Managing Repurchase Obligations in ESOP Companies

Employee Stock Ownership Plans (ESOPs) are a powerful tool for closely held companies to motivate and engage employees while facilitating corporate financial management. However, the benefits of ESOPs demand certain financial responsibilities, particularly in managing the repurchase obligation. In this article, Dan Markowitz, CPA, Boulay’s ESOP advisory leader, delves into the importance of monitoring and planning for this obligation and offers insights into how ESOP companies and their sponsors can navigate it successfully.

Understanding the Repurchase Obligation

Companies owned by an ESOP trust allow for their employees to have the financial benefits of ownership through a retirement plan. As participants leave the company due to retirement, disability, death, or voluntary or involuntary termination, the company is required to repurchase their ESOP shares according to the plan’s distribution policy. This obligation can have a substantial financial impact, as the company needs to fund the distribution with cash either through the ESOP trust, or through a redemption of shares from the participant. Both S corporation and C corporation ESOPs must be prepared to pay cash equal to the stock’s value in a participant’s account, in accordance with the payment terms in the ESOP plan document. An experienced ESOP advisor can help lead plan sponsors through these rules and regulations in order to properly prepare for this future obligation.

The Importance of Planning

To ensure the ESOP’s success as a motivational tool and a means of corporate finance, it is crucial for plan sponsors to develop a comprehensive plan for funding their repurchase obligation. A recommended first step is conducting an ESOP repurchase obligation or an ESOP sustainability study to forecast the company’s repurchase obligation several years into the future. To take it one step further, an ESOP sustainability study not only tells the company what the repurchase obligation is from the plan, it also evaluates the options on how the company will pay for the repurchase obligation. Failing to forecast and plan for the repurchase obligation and how to fund the amount can lead to several issues:

1.  Value of Company Stock: The price per share may move with unintended consequences with an increase or decrease with the number of shares outstanding.

2.  Employee Morale Decrease: A drop in the stock’s market value can negatively affect employee morale without the proper communication.

3.  Impact Banking Relationship: It may become challenging to secure additional bank debt if the company takes on debt to fund repurchase obligation without understanding the other strategic initiatives of the business.

4.  Potential Insolvency: Unexpected cash flow demands can lead to insolvency of the company or a sale of the business to fund the repurchase obligation.

5.  Benefit Level Analysis: The plan’s benefit level may no longer align with the company’s objectives or be competitive in the marketplace.

Preparing for the Future

Many ESOP companies are unaware of the extent of their future repurchase obligation, which poses a significant risk to the sustainability of the company. If the obligation suddenly becomes too large and the company lacks the immediate cash to fulfill it, they may be forced to terminate their ESOPs through a liquidation of the company or a buyout of the ESOP.

Alternative Funding Methods

ESOP companies can consider various strategies to handle the repurchase obligation. An ESOP sustainability study will navigate the options and determine if cash contributions, S-Corp distributions, redemption of shares or sale of new shares to the ESOP (releverage) is the appropriate strategy to fund the repurchase obligation. In most cases, it is a combination of these strategies that will allow the company to be sustainable into the future.

Helping You Get There…

ESOP repurchase obligation and ESOP sustainability studies are a vital tool for projecting benefit levels and the necessary cash flow to sustain the retirement plan. Failing to map out a funding strategy for the repurchase obligation can jeopardize the long-term viability of the ESOP and the company. Proper planning and financial management are essential to harness the benefits of ESOPs while fulfilling their financial responsibilities. Boulay’s ESOP advisory team is committed to helping you get there. To learn more, connect with us today.