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R E P R I N T FINANCIERWORLDWIDE.COM PREPARED ON BEHALF OF 10QUESTIONS MANAGING REPURCHASE LIABILITY ARISING FROM AN ESOP REPRINTED FROM EXCLUSIVE ONLINE CONTENT PUBLISHED IN: JULY 2013 FINANCIER WORLDWIDE corporatefinanceintelligence © 2013 Financier Worldwide Limited. Permission to use this reprint has been granted by the publisher. www.financierworldwide.com REPRINT | FINANCIERWORLDWIDE.COM MANAGING REPURCHASE LIABILITY ARISING FROM AN ESOP FW talks with Regina Carls, director of the ESOP Advisory Group at JPMorgan Chase & Co, about Managing repurchase liability arising from an ESOP. Regina Carls Director ESOP Advisory Group JPMorgan Chase & Co Regina Carls is director of the ESOP (Employee Stock Ownership Plan) Advisory Group at JPMorgan Chase & Co. She is dedicated to helping bankers and their privately held clients evaluate the benefits of selling stock to an ESOP and therefore creating liquidity for the owners in the transaction. Ms Carls has been with Chase for more than 20 years. Prior to spearheading the ESOP Advisory Group, she was a division manager within Middle Market Banking. She is also a member of the ESOP Association headquartered in Washington, D.C and serves on their Banking and Finance Committee. Ms Carls can be contacted on +1 (630) 221 2116 or by email: [email protected]. FW: As a starting point, could you provide a brief borrows from a bank and lends the proceeds to the ESOP overview of ESOPs, including the different types and – the ‘internal loan’ – to finance the stock purchase. A structures of ESOPs? leveraged ESOP still has outstanding debt from its share purchase. A non-leveraged ESOP is one in which the Carls: ESOPs are qualified retirement plans that give company makes periodic contributions to the ESOP in employees an ownership interest in their company by stock and/or cash and where the ESOP does not have any investing primarily in the employer’s stock. ESOPs have outstanding debt. ESOPs typically provide significant tax numerous tax advantages and unlike other qualified benefits for both sellers and sponsor companies. Under plans, ESOPs are allowed to borrow in order to finance certain circumstances, sellers can defer capital gains the purchase of employer stock, making it a very useful and net investment income taxes on their gain from the ownership transition tool. There are two types of ESOPs. sale. Companies can deduct their contributions to the A Leveraged ESOP has borrowed money to purchase plan and S corporations’ income accruing to the ESOP employer stock. In a typical leveraged ESOP, the company – as a shareholder – is not taxed. S corporations owned 2 FINANCIERWORLDWIDE.COM | REPRINT MANAGING REPURCHASE LIABILITY ARISING FROM AN ESOP 100 percent by an ESOP are substantially free of income In either case, the shares are put into treasury. Recycling taxes. involves the contribution of cash to the ESOP by the company, which the ESOP distributes to the participant FW: What are the circumstances that trigger repurchase instead of stock. With recycling, the shares remain in the obligation? What is the timing of these repurchases? trust and are reallocated among the remaining participants in the plan. Companies often employ a combination of Carls: ESOP participants have the right to receive their redemption and recycling so as to better manage the vested account balances after they depart the company benefit levels delivered to participants. and the sponsoring company is obligated to repurchase this stock when it is a closely held corporation. This is FW: What key factors drive the magnitude of a firm’s referred to as ‘repurchase obligation’. The events that repurchase obligation? trigger the company’s repurchase obligation are: death, disability and retirement; terminations – voluntary or Carls: Repurchase obligation is a function of two factors: involuntary; and diversification. The laws governing first, the number of shares that are put to the company by ESOPs allow for some flexibility in the timing of the start former participants; and second, the per share stock price. of a company’s repurchase obligation as well as the period The number of shares put to the company for repurchase over which payments are made. Generally, distributions each year is driven by the pace of participants’ separation related to death, disability or retirement begin the year from service. This, in turn, is primarily dependent on the following a participant’s separation from the service. workforce’s age demographics and turnover rate. Plan Distributions related to other terminations of employment design and distribution policy also have a significant impact can start several years later. The distribution may be paid as they govern vesting and timing of distributions. There in a single cash payment or the company may chose to are numerous factors which affect the ‘per share stock price’ make up to five equal annual instalment payments. The of a company, including the company’s performance, the ESOP plan document details these provisions, although performance of the capital markets, and the company’s a company can choose to pay repurchase obligations in capital structure. Predicting future repurchase obligations a more liberal – that is, faster – manner under a separate can be a complex exercise. Nonetheless, it is important that distribution policy. they be quantified and managed like any other corporate obligation in order to protect the company’s ability to FW: Upon the event of death, disability, retirement, or grow and operate the business without undue financial termination, companies must repurchase stock. What risk. Therefore, companies should examine actuarial as methods are used to carry out a stock repurchase? well financial data to get as accurate of a projection of future cash requirements as possible. Carls: The company has a few options it can employ to convert participants’ shares from stock to cash. The most FW: Does the repurchase obligation affect value? common are redemptions and recycling. Redemptions are simply the purchase by the company of the participant’s Carls: The impact on stock value of repurchase obligation, shares either from the participant – after they have been if any, will depend on whether a company redeems or distributed – or from the ESOP. In the latter case, the recycles shares. Stock price is determined by dividing ESOP will distribute cash in lieu of stock to the participant. total equity value by the number of shares outstanding. 3 REPRINT | FINANCIERWORLDWIDE.COM MANAGING REPURCHASE LIABILITY ARISING FROM AN ESOP Redeeming shares causes equity value to decline by the by tapping into unused debt capacity, although borrowing amount of the cash outflow and total shares outstanding for this purpose must be done carefully. The company declines by a commensurate amount. Therefore, while total may potentially be able to modify distribution policies equity value declines, per share value remains unchanged. to slow the pace of repurchase obligation. Prefunding Recycling shares involves the ESOP distributing cash can be achieved by creating a sinking fund on the firm’s instead of stock to participants, funded by a company balance sheet, or accumulating cash in the ESOP. Funding contribution. The shares that would have been distributed a sinking fund for future repurchase obligations gives the are retained in the ESOP and reallocated to the remaining company more financial flexibility while reducing financial participants – creating an incremental benefit to the risk and increasing employee retirement security. However, participants. Thus, the equity value declines because of the this may not be the most productive use of capital and incremental benefit cost in the company’s cost structure the cash remains exposed to creditor claims. Cash can but the number of shares outstanding does not decline – as accumulate in the ESOP trust through excess contributions in the case of redemptions – because all shares remain in and dividends on ESOP held stock. Accumulating cash in the ESOP. To the extent that the benefit expense incurred the ESOP insulates it from creditor claims. However, the by recycling shares is equal to a normal retirement benefit cash is then not accessible to the company for corporate level, then recycling will not be dilutive to share value. On purposes. the other hand, if it exceeds a normal retirement benefit level, it will be dilutive to share value. Another less obvious FW: Repurchase obligation is a demand for capital. factor is the ‘opportunity cost’ associated with repurchase Does the repurchase obligation impair a company’s obligation arising from the diversion of cash from ability to grow? meaningful investment opportunities. Where repurchases are overly large, this will likely detract from the company’s Carls: If properly managed, repurchase obligation should ability to grow and consequently will impair value. not affect growth. Repurchase obligation is an ongoing retirement benefit. Therefore, if total retirement benefit FW: Repurchase obligations are not recorded on the inclusive of the repurchase obligation is within historical balance sheet and yet, may have a material impact or industry norms, it really isn’t an incremental claim on on the firms demand for capital. What options are capital. Moreover, the likely tax benefits accorded to available to firms when it comes to funding their ESOP ESOP owned companies, particularly 100 percent ESOP repurchase obligations? owned S corporations, often more than offsets repurchase obligation, meaning that a company could still experience Carls: There are four categories of funding options for ESOP more capital formation even after repurchase obligations companies: first, pay-as-you-go; second, utilise unused than an identical non-ESOP owned company subject to debt capacity; third, prefund the liability; or fourth, create corporate income taxes. Proper management requires an internal market among participants and employees. periodic assessment of distribution policy, which governs Each method has advantages and disadvantages. Proper the pace of how repurchase obligations are paid, and analysis and planning is critical to developing a strategy careful consideration of the company’s valuation to insure that suits all of the company’s needs. Companies with that the stock is not overvalued. sufficient cash flow commonly use the pay-as-you-go approach. Spikes in repurchase obligations can be satisfied 4 FW: What happens when the Company suffers distress? FINANCIERWORLDWIDE.COM | REPRINT MANAGING REPURCHASE LIABILITY ARISING FROM AN ESOP How is the repurchase obligation satisfied in these cash flows in forecasting future cash flows and share price circumstances? for purposes of forecasting and planning for repurchase obligations. While corporate structure may impact value, Carls: Flexibility in a company’s distribution policy is critical the more material contributors to the magnitude of in this circumstance. Even if the company has historically repurchase obligation will be the overall level of ESOP paid departing participants more rapidly, it can lengthen ownership and future share appreciation driven by payout periods if the plan allows it. The company may operating performance. also need to assess traditional methods of cost reduction to determine whether any exacerbation of repurchase FW: What difficulties might arise when amending obligation makes them untenable. Ultimately, a distressed existing ESOPs to address repurchase obligation? company needs to work with its primary capital sources What are common strategies used to resolve such – banks in particular – to determine if additional capital is issues? available. In more extreme cases where additional capital is unavailable and where the payments threaten access to Carls: Plan design and distribution policy can have a existing critical capital sources (primarily senior bank debt), substantial impact on the timing and magnitude of an a company may need to negotiate payment forbearance ESOP company’s future repurchase obligations. Delays with the ESOP trustee. in distributions, lump-sum versus instalment payments, redeeming versus recycling shares, re-leveraging ESOP FW: How do stock repurchase obligations differ for S shares, and rebalancing or reshuffling ESOP shares corporations and C corporations? In what ways does this within the Trust can all impact repurchase obligation. It is affect planning for, and funding, stock repurchases? generally considered best practice to design the plan in a manner that will afford the company maximum flexibility Carls: Corporate structure does not change the in managing its obligations. For example, the plan may fundamental concept of repurchase obligation – that the stipulate that distributions be delayed and be paid over company must convert shares to cash when participants instalments to the maximum extent allowable under depart from the company. Repurchase obligation is a ERISA. The company, in practice, may pay participants out function of the timing of employee departures and the faster than is stipulated in the plan so long as it is done so value of the company’s stock. It is important to understand in a non-discriminatory way. If an ESOP is designed with the drivers of repurchases and incorporate the repurchase less flexibility, a company experiencing a liquidity crisis obligation forecasting and planning into the Company’s may have difficulty managing through periods of high strategic planning process. While timing of repurchase repurchases and could be limited in its ability to amend obligations is not directly a function of corporate structure, the plan in the time or manner that is necessary. There are the value of the stock may be quite different. For example, rules that could constrain the company’s ability to change the value of stock in a 100 percent S Corporation ESOP how ESOP repurchases are handled. Also, amendments should increase at a greater pace – all else equal – because that ultimately extend distribution terms are often viewed it does not pay taxes. This incremental cash savings as a ‘take away’ by ESOP participants and may provide accrues to the value of the equity thereby increasing share the basis for a participant or the Department of Labor value and repurchase obligation. One hundred percent lawsuit for improper amendment of the plan’s distribution S Corporation ESOPs must consider these incremental provisions. 5