Employee Stock Ownership Plans (ESOPs) provide a robust framework for engaging employees and enhancing corporate financial strategies in closely held companies. Despite the motivational and economic benefits, ESOPs also require certain financial commitments, primarily the repurchase obligation. Effectively managing this responsibility is essential to ensuring the ESOP company’s success and sustainability. Here, Dan Markowitz, CPA, Partner, and Boulay’s ESOP advisory leader, discusses the complexities of the Repurchase Obligation and ESOP Sustainability to allow for cash available for Repurchase Obligation and other strategic initiatives.
Understanding the Repurchase Obligation
ESOP-owned companies allow employees to enjoy the financial rewards of ownership through retirement plans. When employees retire, pass away, or leave the company for any reason, the company must fund the value of their ESOP shares in accordance with the plan’s distribution policy. To ensure the long-term success of an ESOP, companies must plan ahead for the repurchase obligations. This process typically starts with an ESOP sustainability study, which projects the company’s future financial commitments for buying back shares and provides strategies for managing those obligations successfully along with making cash available for other strategic initiatives. Failure to plan effectively can lead to several issues:
1. Stock Instability: The price per share can fluctuate unexpectedly if the number of outstanding shares changes.
2. Banking Challenges: Companies may face difficulties securing additional debt if they take on too much debt to cover repurchase obligations.
3. Risk of Insolvency: Without proper cash flow management, the burden of a repurchase obligation may lead to insolvency or force the company to sell.
4. Misalignment: The ESOP’s benefit structure may no longer align with company objectives or market competitiveness.
5. Other Strategic Initiatives: If the company uses all of their available cash and borrowing for repurchase obligation, it will limit the company’s organic and inorganic growth.
Opportunity Costs and Capital Allocation
Different financial commitments can affect a company’s return on invested capital, influencing its plans for repurchase obligations. Every dollar used to fund repurchase obligations is a dollar that cannot be reinvested in the business. This introduces the concept of opportunity cost: companies must consider whether repurchasing shares decreases shareholder value by diverting funds from potential investments. With the unique tax benefits associated with ESOPs, companies are able to experience favorable financial outcomes despite the repurchase obligation.
Redemptions and Recycling of Shares
Companies have two primary methods of managing repurchase obligations: redeeming or recycling shares. Redemption involves buying back and retiring shares, while recycling involves reallocating shares to the remaining participants. Each approach has distinct financial implications:
- Redemption: In theory, redeeming shares at fair market value should not impact per-share price on day one. However, if the company continues to grow post redemption and the price per share will grow faster than the equity value and can potentially create have and have nots within the ESOP.
- Recycling: Recycling shares by reassigning them to remaining ESOP participants can also affect stock value. This process doesn’t have a dilutive impact on share price, and the number of outstanding shares remains the same. The impact of recycling shares depends on the company’s overall cash flow and benefit structure.
- Redemption and Releverage: One option to handle the repurchase obligation is to redeem shares and then sell the redeemed shares back to the ESOP in exchange for a note. Shares on the releverage note will be allocated for a long-term period and will keep the outstanding shares outstanding the same. While releveraging might be the right answer, understanding the impact of releverage on all participants and the impact on future participants is vital.
Preparing for the Future
If an ESOP company doesn’t fully understand their future repurchase obligation and how to pay for the repurchase obligation, it can threaten the long-term sustainability of the company and the ESOP plan. If the ESOP repurchase obligation is not properly managed, the company may be forced to terminate their ESOP, leading to the company’s liquidation or a buyout of the ESOP. To maintain sustainability, companies should adopt a combination of funding strategies, including cash contributions, S-Corp distributions and issuing new shares to the ESOP. An experienced ESOP advisor helps companies choose the right mix of strategies to ensure they can meet their repurchase obligations without jeopardizing long-term sustainability of the company.
Helping You Get There…
Successfully navigating repurchase obligations is key to the long-term health of an ESOP and the sponsoring company. By conducting regular repurchase obligation studies, understanding opportunity costs, and choosing the appropriate funding strategies, companies can mitigate financial risks and maximize the benefits of their ESOP. Boulay’s ESOP advisory team is dedicated to helping companies navigate these complexities and develop strategies for long-term success. Connect with us today to learn more about how we can support your ESOP planning and management needs.