ESOPs: A Need to Focus on Creating Transferable Value

Thoughtware Article Published: Oct 25, 2018
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Over the last 20 years, ESOPs have become a popular and effective way to transfer ownership of privately held companies. The primary driver that’s contributed to this popularity is the desire of company ownership and leadership to preserve and sustain company legacy, and the ESOP’s potential to achieve this goal. This isn’t just supported by anecdotal evidence, but also by many surveys. In BKD’s most recent succession survey, the two top factors among privately held companies in considering a future transfer of ownership were a) ensuring the company’s future success and b) preserving culture and legacy.

While selling to an ESOP often is the first step in achieving this goal, it’s by no means the end of the process. In fact, while selling to an ESOP can take many months of intense effort and negotiations, it may be the easiest step toward achieving the ultimate goal of preserving company legacy. Once the ESOP is set up, the real work of preserving legacy and creating transferable value begins. Having said that, this is also where many companies—including ESOPs—fail.

Before we go further, let’s define transferable value. Most companies and owners understand the concept of value, and often simply equate value to a multiple of a company’s current cash flow. However, companies, including ESOPs, need to think more comprehensively in terms of transferable value. Transferable value, as alluded to, is more comprehensive, and is focused not just on current cash flow levels, but on identifying the variables necessary to preserve, sustain and grow current cash flow. Thus, transferable value considers risk, growth opportunities and institutional knowledge, among others.

A focus on creating transferable value often is a weak link among ESOP companies. Failure to acknowledge and work on transferable value can jeopardize achieving the desired goals of why the ESOP was established, and thus result in a lot of fruitless work and effort. While many companies struggle in this area, here are a few reasons ESOPs specifically may fail.

  • First, selling to an ESOP involves several months of intense effort. Once the sale is complete, the intensity of the effort can often lead to a sensation that “we’ve crossed the finish line,” when in reality you’ve only made it to the starting gate.

  • Second, creating transferable value involves various skills for which owners and leaders have little experience. For example, while BKD’s recent succession survey indicated 77 percent of our respondents will face a change in leadership within the next 10 years, less than 35 percent of those companies have experienced a change in leadership. Therefore, many companies may not have the know-how to navigate a successful transition.

  • Third, the routine activities of the business divert owners and leadership from focusing on the things that are necessary for future success. Since creating transferable value is an ongoing and continuous process, it requires intentional and continuous effort, from which the daily grind can quickly divert our attention.    

While future articles will cover some of these topics in more detail, there are a few areas where we believe ESOP companies should begin focusing time and energy to create transferable value (if they aren’t already). First is the development of “institutional knowledge.” While many CEOs are very good at what they do, they fail to “institutionalize” their knowledge, experiences and relationships. This is problematic for two primary reasons. If the CEO becomes unable to fulfill his or her duties for whatever reason, the company’s operations—and thus its value—are immediately impaired. The CEO needs to ask “What knowledge and relationships do I have that are critical to the success of the business?” After that, the process of developing a plan to broaden that knowledge and relationship within the organization can begin. The development of processes and procedures can often facilitate the development of institutional knowledge. Also, developing institutional knowledge increases the bandwidth of the company, positioning others to have the skills and abilities to create more opportunities for the organization.   

Next, companies should develop a continuous habit of strategic planning. If done correctly, strategic planning can educate and professionalize the next generation leadership team, improve resources, align the company to work collaboratively toward a unified and stated goal, identify and mitigate risks and increase transferable value. While many companies would say they do strategic planning, it’s often done informally and excludes detailed accountability measures and goal monitoring. In general, strategic planning is most successful when facilitated by an outside advisor who is independent and objective and is familiar with best practices.

Finally, regardless of the current age of the leadership team, there should be a continuous focus on identifying and developing next generation leadership. The two items above—creating institutional knowledge and strategic planning—are instrumental and important parts of developing next-generation management. However, this also requires an intentional focus and additional steps for success. For example, have you done an assessment of your management team? This can help put each member in the right seat, as well as identify blind spots where additional training and education can help shore up weaknesses. Also, are there any gaps in your current management team that need to be filled for a successful transition? Here, it’s important to not just consider current gaps, but future gaps based on the predicted state of the business resulting from your strategic planning.

This brief article is not intended to be a holistic guide to creating transferable value, but hopefully it has encouraged you to step back and ask if you and your company are doing the hard work necessary for any company—ESOP companies specifically—to achieve long-term success. If you’ve already created an ESOP or are considering creating an ESOP, don’t delay in this endeavor. The hope is that more companies not only pursue the rewarding path of employee ownership, but they sustain and succeed in their goals by creating transferable value.

Be on the lookout on future articles on this topic, but if you have any questions or comments in the meantime, contact Alan or your trusted local BKD advisor. 

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