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Home > ESOPs > Articles Online > Administrator's Notebook >
There is no more often discussed topic in the world of employee ownership than the obligation to repurchase shares from participants after they leave the company. This is usually referred to as ESOP Repurchase Liability (which has, by dint of fearful and constant usage, earned a set of initial capital letters of its own). Some of us, though, prefer to use the more accurate (less lethal sounding and definitely lower case) phrase "repurchase obligation" instead.
As one who frequently puts on seminars on ESOP-related matters, though, I know that if you want to fill a meeting hall (over and over again) just announce a presentation on the topic by either name. You'll have 'em hanging from the rafters and begging for more. Yet for all the discussion, the topic remains much more discussed than resolved, and I think I know why. Don't spread it around, but I think the "repurchase liability" problem remains a primary issue because there isn't a solution (at least in the sense we usually look for one). Maybe that is because, in fact, an ESOP doesn't create repurchase liability at all.
Before you click me off for the obvious lunatic that I am, hear me out. Repurchase liability is not a reflection of any ESOP characteristic. It is a reflection of the illiquidity faced by shareholders in closely held corporations. In every closely held corporation, eventually someone must face some hard decisions in attempting to distribute the value of equity to retiring shareholders. Whenever a closely held shareholder wishes to cash out, either he or she or the remaining shareholders or new shareholders or the company itself (or any combination) must develop a strategy and take steps to accomplish it. This may include looking at sales to outsiders, public offerings, internal sales to other shareholders or retirement of shares by the company or, in relevant particular, the establishment of an ESOP. None of this is changed materially where an ESOP is the shareholder.
Nevertheless, the idea of studying and preparing for ESOP share repurchase has become an often almost fanatical concern of ESOP companies. As a matter of fact, I have never seen a case in which the ESOP repurchase obligation forced a company to liquidate or go out of business (as I've heard described--usually by someone selling a solution to the "problem"). Nevertheless, it is a significant issue, and I have seen many ESOP companies whose business planning has had to be significantly altered to accommodate it. After all the hysteria dies down, though, the repurchase issue remains one any prudent ESOP sponsor will take seriously.
Strictly speaking, of course, measurement and planning are not obligations. The obligation is that attributable to the sponsoring company under what is called (not quite correctly) a "put option" which is required by Internal Revenue Code section 409(h). Section 409(h) provides, in general, that a participant who receives shares of stock as a distribution from an ESOP must be given the right to sell such shares back to the company at their then-fair market value. In the early years of an ESOP, these obligations are small and easy to deal with (or ignore), but as the ESOP matures, the number and value of such distributed shares tends to increase, sometimes to alarming dimensions.
Anyway, I'm not here to convince you that repurchase planning is important. Nor am I here to scare you into buying any particular solution to the problem. Nor, for that matter, am I here principally to discuss the legal issues related to it. I'm assuming that you are serious about it and my purpose here is to help you frame an approach to projecting it.
It is important as a beginning point to acknowledge that the repurchase obligation is also not a single issue. It is woven into the fabric of the ESOP. It is equally a function of requirements of law, the operation of the ESOP, demographic and operational characteristics of the company, and policy decisions the company makes. The projection process, therefore, is very complex, and you are almost certain to require help of some sort in order to do a competent job of making the forecast, but the responsibility is yours.
You may decide to buy repurchase liability forecasting software. The PERLS package (from Principal Financial Group), which has been around for many years, is a useful tool for converting the operational variables in your plan into ESOP account and distribution results. Telescope, another self-operated package (from ESOP Economics) is available as well. But whether you use a commercial software package or retain a consultant or just make a projection yourself, the main point is to get the planning underway based on a reasonable forecast, and it is our intention here to help define exactly what that is.
Since this is a largely statistical process, some sort of grouping methodology is necessary in order to manage the data. Unlike strictly actuarial studies (which can rely on tables to forecast death and disability), in order to be useful, an ESOP repurchase study must be able to forecast account balances for people who leave the company for any reason. Therefore, it is necessary to group employees not just on the basis of age and gender, but on the basis of other characteristics which most influence the object of the forecast. We group employees for this purpose based on the interaction of compensation level and relative length of vesting service. These two variables are by far the best available predictors of ESOP account development and therefore the eventual repurchase obligation.
The mechanics of this process in our model start with the assignment of a relative score between 0 and 1 (similar to a percentile) to each active employee in the file on each of the two characteristics (i.e., vesting service and compensation). The resulting scores are then combined, the totals are arrayed in ascending order, and the census is divided into an appropriate number of statistical groups. In most cases, five groups are a useful number where Group 1 is the shortest-term, lowest-compensated group, and Group 5 is the longest-term, highest-compensated group.
The experience has been that, barring some major change in the corporation, employee groups described in this way remain relatively stable (that is, relative to one another) over time. More to the point, these groups within a particular company act consistently in terms of salary increases, plan account development, vesting, turnover, growth rate net of turnover, and other factors relevant to repurchase liability.
However you elect to group the subjects or the methods you use to get there, the important point is that a useful forecast will be based on groupings that reflect your population and are related to the factor being forecast.
The second set of variables your study model needs to incorporate is the set of operational factors from your plan that influence the development of accounts and distributions. It is only sensible to build a model that recognizes the factors most related to the objective. For this purpose, these include the following plan characteristics:
In an established ESOP, it is the consistent experience that the vesting percentages of the various groups, once they stabilize, remain very stable over time barring significant events within the company. That is, as a function of turnover and replacement processes, the vested percentage of the established groups tends to remain the same from year to year. Significant exceptions to this occur in times of dramatic expansion (where group vested percentages tend to drop) and dramatic contraction (where group vested percentages tend to climb), but barring these types of events, measuring vesting levels within each group will generally give you a reasonable picture of such on a going-forward basis, and, of course, vested balance is the distributable amount upon termination (or such later time as your policies dictate).
A second operational factor that affects relative balances is the rate at which individual and group compensation changes. Clearly, if one group's compensation is increasing faster than others', we would expect its relative share of the ESOP to increase faster as well.
In fact, though, compensation increase rates tend to be the least sensitive variable in the process. First, changes in compensation tend to be generally uniform across the population, and therefore, there is no effect on the operational result. Second, at the level within the company at which we would most expect dramatic compensation increases, the law limits how much compensation we can take into account for plan purposes. This has the effect of dampening the benefit value of absolute compensation changes.
Nevertheless, compensation change rates do serve to adjust the relative allocation of shares acquired based on contributions or forfeited upon termination among the groups. So, to the extent a particular subset of employees experiences compensation increases at a rate significantly faster than other subsets its proportional ESOP holdings will increase faster as well.
The vast bulk of an ESOP's repurchase obligation will emerge from pre-retirement, vested turnover. Overall, due to the age and nature of most employee populations today, retirement, disability, and death will account for a very small portion of the ESOP's repurchase obligation. So, the relevant turnover rate is a factor representing actuarial death and disability, anticipated retirements and pre-retirement turnover.
Since this latter factor varies so significantly from company to company, we suggest that actual rates be computed for your company over time on the basis of the study groups as described above. This process should be repeated yearly until reliable rates are established.
Planning note: Purely from the perspective of the repurchase obligation, turnover creates some odd outcomes. For example, to the extent the ESOP and related activities create a highly motivated workforce, they can also have the effect of reducing turnover--which seems like a good thing except that it also means larger account balances at all levels within the company; a higher general level of vesting in the plan; and a much smaller proportion of forfeitable to non-forfeitable benefits, which ultimately come together to create a larger deferred obligation. There's no real answer to this, but I find these interactions interesting.
The rate at which the number of employees in each of the groups will increase can be a significant factor in projecting the rate at which ESOP benefits will accrue among the groups. As with compensation, the growth rate among the groups can affect the relative distribution of shares among the groups and therefore the outcome.
All of the above relate to characteristics of the employee groups that affect repurchase liability. With respect to your ESOP itself, the most significant variables are the required treatment of the shares, the rate at which shares enter employees' accounts, policy decisions regarding the criteria for the distribution and share repurchase, and, of course, the value of the stock.
If one even spends a few idle moments perusing the rules related to ESOP share distribution and repurchase, one will note that the requirements related to a particular share of stock are very different depending on its class, the time it was acquired, and the circumstances surrounding its acquisition. For example, shares acquired in a non-leveraged, 1042 transaction after 1986 are subject to significantly different requirements than shares acquired with a loan before 1987. A competent forecast model, then, must be able to track multiple types or classes of shares, especially where the company wants to take maximum advantage of legal parameters.
The most basic design factor influencing the repurchase obligation is the rate of shares entering participants' accounts. This is generally controlled by the contribution rate for the plan, which in a leveraged ESOP is often a function of ESOP loan amortization. In many respects, a leveraged ESOP is easier to forecast than a non-leveraged one since the loan repayment schedule is known at the outset and, absent prepayments on the debt, the actual rate of shares released and allocated to participants' accounts, therefore, is known as well.
Planning notes: To help control the emergence of the repurchase obligation, consider the following:
This process, however, gets even more complicated when dividends play a role. Dividends are frequently used today to repay ESOP debt. Where this occurs, it may very well require your forecast model to project share addition to accounts based on account balance rather than compensation (often with very different results). It also may require you to segregate shares that pay dividends from other shares as the dividends may generally only be applied to release the shares that generated them (with one significant purchase timing exception).
Probably the two most significant design features affecting the repurchase obligation are the policies regarding distribution timing and forfeiture reallocation. We acknowledge that here for two reasons: first, those policies must be incorporated into any repurchase forecast model, and second, where the repurchase obligation is a problem, those policies are the first place to look for solutions.
In any case, under current law, distributions can be made anywhere from immediately following termination of service to up to six years after termination. Likewise, given certain conditions, forfeitures can be reallocated among remaining participants' accounts at almost any point along the same spectrum. The choice here has an obvious and profound impact on the accumulation of shares in the plan as well as their outflow. No proper model can forecast without taking these into account.
Planning note: Because these policies have a substantial influence on repurchase cost, they can be structured to help contain it. For example:
The share repurchase vehicle is also important in the model. Where shares are repurchased by the ESOP upon distribution (usually called "recycling" these days) the payments will be pretax, but the company will have to fund the repurchase of the same shares over and over again. This is mainly a non-issue since someone must own 100% of every company all the time, but most practitioners argue that it is important nevertheless. Where the shares are repurchased by the company and retired, they leave circulation permanently, but the cost is after-tax (therefore, usually about 40% higher). The key here is to be sure that you are forecasting and comparing results consistently.
Planning Note: There is a third alternative in the recycle vs. retire controversy. Again, where your stock value is increasing, temporarily retiring shares and then later recontributing them to the plan has the effect of increasing the tax benefit to the company. For example, say your stock is worth $10 per share and is going up at 10% per year. If you contribute enough to the ESOP to fund distributions, you'll pay $10 and get $10 of tax benefit. If you retire the stock temporarily, you'll pay $10 (which at that point is $0 tax benefit). But when you recontribute the same shares next year, your tax benefit will be $11. Watch out for the downside, though. Obviously, where the stock drops in value, the opposite result occurs.
Unquestionably the most important factor in the cost of ESOP share repurchase (as well as, unfortunately, the least easily projected) is the value of the shares at various points in the future when shares will be required to be repurchased. Any competent model must be able to reflect changes in the value of shares that are consistent with other company financial planning. Where possible, this factor should be introduced with the guidance of the appraiser who annually renders valuation opinions.
It is astonishing how often critical factors (like the intended sale of a division or subsidiary or a significant acquisition or downsizing) are not disclosed in the process of making a repurchase forecast. It is safest to say that any corporate event will have an effect on the ESOP repurchase obligation whether because it will cause an unusual number of terminations or hires, or because it will have a significant impact on value. It is nearly impossible to do a proper ESOP forecast outside of the contest of an overall business plan.
So, that's it. If your repurchase forecast model includes all these factors and flexibilities, then you will likely get reliable planning results. We would presume that the less comprehensive the model, the less reliable the results. But the truth is (he wrote, basically shooting himself in the economic foot) that any study, however inadequate, is certainly better than no study and probably sufficient to help allay the problem. Since the lead time for required resolution of the repurchase obligation is generally long, if you are watching and dealing with the short-term obligations and making some sort of a projection of the longer-term ones you'll probably be OK.
There is so much written and there are so many avenues of help on the subject that just diving in is likely to produce useful (if not exhaustive) results.
Copyright © 2002 by The National Center for Employee Ownership (NCEO) (phone 510/208-1300; email nceo@nceo.org; WWW http://www.nceo.org/). All rights reserved.
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