Transcript associated cash requirements

2013 Carolinas Chapter
Summer ESOP Conference
The Repurchase Obligation
1
ESOP Repurchase Obligation
Represents a closely held company’s obligation to buy
back shares of stock from ESOP participants
 Future Distribution Funding

 “Put
option” may entitle participants to have shares distributed
and then purchased by the company at fair market value
 ESOP document may provide that participants receive cash
from the Plan for their shares (S corporation, or C-corporation
with bylaw restrictions)

Future Diversification Funding
 Diversification
participation
2
rights begin at age 55 with 10 years of plan
Repurchase Obligation Study
A repurchase obligation study is a long-term projection
of ESOP distributions and the associated cash
requirements that a company will face


AND
An analysis of strategies for managing and funding the
resulting obligations

3
When Should a Study Be Done?
Feasibility /Initial Design Stages




Lender may require it
Assess impact of expected cash flows to plan sponsor
Modeling can be used as a tool for ESOP plan design
Ongoing Assessment –no hard and fast rule on how
often a study should be updated





4
When reality diverges from recent assumptions
ESOP is considering a new transaction
When there is a need to assess changes in distribution
policies or funding strategies
Otherwise, generally every 2-3 years
What Impacts Repurchase Obligation?
Employee demographics, age profile
Employee turnover rates and patterns
Death, disability
Changes in size of workforce
Salary increases, compensation of new hires
Stock acquisition loan term; debt prepayments
Share value/appreciation (depreciation) in value
Distribution Policies and Practices
Election rates - Diversification
Plan design










5
Plan Design








6
Eligibility and entry provisions
Allocation provisions
Vesting schedule
Definition of Retirement Age
Plan distribution rules
In-Service distributions, if any
Diversification rules, including any early or expanded
diversification features
Account segregation
WHO’S RESPONSIBILITY?
7
Who’s Responsibility?
Corporate obligation to plan for and fund repurchase
liability
Code states that it is a corporate obligation




8
Where there are internal trustees, the lines of responsibility
can get murky
Possible for internal trustees to have a fiduciary
responsibility for repurchase liability
Who’s Responsibility?
Trustee should take a proactive approach to
repurchase liability




9
If funding the repurchase liability becomes an issue with the
company, it will become an issue for the trustee
Trustee should understand the nature of the liability and
funding mechanism
How does this affect the valuation?
Who’s Responsibility?


Company has responsibility to set distribution policy
and plan provisions that govern distributions
Distribution provisions




10
5 year wait and 5 year installment payout for terminees?
Recycle vs. redeem (or combination)
Segregate
Diversification provisions
Who’s Responsibility?

Valuation Report


11
Should contain a section to explain/address repurchase
liability and how it has been factored into the valuation
report
If a repurchase study has been conducted, the appraiser
should review the study with the company or trustee to
determine how repurchase will be factored into the
valuation
PAYING FOR REPURCHASE LIABILITY
12
How Is Repurchase Liability Paid?

Sell the company


Results in immediate liquidity for participant shares
Redeem shares

Company buys back shares and shares are retired to treasury
account



After-tax dollars that leave the company purchase shares
Will not receive any further value allocation in the annual appraisal
Recycling

13
Results in shares being recirculated in the ESOP Trust
Redemption
Will not have to repurchase these shares in the
future
 Company can elect to re-contribute these shares
or a portion of them to the plan
 May be a benefit to departing participants if NUA
(net unrealized appreciation) exists
 Trustee should be concerned if other
shareholders exist
 Reduces number of outstanding shares

14
Redemption Example
Ex – 100% ESOP company is worth $5 mil with a
$50/share value. There are 100,000 shs
outstanding. Departing participants have 10,000
shs. So $500,000 leaves the company to
repurchase shares from participants. Company is
now worth $4,500,000.
 Company now has only 90,000 shs outstanding.
$4,500,000/90,000 = $50/sh

15
Redemption Distribution Example
OIA Balance
Share
Balance
Share Value
Participant
John Doe
$ 4,085.23
Jane Doe
$ 675.38
Rosetta Stone
$ 6,487.22
Total
$ 11,247.83 10,000.00 $ 500,000.00
5,872.38 $ 293,619.00 Rollover
$
293,619.00 $
4,104.23
$ 297,704.23 $
675.38 $
2,186.00 $
103.10
4,083.90 $ 204,195.00 Direct Taxable $ 210,682.22 $ 42,136.44 $ 6,487.22 $
204,195.00 $
-
43.72 $ 2,186.00 Direct Taxable $
Assumptions: Company redeems shares
Stock distributed from the trust
No state tax withholding involved
Share price = $50
16
Distribution
Gross
Federal Available for Net Distribution Net Distribution
Type
Distribution Withholding Withholding from Company from ESOP Trust
-
2,861.38 $ 572.28 $
$ 511,247.83
$
500,000.00
Recycling



17
If other outside shareholders then won’t have to worry
about losing ownership %
Number of shares outstanding and ESOP % remains
constant
Will have to repurchase the same shares again in the
future –over and over again
Recycling Example

Using same data from redemption example:


18
Ex – 100% ESOP company is worth $5 mil with a
$50/share value. There are 100,000 shs outstanding.
Departing participants have 10,000 shs. So $500,000
leaves the company and enters plan as a contribution.
Company is now worth $4,500,000.
Company still has 100,000 shs outstanding.
$4,500,000/100,000 = $45/sh
Segregation

Results in recycling of shares within the plan



19
Repurchase is funded within the plan immediately
Fiduciary liability for the investment of cash until time of
distribution
Shares within the plan are allocated to active participants
currently contributing to the company
FUNDING ALTERNATIVES
20
Sinking Fund - ESOP

Advantages




21
Contributions and earnings are tax deductible
Provides a mechanism for newer participants to get stock
in their accounts
Allows non-100% ESOP to maintain ownership
percentage
Cash not available to creditors
Sinking Fund - ESOP

Disadvantages


22
Cash accumulates inside the ESOP and cannot be used for
corporate purposes
Shares must be recycled
 May result in inactive participants accumulating more
shares as their cash is being used to purchase shares of
those currently eligible for distribution
Sinking Fund - ESOP

Other Considerations

Not a $ for $ offset against repurchase as participants
will accumulate OIA balances that will have to be paid

May not be ideal where repurchases are lumpy or
inconsistent from year to year
Could result in larger than anticipated allocations in
some years

23
Valuation Issues
24

Could result in reduced earnings and cash flow
for valuation purposes

Loss of flexibility as cash is no longer a corporate
asset

Is more cash than currently needed being set
aside in the ESOP?
Valuation Issues
 Growth
rates considered in the ESOP valuation
could be negatively impacted as cash is diverted
to fund repurchase obligations versus investing in
projects to grow the company
 Also, a
potential negative impact on the cost of
capital calculation = competing need of ESOP
with company need to reinvest in the business
 Changing
ability to honor the put right may also
be reflected in a higher discount for lack of
marketability
25
Sinking Fund - Company

Advantages



26
Can contribute cash to plan as needed or use to redeem
shares
 Retain flexibility to redeem or recycle shares
Asset of the company so can still be used for corporate
purposes if necessary
Improves liquidity of the company
Sinking Fund - Company
Disadvantages





27
Cash is typically added to value on a $ for $ basis when
valuing company stock which results in the value
increasing (is this a disadvantage???)
Contributions to the corporate sinking fund are not
deductible
Investment yields may be taxable
This balance sheet asset isn’t protected from creditors in
the event of bankruptcy
Valuation Issues


Cash is added to value on a $ for $ basis
Balance sheet cash is available for growth


28
To the extent the cash is needed for repurchase, growth
could be slowed
Impact on cost of capital may be minimal
Pay As You Go

Advantages



29
Flexibility with cash to redeem or recycle
Cash isn’t tied up in the plan or in a sinking fund on the
balance sheet
Can contribute a certain desired percentage of
compensation to the plan each year
Pay As You Go

Disadvantages




30
Lack of planning for big events or unanticipated large
payments
Cash flow availability could be problematic if timing of
distribution event and amount is unpredictable
In the event of poor performance, the company may be
restricted from putting cash in the ESOP
Contributions must be within deduction limits
Valuation Issues

Similar to those listed before depending on
whether shares are redeemed or recycled, i.e. –
growth rates, cost of capital assumptions…

Cash flows may be unpredictable


31
Difficult for the appraiser to predict the cash flows from
year to year
Use of normalized retirement plan benefit may be used to
smooth the impact
Other Funding Alternatives

COLI – corporate owned life insurance

Re-Leverage the ESOP

External debt
32
Questions?
Dolores Lawrence
Blue Ridge ESOP Associates
[email protected]
Brant Armentrout
ComStock Advisors
[email protected]
Dawn Goestenkors
First Bankers Trust Services, Inc.
[email protected]
33