As lenders mull ownership shifts, ESOPs provide beneficial alternative

March 1, 2021 6:34 AM

Since origination booms are considered the best time to get a good price for a company, its assets or its shares, initial public offerings and special purpose acquisition companies have drawn a lot of attention lately.

But given that employee retention is key to the long-term profitability of mortgage companies, there’s another underutilized strategy that the latest Best Companies to Work For data suggests owners may want to consider: employee stock ownership plans.

In a market where voluntary turnover even at the Best Companies in some cases topped 70% last year, lenders with employee stock ownership plans kept that rate at 25% or lower. The three ESOPs in the list each also ranked within the top 10 among companies their size.

“Particularly last year, when you had so many operational staff and loan officers working so many hours, and I would encourage anybody that’s running a mortgage bank and considering options to give it a strong look,” said Gellert Dornay, founder of Axia Home Loans.

ESOPs are the most common form of employee ownership in the United States and have been standardized in the tax code since 1974.

Across all industries, there are 6,460 ESOP plans covering 14.2 million people, according to the National Center for Employee Ownership. A handful of lenders have them, and they are most typically favored by private owners who are retiring and see their employees as successors.

An ESOP is set up as a trust fund that serves as a vehicle for the company’s shares has limited tax-deductibility. That deductibility is currently based on a percentage of earnings before interest, taxes, depreciation, and amortization. In 2022, it becomes a percentage of EBIT instead. The shares are generally distributed to employees on an equitable basis and the company must buy departing workers out when they leave.

A small but influential group

Roughly 15% of ESOP sponsors are in the finance, insurance and real estate industry segment that includes mortgage companies, according to the National Center for Employee Ownership.

While private companies with ESOPs don’t have to disclose their financials publicly, historically they tend to get a 2.5% increase in their sales, employment and productivity after forming the ESOP, according to the center.

“If you look at things like turnover rates, customer satisfaction, and corporate performance, ESOP companies do quite a bit better,” said NCEO Founder Corey Rosen.

The most highly ranked ESOP in this year’s Best Mortgage Companies to Work for list is Fairway Independent, which was No. 2 among large companies this year, and No. 7 overall.

Fairway describes its ESOP as one of several key perks it offers. It’s a particularly important one now because it appealed to certain professionals who are in demand due to the refi boom.

“The ESOP was good for attracting and retaining folks on the ops side,” said Chief Financial Officer Len Krupinski, noting that operations were in heavy demand because efficient loan closings had high strategic importance this year.

White House Press Secretary Jen Psaki Holds Briefing

Jared Bernstein, White House economic adviser, speaks during a news conference in the James S. Brady Press Briefing Room at the White House in Washington, D.C., on Friday, Feb. 5, 2021, as White House Press Secretary Jen Psaki stands by. Photographer: Oliver Contreras/Sipa/Bloomberg

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A Biden adviser wants an office for ESOPs

ESOPs are a timely strategy to consider not only because ownership alternatives and retention are top of mind, but because they’re on a Biden administration’s radar screen.

There should be a government office to support ESOPs because there’s a lack of awareness about them, Biden adviser Jared Bernstein wrote in a recent study commissioned by the Employee-owned S Corporations of America.

That office could be placed within the Commerce Department or the Small Business Administration, suggested Bernstein, a senior fellow at the Center on Budget and Policy Priorities.

Other proposals such as tax incentives to sell to employees, and the creation of entities that could help provide capital for such purchases have been backed by Ownership America, a separate group of advocates that includes Dornay at Axia Home Loans.

Privately-funded employee ownership investment corporations, for example, could be created to help bridge gaps whe capital resources needed for an ESOP transaction aren’t available.

Patterned after similar investment corporations that small businesses use, EOICs would contribute funds to an ESOP in a subordinated position that would serve as equity, making the company more eligible for other financing.

To incent investment in EOICs, the paper calls upon congress to reduce the taxable interest income from them by half.

While Bernstein has advocated for more awareness of existing ESOP benefits, he has opposed additional tax breaks. The creation of EOICs, however, otherwise would be “budget neutral” to the government, the paper by Ownership America noted.

Also, the Biden administration may weigh whether tax breaks may be worth the benefits ESOPs have as community wealth-building tools, said Dornay, who originally learned about employee ownership from a Catholic business group and became intrigued with them for that reason.

Why ESOPs work, but have their limits

Having an ESOP office could be helpful because there is a lack of industry familiarity with their tax-advantaged structures and how to manage them, Dornay said.

ESOPs can, for example, complicate the approval of corporate credit lines that mortgage companies use to fund home loans if the warehouse lenders that provide the LOCs are unfamiliar with the structure, Dornay said. However, once they understand it, an ESOP should not be a barrier to such approvals, he said.

Warehouse line agreements typically include a guarantee from a primary beneficiary of profits from the company, but in an ESOP, the profits are divided among the employees, so standard pacts have to be adjusted to account for that.

Not every owner may want to operate without a primary shareholder, and that’s among the reasons ESOPs aren’t widely used, said Axia CEO Alex Rosenblum.

“It’s a very generous move, especially when you are selling 100% back to employees,” he said, noting that there are alternate ways to give employees access to ownership stakes.

Also, as more employees join an ESOP company, existing ones may be concerned about dilution in the value of their shares. But share structures can be changed to address that if needed. Profits have been so strong in the past year that it hasn’t been an issue, executives interviewed for this article said.

Because employee stock is not a tangible benefit until retirement, it needs to be explained to employees to have value as a recruiting and retention strategy, said Julie Fry, chief human resources officer at Fairway.

“That’s why one of our initiatives in 2021 involves financial wellness for our employees and part of them will be educating them on what the ESOP is, how they personally contribute to it and what it can do for them long-term,” she said.

ESOPs don’t resonate with all employees in the long run. Some, for example, might not like the lack of diversification in the investment when compared with traditional 401k plans, although it can co-exist with these. It also appeals more to operations professionals than those in sales.

"It’s a good benefit but it depends who you are recruiting. If you’re going after a big producer, the benefit from the ESOP is not going to be really substantial in comparison to something like their signing bonus or the strength of your fulfillment platform,” said Rosenbaum.

Ultimately, an ESOP has its limits and can be complex and expensive to implement, but it can give companies that have it more consistent profits with fewer cyclical swings because of the team dynamic it encourages, executives agreed.

Establishing an ownership entity is not easy to do, but it’s valuable because if people have ownership in something, they treat it more favorably than if they don’t, said Doug Schukar, chairman of CEO of USA Mortgage.

An ESOP “is definitely an effective recruiting tool, and when it comes to retention, it can be a good way to make sure you’ve got the right people on board,” he said.