Employee stock ownership plans, used for years as a tool of corporate finance and employee motivation in the corporate world, may have a place in the restructuring of the healthcare delivery system.
ESOPs may be attractive for several reasons:
They offer a way to leverage the purchase of clinics, practices and other healthcare assets, with acquisitions paid from future cash flow.
Although ESOP financing isn't related to tax-exempt status, the tax incentives granted to ESOPs under the Internal Revenue Code can make the rate on ESOP borrowing almost equivalent to that of tax-exempt debt for borrowers of similar credit quality.
ESOPs can align the long-term financial interests of employees-including physician employees-with those of the employer. Such plans also are an effective way to interest and involve employees in setting and meeting organizational goals.
ESOPs offer employees deferred compensation as well as the opportunity to receive current dividends based on a measurable, employment-related yardstick-the success of the employer.
Accountable plans.In many respects, ESOPs are similar to other tax-qualified retirement plans. They're governed by the tax code and the Employee Retirement Income Security Act; they must meet the requirements that apply to profit-sharing plans as well as special ESOP requirements. Each participating employee has an account to which allocations are made, and distributions can be made on certain events, typically retirement, termination of employment, death or disability.
Would physicians be interested in participating in an ESOP? The 394-bed Houston Northwest Medical Center has an ESOP, but its physicians aren't employees, said Patricia Justice, director of human resources and the administrator of the ESOP plan. "Since the implementation of our ESOP in 1989, some of our physicians have expressed interest in being involved in (its) success," she said.
Lender rewards.An ESOP's primary or sole investment is in employer securities. Provisions allow them to borrow funds to purchase these securities. Incentives for lenders include the ability to exclude interest income on an ESOP loan, thus lowering borrowers' funding costs.
ESOPs can be maintained only by using the shares of stock corporations, unless the applicable state membership corporation law allows free transferability of shares. However, it's possible for not-for-profit institutions to achieve the benefits of ESOPs for themselves and employees by using for-profit subsidiaries.
The accompanying chart (p. 34) details how an ESOP works, particularly for a healthcare provider that seeks to acquire physician practices to build a healthcare network.
There's considerable flexibility in using ESOPs in traditional business transactions. Such benefits include financing acquisitions and spinoffs, raising new capital, buying out current shareholders and diversifying controlling shareholders away from the business.
Most of these may be applicable to the formation or expansion of integrated delivery systems, and an ESOP-financed arrangement can take many forms, so transactions don't have to conform to one specific model.
"An ESOP can make a lot of sense as a way to finance the creation of an integrated system," said Patrick Hurst, a senior vice president of Houlihan, Lokey, Howard and Zukin, an investment banking and valuation firm that specializes in ESOPs.
Tax advantages.ESOP financing offers tax advantages for a taxable entity and flexibility for a tax-exempt entity-often with comparable interest rates to tax-exempt financing techniques, such as the creation of a foundation that issues tax-exempt bonds.
Also, careful structuring and application of the tax code's "controlled group" rules can allow a hospital or physician group to maintain voting control in the corporate structure while obtaining the additional incentives available when the ESOP owns more than 50% of the value of the sponsoring corporation.
While an ESOP can provide attractive financing and important employee incentives, it can't make a bad transaction a good one. Any ESOP-financed acquisition can be only for its fair-market value, which is determined using the same criteria and methods that are used for any other acquisition strategy.
Also, ESOPs shouldn't be viewed solely as a financing issue. An ESOP is an employee benefit plan, and it should be regarded as part of the total compensation program for employees. Perhaps its most important benefit is the ESOP's potential to motivate employees and involve them in meeting the system's goals.
Here are some ways that ESOPs could be used in healthcare systems:
A new corporation, controlled by physicians, could establish a subsidiary that's an ESOP corporation. It could be used to acquire the assets of the physician practices and other entities, such as clinics, and employ the non-physician employees.
A tax-exempt hospital may form a for-profit subsidiary that creates an ESOP. Using ESOP financing, the subsidiary could acquire a large physician group. The new physician employees and the employees transferred into the subsidiary would participate in the ESOP.
The owners of a privately held nursing home corporation or home health service may establish an ESOP that acquires at least 30% of the stock of the parent corporation. The owners can roll over the proceeds of their sale to the ESOP in a tax-free transaction to purchase more nursing homes, home health agencies or related entities.
An acquisition or combination of healthcare entities is complex, and the use of an ESOP adds additional structural, financial and legal concerns. But ESOPs address issues that are fundamental to many proposed combinations, specifically the source of financing and the motivation and retention of personnel.