While employee share ownership plans are popular with manufacturers and professional service companies, ESOPs and financial institutions seem like weird bedfellows. Yet commercial and investment banks, insurance brokers, asset management and real estate companies are the tthe most common users of these plans, which make up almost a sixth of the country’s roughly 6,600 ESOPs.
What explains their popularity? First and foremost, financial institutions value an ESOP’s ability to provide tax-deductible liquidity; to support an orderly succession in the next management generation; and expand employee ownership, which can improve employee engagement, long-term retention, morale, and growth.
Community banks paved the way 40 years ago when a wave of mutual companies transformed their corporate structures into public companies. These banks used ESOPs to give their employees an equity stake while tapping community sources and outside investors for capital, particularly in conjunction with a public offering of shares. Today, nearly 800 US banks offer ESOPs, according to the Wisconsin Banking Association.
Aligning the interests of employees with those of external shareholders creates tremendous benefits, notes Greg McClure, partner at Crowe LLP and a specialist in financial institutions. “When employees receive the ESOP statement and see the value of their investment, it is a powerful incentive.”
McClure also notes that ESOPs are a useful asset transfer tool, especially as an alternative to selling, as they allow the owner of a large banking stake to cash out an illiquid investment while maintaining the bank’s independence. While the seller does not receive a premium, he receives the fair value for his shares. In addition, selling shareholders may, in certain situations, permanently defer capital gains in order to reduce the perceived delta between the fair market value of an ESOP and a potentially strategic premium.
This ESOP function is proving to be particularly important for smaller, unlisted community banks that cannot easily enter the public markets, but still want to control their fate and continue as an independent, community-oriented institution. In addition to continuing to exist as a stand-alone entity, the bank benefits from the tax deduction for dividends used to pay off the bank’s ESOP debts.
The main constraint on the size of a bank’s ESOP is its impact on regulatory capital. The ESOP’s purchase of the bank’s shares is funded through a loan that is included in the bank’s regulatory capital ratios. Careful analysis is needed to ensure that the bank’s capital structure is not unduly compromised and that the bank’s profitability can meet the interest expense of the loan.
McClure says that despite the necessary planning, no bank has ever said, “We wish we hadn’t.” He cites an institution in Louisiana with a large single shareholder. Concerned that the older shareholder might die, his advisors considered the possibility of the bank’s ESOP buying his shares. The independence of the bank was the main priority of the shareholder and the bank’s board of directors; Since it was a very profitable institution, the bank could have absorbed the lower profitability from borrowing to buy its shares.
Given the financial benefits of an ESOP and the commitment to employees, other financial institutions have turned to this structure. Eddie Brown, founder of Brown Capital Management – the country’s second oldest black-owned investment management firm – graduated from an ESOP in 2016. The 36-person employee-owned company managed assets of $ 14 billion last year.
Legacy and succession played an important role when Brown started his ESOP. Speaking of Barron’s last year, he said, “People said, ‘You have to sell the company,’ and I said, ‘No, we have the second oldest African-American owned investment management company in the world. I want to keep our place in history. We’ll find out. ’” When converting to an ESOP, Brown gave equity to all employees.
A similar desire to transfer significant amounts of the founder’s equity while maintaining independence and continuity motivated The Graham Company, one of the largest insurance and benefits brokers in the Mid-Atlantic region, to close a 100% ESOP in March 2017. Over five decades, Chairman and CEO Bill Graham grew the Philadelphia-based brokerage firm from $ 300,000 in sales and six employees to over $ 50 million in sales and more than 180 employees. Along the way, the organization received numerous awards for its workplace culture, including the Best Places to Work award.
Ken Ewell, Graham’s President and Chief Operating Officer, told Employee Benefit News that “For an agency with a strong, healthy culture, a strong sense of purpose, leadership, and a desire to remain privately owned, it is performance-driven ESOP “is the right choice.”
The trend continues. Last year, Verit Advisors helped a highly regarded investment bank close an ESOP. Founded in 1994, the business-oriented company with a focus on the community banking sector expanded its services to include capital market advice, share underwriting, and asset and liability management. It created the ESOP to provide liquidity to partners who had amassed significant holdings and a path to property and wealth creation for colleagues who had recently joined the company.
Don’t expect these unexpected marriages to go away anytime soon. Financial services companies are some of the most creative ESOP enthusiasts – and the stories behind their advertising usually explain why.