Are your company’s ESOP repurchase obligations like a monster hiding in the closet? How can you develop a plan for managing and funding repurchase obligations if you don’t know what they are?
An ESOP company with privately-held stock has a statutory obligation under the Internal Revenue Code to purchase ESOP shares from separated employees.
This repurchase obligation is the liability a company incurs when terminated participants are entitled to receive distributions from an ESOP. How and when payment is due varies by plan design; each company defines the timing, method, and form of distributions in their ESOP document.
A repurchase liability study is a means by which an ESOP company can forecast their ESOP repurchase obligations. And most companies, especially early on in the life of the ESOP, stop there. They don’t consider the funding of the obligation. Longer term, it is this funding obligation that is the primary reason for failure of 18% of ESOPs.
The reason is that a company does not incur repurchase obligations until at least Year Six in the life of the ESOP. In cases where there is a seller note, the repurchase obligation may be even later because the repurchase obligation is usually in a subordinated position to the seller note.
Would it surprise you that properly managing ESOP repurchase liability is not just a funding obligation, it’s a fiduciary obligation, too? A passive, “pay-as-you-go” approach may not satisfy fiduciary requirements or be a prudent way for your company to address repurchase obligation.
A company should structure a funding strategy that ensure liquidity to pay ESOP participants. Doing so meets the fiduciary obligations, and helps in many other ways:
- Reduces the risk that the cash required to repurchase ESOP shares will deplete future operating funds or impede investment opportunities such as making acquisitions, purchasing plants and equipment, and hiring employees.
- Avoids having future ESOP repurchase costs negatively impact the company’s financial decisions.
- Enables the company to achieve and maintain a targeted employee benefit cost as a percentage of total compensation cost.
Doug McClure, CEO of Global Investment Strategies, recommends a straightforward five-step process to structure a funding strategy and manage the repurchase obligation.
Step 1: Forecast the liability
Based on a census of ESOP participants, make reasonable projections on the quantity and timing of the events that trigger the need to convert ESOP shares into cash using corporate funds. Those events include:
- Termination of employment (for any reason)
Step 2: Prepare a repurchase liability forecast
The main reason for preparing a forecast of repurchase obligations (often called a repurchase obligation study) is to avoid surprises. A study may be required by the appraiser who values your ESOP stock, or by a prospective lender when ESOP financing is sought.
Repurchase liability forecasts take into account the number of outstanding shares, total projected employee benefit cost structure of the company, and the possible effect of different funding methods on future cash flows, all of which can impact the future stock price. Your ESOP appraiser’s input can be an integral part of this kind of forecasting.
A good study will help you to anticipate the magnitude and the timing of the liquidity needs for repurchases and to project the size of individual account balances. This information, obviously, is useful for preparing budgets and long-term plans. A repurchase obligation study can also be used as a planning tool to examine the impact of changes in the ESOP. For example:
- How will a change in distribution rules from lump sums to installments, or vice versa, affect the repurchase obligations?
- How will the ESOP’s acquisition of additional shares affect the liquidity requirements for repurchases?
- How will repurchase obligations be affected by handling repurchases through the ESOP versus having the company redeem the shares?
- What will be the effect of changes in the employee demographics or of actuarial factors such as turnover?
- How will individual account balances, as well as the overall liquidity requirements, be affected by any of these changes?
- How effective will a proposed funding strategy be in meeting future liquidity needs?
The projected repurchase obligations, expressed in the number of shares required to be repurchased, can also be used iteratively in a valuation model as a factor in valuing the ESOP stock.
Step 3: Evaluate funding alternatives
There are several ways to fund repurchase obligations. Common methods include:
- Using the pay-as-you-go approach with cash from working capital or earnings
- Tapping unused debt capacity, paying participants with a line of credit, term loan, or note
- Pre-funding the liability on the company’s balance sheet by investing in corporate owned life insurance (COLI)
Without a doubt, the most effective method is pre-funding the forecasted liabilities with corporate owned life insurance. The policy matures in the early years when there are virtually no repurchase obligations to pay out. When events requiring repurchase do arise, there is value in the policy that pays to repurchase the shares.
The policy is an asset on the company’s balance sheet and there is little to any impact on the cash flow of the business. Plus, having the insurance in place is a favorable factor in valuing company shares and getting favorable terms for any notes needed to fund the ESOP.
Step 4: Consider the effects on the plan design and administrative actions
Plan fiduciaries should evaluate the effect plan design and administrative actions can have on projected and actual repurchase liability costs, including releveraging, rebalancing or reshuffling, delays in distribution, lump-sum versus installment distributions, and redeeming versus recycling.
Step 5: Monitor, evaluate and make adjustments
The final step is to periodically monitor the cost projections and actual results, then re-evaluate the assumptions used in the study. Doug McClure suggests doing this on an annual basis.
A comprehensive ESOP repurchase liability review and analysis of current results and future projections should be presented to the board of directors along with funding methods. Items to review should include:
- Repurchase liability assumptions
- Corporate cash flow and debt projections contrasted with the repurchase liability forecast
- Corporate strategic plans
- ESOP provisions
- Investment results
- Roles and responsibilities of the board of directors, trustee and senior management in the repurchase liability process
With proper planning and funding, fiduciary repurchase obligation issues are more manageable. Companies that fail to plan properly to meet ESOP repurchase obligation may have negative impacts on cash flow. These negative impacts cascade to changes in distribution policy. Promises made to employees lowers morale because depended on retirement benefits may not come to fruition. Other negative cascades include higher cost of capital, lower company value, or perhaps threats to the ongoing viability of the business.