Chief financial officers have a responsibility to optimize capital efficiency and protect the integrity of the balance sheet. Some, though, overlook the risks their employee stock ownership plans pose to those goals, or they miss financial opportunities by failing to plan for their repurchase liabilities.
ESOPs provide private company owners and stockholders real advantages when making the transition to successor owners. Forming an ESOP creates a market for the stock by selling a portion or all of the company to the plan. It also provides significant tax and liquidity advantages for the shareholders. In addition, the ESOP creates incentives for employees who participate. Corporate ownership through the ESOP trust gives employees a keen interest in the overall performance of the company and increasing the company's share value. Increased share value translates to larger retirement account balances, improved morale and better retention.
ESOP sponsorship brings with it unique responsibilities. In order to assure employees of the ESOP's financial viability, the corporate finance team must develop a plan to fund the plan's repurchase liabilities.
Most private companies begin this process by conducting a comprehensive actuarial repurchase obligation study, examining the employee population and forecasting the company's obligation.
The study considers four factors: retirement, death or disability, termination and diversification.
When vested participants retire, die, become disabled, are terminated from employment, or when certain participants reach age 55, the ESOP's repurchase obligation is triggered. Internal Revenue Code section 409(h) provides that a vested participant who is eligible for a distribution must be given a “put option” enabling him or her to sell shares back to the company. The put option can be triggered with as little as 60 days' notice. In other words, the company must make a market for the company stock held in the participant's account. The RPL is off balance sheet. The company has a real obligation to purchase the shares; however, they are not required to account for this liability on their financial statements.
The cost of procrastination
Many challenges can arise for companies without an established financial plan to address the repurchase liability, including: devaluation of company stock; poor employee morale as a result of potentially declining company stock values; limited ability to secure corporate credit; personal liability for ESOP fiduciaries; and company insolvency created by repurchase cash flow demands.
Companies with new ESOPs might tend to ignore the obligation because, in the early years, repurchase liabilities are relatively small and manageable. As individual ESOP accounts grow and share value increases, the obligation also can grow significantly. It is easy for ESOP sponsors to develop a false sense of security when current corporate cash flows can easily sustain the liability. But these sponsors might be surprised by the growth of the obligation. Employee retirements are predictable; however, deaths, disabilities and terminations are random and difficult, if not impossible, to accurately anticipate.
Failing to plan and fund the repurchase obligation might force a plan termination or corporate liquidation, or result in an initial public offering or merger. Lack of a plan might also create inadvertent credit challenges and cash flow problems. With this in mind, credit facilities now often require current actuarial studies from their business customers with significant ESOP stock ownership.
The ESOP repurchase liability should not be taken lightly. Plan fiduciaries have a legal duty to manage the obligation responsibly; prudent companies formulate very specific strategies. Many engage ESOP valuation consultants to prepare repurchase studies based on relevant actuarial assumptions.
A repurchase study creates a road map for corporate finance and investment teams to anticipate the negative cash flow events associated with the repurchase of ESOP shares. While, depending on the plan's design, the ESOP trust may make the repurchase from employees or beneficiaries, it is ultimately the sponsoring company's obligation if the trust has insufficient assets. With a repurchase plan in place and routine monitoring, the repurchase liability can be very manageable.
Building a strategy
Once the repurchase study is complete, then it's time to build the financial plan. The plan should incorporate three other components, in addition to the repurchase study:
- an investment strategy;
The strategy aligns corporate objectives, potential tax ramifications and investments. (The investment strategy should consider market volatility, interest rates and glidepath.) During the planning process, an in-depth analysis should compare the utilization of mutual funds, corporate-owned life insurance, or a combination of the two. The fully developed strategy will match cash flows predicted in the repurchase study with the financial plan, creating a sinking fund to assure asset availability when the repurchase obligations mature and come due.
The types of investments in the financial plan should encompass all classes and styles. Additionally, COLI should not be overlooked. As mentioned, the repurchase liability is excluded from the balance sheet; as are life insurance death benefits. Using COLI as part of your strategy will not only provide a cash accumulation tool, but also create death benefits, payable to the company, which offset the ESOP repurchase cost and protect the company from losses associated with the untimely death of key personnel.
Choosing the right mix of financial tools will depend on the sponsoring company's unique circumstances. The approach must consider not only the plan itself, but also other stock plans, qualified plans and nonqualified plans to provide an integrated approach to total retirement and wealth creation strategies.
Daniel Barry is a Charlotte, N.C.-based senior vice president with Lockton Cos. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.