Blue Ridge ESOP Associates Industry News

Cash Flow Required to Fund the Internal ESOP Note

Posted by Jon A. Williams, QKA

Nov 15, 2016 1:48:03 PM

It is very common for an ESOP to purchase shares through a leveraged transaction. It is also very common to see a two part transaction agreement between three entities: the Company, the ESOP and a financial institution. In stage one, a financial institution will lend the money to purchase the ESOP shares to the Company with a loan agreement, from this point on referred to as the External Note (aka Company Note). The second stage is the loan agreement between the Company and the ESOP to purchase the shares, from this point on known as the Internal Note (aka ESOP Note). In this scenario you have two separate loan agreements.

The ESOP Note and the cash flow required to pay the note is the focus of this discussion. Yes, cash flow required to pay that note was mentioned. You may ask, why would we make payments on the ESOP Note when the actual debt payments are made on the Company Note!? You would be asking a good question and you must understand the difference when purchasing ESOP shares.

You would be accurate in thinking of the Company Note as the note in which the debt payments are facilitated. The ESOP Note is more of a paper tiger in the sense that the payments on the note will trigger the release of shares. The debt payments on the ESOP Note are really just a series of transfers from the Company to the ESOP and then back to the Company whereas the Company Note payments are made from the Company to the financial institution or other lendor.

With an ESOP Note payment, the Company makes a contribution to the ESOP for the ESOP Note payment. The ESOP then makes the internal loan payment by transferring that money back to the Company. A long time ago in a galaxy far away, this would have been recorded by a journal entry. However, a 2010 Technical Advice Memorandum states that this cannot be handled with a journal entry and cash must be transferred to facilitate the ESOP Note payments.

What this means is that the ESOP Note payment schedule must be designed so that it does not conflict with cash necessary to make the Company Note payments or other cash flow requirements. If the ESOP Note payment is scheduled as an annual payment, this could be a large amount of cash needed to facilitate the payment. Yes, the cash goes from a Company account to an ESOP account and back to the Company account but this could take a day or two and this cash will be tied up and unusable for that time period.

Too many times, an ESOP Note is designed without much consideration of cash flow, mainly because those payments used to be reported with a journal entry. However, the rules have changed, so the industry must adapt and ensure that Plan Sponsors are transferring the cash required to make an internal loan payment.

If you are considering an ESOP Stock purchase, whether a new ESOP or purchasing the remaining shares to become 100% ESOP, you must consider the cash flow required to fund the ESOP Note as well as the Company Note when designing the provisions of those loans.

Topics: ESOP Note, ESOP Stock Purchase