Funding ESOP Repurchase Liabilities: Protecting Cash Flow for the Long Term
Funding ESOP Repurchase Liabilities
Funding Repurchase Liabilities with ESOPs
Employee Stock Ownership Plans (ESOPs) serve as a powerful tool for businesses to align the interests of employees with those of shareholders, while also providing a mechanism for funding future repurchase liabilities. Here's a detailed look at how ESOPs can be structured to manage these liabilities:
Understanding ESOPs and Repurchase Liabilities
An ESOP is a qualified employee benefit plan designed to invest primarily in the securities of the sponsoring employer. Employees accrue shares of the company over time, which can vest according to various schedules. However, when employees leave the company (retirement, resignation, etc.), they are entitled to receive the value of their vested shares. This creates a repurchase liability for the company, as it must buy back those shares.
Strategy for Funding Repurchase Liabilities:
We help companies anticipate and plan for repurchase obligations
01
Forecasting Liabilities
Companies must first estimate future repurchase obligations. This involves forecasting employee turnover, retirement rates, stock price volatility, and the vesting schedule. Detailed actuarial analyses can assist in creating these forecasts.
02
Leveraged ESOPs
One common strategy is to use a leveraged ESOP where the plan borrows money to buy company shares. The company then contributes cash to the ESOP to repay the loan over time. This increases the number of shares within the ESOP, which can be used to offset future repurchases.
03
Sinking Fund
Setting up a sinking fund within the ESOP where the company contributes cash or securities regularly. These contributions are earmarked specifically for repurchasing shares from departing employees. This not only funds the liability but also reduces the financial strain at the time of repurchase.
04
Profit Contributions
Allocating a portion of annual profits directly into the ESOP for repurchase purposes can be beneficial, especially in profitable years. This approach helps in building up reserves when the company's financial performance is strong.
05
Reinvestment of Dividends
If the ESOP holds dividend-paying stock, dividends can be reinvested back into the plan rather than distributed. This increases the ESOP's cash reserves, which can later be used for share repurchases.
06
Stock Price Management
Managing the stock price to avoid spikes before repurchase dates can also be crucial. If the stock price is too high, repurchasing can become excessively costly. Strategies might include stock splits or strategic timing of share buybacks.
07
External Financing
While less ideal due to interest costs, borrowing from external sources specifically for repurchasing shares can be considered, especially if internal cash flows are not sufficient.
08
Tax Benefits
Utilizing the tax advantages of ESOPs can indirectly help fund repurchase liabilities. Contributions to ESOPs are tax-deductible, which can conserve cash for repurchases.
Challenges and Considerations:
Cash Flow Implications:
Heavy reliance on ESOP funding for repurchases can strain cash flows, particularly if not managed with foresight.
Stock Dilution:
Issuing new shares to the ESOP might dilute existing shares' value, which needs careful management.
Regulatory Compliance:
ESOPs are subject to complex regulations under ERISA, IRS, and DOL, requiring specialized legal and financial advice.
In Conclusion:
In conclusion, funding repurchase liabilities through ESOPs involves strategic planning, financial foresight, and a deep understanding of both the company's financial health and the legal landscape surrounding ESOPs. When executed correctly, it not only meets the obligations to employees but also reinforces a culture of ownership and loyalty within the firm.
Hedging for the ESOP Future Liability
Funding for repurchase obligations can be segmented into five categories:
- Current operating cash flow (“pay as you go”)
- Advance funding/“sinking fund”
- Borrowings/ debt
- Internal markets
- Third-party solutions (sale)
Some companies find a combination of funding methods works best, although finding the right combination requires you assess the advantages and disadvantages of each strategy. Further, the strategies carry varying levels of flexibility and can be modified each year as the facts change.
In a frequent first step in the evaluation process, the ESOP company obtains a third-party actuarial repurchase obligation study which often leverages proprietary software. This software integrates the various financial and non-financial factors and assumptions that impact the timing and magnitude of the ongoing liability.
The following is a brief summary of main funding strategies for repurchase obligation, including an alternative sinking fund technique using corporate-owned life insurance (COLI):
Best Practice Hedge for the Corporate Balance Sheet
COLI is an institutionally priced and managed asset used to fund certain corporate benefit obligations. It is a unique, high-cash-value asset which displays significant tax efficiencies when offsetting balance sheet liabilities. Used as a best practice investment vehicle, optimally in long-term forecasting (10-20 year repurchase obligation liability), COLI can be actuarially sized to hedge the ESOP repurchase obligation.
COLI tax advantages include:
- Earnings and cash value increases from policies’ investment allocations not subject to current income tax.
- Policy cash values can be accessed tax-free via policy loans and withdrawals.
- Employees’ lives insured by the policies, and death benefits payable not subject to income tax.
COLI does carry certain costs of insurance that need factoring into the funding decision. But over a multiple-year period, the costs of COLI (plus typical death benefits paid) showcase COLI as a best practice funding approach, particularly when compared to a sinking fund or taxable investments.
Learn more
Explore how sellers can defer capital gains tax when selling to an ESOP
See our broader approach to ESOP design and administration
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