How Do Employee Stock Ownership Plans (ESOPs) Impact Corporate Governance?

Questions about corporate governance in ESOP companies are common among business owners who are exploring this employee benefit plan. The biggest questions revolve around the ESOP’s impact on corporate governance and whether or not forming an ESOP will affect board function and responsibilities in this area.

In general, forming an Employee Stock Ownership Plan or ESOP does not have to affect corporate governances, but in some cases, it does.

What is Corporate Governance?

Corporate governance is a broad term that is used to refer to the general rules of operation, practices, and processes that are used in running a business. Specifically, it refers to the interactions between the board of directors, senior leadership, shareholders, and other stakeholders.

Organizations follow corporate governance direction to make the decisions that guide the company. Ideally, decisions will be made that balance the needs of all affected parties and guide the organization towards growth and success. Corporate governance also sometimes includes the organization’s approach to sustainability practices, ethical behaviors and expectations, compensation strategies, and risk management.

Corporate governance is driven by the company’s board of directors who provide strategic direction for the business and establish the rules, policies, and procedures that will be enacted. These directives have an enormous impact on company performance, success, and culture, talent attraction and retention, and the public perception of the organization.

Corporate Governance in ESOP Companies

In family-owned or closely-held companies, both of which are often candidates for an ESOP, it is not unusual for the business owner(s) to also hold leadership and/or management positions within the business. In those situations, it is clear who controls business decision-making and is in charge of corporate governance: the owner.

When an ESOP is formed, business owners sell their shares of company stock to the ESOP where the shares are held in trust and managed by an ESOP trustee. This can raise the question of who “controls” the company if the owner no longer has a controlling ownership interest in the business stock.

But control over company stock and control over company direction are two separate responsibilities and can be split between multiple people. It is possible for the owner who sold their shares to the ESOP to retain their leadership position in the company, remain on the board of directors and thus, still have responsibility for corporate governance. The ESOP trustee, on the other hand, becomes the shareholder of record for the stock.

In this situation, the former owner and board retain control over corporate governance while the ESOP trustee controls company stock shares. The trustee is appointed by the board, elects board members, and has a fiduciary responsibility to protect the trust’s assets for the benefit of the plan participants, among other responsibilities. The trustee does not sit on the board, but remains independent of it to avoid conflicts of interest. To learn more about an ESOP trustee’s responsibilities, read our blog post, Duties and Responsibilities of ESOP Trustees.

Unless the responsibilities are specifically changed, the board has the same duties after an ESOP is formed as they had before it was formed. The board still oversees company direction, provides strategic guidance, appoints officers and leaders, approves the budget, and has oversight of the day-to-day operations of the business.

An ESOPs Impact on Corporate Governance

An ESOP’s impact on corporate governance is minimal. Board member responsibilities related to corporate governance are not affected by the formation of an ESOP and board members generally remain in place. The only change is the addition of the ESOP trustee who, even though they do not sit on the board, has a duty to oversee the decisions and make sure they are in the best interests of the ESOP.

Despite no substantive change in governance after forming an ESOP, there are three ways an ESOP could impact corporate governance.

1. Alignment of Employee and Shareholder Interests

ESOPs create a shared sense of ownership between owners and employees. Employees are no longer working just for someone else to reap the rewards. Their work and performance has a direct impact on company success and share value which is reflected in their ESOP account balances. Knowing that there is a real, financial reward for them can improve employee motivation and performance and create a stronger understanding of how share values are affected by business decisions and operations. As shareholders, employees have a voice in how a business is run and, by extension, corporate governance.

2. Challenge Decision-Making

ESOPs can change the dynamics of the board of directors and impact strategic decision-making. A company that forms an ESOP usually does so for a reason. Some reasons to form an ESOP, beyond simply an owner’s exit strategy, include: creating a legacy, remaining a crucial employer in a local market, or sharing the wealth that comes from business success with valued employees. Any of these reasons can challenge a board to make different decisions or think about their corporate governance approach in a new way, depending on the desired outcomes.

3. Influence the Corporate Culture

ESOPs are well-known for influencing corporate culture. They create a shared interest approach and promote a culture of accountability. This can impact internal communications and transparency. Employees will need and should receive much more information about share performance and the financial benefits of ESOP participation. This insight into company financials can help employees feel more invested in how the company does business and what they can do as an employee to improve company performance and increase share value.

ESOPs level the playing field somewhat by uniting everyone in the company, from the lowest levels to the highest, to work toward shared goals. Defining these goals and how to get there is a core function of corporate governance, which employees may now feel they have a greater say in.

The Potential of ESOPs as a Tool for Improving Corporate Governance

ESOPs create a situation where everyone gains or loses together. This kind of shared benefit encourages transparency, accountability, fairness, and responsibility – the four pillars of excellence in corporate governance. When so many people are invested emotionally and financially in the business, it can force a board to re-examine their corporate governance practices to make sure they align with and support the interests of all stakeholders. What the company does and how it does it becomes much more visible.

Companies with bad corporate governance rarely make it. They are eventually taken down by scandals or financial mismanagement. ESOPs make it much more difficult for bad corporate governance to take hold. They reward good corporate governance by naturally supporting ethical and equitable business practices, which lead to long-term financial stability.

Final Thoughts

Forming an ESOP doesn’t necessarily affect corporate governance but it does give businesses an opportunity to ask questions and examine who they are and how they operate, consider who they want to be and where they want to go, and create plans for how to get there. These are all foundational considerations that guide corporate governance decisions.

For deeper insight into corporate governance in ESOP companies, visit the National Center for Employee Ownership (NCEO) and download their book, ESOPs and Corporate Governance.

To learn more about the ins and outs of forming an ESOP, contact Aegis Trust Company.