ESOP Repurchase Obligation Insights
Some More Basics: Factors Affecting Repurchase Obligations
February 1999In my last column, I went "back to basics" and reviewed the rules that give rise to the ESOP repurchase obligation. I think it might also be useful to examine the factors that affect the magnitude and timing of the ESOP repurchase obligation. These factors can be grouped into three types:
- The value of the stock in the ESOP
- The velocity with which the stock turns over
- The way in which repurchases are handled
Value of Stock in the ESOPIt is intuitively obvious that repurchase obligations will vary directly with the value of the stock in the ESOP. This value, in turn, is directly related to the number of shares that is held by the ESOP and value of those shares. What is most important in determining whether repurchase obligations are likely to be a problem is the percentage of stock owned by the ESOP. Companies with 100% ESOPs have bigger repurchase obligations than companies with minority ESOPs. The higher the percentage that the ESOP owns, the more likely it is that the company will have to deal with some significant planning issues.
The stock price, while directly affecting the value of the stock held by the ESOP, is much less likely to cause real problems. A growing stock value implies that the business is growing. This usually means that the whole context in which repurchase obligations need to be viewed is also growing: covered compensation, cash flow, etc.
Velocity with Which the Stock Turns OverRepurchase obligations will also be directly affected by the velocity with which shares turn over in the ESOP. This is related to several factors, the most important of which are turnover and, in smaller companies, the age distribution of the participants with the largest account balances.
In most companies, turnover is the factor that accounts for the largest number of shares being "triggered" for repurchase. In high turnover situations, certain plan provisions can combine with turnover to affect the number of shares that must be repurchased. The most significant of these are the vesting schedule and the timing of reallocation of forfeitures. A rapid vesting schedule will increase the number of shares to be repurchased due to turnover. Another factor is the time at which forfeitures are reallocated. Delaying the reallocation of forfeitures as long as possible will tend to lower the number of shares to be repurchased. By leaving shares in "forfeiture suspense," this tends to keep the number of shares allocated to active participant accounts lower than they would be if forfeitures were reallocated immediately.
In the early years of an ESOP, several additional factors will increase the number of shares that have to be repurchased due to turnover. Counting years of service prior to the ESOP effective date for purposes of vesting will increase participants' vested percentages. This may be desirable for other reasons, but it will tend to increase repurchase obligations for turnover. Similarly, accelerating payment of ESOP acquisition loans, which may be desirable for other reasons, will tend to increase payouts from the ESOP by causing account balances to build up quickly.
In smaller ESOP companies, the age distribution of the employee population becomes an important factor. Many smaller companies tend to have a number of key employees who are relatively close in age. They are often among the older employees and usually have the largest account balances and lowest turnover rates. This tends to make repurchase obligations "lumpy" as this group exercises diversification rights and retires.
The Way in Which Repurchases Are HandledThe ways in which share repurchases are handled also affect repurchase obligations. These include the timing and form of distributions, as well as whether repurchases are effected through redemptions or shares are recirculated in the ESOP.
Distributions that are delayed do not directly affect the overall number of shares that must be repurchased, but they affect the timing of the cash requirements associated with the repurchase of the shares. In a period when the stock price is rising, delaying distributions can actually result in higher cash requirements. Similarly, distributions that are made in installments during a period when the stock price is rising will have greater cash requirements overall. (Companies obviously must weigh the advantages and disadvantages.
Finally, whether repurchases or handled through redemptions or by recirculating stock in the ESOP will affect the number of shares in the ESOP and thus the number of shares that must be repurchased. While redeeming shares will tend to reduce the number of shares that have to be repurchased over time, determining the overall effect is on the cost of repurchases is a complicated analysis that was explored in a previous column.