When participants of ESOPs that hold closely held stock (e.g., stock that is not readily tradable on an established securities market) become eligible for a distribution, the company has the obligation to repurchase the shares to provide cash for the distribution. As ESOPs mature the repurchase obligation can have a significant effect on company cash flow. ESOP participants can elect to take their vested account balance after they separate from the company due to death, disability, retirement, or termination. In addition to the previously listed events, active participants who reach age 55 and have ten years of participation can elect to diversify a portion of their shares. The plan can allow other distribution options such as distributions while still employed with the company, diversification beyond the statutory requirements and other forms of distributions. When a participant elects or is forced to take a distribution, the sponsoring company is obligated to repurchase the portion of the company value that is held as stock in participants accounts.
In the beginning years of an ESOP the repurchase obligation usually isn’t concerning. The value may be depressed due to debt from the ESOP transaction, shares are held in the suspense account and participants might not be fully vested. However, as the ESOP matures repurchase obligation can start to rise.
- Company is close or has completed paying debt related to the ESOP transaction.
- A significant number of shares have been released and allocated to participants as the ESOP loan(s) are repaid.
- Participants are near or fully vested.
- ESOP is nearing the point of offering statutory diversification to participants who have reached age 55 and 10 years of participation.
As an ESOP matures the cash required for the repurchase obligation can start to weigh on the company strategy and goals. The repurchase liability can be a surprise to the company. There are several proactive measures the company can take to prepare for future repurchase liability. The most common lever pulled is the repurchase obligation strategy. This includes the three “R”s: recycle, redeem, and releverage. There are advantages and disadvantages to each strategy to consider and the decision in repurchase obligation strategy can be made on an annual basis. There isn’t a one size fits all and every company can align their ESOP strategy with their own unique company goals.
Recycle is the practice of using cash in the ESOP Trust to convert participants out of their stock position at the time of distribution. Over time, cash normally is put into the ESOP trust as an employer contribution and/or dividends/Sub S distributions. The cash in remaining participant’s accounts are used to buy the stock of the departing participants and in effect are “recycled” since the net effect to the overall shares held in the ESOP Trust is zero after the transaction. In this process, company stock remains the ESOP Trust and the distribution is processed in the form of cash.
Redeem is the practice of the company purchasing and retiring shares. The shares usually retire and become Treasury shares thus reducing the shares outstanding but see the Redeeming vs. Recycling article for other options. The company can purchase shares directly from the ESOP trust. In this process, the company deposits cash to the ESOP to purchase the shares. Stock leaves the ESOP Trust and the ESOP pays distributions in cash. Alternatively, the company can purchase and redeem shares from former ESOP participants that received stock distributions from the plan. With stock distributions, the shares are distributed from the ESOP and bought by the company outside of the ESOP. The proceeds from the stock sale to the company are given to the participant.
While purchasing stock from the ESOP Trust and distributing stock both end up with stock leaving the ESOP, the distinction is very important. If shares are purchased from the ESOP Trust, the price paid for the shares must be at the fair market value on the day the shares are redeemed. This involves having a valuation firm determine the price on the day of the redemption. A stock distribution does not require obtaining a value on the day of the stock distribution. Shares are bought by the company outside of the ESOP at the most recent fair market value (with some exceptions if there were events since the most recent value that would impact the value).
Releverage involves adding shares to an ESOP by having the ESOP purchase shares from the company with an internal loan. The shares can be from current repurchase obligations or they can be issued from Treasury shares. A releveraging transaction that is done by issuing Treasury shares can reduce share value as the additional shares are now outstanding for valuation purposes, which in turn can lower the repurchase obligation.