Nuts & Bolts of ESOP Sustainability - ESOP Feasibility
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Nuts & Bolts of ESOP Sustainability

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According the National Center for Employee Ownership, there were approximately 10,900 ESOPs in the United States at the end of 2011. Fifteen years ago when I started working in this field, the number was approximately 11,000. The number of ESOPs suggests little or no growth in employee ownership, but the assets held by ESOPs tell a different story.

Much of the asset growth in ESOPs can be attributed to changes in the tax code in 1998 that made 100% ESOP ownership in an S Corporation feasible. With so many ESOPs today becoming majority or full owners, managing the finances of both the company and the plan in a sustainable fashion is critical.

SES Advisors applies its expertise in plan design, finance, feasibility and recordkeeping to help ESOP companies develop sustainable ESOP practices. This includes repurchase obligation forecasting; distribution policies; plan funding alternatives; benefit policies; management incentive plans; and best practices for corporate governance.

In this article, I present some practical tools and advice for keeping your ESOP sustainably funded.

5 Characteristics of Sustainable ESOP Companies

  1. Develop and periodically review a repurchase obligation funding plan and capital budget;
  2. Have a sound understanding of company valuation methodology – particularly the linkages between company decisions, valuation, ESOP benefit levels and repurchase obligation;
  3. Develop prudent and fair benefit plans, incorporating repurchase obligation funding decisions and fair compensation principles;
  4. Promote and foster an employee ownership culture; and
  5. Engage in practices of well-managed companies such as: good governance procedures, appropriate management incentive/compensation policies and succession plans.

Repurchase Studies
Sustainable ESOP practices and policies are built on the foundation of a good repurchase obligation study. An ESOP sponsor should consider this forecast to be as integral to management of the companys finances as a capital expenditure budget.

A repurchase study should provide:

  • Estimates of the total repurchase obligation and related capital needs over the next several years;
  • A sensitivity analysis for a range of company growth and profitability outcomes; and
  • Benefit outcomes for individual or groups of participants at various ages/situations and demonstrations of how funding decisions impact these stakeholders.

Stock Appraisal Methods and their Link to Sustainability
Generally valuation methods that rely heavily on cash flows are more compatible with ESOP sustainability because the valuation outcome changes proportionally as profitability changes, thereby reducing repurchase obligations in a downturn and better matching available capital. Even in discounted cash flow or earnings capitalization valuations, the impact of the reduced profits is not immediately proportional because these methods typically look back to profits over the last few years and ahead to profits over the next few years based on the companys financial forecast.

A sustainable ESOP company makes its best effort to deliver the best information possible to its independent appraiser and trustees in order to ensure that the price being paid to redeem or recycle its stock is both fair and sustainable.

Combining Appraisal Methodology, Repurchase Forecast & Funding Decisions
A good repurchase funding study will combine the employee turnover rate analysis, the concentration of ownership and the valuation forecast and methodology to produce a flexible, integrated model that demonstrates the impact of an ESOP companys distribution policies, funding policies and loan structure.

SES Advisors combines these concepts into an ESOP Asset Turnover Rate (EATR). EATR is a measurement of the percentage of the ESOPs company stock assets the company or the plan will have to repurchase in a given year (or over a longer period). EATR typically ranges between 4 and 15 percent in any plan year. In the long run, EATR will tend to
average between 5 and 10 percent.

EATR allows us to compare the ESOP repurchase obligation and benefit levels to other ESOP companies. Combined with valuation concepts such as multiples of EBITDA, EATR also allows simple evaluations of whether the tax benefits of being an ESOP company will largely fund the future repurchase obligation.

Applying the Concepts

If your ESOP repurchase obligation is unsustainable, there are several options to consider:

  • Find out if your appraiser is willing to factor the cash flows related to the repurchase obligation into his or her analysis;
  • If your appraiser is not willing to factor the obligation, take pro-active steps to achieve a reduction in valuation by either pre-funding the ESOP trust ahead of the obligation, or engaging in a re-leveraging transaction;
  • Consider segregation of terminated accounts ahead of any bubble in the repurchase obligation;
  • Understand the repurchase obligation funding methodologies and how they affect benefit levels and company value differently (e.g. dividend funding vs. contribution funding);
  • If you have disparity in benefit levels created by past plan design or funding policies (commonly referred to as the have/have not problem), consider a re-leveraging transaction or a prefunding strategy combined with account rebalancing;
  • Set a benefit target rate based on a reasonable compensation analysis (e.g., a target percentage of annual compensation that may or may not be adjusted for annual profitability); and
  • Understand the funding techniques to employ if the repurchase obligation exceeds available cash plus the target contribution in any year.

ESOP sustainability is ultimately a matter of ensuring that your ESOP company has sufficient financial resources and planning tools to meet its future repurchase obligations and the right corporate governance structure and culture to ensure you get the most out of your ESOP. We strive to provide
knowledge, experience, and planning tools to help our clients incorporate these concepts in their companies.

 

Contact the Author
Brian Wurpts, Vice President
215-508-5640

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