Report on NCEO's Task Force on ESOP Valuation and the Repurchase Obligation
The NCEO recently convened a task force of trustees to issue a report on the current situation regarding valuation and the ESOP repurchase obligation. We have now released the Report of the NCEO Task Force on ESOP Valuation and the Repurchase Obligation (PDF; also see the embedded version below), which discusses the basic problem, governing authority, common approaches, ESOP valuation basics, specific issues, and recommendations for companies.
The obligation every ESOP company has to buy shares back from employees after they leave or become eligible to diversify their ESOP accounts creates a significant annual expense. Shares allocated to employees are bought back based on a valuation that assumes a willing financial buyer would purchase all the shares and eliminate the repurchase obligation. That means the valuation may not include the company’s liability for the repurchase obligation in the share price.
This can create a dilemma for ESOP companies. If ESOP companies put cash into the ESOP to fund the future obligation, it removes the cash from the company’s assets. This automatically adjusts the valuation for the liability. But if the company retains the cash, even if theoretically set aside for the same purpose, the assets are counted as if they are not committed to the repurchase. However, putting enough cash into the ESOP to fund the repurchase obligation may mean the company’s benefit levels are not sustainable. Alternatively, the company might be better off deploying the cash elsewhere. Thus, funding the obligation is a substantial additional cost, but that cost is not directly counted when the appraiser calculates value.
Other expected future costs, such as deferred compensation, equity rights that can be exercised in the next several years, a substantial balloon payment on a loan, and other deferred costs would all be reflected on financial statements and result in a lower value per share. If these obligations are not included in the valuation, the company could overpay for shares that might be liquidated before these obligations are due. Similarly, with an ESOP, if the repurchase obligation is ignored in the valuation, people who leave in the near term may be paid a higher price at the expense of those who stick around for the long term. In extreme cases, a company may find that this creates a repurchase obligation it cannot sustain. But if the valuation assumes a willing buyer would come in and buy 100% of the company (rather than buying some shares but not the whole company), the obligation would go away and arguably should not be counted.
The consensus view today among ESOP trustees and appraisers on the issue of repurchase obligations and valuation is more nuanced, however. While some appraisers still say the repurchase obligation should be ignored, the large majority at least consider it. They may decide it is not an issue for now, often arguing the company has the funds, either in reserve or in the ESOP, to cover the obligation, or they may incorporate the repurchase obligation in the discount for lack of marketability, the company risk factor, projected future earnings, or a combination of factors.
While the large majority of ESOP companies are able to handle the repurchase obligation on a sustainable basis, a strong argument can be made that if the expected liability was reflected in the appraisal, it would make ESOPs more sustainable. Theoretically, the best way to do this is to count the obligation as a future liability, but the standard of value used for valuation makes this difficult to do. The only way to fully resolve this issue would be for the Department of Labor to allow valuations to reflect the repurchase obligation in its forthcoming valuation regulations.
To help inform that process, the NCEO convened a task force of trustees to issue the above report on the current situation. Task force members included:
- Chip Brown, TI-Trust
- Kjersti Cory, SCJ Fiduciary
- Brian Ippensen, TI-Trust
- Mickey Maier, Professional Fiduciary Services
- Jeanine Pendergast, Spinnaker Trust
- Joel Phillips, Fiduciary Services
- Kyle Spader, Acumen Advisors
- Scott Storjohann, GreatBanc Trust
- James Urbach, Urbach Law