ($205,000 in 2004) by 25 percent—and then multiply that subtotal by the life of the loan. For example, if you have eligible payroll of $1 million and a 10-year loan, you can borrow up to $2.5 million ($1 million × .25 × 10). Make sure this is enough to fund your annual ESOP contribution.

An ESOP can become less attractive when profits shrink, layoffs increase or employees leave the company sooner than expected. You can set your own timetable for repurchase, but sufficient shares must be available for the annual allocation to individual accounts.

For a “mature” ESOP, which has substantially repaid its debt, all shares may have been allocated. If you decide to “rebalance” participant accounts so that each has a uniform percentage, long-term employees may complain that their account value has been reduced. In some cases, you may choose to terminate the ESOP in that circumstance.

Other potential disadvantages include the financial disclosures associated with the issuance of participant account statements, failure of the trustee to make fiscally responsible decisions, and the discomfort of ceding some voting control to employees.

In the extreme, disgruntled stockholders can sue over the creation of an ESOP (especially if it replaces another retirement program), the perceived dilution of their account value, or the methods used for establishing valuation. They can target not only the trustee, but also anyone operating as a fiduciary (including company managers and the board of directors) and making decisions that affect the ESOP.

The Internal Revenue Service and Department of Labor can also initiate lawsuits for nonpayment of taxes and ERISA violations, although these types of actions are usually reserved for precedent-setting issues or larger plans. Target areas include conversions of other profit-sharing plans, valuations and takeovers as well as failure of fiduciaries to act on behalf of shareholder interests.

Perceived gains in productivity following plan implementation often quickly level or evaporate, and employees may be uneasy with the idea of relying on the performance of a contracting company to fund a major part of their personal retirement, so positive effects on moral may be questionable. This is especially likely if your firm experiences cyclical variations in profitability.

So, who wins the ESOP race—the company or the employees? It really depends on your strategic goals, financial strength and the employee’s attitude. Now that you know some of the pitfalls, as well as the advantages, you will not enter the race without adequate preparation and training.

Select your course carefully, and an ESOP could be the best strategic move you ever make. For more specific information, consult the National Center for Employee Ownership (http://nceo.org) or the ESOP Association (www.esopassociation.org).    EC

NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at [email protected].