From the onset, management must make the ESOP’s sustainability a priority, regardless of its ownership stake.

September 01, 2016

Employee stock ownership plans (ESOPs) provide companies, selling shareholders and employees numerous benefits. But before any of these stakeholders reap the numerous benefits of an ESOP, company management must commit significant time and resources to its formation and administration. From the onset, management must make the ESOP’s sustainability a priority, regardless of its ownership stake.

This article discusses the importance of understanding the relationship between a company’s valuation and an ESOP’s sustainability. Specifically, companies should seriously consider employing certain best practices, such as having an interactive repurchase obligation study performed.

Common reasons for ESOP termination

A common reason for an ESOP’s termination is an attractive acquisition offer. When an interested third party presents a serious acquisition offer to a company, the company’s board of directors and the ESOP trustee have the fiduciary responsibility to consider it.

One of the most common reasons for an ESOP’s termination is an overwhelming repurchase obligation. Because the statutory put option creates a market for the ESOP-held stock, a ballooning repurchase obligation could have a detrimental impact on a company’s ability to sustain its ESOP.

Once an ESOP transaction closes, management will typically shift its focus to managing the company’s operations. For the first few years, stock repurchases are usually limited, given the lack of allocated and vested shares and, in cases of leveraged transactions, the high levels of debt and low share price. As time passes, shares are allocated and debt is repaid, the repurchase obligation liability can build quickly and command an increasing share of the company’s cash flow. If management has not planned adequately, the company may resort to using cash that otherwise would have been used to contribute to the firm’s growth to satisfy the repurchase obligation. As a result, inadequate planning could limit the company’s growth trajectory, causing its stock price to drop.

An ESOP might also be terminated because of poor underlying financial performance. If the plan sponsor performs poorly, the company’s stock price likely will drop, so the ESOP is less likely to provide a meaningful benefit to employees. Another reason for termination might be due to changes in management’s philosophy toward employee ownership. As a result of top-level turnover or a change in vision, management or the board of directors may alter its philosophy, deciding that an ESOP is no longer the desired or optimal long-term ownership structure.

Interactive repurchase obligation studies

Left unmanaged, repurchase obligations can stifle a company’s cash flow and potential growth, thereby jeopardizing the ESOP’s long-term sustainability. In order for management to understand the potential future liability that the repurchase obligation could create, it should consider performing an interactive repurchase obligation study.

Generally, a repurchase obligation study is a long-term projection of an ESOP’s required share repurchase due to qualifying events (e.g., retirement, diversification, death, disability) and the ESOP sponsor’s matching cash requirements. These studies vary in their level of detail, from basic financial models with few assumptions to complex actuarial simulations with multiple inputs and outputs. Although management can use specially designed software to complete studies internally, most ESOP-owned companies regularly engage outside professionals to perform more in-depth analyses.

An interactive repurchase obligation study models the circular relationship between a company’s future repurchase obligations and its projected future stock price. Payouts by the company depend on the stock price, and the projected future stock price depends on the amount of cash in the company, debt balances and shares outstanding. An interactive repurchase obligation study is most useful when performed as a collaborative effort among a company, a consultant who specializes in repurchase obligation studies and a valuation expert. In this collaboration, each of the three parties is responsible for certain parts of the study:

  • The company prepares long-term financial statement projections and provides the valuation expert and the consultant all the information they require to perform the analysis.
  • The valuation expert, relying on the data the company provides, estimates future stock prices over a long-term period.
  • The consultant, using various inputs (e.g., projected stock prices, plan participant census data, plan distribution policies), calculates the projected repurchase obligations.

Because the projected repurchase obligations affect the projected cash and debt balances as well as the shares outstanding assumed in the valuation analysis, the valuation expert updates the valuation projections, which the consultant then uses to adjust the projected repurchase obligations. Multiple iterations of this process are performed until a steady state is reached. In order to maximize the usefulness of the process, oftentimes management or its advisors prepare financial projections under various high- and low-growth scenarios and perform a repurchase obligation study
for each.

Once the repurchase obligation study is complete, management and its advisors analyze the potential impact of plan design decisions and growth scenarios on the company’s future cash requirements. Using such information, and with guidance from its advisors, management or the ESOP trustee may choose to modify the company’s ESOP distribution policies or targeted share releases in order to position the company to satisfy future repurchase obligations most effectively while minimizing these obligations’ impact on the company’s ability to finance growth.

Most ESOP-owned companies do not perform interactive repurchase obligation studies every year. Rather, they perform one early in the life of the ESOP and then update it periodically. Some companies may find it necessary to update their studies if they are considering a significant stock transaction, especially if the ESOP is buying stock or the demographics of plan participants change materially.

Funding options

Companies that perform interactive repurchase obligation studies have the advantage of foresight when it comes to the timing and magnitude of future repurchase obligations. Management can use this knowledge to prepare accordingly, including deciding whether to maintain or modify how repurchases are funded. Funding options available to a company typically include 1) using existing cash from the balance sheet, 2) forming a sinking fund within the ESOP, 3) raising outside debt and engaging in a leveraged transaction, and (4) purchasing corporate-owned life insurance to offset some of the obligation. When determining how to fund a repurchase obligation, a company should consider the impact each funding option will have on its day-to-day operations, as well as its cash availability and valuation.

Using existing cash from the balance sheet

Under this method, the company uses cash from its balance sheet to fund repurchase obligation liabilities as they arise. The advantage of this option is that it provides operational flexibility, which could make sense for a company with stable cash flow and manageable repurchase obligations. The disadvantage is that it could lull the company into a false state of preparedness. In the event the company underperforms and cash flow decreases, or in the case of a mature ESOP that requires large repurchases, cash might not be available to fund repurchases.

Forming a sinking fund within the ESOP

For taxable corporations, this proactive method of repurchase obligation funding creates a tax deduction, and it can be implemented only if the company intends to recycle shares within the ESOP. Although transferring cash from the company’s balance sheet to the ESOP’s sinking fund typically results in a lower stock price, the value of participant accounts is unchanged due to the increase in cash within the ESOP. Once the cash is in the ESOP, however, it can no longer be used for general corporate purposes, which could limit the company’s operational flexibility.

Raising outside debt and engaging in a leveraged transaction

Although limited to companies with sufficient borrowing capacity, this method of repurchase obligation funding is especially useful in the case of unusually large repurchase obligations and, depending on the company’s cost of capital, could be less expensive than other options. In a leveraged transaction, a company borrows funds from a third-party lender in order to repurchase shares from eligible participants. In this manner, a company can convert a large one-time repurchase obligation to a debt obligation that is paid over time, maintain corporate cash to fund operations and growth initiatives, and take advantage of low interest rates and the interest expense tax deduction.

Purchasing corporate-owned life insurance to offset some of the obligation

The risk of unanticipated significant repurchases is greater for mature ESOPs with large participant account balances. As a result, many companies purchase life insurance policies on these high-balance participants to complement other funding methods. Although insurance incurs an additional cost, it provides companies protection against the cash demands of an unanticipated significant repurchase due to a participant’s death.

Conclusion

An ESOP’s long-term sustainability depends on a proactive management team that understands the value of strategic planning. By performing interactive repurchase obligation studies, a company and its advisors can formulate an appropriate strategy to satisfy and fund future stock repurchases. It is important that companies recognize that the relationship between a company’s stock price and the ESOP’s sustainability should not be about limiting repurchase obligations. Companies should understand how their stock price can maximize the period during which the ESOP provides a fair and meaningful benefit to employees.