Insights

Repurchase Obligation Studies: Planning for Cash Outflows

June 22, 2017


By Peter J. Shuler
 

Employee stock ownership plans (ESOPs) can provide substantial benefits for employees. Individual payouts in the hundreds of thousands of dollars are not uncommon, and some ESOPs have participants with balances in the millions and, although rare, even tens of millions of dollars. The flip side of an ESOP's financial benefit to employees is the cost of that benefit to the company.

For privately held ESOPs, no public market is available to convert the stock in participant accounts into spendable or investable cash. By law, the company sponsoring the ESOP is responsible for funding all distributions and diversification payments from the plan. Known as the repurchase obligation, this funding requirement represents an outflow of cash from the company and, as with any anticipated cash flow, the company should plan for it. Court cases have concluded that it is not just a good idea or a best practice to plan for the repurchase obligation, it is a fiduciary responsibility.

The Science of Estimating Repurchase Obligations

Many claims on company cash – repayment of debt, payroll, other operating expenses, or capital investments – either are known or relatively easy to estimate. The repurchase obligation is not as easy to estimate, however. In most cases, the date an employee is going to leave a company is unknown until it happens, as are how many shares the departing employee will have in his or her account and the value of those shares at the time of distribution.

Though the repurchase obligation might never be as predictable as other company expenses, a repurchase obligation study can provide an estimation that, if stress-tested sufficiently, can help a company plan for the upcoming cost. Such studies project the allocations of ESOP stock to existing and future employees over the period of the study, generally 10 to 15 years, and then project when payouts resulting from distribution and diversification will be due.

Repurchase obligation studies can range from simple to sophisticated and complex. Simple studies usually are performed via spreadsheet and can work in simple situations – such as for companies with a small, stable workforce (minimal turnover and workforce growth) that sponsor ESOPs with simple allocation and distribution provisions. The tipping point for moving from a simple study to a more thorough, complex study is the inclusion of turnover or “normal” termination assumptions (turnover and normal termination refer to all separations from employment except death, disability, and retirement.)

Although it is possible to perform complex repurchase obligation studies via a spreadsheet, the time and spreadsheet acumen required to accomplish such a feat are significant. Consequently, most repurchase obligation studies are performed using commercially available software.

Repurchase Studies: The Nuts and Bolts

An organization’s decision to perform a repurchase study on its own or to engage a third-party professional depends primarily on the time and knowledge of its employees. Companies that perform their own studies can save money, are able to run studies whenever they want at no additional cost, and most likely will gain a deeper understanding of the factors that drive the repurchase obligation. On the other hand, a third-party professional may have the knowledge and expertise to run the study quickly, to catch issues a company might overlook or not anticipate, and to thoroughly describe the results.

In most cases, a repurchase study should be performed in the first three to five years after an ESOP is established and every two to three years thereafter. If a significant change in a plan’s distribution provisions is being considered, especially one that will accelerate payouts, a study should be run before the change is made to determine the impact. A study also should be performed when it becomes apparent that the previous study assumptions are no longer reasonable, such as when sustained increases in the stock price are significantly higher than anticipated.

As previously mentioned, a thorough repurchase obligation study will project allocations to current and future participants over the period of the study and estimate when participants will take their distributions. Consequently, a good study requires a significant amount of information. Any variable that impacts allocations and the timing or method of distributions and diversifications should be incorporated into the study. These variables include:

  • Payroll information, including employees’ hire and termination dates, wages, and hours
  • Participant balances at the beginning of the study, including amounts diversified and paid as installments in years prior to the study
  • ESOP provisions regarding entry, allocation eligibility and method, vesting, forfeitures, and distribution timing and method
  • Stock price projections for each year of the study
  • Projected ESOP financial activity each year (contributions, dividends, loan payments, and share releases)
  • Anticipated distribution funding method (redeem, recycle, or re-leverage)

Certain workforce assumptions also will need to be made, including assumptions about turnover rates, workforce growth, salary growth, and the average ages and initial salaries of future employees. The study will be far more accurate if these variables can be assigned to specific groups of employees within the company.

For example, a company might have a 20 percent overall turnover rate, but turnover might be 30 percent on the factory floor, 20 percent in the sales department, and 5 percent in management. Applying the 20 percent overall turnover rate to all employees will overstate the repurchase obligation related to management (who usually have the largest balances) and understate it for factory workers. The same logic applies to workforce growth, salary growth, and other metrics. Creating employee groups and assigning each participant to an employee group will result in a much more accurate study.

Next Steps

Once all of the assumptions and data are entered, and the study has been run, a report should show the cash requirements to fund distributions and diversification by year and by distribution reason (death, disability, retirement, other terminations, and diversification). Ideally, the shares driving the repurchase obligation also will be shown by year and by distribution reason as this information can help the company differentiate whether employee demographics, stock price fluctuations, or both are driving peaks and valleys in the repurchase obligation. A comprehensive study also will illustrate:

  • All of the cash and stock activity in the ESOP by year
  • The repurchase obligation and total cash going into the ESOP as a percentage of compensation
  • Graphs of the repurchase obligation, the shares driving it, and the compensation percentages for the ESOP
  • Demographic activity (beginning employees, turnover, retirees, new hires, ending employees, and so on)
  • Projected balances for specific employees, if desired

Once the repurchase obligation study is completed, the results should be incorporated into the company’s cash flow projections to help determine whether the repurchase obligation is easily manageable, inhibits company growth or investment, or causes a serious cash crunch. If either of the latter two situations are projected, the company’s options should be discussed with its ESOP counsel or third-party administrator. Some plan provisions and funding alternatives can ameliorate a runaway repurchase obligation.

Stress-testing the repurchase obligation is imperative. What if everyone elects diversification? What if the stock price skyrockets, increasing the repurchase obligation? What if turnover is higher than expected or many older participants with large balances retire in the same year? The repurchase obligation could be much higher than indicated in one testing scenario. Running multiple scenarios with varying assumptions and incorporating the results into the company’s cash flow projections can give the company the information it needs to plan appropriately.

Preparation Is a Good Thing

It’s understandable that the phrase “repurchase obligation” often scares leaders of ESOP companies because an unknown and unquantified claim on company cash is frightening. However, a good repurchase obligation study, while still very much an estimate, can give the company the information it needs to start planning for such cash outflows.

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Pete Shuler
Principal