We are not talking about Star Wars when we mention the Dark Side of ESOPs. We are talking about a very real, financially and fiduciarily binding obligation each ESOP must deal with – the repurchase of company shares of stock that employees participating in the ESOP own.
The term Dark Side was actually used by an ESOP client of ours. To illustrate the magnitude of what some ESOP companies might face, Doug McClure, CEO of Global Investment Strategies, shared some details.
Our client is looking at a possible $250M Repurchase Obligation over the next 10 years. For a business that nets about $15M – $20M per year, that is an enormous obligation that will demolish any positive cash flow, and dramatically increase debt load.
To explain, in an ESOP there is a fiduciary responsibility to pay an ESOP member (participating employee) fair market value for any shares in the company that they own and are fully vested. These payouts to the employee are triggered by an event, be it retirement, termination, disability or death.
The Repurchase Obligation is a financial factor often brushed aside when an ESOP is first formed. The predominant reason for this is that any Repurchase Obligation will not usually begin until the 6th or 7th year after an ESOP is formed. Many companies figure they can address funding of the Repurchase Obligation sometime in the future. It’s just not something they need to worry about today.
Also, how the money gets paid is dictated by the ESOP itself, according to terms defined when the ESOP formed. Factors that impact the timing of paying Repurchase Obligations include:
- If the ESOP used leverage (a loan) to pay the exiting owner, payments on that loan have a preferred position over Repurchase Obligations (the loan gets paid first)
- ESOPs have vesting schedules for employee owned shares, usually over a 3 to 5-year period
Let’s be clear here – the ESOP has a fiduciary responsibility to pay the Repurchase Obligation. They will have to pay this money when it is due. It may not be right away, but it will be owed.
This is the unspoken, dark and expensive side of an ESOP to which our client referred.
Well, there is an elegant solution. At an early stage in the life of an ESOP, preferably in the beginning, the ESOP company should purchase Company Owned Life Insurance (COLI).
Why this works is simple. A COLI product, when it matures, pays for an employee’s shares. There is no cash drain on the business. Plus, a COLI product:
- Is an immediate asset on the balance sheet?
- Companies can finance the payment of premiums, further reducing any strain on cash flow.
- Every employee participating in the ESOP has an immediate tax-free death benefit for their heirs.
- The COLI product enhances the benefit package for employees, making the company more competitive in their search for talent.
- There are significant tax advantages associated with a COLI product.
Let’s again be clear, but in a positive way – a COLI product satisfies the debt an ESOP will incur with their Repurchase Obligation.
If you are an ESOP, or considering becoming an ESOP, we will be happy to explore with you the structure, financing, feasibility, and Repurchase Obligations you are looking at. We can help with forecasting the potential liability, the details on the COLI product, and the best timing for the COLI product.
Contact Doug McClure at 520-360-8177 or firstname.lastname@example.org.