Closely held corporations that sponsor an employee stock ownership plan (ESOP) have a financial obligation to repurchase (or buy back) the stock held by participants who have a distributable event or are eligible for diversification. Depending on the terms of the plan document, a distributable event could occur because of termination of employment, retirement, death, or disability. Diversification opportunity in an ESOP occurs when a participant is age 55 and has 10 years of plan participation.
Why do a study?
As a plan matures, account balances in the ESOP can become quite large, requiring significant cash outlays from the company to provide liquidity for the distributions. Unlike other retirement plans, financial changes to an ESOP impact the financial statements of the company, so it would seem prudent to do a repurchase liability study because understanding the potential cash requirements over time is critical for financial planning for the company.
Who should do a study?
Early in the life of an ESOP, and especially if the ESOP is leveraged, there may not be a distribution event for several years, and if there is such an event, the repurchase obligation is not very high. But as time goes by and the ESOP matures, the potential repurchase liability grows. A repurchase liability study should be considered if any of the following apply:
• There is an ESOP that is making regular distributions to participants
• The company stock is increasing in value
• The company is considering other ESOP transactions, such as re-leveraging
• The company is considering a change in plan design
How often should plan sponsors do a study?
The frequency with which studies should be done varies by circumstances. If an ESOP is relatively new, you may only need to do a study on a five-year interim basis. However, in practice, most mature ESOPs do a study once every three years.
If distribution options are changing or accelerating you may want to perform a study that includes various scenarios to determine the impact of the changes on the provisions. Also, if re-leveraging, purchase of additional shares, or further changes are planned to the funding of the distributions, a repurchase liability study would be a prudent course of action.
How to select a repurchase liability study provider
Here as some tips for selecting a repurchase liability study provider:
Experience. Be sure to hire someone who is well versed in ESOPs and with whom you can communicate regarding particular challenges.
Analysis. Ask for a sample report, which includes the narrative regarding the results of the study. It is critical that whomever is hired to run your report can clearly interpret the results and help you understand how they interact with the cash flow of your company.
Assumptions. It is also important that the correct assumptions are used to get the most accurate projections possible. For instance, you might want to use your plan’s average diversification rate rather than the worst case scenario of 100% diversification. The change in assumptions will produce significantly different results. Your repurchase liability obligation study provider should be able to help you understand the significance of the assumptions.
How might the study affect plan design or operational decisions?
Case Study 1: Engineering and manufacturing company, 1,500 employee owners
The study: An engineering and manufacturing client hired Milliman to conduct a repurchase liability study that included both a base scenario and alternative scenarios.
The challenge: The client wanted to determine how to handle its repurchase liability obligation, as well as model the possibility of re-leveraging. Specifically, the client wanted to know when to re-contribute repurchased shares and to understand how re-leveraging would impact cash flow.
The impact: The results report and accompanying consulting provided clarity to the company. As a result, the company is reviewing potential changes to the way the repurchase obligation is handled to avoid issues in the future. Specifically, it is considering changing from redeeming the shares and recycling on a periodic basis to recycling the shares on a more frequent basis.
Case Study 2: Engineering and architectural company, 1,000 employee owners
The study: An engineering and architectural client hired Milliman to run a base study on its current distribution policy, as well as alternative scenarios at varying levels to determine how changes would impact the cash flow.
The challenge: The client was considering changing its policy to provide for acceleration of distribution for certain circumstances (death, divorce, stock balances under a certain threshold).
The impact: Based on the results of the study, the client was able to assess the projected financial impact of the proposed change, deciding to amend its distribution policy to better benefit participants. Without the study, it would have been difficult to assess the financial impact to the cash flow, which is a critical piece of information needed when making changes to ESOPs.
In conclusion, closely held companies that sponsor an ESOP should strongly consider conducting a repurchase obligation study at regular intervals or when considering a financial transaction involving the ESOP. To learn how a repurchase liability study can benefit you, email us.