Managing repurchase liability arising from an ESOP
July 2013 | 10QUESTIONS | PRIVATE EQUITY
FW talks with Regina Carls, director of the ESOP Advisory Group at JPMorgan Chase & Co, about managing repurchase liability arising from an ESOP.
FW: As a starting point, could you provide a brief overview of ESOPs, including the different types and structures of ESOPs?
Carls: ESOPs are qualified retirement plans that give employees an ownership interest in their company by investing primarily in the employer’s stock. ESOPs have numerous tax advantages and unlike other qualified plans, ESOPs are allowed to borrow in order to finance the purchase of employer stock, making it a very useful ownership transition tool. There are two types of ESOPs. ALeveraged ESOP has borrowed money to purchase employer stock. In a typical leveraged ESOP, the company borrows from a bank and lends the proceeds to the ESOP – the ‘internal loan’ – to finance the stock purchase. A leveraged ESOP still has outstanding debt from its share purchase. A non-leveraged ESOP is one in which the company makes periodic contributions to the ESOP in stock and/or cash and where the ESOP does not have any outstanding debt. ESOPs typically provide significant tax benefits for both sellers and sponsor companies. Under certain circumstances, sellers can defer capital gains and net investment income taxes on their gain from the sale. Companies can deduct their contributions to the plan and S corporations’ income accruing to the ESOP – as a shareholder – is not taxed. S corporations owned 100 percent by an ESOP are substantially free of income taxes.
FW: What are the circumstances that trigger repurchase obligation? What is the timing of these repurchases?
Carls: ESOP participants have the right to receive their vested account balances after they depart the company and the sponsoring company is obligated to repurchase this stock when it is a closely held corporation. This is referred to as ‘repurchase obligation’. The events that trigger the company’s repurchase obligation are: death, disability and retirement; terminations – voluntary or involuntary; and diversification. The laws governing ESOPs allow for some flexibility in the timing of the start of a company’s repurchase obligation as well as the period over which payments are made. Generally, distributions related to death, disability or retirement begin the year following a participant’s separation from the service. Distributions related to other terminations of employment can start several years later. The distribution may be paid in a single cash payment or the company may chose to make up to five equal annual instalment payments. The ESOP plan document details these provisions, although a company can choose to pay repurchase obligations in a more liberal – that is, faster – manner under a separate distribution policy.
FW: Upon the event of death, disability, retirement, or termination, companies must repurchase stock. What methods are used to carry out a stock repurchase?
Carls: The company has a few options it can employ to convert participants’ shares from stock to cash. The most common are redemptions and recycling. Redemptions are simply the purchase by the company of the participant’s shares either from the participant – after they have been distributed – or from the ESOP. In the latter case, the ESOP will distribute cash in lieu of stock to the participant. In either case, the shares are put into treasury. Recycling involves the contribution of cash to the ESOP by the company, which the ESOP distributes to the participant instead of stock. With recycling, the shares remain in the trust and are reallocated among the remaining participants in the plan. Companies often employ a combination of redemption and recycling so as to better manage the benefit levels delivered to participants.
FW: What key factors drive the magnitude of a firm’s repurchase obligation?
Carls: Repurchase obligation is a function of two factors: first, the number of shares that are put to the company by former participants; and second, the per share stock price. The number of shares put to the company for repurchase each yearis driven by the pace of participants’ separation from service. This, in turn, is primarily dependent on the workforce’s age demographics and turnover rate. Plan design and distribution policy also have a significant impact as they govern vesting and timing of distributions. There are numerous factors which affect the ‘per share stock price’ of a company, including the company’s performance, the performance of the capital markets, and the company’s capital structure. Predicting future repurchase obligations can be a complex exercise. Nonetheless, it is important that they be quantified and managed like any other corporate obligation in order to protect the company’s ability to grow and operate the business without undue financial risk. Therefore, companies should examine actuarial as well financial data to get as accurate of a projection of future cash requirements as possible.
FW: Does the repurchase obligation affect value?
Carls: The impact on stock value of repurchase obligation, if any, will depend on whether a company redeems or recycles shares. Stock price is determined by dividing total equity value by the number of shares outstanding. Redeeming shares causes equity value to decline by the amount of the cash outflow and total shares outstanding declines by a commensurate amount. Therefore, while total equity value declines, per share value remains unchanged. Recycling shares involves the ESOP distributing cash instead of stock to participants, funded by a company contribution. The shares that would have been distributed are retained in the ESOP and reallocated to the remaining participants – creating an incremental benefit to the participants. Thus, the equity value declines because of the incremental benefit cost in the company’s cost structure but the number of shares outstanding does not decline – as in the case of redemptions – because all shares remain in the ESOP. To the extent that the benefit expense incurred by recycling shares is equal to a normal retirement benefit level, then recycling will not be dilutive to share value. On the other hand, if it exceeds a normal retirement benefit level, it will be dilutive to share value. Another less obvious factor is the ‘opportunity cost’ associated with repurchase obligation arising from the diversion of cash from meaningful investment opportunities. Where repurchases are overly large, this will likely detract from the company’s ability to grow and consequently will impair value.
FW: Repurchase obligations are not recorded on the balance sheet and yet, may have a material impact on the firms demand for capital. What options are available to firms when it comes to funding their ESOP repurchase obligations?
Carls: There are four categories of funding options for ESOP companies: first, pay-as-you-go; second, utilise unused debt capacity; third, prefund the liability; or fourth, create an internal market among participants and employees. Each method has advantages and disadvantages. Proper analysis and planning is critical to developing a strategy that suits all of the company’s needs. Companies with sufficient cash flow commonly use the pay-as-you-go approach. Spikes in repurchase obligations can be satisfied by tapping into unused debt capacity, although borrowing for this purpose must be done carefully. The company may potentially be able to modify distribution policies to slow the pace of repurchase obligation. Prefunding can be achieved by creating a sinking fund on the firm’s balance sheet, or accumulating cash in the ESOP. Funding a sinking fund for future repurchase obligations gives the company more financial flexibility while reducing financial risk and increasing employee retirement security. However, this may not be the most productive use of capital and the cash remains exposed to creditor claims. Cash can accumulate in the ESOP trust through excess contributions and dividends on ESOP held stock. Accumulating cash in the ESOP insulates it from creditor claims. However, the cash is then not accessible to the company for corporate purposes.
FW: Repurchase obligation is a demand for capital. Does the repurchase obligation impair a company’s ability to grow?
Carls: If properly managed, repurchase obligation should not affect growth. Repurchase obligation is an ongoing retirement benefit. Therefore, if total retirement benefit inclusive of the repurchase obligation is within historical or industry norms, it really isn’t an incremental claim on capital. Moreover, the likely tax benefits accorded to ESOP owned companies, particularly 100 percent ESOP owned S corporations, often more than offsets repurchase obligation, meaning that a company could still experience more capital formation even after repurchase obligations than an identical non-ESOP owned company subject to corporate income taxes. Proper management requires periodic assessment of distribution policy, which governs the pace of how repurchase obligations are paid, and careful consideration of the company’s valuation to insure that the stock is not overvalued.
FW: What happens when the Company suffers distress? How is the repurchase obligation satisfied in these circumstances?
Carls: Flexibility in a company’s distribution policy is critical in this circumstance. Even if the company has historically paid departing participants more rapidly, it can lengthen payout periods if the plan allows it. The company may also need to assess traditional methods of cost reduction to determine whether any exacerbation of repurchase obligation makes them untenable. Ultimately, a distressed company needs to work with its primary capital sources – banks in particular – to determine if additional capital is available. In more extreme cases where additional capital is unavailable and where the payments threaten access to existing critical capital sources (primarily senior bank debt), a company may need to negotiate payment forbearance with the ESOP trustee.
FW: How do stock repurchase obligations differ for S corporations and C corporations? In what ways does this affect planning for, and funding, stock repurchases?
Carls: Corporate structure does not change the fundamental concept of repurchase obligation – that the company must convert shares to cash when participants depart from the company. Repurchase obligation is a function of the timing of employee departures and the value of the company’s stock. It is important to understand the drivers of repurchases and incorporate the repurchase obligation forecasting and planning into the Company’s strategic planning process. While timing of repurchase obligations is not directly a function of corporate structure, the value of the stock may be quite different. For example, the value of stock in a 100 percent S Corporation ESOP should increase at a greater pace – all else equal – because it does not pay taxes. This incremental cash savings accrues to the value of the equity thereby increasing share value and repurchase obligation. One hundred percent S Corporation ESOPs must consider these incremental cash flows in forecasting future cash flows and share price for purposes of forecasting and planning for repurchase obligations. While corporate structure may impact value, the more material contributors to the magnitude of repurchase obligation will be the overall level of ESOP ownership and future share appreciation driven by operating performance.
FW: What difficulties might arise when amending existing ESOPs to address repurchase obligation? What are common strategies used to resolve such issues?
Carls: Plan design and distribution policy can have a substantial impact on the timing and magnitude of an ESOP company’s future repurchase obligations. Delays in distributions, lump-sum versus instalment payments, redeeming versus recycling shares, re-leveraging ESOP shares, and rebalancing or reshuffling ESOP shares within the Trust can all impact repurchase obligation. It is generally considered best practice to design the plan in a manner that will afford the company maximum flexibility in managing its obligations. For example, the plan may stipulate that distributions be delayed and be paid over instalments to the maximum extent allowable under ERISA. The company, in practice, may pay participants out faster than is stipulated in the plan so long as it is done so in a non-discriminatory way. If an ESOP is designed with less flexibility, a company experiencing a liquidity crisis may have difficulty managing through periods of high repurchases and could be limited in its ability to amend the plan in the time or manner that is necessary. There are rules that could constrain the company’s ability to change how ESOP repurchases are handled. Also, amendments that ultimately extend distribution terms are often viewed as a ‘take away’ by ESOP participants and may provide the basis for a participant or the Department of Labor lawsuit for improper amendment of the plan’s distribution provisions.
Regina Carls is director of the ESOP (Employee Stock Ownership Plan) Advisory Group at JPMorgan Chase & Co. She is dedicated to helping bankers and their privately held clients evaluate the benefits of selling stock to an ESOP and therefore creating liquidity for the owners in the transaction. Ms Carls has been with Chase for more than 20 years. Prior to spearheading the ESOP Advisory Group, she was a division manager within Middle Market Banking. She is also a member of the ESOP Association headquartered in Washington, D.C and serves on their Banking and Finance Committee. Ms Carls can be contacted on +1 (630) 221 2116 or by email: firstname.lastname@example.org.
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