Forecasting ESOP Repurchase Obligations

Are your company's ESOP repurchase obligations like a monster hiding in the closet? How can you tell if they're a fire-breathing dragon or a harmless little mouse? How can you develop a plan for managing and funding repurchase obligations if you don't know what they are? Obviously, some projections are needed.

The main reason for preparing a forecast of repurchase obligations (often called a repurchase obligation study) is to avoid surprises. A study may be required by the appraiser who values your ESOP stock, or by a prospective lender when ESOP financing is sought.

What Information Can You Get from a Study?

A good study will help you to anticipate the magnitude and the timing of the liquidity needs for repurchases and to project the size of individual account balances. This information, obviously, is useful for preparing budgets and long term plans. A repurchase obligation study can also be used as a planning tool to examine the impact of changes in the ESOP. For example:

• How will a change in distribution rules from lump sums to installments, or vice versa, affect the repurchase obligations?
• How will the ESOP's acquisition of additional shares affect the liquidity requirements for repurchases?
• How will repurchase obligations be affected by handling repurchases through the ESOP versus having the company redeem the shares?
• What will be the effect of changes in the employee demographics or of actuarial factors such as turnover?
• How will individual account balances, as well as the overall liquidity requirements, be affected by any of these changes?
• How effective will a proposed funding strategy be in meeting future liquidity needs?

The projected repurchase obligations, expressed in the number of shares required to be repurchased, can also be used iteratively in a valuation model as a factor in valuing the ESOP stock.

Should You Do Your Own Study or Get Outside Help?

Should your company do its own repurchase obligation projections or have a study done professionally? The quality of the assumptions and the array of variables that are used in the study affect the quality of the results, so the answer depends on the complexity of the situation and the internal resources that your company has available.

The main advantages of using an outside firm are to take advantage of the model that they use for doing projections and their expertise in developing assumptions, analyzing results, and incorporating the information from the study in repurchase obligation planning.

If your company is comfortable with its ability to do develop assumptions and analyze results, then doing your own study makes sense. In simple situations, the projections can be done in a spreadsheet model. However, the array of variables used in the model must be complete enough to provide meaningful results, and spreadsheet models can become quite cumbersome as the number of variables increases. This can limit your ability to easily change assumptions to examine alternative scenarios. Software that is designed specifically for projecting ESOP repurchase obligations may be more efficient and provide more flexibility.

The Projections Are Only as Good as the Assumptions

Whether you are doing your own study or working with an outside professional, the quality of the projections will be only as good as the quality of the assumptions. The assumptions need to be reasonable, particularly since repurchase studies are typically very long term projections, and the compounding effect of an unreasonable assumption will be magnified over time. This is most noticeable in assumptions about future growth in the value of the stock.

It is also important to make sure that the assumptions you are using in the repurchase study are internally consistent. For example, the assumptions you are using about future changes in the size of the workforce and growth in compensation in your repurchase study should be consistent with your assumptions about growth in the business (and, presumably, changes in the value of the stock). The workforce and compensation assumptions will affect any calculations in the repurchase projections that are based on covered compensation. These might include projected contributions and limits on deductibility. If the assumptions that affect total covered compensation are inconsistent with the assumptions about the value of the stock, it is likely that incorrect conclusions will be drawn about the level of funding that is required.

The assumptions you use in your repurchase study should also be consistent with those in your other corporate projections, such as your five-year plan. How can you use repurchase projections in your corporate planning if they are based on inconsistent assumptions?

How Often Should You Update Projections?

I am frequently asked how often a company should update its repurchase obligation projections. There is no absolute rule about this. Ideally, repurchase obligations should be considered in the initial design of the ESOP and projections should be done at that time. After an initial study is done (and an appropriate plan has been developed to manage and fund the repurchase obligations), the projections should be updated whenever reality starts to diverge significantly from the assumptions, but at least every few years. It is important to keep in mind that any particular set of repurchase obligation projections is the result of a particular combination of assumptions that will almost certainly be different from the reality that eventually unfolds. It may make sense to do projections based on more than one set of assumptions to explore a range of possible outcomes and to develop an understanding of the impact of different variables on the results.