Considering the ESOP Repurchase Obligation and Its Effect on Fair Market Value
Written by Anne R. Meltzer, CPA/ABV
Have you considered the ESOP Repurchase Obligation? This refers to the “put” right which obligates the company to purchase an employee’s shares. The majority of ESOP repurchases are due to employee terminations and retirements. Since both of these situations are fairly predictable, the repurchase obligation is also predictable and manageable.
The impact of the repurchase obligation on fair market value depends most strongly on the 1) percentage of stock owned by the ESOP, 2) distribution rules within the plan document and 3) the methods used to repurchase the shares.
There are two primary repurchase obligation strategies or methods: the Recycling Compensatory Transaction Method and the Redemption Capital Transaction Method. These methods are very different and have a different impact on the valuation of the ESOP company.
- The company makes tax deductible contributions to the ESOP.
- The ESOP purchases shares from departing participants and “recycles” the shares.
- Shares are reallocated to the remaining participants and remain outstanding.
This transaction perpetuates the ESOP and is a compensatory transaction that may affect fair market value of the company. The total number of shares does not change, but the company incurs compensation expense. The company’s value could be impacted if the repurchase obligation is large and negatively effects the company’s working capital position.
When valuing a company that uses the recycling method to fund its repurchase obligation, the valuation analyst must consider the continuous nature of the repurchase obligation over many years. The repurchase obligation can affect the share price and the share price affects the repurchase obligation. A repurchase obligation study will project the number of shares expected to be repurchased and the projected share price. The projected recycling contributions need to be treated as an operating expense. Finally, the valuer needs to consider the impact of a normalized level of employee benefit expense.
- The ESOP distributes shares to the departing employees.
- The company transacts with the departing participant in a “redemption” that is a non-deductible capital transaction.
- The shares are then retired to the treasury and/or can be recontributed to the ESOP.
Redemption transactions reduce the number of shares outstanding to the ESOP and can often reduce the size of the repurchase obligation. The total enterprise value of the company may grow while the number of shares outstanding declines, thus increasing the per share value over time. Individual account balances will grow with increases in the enterprise value, as contributions to the ESOP are not usually made using this method.
The redemption method as a capital transaction does not generally affect fair market value to the extent that redemptions are manageable and within the projected cash flow of the company. A company which must borrow to fund its repurchase obligations generally will have a negative impact on value.
In either case, the repurchase obligation must be considered and reviewed each year when valuing ESOP companies. Keep this in mind the next time you are reviewing an ESOP valuation, or if you are considering adopting an ESOP.
If you have any questions regarding this article or ESOPs in general, please direct your questions to Anne Meltzer.