2013 Carolinas Chapter Summer ESOP Conference

The Repurchase Obligation

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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 rights begin at age 55 with 10 years of

plan participation

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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

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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 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

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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

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Plan Design 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

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WHO’S RESPONSIBILITY?

Who’s Responsibility? Corporate obligation to plan for and fund

repurchase liability Code states that it is a corporate obligation

Where there are internal trustees, the lines of responsibility can get murky

Possible for internal trustees to have a fiduciary responsibility for repurchase liability

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Who’s Responsibility? Trustee should take a proactive approach

to repurchase liability 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?

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Who’s Responsibility? Company has responsibility to set

distribution policy and plan provisions that govern distributions

Distribution provisions 5 year wait and 5 year installment payout for

terminees? Recycle vs. redeem (or combination) Segregate Diversification provisions

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Who’s Responsibility? Valuation Report

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

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PAYING FOR REPURCHASE LIABILITY

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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 Results in shares being recirculated in the ESOP

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RedemptionWill not have to repurchase these

shares in the futureCompany 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 ExampleEx – 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

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Redemption Distribution Example

OIA BalanceShare

BalanceShare Value

Distribution Type

Gross Distribution

Federal Withholding

Available for Withholding

Net Distribution from Company

Net Distribution from ESOP Trust

ParticipantJohn Doe 4,085.23$ 5,872.38 293,619.00$ Rollover 297,704.23$ -$ 293,619.00$ 4,104.23$

Jane Doe 675.38$ 43.72 2,186.00$ Direct Taxable 2,861.38$ 572.28$ 675.38$ 2,186.00$ 103.10$

Rosetta Stone 6,487.22$ 4,083.90 204,195.00$ Direct Taxable 210,682.22$ 42,136.44$ 6,487.22$ 204,195.00$ -$

Total 11,247.83$ 10,000.00 500,000.00$ 511,247.83$ 500,000.00$

Assumptions: Company redeems sharesStock distributed from the trustNo state tax withholding involvedShare price = $50

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Recycling 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

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Recycling Example Using same data from 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 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

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Segregation

Results in recycling of shares within the plan 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

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FUNDING ALTERNATIVES

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Sinking Fund - ESOP Advantages

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

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Sinking Fund - ESOP Disadvantages

Cash accumulates inside the ESOP and cannot be used for corporate purposes

Shares must be recycledMay result in inactive participants

accumulating more shares as their cash is being used to purchase shares of those currently eligible for distribution

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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

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Valuation IssuesCould 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?

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Valuation IssuesGrowth 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

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Sinking Fund - Company Advantages

Can contribute cash to plan as needed or use to redeem sharesRetain 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

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Sinking Fund - Company Disadvantages

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

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Valuation Issues Cash is added to value on a $ for $ basis Balance sheet cash is available for

growth To the extent the cash is needed for

repurchase, growth could be slowed Impact on cost of capital may be minimal

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Pay As You Go Advantages

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

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Pay As You Go Disadvantages

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

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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 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

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Other Funding Alternatives COLI – corporate owned life insurance

Re-Leverage the ESOP

External debt

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Questions?

Dolores LawrenceBlue Ridge ESOP Associatesdlawrence@blueridgeesop.com

Brant ArmentroutComStock Advisorsbarmentrout@comstockadvisors.com

Dawn GoestenkorsFirst Bankers Trust Services, Inc.Dawn.Goestenkors@FBTServices.com

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