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10QUESTIONS
MANAGING
REPURCHASE
LIABILITY ARISING
FROM AN ESOP
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JULY 2013
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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
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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.
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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
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FW: What happens when the Company suffers distress?
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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.
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