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ESOP Repurchase Obligation Insights

Redeeming vs. Recirculating ESOP Shares, Part Two

Judith Kornfeld

October 1998

(Judith Kornfeld)This is the second part of a two-part article that explores the issues that should be considered when analyzing the cost and non-cost implications of handling ESOP repurchase obligations by recirculating stock in the ESOP versus having the corporation redeem the stock. Part One considered the mechanics of redeeming vs. recirculating ESOP stock and some of the non-cost issues. This Part Two will explore the cost implications.

The cost of redeeming versus recirculating stock depends on several factors:

The total number of shares to be repurchased over time will always be lower when stock is redeemed, so the overall cost of redeeming versus recirculating will depend on the effect on the per-share value of the company's stock.

When shares are recirculated, the cash that is contributed to the plan is treated as an employee benefit expense. Appraisers say that the contributions should have no effect on the value of the enterprise or the per-share value, as long as the contributions (combined with all other benefit expenses) do not exceed what would be considered a "normal" level of employee benefit expense for the company. In other words, neither the value of the enterprise nor the number of shares outstanding is affected, and the share price should be left unchanged.

On the other hand, redeeming stock is a capital transaction that reduces the value of the enterprise by the amount paid for the redeemed shares. As long as the company pays fair market value for the shares, the per-share value of the remaining shares should be left unchanged. In other words, both the value of the enterprise and the number of shares outstanding are reduced, but per-share value does not change. When compared to a company that is recirculating stock in its ESOP, a company that is redeeming stock should have a lower enterprise value and the difference in value should grow over time.

This may not always be how things work in practice, however, in the scenario where shares are being redeemed. In theory, the reduction in enterprise value from redemptions should have long-term implications for the value of the enterprise. In at least some situations, though, it seems that the enterprise value is not reduced unless redemptions are so large as to impair working capital or require the company to incur debt to meet them. This seems to be true, at least, in situations where the company is profitable and profits are sufficient to cover the redemptions and maintain a sufficient level of working capital to sustain growth. The cost of redemptions presumably comes out of profits that would otherwise be paid out as compensation or dividends. The result is that the enterprise value continues to grow while the number of shares outstanding declines due to redemptions, i.e., it has an antidilutive effect. In contrast, in a recirculate scenario where the number of shares outstanding is static, the per-share value changes in the same proportion as the enterprise value. This may not be true in every situation, but the consequences for any analysis of redeeming versus recirculating are important enough that the issue should be discussed with the appraiser who does the valuation of the company stock.

Whether or not redemptions are antidilutive has implications for the total cost of repurchase obligations, the value of ESOP participants' account balances, and the value of stock held outside the ESOP.

Redeeming versus recirculating stock also has implications for the ESOP as an ongoing employee benefit. When shares are being redeemed, no shares from repurchases are available to be allocated to participants. If no new shares are coming into the accounts from discretionary contributions or amortization of ESOP loans, the new participants in the ESOP will receive shares only from the reallocation of forfeitures. The implication is that the ESOP's role as an employee benefit will be diminished, and some additional qualified retirement plan will have to be provided. This has a cost associated with it that should be added to the cost of redemptions when comparing them to the cost of recirculating. By comparison, recirculating creates an ongoing, if somewhat uneven, source of shares to be allocated to participants. If recirculating is combined with ongoing cash contributions to the ESOP at a level that is appropriate as an employee benefit and the accumulated cash balances are used to fund repurchase obligations, the result should ultimately be an allocation of shares among participant accounts that bears some reasonable relationship to compensation and length of service.

The bottom line is that you cannot adequately analyze the redeem versus repurchase issue without considering the relative cost, the impact on ESOP participants, and the impact on non-ESOP shareholders. To do this analysis, you need to take into consideration the effect on per-share value.

Author biography and other columns in this series

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