The principal disadvantages and possible problem areas that should be evaluated in considering an ESOP are as follows:

1. Dilution. If the ESOP is used to finance the company's growth, the cash flow benefits must be weighed against the rate of dilution.

2. Fiduciary Liability. The plan committee members who administer the plan are deemed to be fiduciaries, and can be held liable if they knowingly participate in improper transactions.

In general, the fiduciary liability under an ESOP is less than the fiduciary liability under a profit sharing plan, since the ESOP is primarily invested in employer stock. Under a profit sharing plan, the fiduciary has a wide range of choice of investments. The fiduciary must, therefore, diversify the investments, and all investments must meet the fair rate of return requirement. An ESOP, on the other hand, is exempt from the diversification and fair rate of return requirements, since the ESOP is designed to invest in employer stock.

3. Minority Shareholders. The ESOP, in effect, creates an additional shareholder, which is essentially in the same position as a minority shareholder. Thus, the major shareholders can be held liable if they engage in activities which are detrimental to minority shareholders. On the other hand, an ESOP participant does not stand in any preferred status to other minority shareholders.

4. Disclosure. During their participation in the ESOP, plan participants are not entitled to receive annual reports or attend annual shareholders' meetings. Upon distribution, however, the employee is then entitled to receive annual reports and attend shareholders' meetings, if he holds the stock rather than sells it back to the ESOP.

5. Valuation. The stock must be valued annually in order to establish the value of the stock for purposes of purchasing the stock, allocating the stock, and distributing the stock. If the valuation is prepared by a qualified third party, the valuation should be immune from subsequent adjustment. If, however, the stock is over-valued, the consequence depends upon whether the stock was contributed or purchased.

If the stock was contributed by the company at an excessive valuation price, the penalty would be a reduction of the deduction that the company had taken for the contribution. If the stock was purchased by the ESOP, the deduction would not be affected, but the seller would be required to pay back the excess purchase price. In addition, under ERISA, the seller is subjected to a 5 percent penalty tax for each year that the stock was overvalued.

6. Liquidity. If the value of the stock appreciates substantially, the ESOP and/or the company may not have sufficient funds to repurchase stock, upon employees' retirement. In most cases, very little liquidity will be needed in the first 5 years of the plan, since most employees who terminate in the early years are only partially vested.

After the first 5 years, the ESOP will normally need to keep approximately one-third of the fund in liquid investments (in order to provide liquidity for retiring or terminating employees). However, if the stock appreciates dramatically, the liquidity needs will increase correspondingly.

7. Stock Performance. If the value of the company does not increase, the employees may feel that the ESOP is less attractive than a profit sharing plan. In an extreme case, if the company fails, the employees will lose their benefits to the extent that the ESOP is not diversified in other investments.

8. Pro Rata Offers. Any offers to purchase stock on behalf of an ESOP must be made on a pro rata basis to all shareholders. Thus, unless the remaining shareholders agree otherwise, a retiring shareholder, for example, cannot sell his stock without offering other shareholders the opportunity to also sell stock on a pro rata basis. This is the same requirement that applies to corporate stock redemptions.

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