Repurchase Liability Basics and the Effect on the Valuation

Transcription

1 Repurchase Liability Basics and the Effect on the Valuation March 24, 2017 Owen Schmidt Director of Sales Consulting Principal Laurie-Leigh White Sr. Vice President BVA Group

2 Table of Contents Introduction Overview of Repurchase Liability Monitoring Repurchase Liability Forecasting Repurchases Settling Repurchase Liability Impact of Repurchase Liability to Annual Valuation 2

3 Introduction Repurchase Obligation is Not a Time Bomb! Not the nature of ESOP it is the nature of closely held stock. Symptom of success. Preparation is the key. In any case, a manageable factor in the operation of a company with an ESOP. 3

4 What is the Repurchase Obligation? A claim on the future cash flow of the company that sponsors the ESOP. A general obligation of the plan sponsor. An off-balance sheet liability. 4

5 What creates the Repurchase Obligation? A participant either leaves the company or makes a request for a distribution due to: Retirement Death Disability Diversification Termination (voluntary or involuntary) 5

6 Managing the Repurchase Liability The company is responsible for monitoring the repurchase liability. The legal obligation to repurchase shares rests with the company, and the ESOP trustee is not obligated to use the cash balances in the trust to fund repurchases (unless the plan documents specifically require it). The trustee is obligated to act in the best interest of the plan's participants and must make that determination when using the cash balances to fund distributions. Monitoring the repurchase liability can include the following steps: Perform strategic planning for long term business objectives of the company and the ESOP. Create an expectation of the cash flow needs to satisfy the repurchase obligation going forward. Determine which approach to funding the repurchase obligation is most suitable for the ESOP/company. 6

7 ESOP Repurchase Planning So Where Do We Start? Repurchase Obligation Planning is not performed in a vacuum. It is a part of the Corporate Business Plan. A repurchase obligation study needs to be tailored to the needs of the Business. What factors will determine our most likely Repurchase Obligations? What factors may change and need to be tested? What do the results mean for the Sponsor Company? 7

8 Managing the Repurchase Liability Repurchase obligations are impacted by: Company stock price Share allocation Distribution policy and share repurchase strategy Employee demographics 8

9 Strategic Planning For ESOP To determine the best route for managing the repurchase obligation to achieve the company s long-term objectives, the company needs to identify the objectives as it relates to the ESOP. There are three objectives (not all of which are mutually exclusive): Remain employee owned; Maximize the value of the company; or Sell the company. 9

10 Strategic Planning for ESOP Objective Remain Employee Owned Consideration Requires a long term outlook and typically leads to a more conservative approach to funding the obligation. Maximize Value of the Company At some point the business may need to use cash that would otherwise be reserved for repurchase obligation funding to reinvest in the company. Sell the Company Repurchase obligation planning will be more short-term focused than under the other two approaches. 10

11 Strategic Planning For ESOP Minimize the competition for cash flow and capital between repurchase obligation and reinvestment in the business while balancing between multiple objectives. Provide ongoing retirement benefits to employees Fund repurchase obligations Ensure sufficient capital generation to provide for required reinvestments and pursue growth opportunities An overwhelming repurchase obligation can be a driver behind the sale of ESOP-owned companies and the termination of their ESOPs. 11

12 Trustee Responsibilities Part of the responsibilities of the ESOP trustee related to the repurchase obligation include: 1. Ensuring that management and the board, if applicable, have implemented policies to fund and meet the repurchase obligation. 2. Reviewing the repurchase obligation study performed to determine if the trustee agrees with its conclusions and actions steps. 3. Participating in the presentation of the repurchase obligation study by management. 12

13 Forecasting Repurchase Obligation A crucial step in forecasting the repurchase obligation is the performance of a repurchase obligation study or analysis of the ESOP participants. This study considers actuarial and financial variables to provide a long-term projection of ESOP distributions and expected cash requirements for a company. Ideally, a repurchase liability study would be performed during the formation of the ESOP as well as when there have been significant changes in the employees in the plan or when the assumptions used in the previous analysis are considered to be out of date. These studies can take weeks to perform. 13

14 Forecasting Repurchase Obligation Typically a third party is required to perform this study and build the financial model associated with it. The report can provide a combination of the following items: Summary of findings and recommendations Detailed description of the assumptions that were used Detailed schedules showing year-by-year projections Individual projections for participants with the largest account balances 14

15 What is a Repurchase Obligation Study? A long-term projection that forecasts the timing and amount of a company s ESOP repurchase obligations. Value and timing of shares up for repurchase. Availability of cash or reserves. 15

16 Why Perform a Repurchase Obligation Study? Budgeting Everyone loves a budget. Forecasting Repurchase Obligation Studies work better than tea leaves. Funding Making sure that the cash needs of the organization are met. Fiduciary Obligation Meet due diligence requirement for Board of Directors and ESOP trustee. They are just plain fun! 16

17 When Should a Repurchase Obligation Study be Prepared? Before ESOP transaction is consummated Three to four years after ESOP formation Major corporate events Merger, acquisition, etc. Downsizing Every three to four years otherwise, compare assumptions to results When projections from past studies don t match reality 17

18 Parties Involved in Repurchase Obligation Study Company s management, such as Controller, CFO and/or VP of Finance. ESOP consultant with repurchase obligation experience is retained by management. ESOP trustee s valuation firm may be asked to comment on the methodologies used in projecting the future share value estimates. Board of Directors and ESOP trustee should review the management s final report to understand how management proposes to fund the future repurchase obligation. 18

19 Settling the Repurchase Liability Each time stock is ready to be put to the company by a former participant, the company must make a decision how it will satisfy the obligation through one of the following: Redeem the shares directly Recycle using current company funding Releverage using cash already in the ESOP Each of the options has different cash flow and valuation impacts. These approaches can be used in isolation or in combination to fulfill the obligation. 19

20 Redeeming A redemption is where the company directly purchases the shares from the former employee and those shares are immediately retired into the ESOPs treasury stock. This transaction resembles a stock buyback. Some key characteristics of redeeming the stock are: The transaction occurs directly between the company and the participant. Redemptions are non-dilutive if they occur at fair market value as: The total shares outstanding decreases; and Cash is reduced by the cash required to pay for the shares, which in turn decreases equity value based on the reduction in cash. 20

21 Recycling Shares are repurchased with cash already held within the plan or through tax-deductible contributions made by the company to the ESOP. The shares are thus recycled back into the available pool of shares and will be owned by another participant. The cash used to buy the shares is provided by the company through either an employer contribution of cash to the ESOP, or contribution of company repurchased shares to the ESOP. If funded through an employer contribution, that contribution to the ESOP is tax deductible by the company. 21

22 Releveraging Shares are redeemed by the company and resold to the ESOP in exchange for a loan. Subsequently, the shares are allocated to the participants as the new loan is repaid. Releveraging allows the company to allocate the repurchased shares over a longer time period as compared to simply recycling all of the repurchased ESOP shares in one year. As a result, the company is able to more easily manage its targeted benefit levels for ESOP participants. Releveraging is frequently utilized when companies need to address large ESOP repurchases in a given year. Another purpose of releveraging is not only to maintain ESOP ownership, but also to address the haves and have nots issue that occurs when most of the ESOP shares have been allocated and there may not be a sufficient amount of remaining ESOP shares to allocate to existing and future employees. 22

23 Valuation Impact of Redeeming Generally a price neutral event as the company s total equity value is reduced as the company has to pay out cash for company stock, and the number of shares outstanding that is used in the determination of the per share value is reduced. Given the reduction in the equity value and the reduction in the number of shares outstanding, the price per share remains the same on the date of redemption. As the number of shares outstanding are reduced as part of this transaction, it can impact future share price as future company growth is concentrated into fewer shares. 23

24 Valuation Impact of Recycling The cost of recycling shares is expensed on the company s income statement, and is therefore dilutive to company value as the earnings of the company are lower but the total number of shares outstanding is unchanged. The company will get to realize a tax deduction for the expense. There is no change in the number of shares outstanding as the shares repurchased by the company are allocated to current participant accounts based on the ESOP s design. 24

25 Comparison of Redeeming vs. Recycling Redeeming Shares Prior to redemption Shares redeemed After redemption Aggregate equity value $5,000,000 $500,000 $4,500,000 Number of shares outstanding 1,000, , ,000 Value per share $5.00 $5.00 $5.00 Recycling Shares Prior to redemption Shares recycled After redemption Aggregate equity value $5,000,000 $500,000 $4,500,000 Number of shares outstanding 1,000, ,000 1,000,000 Value per share $5.00 $5.00 $

26 Valuation Impact of Releveraging The purchase of shares results from a loan and is dilutive to value as total debt outstanding increases. The shares purchased by the ESOP are allocated to existing participants based upon existing ownership, not based upon levels of compensation (which happens in recycling). As there is no impact to the company s compensation expense, there is not a tax deduction associated with this approach. Releveraging is the only method where the ESOP directly purchases the shares from the employees. With redemption and recycling, the company purchases the shares. As such, if the repurchase is significant, an adequate consideration opinion may be required (important discussion to have with the trustee). 26

27 Comparison of Methods Redeem Recycle Releverage Shares outstanding Reduced No impact No impact ESOP ownership Reduced if <100% No impact No impact Additional shares to employee ESOP accounts No Yes Yes, over time Per share value Anti-dilution Diluted Diluted Employer contribution No Yes and dividends/s distribution Yes and dividends/s distribution Employee group benefited most Employees with larger share balances Depends on funding contribution dividends Contribution Company s cash flows Reduce Not reduced if = benefit expense Income Tax No deduction Deduction for employer contribution Not reduced if = benefit expense Deduction for employer contribution 27

28 Possible Impacts to Valuation This is a topic to discuss with the appraiser. Discount rate calculation the repurchase obligation s impact on future cash flows can be one of the factors considered in the company specific risk premium component of the cost of equity in the discount rate calculation. Net working capital if the company anticipates difficulties in funding its future ESOP redemptions, the valuation analysis may need to consider increased levels of required working capital. However, any excess working capital would likely be added back to company operating value as a non operating asset under the fair market value standard. 28

29 Possible Impacts to Valuation Discount for Lack of Marketability - typical discounts for lack of marketability ( DLOM ) for ESOP valuation purposes are in the 5% to 15% range. This lower level of DLOM as compared with more typical levels for privately held stock is due to the put option provided by ERISA to the ESOP participants. The company s ability to meet the future repurchase obligations can alter the DLOM used in the valuation. If the repurchase obligation is forecasted to be high in the coming years, or the company s ability to fund and meet the obligation is perceived as more difficult, these circumstances might cause the discount for lack of marketability to increase. Conversely, if the company is not forecasting significant obligation in the coming years with significant liquidity to fund its forecasted repurchase obligations, these instances could cause the discount for lack of marketability to decrease. 29

30 30

31 Laurie-Leigh White Laurie-Leigh White is a Senior Vice President of BVA Group. As a Senior Vice President, Ms. White is responsible for overseeing the execution of a variety of valuation engagements. Areas of specialization include oilfield services, technology, food and beverage, and construction and engineering. Ms. White has been involved in hundreds of valuation projects for a wide variety of purposes, including financial reporting, ESOP, valuations for tax purposes, transaction advisory, and fairness opinions. Additionally, Ms. White has been involved in litigation consulting assignments related to economic damages, financials forensics, and valuation matters. Ms. White received a Master of Science in Accounting, a Bachelor of Business Administration in Accounting, and a Bachelor of Arts in Political Science from Southern Methodist University, where she graduated with highest honors. Ms. White is a Certified Public Accountant* who holds the designation of Accredited in Business Valuation, and is an Accredited Senior Appraiser of the American Society of Appraisers with an Intangible Asset Appraisal Specialty. She is a member of the American Institute of Certified Public Accountants and the Texas Society of Certified Public Accountants. Laurie-Leigh White, CPA*/ABV, ASA Senior Vice President Direct Mobile lwhite@bvagroup.com *Although BVA employs CPAs, it is not a CPA firm. Ms. White was recently selected as a recipient of the 2016 AICPA Forensic and Valuation Services ( FVS ) Standing Ovation Recognition program. This program is designed to recognize professionals in the FVS practice area who are 40 or under, hold either the CFF and/or ABV credential, and have exhibited exemplary professional achievement. Ms. White was also a nominee for the Houston Business Journal s Under 40 business and community leaders and was also a nominee for the National Association of Certified Valuators and Analysts 40 Under

32 Owen Schmidt Owen has been with Principal over 15 years and has over 30 years of retirement planning experience. His areas of expertise include the feasibility, design, installation and administration of qualified and non-qualified plans, including ESOPs, 401(k) plans, defined benefit plans, and defined contribution plans. Owen is a member of the National Center for Employee Ownership, The ESOP Association, and a Board Member of the Southwest Chapter of The ESOP Association. He is a frequent speaker on ESOP-related topics. Owen is a graduate of the State University of New York with a Bachelor of Arts degree in Economics. 32

33 Important Information The Presenters gather their data from sources they consider reliable; however, they do not guarantee the accuracy or completeness of the information provided within this presentation. The material presented reflects information known to the Presenters at the time this presentation was written, and this information is subject to change. The Presenters make no representations or warranties, expressed or implied, regarding the accuracy of this material. The views expressed in this material accurately reflect the personal views of the authors and do not necessarily coincide with those of their employers. The Presenters do not provide accounting, tax or legal advice. The information and material presented herein is provided for educational and informational purposes only and is not intended to constitute accounting, tax or legal advice or to substitute for obtaining accounting, tax or legal advice from an attorney or licensed CPA. Laurie-Leigh White and BVA Group are not affiliated with any company of the Principal Financial Group. t j