If your company has an employee stock ownership plan (ESOP), you are probably aware that shares from former employees who leave the company must be repurchased. This is known as an ESOP repurchase obligation (RPO).
For the employee leaving, it’s a good thing – the cash payout represents years of hard work and commitment, and usually makes up a significant part of their retirement.
For the company, however, the RPO is a looming obligation that can influence your future cash flows and ability to grow. The higher the share price, the higher the future payout to departing employees.
In this article, we’ll answer five common questions about repurchase obligations and their impact on your company’s value.
What is an ESOP Repurchase Obligation?
Because your company stock is not publicly traded, Section 409(h) of the Internal Revenue Code requires that the company sponsoring the ESOP must buy the stock back. IRC section §409(h) provides a “put option” enabling participants to sell shares back to the company at fair market value as determined by an independent appraiser.
This is in part to ensure that the ESOP is a successful employee motivational tool and a means of succession planning – your employees need to know they will be receiving the benefit upon exiting the company.
What factors affect the repurchase obligation?
When you, as a business owner, are planning for an upcoming RPO, there are several factors to keep in mind that will affect the total:
- The percentage of stock owned by the ESOP participants
- The plan’s distribution rules
- The methods used to repurchase the shares
- The timing of the distributions
- Participant demographics
What are the methods for purchasing stock back?
There are two main methods that companies use to buy stock back: redeeming and recycling. While both methods can affect the valuation of your company, recycling reduces the value per share while redeeming does not.
Redeeming means that your company buys back ESOP shares as treasury shares and then ‘retires’ them as outstanding shares. The equity value of your company declines by the amount used to purchase the shares, but because the total number of shares decreases, the per-share value remains unchanged.
Recycling the repurchased stock means reallocating the shares to the remaining ESOP participants. In doing so, it may reduce the value per share. Aggregate equity value could decline because of the cost of the contribution.
What impact does an RPO have on a valuation?
It’s not as straightforward of a question as you may think. Because the RPO is an ongoing liability, it represents an unfunded obligation not reflected on your company’s balance sheet. However, not including the RPO could overstate your stock price, which then increases the RPO down the road. Because of this, most valuation professionals include the RPO in the valuation presentation.
A big consideration when it comes to RPOs and valuation is – does the RPO hamper your ability to invest in new opportunities or future growth? Valuation professionals will often take the risk of future growth of the RPO into account by adjusting future cash flows, selecting a higher discount rate, adjusting the multiple, or a higher discount for lack of marketability.
A third-party actuarial study can also help you plan for future costs.
How do I manage my RPO?
The best way to manage this obligation is to keep on top of it. If properly managed and accounted for, the RPO should have minimal impact on growth and value. Regularly considering your ESOP repurchase strategy to make sure it is aligned with ongoing retirement benefits will help your company in the long run.
While there are no simple answers on how RPOs will affect your company’s value, being aware of the potential impact will help you stay on top of the obligation. We hope this article helps answer questions you may have about ESOP repurchase obligations. If you have further questions about this topic, please contact us anytime.