Q: What are the pros and cons of the EOT as compared to ESOPs?
A: EOTs are significantly less expensive and less time consuming than ESOPs. When describing the EOT concept to ESOP folks, it takes them quite a while to wrap their head around how simple it is. EOTs don’t require annual valuations. They aren’t retirement plans, so there is no reason for them to be regulated by the Department of Labor. There is far less reason for litigation, so trustee costs should be much lower. There are no repurchase obligations, and so there is no need for a fancy financial analyst to help with scheduling.
Q: What are the pros and cons of the EOT as compared to worker-owned cooperatives?
A lot of folks are nervous about the unrestricted democracy in a worker-owned cooperative. In contrast, an EOT can be structured just like most ESOPs, with a circular “board appoints trustee, trustee elects board” structure. However, an EOT can also be structured as a “constitutional” democracy where employees have equal voting rights, but constitutional protections ensure basic elements of good governance and financial management, such as requiring reinvestment of a percentage of earnings back into the business. It’s also much easier to accommodate business owners during a sale to an EOT. Most selling business owners aren’t altogether that worried about employee-owners having equal voting rights––they’re just worried about employee-owners having equal voting rights while they’re still “on the hook” with seller financing. An EOT can easily resolve this concern by providing for an independent trustee during the sale period. After the loan is paid back and the business owner is fully “cashed out” of the company, a provision in the EOT trust document can toggle on employee voting rights. You get the benefits of a worker-owned cooperative without the commonplace obstacles that prevent their formation. This same “staging” process for employee voting rights can also be used in ESOP transactions. Perhaps the main differentiator is that EOTs can be structured to maintain the company under perpetual employee ownership. The ESOP trustee has a duty to sell the company out of employee ownership when presented with a sufficiently high offer. We also know that demutualization is a longstanding historical problem with the worker-owned cooperative. For selling business owners whose primary concern is legacy and the perpetuity of the employee ownership structure itself, and who are willing to sacrifice certain tax benefits, then an EOT is the best option.One last note here––a lot of folks also like the fact that certain core values can be locked into an EOT, such as making sure that the company is environmentally responsible, or that it donates some percentage of net income to their state center for employee ownership!
Q: Are there protections for employees when using an EOT, both at the time of the deal and as an ongoing entity?
A: For better or worse, a business owner can do about whatever they want with their company. They can shut the business down forever and sell the physical assets. They can attempt to preserve the business by giving it to a family trust. They can also preserve the business by selling to an employee ownership trust. All of these things can be done on a business owner’s terms without interference from the government. An ESOP is distinguished because selling business owners and businesses receive certain tax benefits. In exchange for these benefits, ESOP transactions and ESOP companies are tightly regulated. Right now, business owners do not receive any tax benefits by selling to an EOT, and so they are not burdened by regulation. As with an ESOP transaction, employees are not paying out of their own pockets on an EOT deal. So, again, a business owner can do whatever they want with their company––as long as employees and taxpayers aren’t paying for it. Problems that may arise here, but most business owners are selling to an EOT for the right reasons.
Q: What would be an ideal scenario in which an EOT makes sense or work best?
A: Right now, ESOPs enjoy immense tax benefits. So, for any company with more than 30 employees and $5M in revenue, an ESOP is probably going to be the best fit. An EOT might be ideal for anything smaller than that. Putting aside company size, if a selling business owner really values the idea of creating a perpetually employee-owned company that can never be sold out, and they are willing to sacrifice the tax benefits, then an EOT would be the way to go.
Q: Looking at the current legal and regulatory framework here in the US, what if any impediments do you see that would, or can, impede the growth of the model?
A: There are no legal or regulatory impediments to the EOT. The EOT can be used today by any company in any state in the country. That said, the main issue moving forward is whether Congress will give EOTs the same tax benefits enjoyed by ESOPs. The quickest way to do this would be to make the EOT an eligible holder of S corporation stock and grant tax-exempt status to EOTs. This would give S corp EOT companies the same tax benefits as S corp ESOP companies. It would also be smart to ensure that ESOP companies can transition to an EOT without suffering any adverse tax impact. I’ve recently spoken with a couple of ESOP companies that would love to transition to perpetual employee ownership and eliminate their endless repurchase obligations, but the tax impact of a transfer to an EOT is just too burdensome.