Utilizing a redemption strategy, the company buys previously outstanding shares from departing ESOP participants and moves the shares to the treasury account. Treasury shares are not considered outstanding shares for valuation purposes. When the total shares outstanding decreases there is an impact to the individual level of ownership and the share value. Participants who have previously received a share allocation benefit from the decrease in shares outstanding as their ownership level increases. Redeeming shares reduces the total shares outstanding and impacts account values as there is a smaller denominator in the share value calculation. The share value appreciates at a greater rate than equity value. The two examples below show the ownership level and share value impact of redeeming shares to treasury.
Level of Ownership Example:
Prior to redeeming shares to treasury there are 1,000 total shares outstanding. There is a participant with forty shares. This participants percent of ownership is 40/1,000, or 4%. Now consider that the company redeems two hundred shares to the treasury account, while this participant continues working for the company. The level of ownership is now 40/800, or 5%.
Share Value Appreciation Example:
When redeeming the denominator in the share value calculation decreases and the share value appreciates at a greater rate than equity value. Consider an Equity Value of $1,000,000. If we use the total shares outstanding from the example above, there are 1,000 shares prior to the redemption and 800 shares after redeeming shares to treasury. The share value before redeeming is $1,000,000/1,000, or $1,000. Assuming the same equity value, the share value after redeeming shares is $1,000,000/800, or $1,250. Reducing the denominator and redeeming shares increased the share value by 25%, with no change to equity value.
RECONTRIBUTION OF TREASURY SHARES
Shares held in treasury can be contributed back to the ESOP. An option is to make a stock contribution to get the shares back into the plan. Companies who consistently redeem shares often will target the value of the total contribution as a percent of eligible compensation, known as the benefit level. When making a stock contribution the company gets a deduction at the current fair market value, and this would count against the deductibility limits under IRC 404(a)(3). Consider contributing the shares on the last day of the plan year, so the year end stock valuation can be used for deciding the contribution value.
The treasury stock could also be releveraged. This allows the company to spread out the allocation of the stock over time, allowing more participants to benefit, and receive added tax deductions on the corporate tax return for the contributions to the ESOP trust to satisfy the ESOP loan debt payments.
Each ESOP is incredibly unique and must consider their own company goals when deciding the best approach to repurchase strategy. There is an ongoing balance between company cash flow and participant benefit levels. The goal is to maximize the expected return for the participant, however, to do so the ESOP program must be sustainable and not hinder the growth of the company. A consideration especially as an ESOP matures is taking a close look at treasury shares. Treasury shares can provide an opportunity for a consistent benefit level and a sustainable repurchase timeframe. Your plan administrator at Blue Ridge can provide more information regarding treasury shares. In addition, Blue Ridge offers ESOP repurchase liability services and has proprietary software ESOPHorizonTM available to help create your ESOP strategy.