9/29/2014. Managing the Repurchase Obligation Before it Becomes Unmanageable. Introduction. Topics that will be covered

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1 Managing the Repurchase Obligation Before it Becomes Unmanageable The New England Chapter of The ESOP Association 2014 Annual Conference October 3, 2014 Mystic, Connecticut Tina DiCroce ESOP Economics, Inc. Barbara Clough Blue Ridge ESOP Associates Michael McGinley Prairie Capital Advisors, Inc. Introduction Managing repurchase obligations is one of the challenges for sustaining the ESOP in the long-term It is important to develop a strategy for how the company will meet its repurchase obligations, to ensure the sustainability of the ESOP To do this, the implications of your plan provisions, loan amortization schedule, repurchase method and sources of funding for the ESOP need to be understood Employee benefit levels will also be affected by the choices you make 2 Topics that will be covered How certain strategies concerning management of the ESOP impact repurchase obligation, benefit levels and share value Amortization of ESOP loan Distribution policy choices Redeeming vs. recycling Funding with cash contributions vs. S distributions/dividends Corrective actions mature ESOPs can take to make the ESOP and repurchase obligation manageable again - Refinancing the ESOP loan - Amending the plan - Releveraging 3 1

2 Understand the Long-Term Impact of your Current Strategy 4 Common Strategies ESOP Companies Adopt without Understanding the Long-Term Impacts Paying off the ESOP loan too quickly Adopting a distribution policy without keeping longterm goals in mind Adopting a redemption strategy to handle repurchase obligations Funding the ESOP primarily (or solely) with S corporation earnings distributions/dividends 5 ESOP Loan Amortization Schedule The term ESOP Loan generally describes the internal loan between the company and the ESOP This loan may not and typically does not have the same repayment schedule as the related external debt In a C corporation, it can be advantageous to accelerate the ESOP loan amortization schedule to recognize tax savings on contributions Contributions to ESOPs are tax-deductible up to the IRC 404(a) limit for deductibility In an S corporation, contributions must be within deductible limits, but tax advantages are not realized at the corporate level 6 2

3 ESOP Loan Amortization Schedule The ESOP Loan Agreement outlines the required principal and interest payments, as well as the share release methodology The Amortization Schedule summarizes the actual principal and interest payments made When a loan payment is made, shares are released from loan suspense and allocated to eligible participants accounts Some companies choose to accelerate payments on the ESOP loan why? They don t like debt They want to take advantage of the tax deduction (C corps) 7 Impact of Accelerating ESOP Loan Payments on Repurchase Obligations & Benefit Levels Accelerating payments can have unintended consequences for managing the ESOP in the long-term Accelerating the payments also accelerates the share release schedule Shares in loan suspense are allocated more quickly, which can result in an uneven allocation of shares over time Participants employed during the years when the loan is repaid may receive a high annual benefit, which may not be replicated after the loan is repaid This can result in the dreaded have vs. have-not issue 8 Benefits of a Long ESOP Loan Amortization Schedule Amortizing the ESOP loan over a longer period of time spreads out the allocation of shares May result in a more even benefit to participants from year to year It also provides shares to new participants further into the future Allocating shares more slowly can also help the company better manage the repurchase obligations in the long-term Cash requirements related to the repurchase of shares allocated from loan suspense are spread over a longer period of time 9 3

4 Impact of Accelerating ESOP Loan Payments on Share Value Things to consider: Is the ESOP loan tied to external debt? How does the appraiser address the ESOP debt in the valuation? Is there a value associated with the ESOP tax shield? If tied to external debt, as a result of the accelerated payment, share value may also be impacted by: Decrease in cash in connection with loan payment Projected interest savings Any related changes in working capital Change in flexibility to meet capital requirements and/or pursue growth (e.g. increases in RO and/or decreases in cash can cause a crowding out effect on other important expenditures) 10 Distribution Policy Distributions can be paid in either a lump sum or installments Companies also may choose to delay distributions for terminations other than death, disability or retirement, i.e., until the sixth year following the terminating event, or in some cases until a loan is repaid The timing and form in which distributions are paid have consequences which need to be weighed when making decisions about distribution policy 11 Distribution Policy Impact on Repurchase Obligations & Benefit Levels Many companies elect to pay all distributions in a lump sum, in the year following termination Prevents terminated participants from benefitting from increases in share value; results in shares being held primarily by active participants However, immediate lump sum distributions can also result in the following unintended consequences: Repurchase obligations which are highly variable from year to year Makes year-to-year cash requirements unpredictable Provides an uneven benefit to participants Accelerate repurchase obligations Shares are reallocated to remaining eligible participants right away 12 4

5 Distribution Policy Impact on Repurchase Obligations & Benefit Levels Delayed distributions and installment payments serve a few purposes: Reduce year-to-year variations in the cash requirements Provide the company with additional time to develop the cash needed for the repurchases Make annual repurchases more predictable Less chance of unexpected high RO due in the event of a reduction in force, large account holder retiring, etc. However, in periods of rising stock values Delays and installments can result in participants being paid out at a higher value Assuming terminated participants remain invested in employer stock, and are not segregated, they will benefit from any increases in stock value 13 Segregating Accounts Impact on Repurchase Obligations & Benefit Levels Segregating accounts is the conversion of terminated participants accounts from employer stock to cash The entire account is usually converted in the year after termination Terminated participants no longer benefit from increases in stock value; company can maintain its normal distribution policy, including any delays and/or installments Gets shares back in the hands of new participants sooner It is important to keep in mind that this strategy, from a cash flow perspective, could be* the same as paying immediate, lump sum distributions *Note that accounts can also be segregated and paid in installments 14 Impact of Distribution / Segregation Policy on Valuation Terminated participants accounts are generally segregated (converted from stock to cash) in a lump sum All else equal, paired with a redemption policy, this would result in no change in stock value as cash is exchanged for shares; cash and shares decrease in parity All else equal, paired with a recycling policy, this would result in a decline in stock value; cash decreases and share count remains unchanged Segregating may result in more variability in the year-to-year cash requirements for the ESOP, which may produce swings in benefit levels and affect share value 15 5

6 Repurchase Method Redeem vs. Recirculate The repurchase method (i.e., redeeming vs. recirculating ) affects the: Number of shares owned by the ESOP Number of shares that will have to be repurchased over time Tax treatment and cost of repurchases Size of participants accounts (and tax treatment of distributions to participants) Value per share of the company s stock 16 Redeeming vs. Recirculating Shares Redeeming Company buys back shares No tax deduction uses aftertax dollars No addition to participant accounts ESOP s ownership reduced (if the ESOP owns less than 100% of the company) Reduces number of outstanding shares May result in per share value growing more rapidly than aggregate equity value in the long-term Recirculating Shares repurchased within ESOP trust, reallocated to remaining eligible participants Can use current contributions (tax deductible) or S corp distributions, or accumulated cash balances Participants account balances are increased ESOP s ownership unchanged Number of shares outstanding remains constant 17 Redeeming vs. Recirculating Shares Unless the plan document dictates how distributions can be handled, a company can change between recirculating and redeeming Redeeming and recirculating can also be combined in various ways for example: Redeem all shares, then contribute stock equal to a target benefit level, or Contribute cash equal to a target benefit level, use the cash to recirculate shares, and redeem any additional shares S distributions or dividends can also provide a source of cash for recirculating; however, they are allocated differently than contributions a topic which will be discussed in a few minutes 18 6

7 Impact of Adopting a Redemption Strategy on Repurchase Obligations & Benefit Levels Some companies adopt a full or partial redemption strategy: To reduce the future repurchase obligation, or To control the benefit level received by participants 19 Impact of Adopting a Redemption Strategy on Repurchase Obligations & Benefit Levels However, handling repurchase obligations with redemptions can have unintended consequences A declining number of shares outstanding over time may result in value per share rising faster than aggregate equity value While the ESOP may own fewer shares, the cost of repurchasing those shares will be higher Communicating to participants the connection between performance to the value per share can become an issue... If the initial ESOP loan is repaid, and the company is not making contributions to the plan, if all shares are redeemed: Existing participants will not receive additional shares, and New participants do not receive a benefit from the ESOP 20 Impact of Adopting a Redemption Strategy on Share Value Under a redemption strategy, the company s cash is used to purchase shares directly from participants. Purchased shares are then retired by the company. No earnings impact Aggregate company value declines No impact on per share value (in that year, but over time...) Cash leaves company, shares outstanding reduced Future stock price growth accelerates Impact of growth in enterprise value and balance sheet de-leveraging spread over fewer shares 21 7

8 Impact of Adopting a Redemption / Re-contribution Strategy on Share Value Under a redemption/re-contribution strategy, the company uses cash to purchase shares directly from participants; some or all of the shares contributed back to the ESOP. Any shares not re-contributed to the plan are retired. Aggregate company value declines Per share value declines; but may be less than only a contribution Cash leaves company, shares outstanding may be reduced 22 Funding the ESOP: Contributions vs. S Corp Distributions/Dividends When recirculating stock, a company can fund the repurchase obligation with cash contributions, S distributions/dividends, or some combination These funding sources are allocated differently: Contributions are allocated based on method described in plan document (in most cases, pro rata to eligible compensation) S distributions/dividends on the other hand, are allocated as follows: Those paid on unallocated shares, i.e., shares in loan suspense, are allocated pro rata to eligible compensation Those paid on allocated shares, i.e., shares in participants accounts, are allocated pro rata to stock balance 23 Impact of Funding Primarily with S Corp Distributions/Dividends on Repurchase Obligations & Benefit Levels Some companies fund the ESOP primarily (or solely) with S distributions/dividends Often occurs when the ESOP owns less than 100% Also occurs when funding exceeds 404 limits Many times S distributions are required However, this strategy can result in a have vs. have-not situation, which affects repurchase obligations and participant benefit levels Shares become concentrated in the account of longer-term participants with larger share balances, who are often closer to retirement age, resulting in higher ROs for retirements New participants with little or no shares, receive little or no additional shares Can also result in compliance issues with dividend whole test 24 8

9 Impact of Funding Primarily with S Corp Distributions/Dividends on Share Value S Corp Distributions (C Corp Dividends) to ESOP No impact on earnings Shares outstanding remain constant Aggregate company value declines Per share value declines since cash leaves company; shares outstanding remain unchanged 25 Corrective Actions for Mature ESOPs 26 Refinancing the ESOP Loan to Manage Future Repurchase Obligations & Benefit Levels ESOP companies partially into their loan who are concerned about having paying off the internal loan too quickly may consider refinancing to stretch out the term In order to refinance an ESOP loan, participants must receive adequate consideration Is this in the best interest of participants? Redeem all shares and create a new ESOP note? 27 9

10 Rebalancing Accounts to Manage Future Repurchase Obligations & Benefit Levels Rebalancing a provision in the Plan Document which results in all participants having the same percentage in cash versus stock as the Trust has overall (excludes segregated balances) Cash MUST be in plan to rebalance Can be a communications issue w/long-term participants 28 Amending ESOP Distribution Policy to Manage Future Repurchase Obligations & Benefit Levels Best practice is to have statutory distribution requirements and longest delay in Plan Document Distribution Policy allows some flexibility relative to timing and manner of payments Typically, if Plan Document has more liberal provisions can be difficult to amend; must grandfather anyone employed when amendment occurs The distribution policy selected impacts share value based on the implied benefit levels and year-to-year variability in cash requirements 29 Releveraging to Manage Future Repurchase Obligations & Benefit Levels Releveraging refers to the ESOP s leveraged purchase of shares that have previously been distributed from the ESOP The purchase is financed with a loan from the company to the ESOP typically with a long amortization schedule The shares are placed in loan suspense and released over time as contributions are used to amortize the loan Advantages of releveraging include: Creates a source of shares to be allocated over a period of time Avoids the effects on value per share resulting from fluctuations in number of shares outstanding 30 10

11 Releveraging to Manage Future Repurchase Obligations & Benefit Levels Releveraging has become an increasingly popular way to manage ESOPs for the long term, by creating a source of shares that can be allocated over time It is used most effectively in periods when repurchase obligations are unusually high Avoids reallocating a large number of shares at one time Sometimes it is done in conjunction with a one-time special diversification/in-service distribution offering However, there are associated complexities and costs similar to any ESOP transaction Competent professional assistance is needed to implement a releveraging transaction 31 Releveraging to Manage Future Repurchase Obligations & Benefit Levels Impact on ESOP Administration & Valuation Each tranche must be tracked separately Important to ensure that appropriate loan payments are made and correct number of shares are released VERY important for S Corporation ESOPs to consider the results of 409(p) testing before entering into any transaction which changes the number of shares in the Trust or the allocation amongst participants If dividends or S distributions are being used as source of repayment, the dividend must follow the shares Essentially, the dividend from one tranche cannot be used as payment on a different tranche 32 Releveraging to Manage Future Repurchase Obligations & Benefit Levels Impact on ESOP Administration & Valuation In situations of releveraging, share value may change based on the extent to which: The company takes on additional external financing or uses cash to execute the transaction (all else equal, more debt or less cash would decrease share value) The company s redemption of terminated participant shares are different than the number of reissued shares Shares sold to ESOP do not need to mirror shares redeemed Aggregate Company value declines Per share value declines vs. straight redemption Cash leaves company, future earnings are lower due to future ESOP compensation expense, shares outstanding change depends on size of re-leverage 33 11

12 Impact of Adopting a Redemption Strategy on Share Value A leveraged redemption involves a corporate redemption followed by a leveraged stock sale to the ESOP Shares sold back to ESOP held in suspense and released as ESOP loan is repaid Shares sold to ESOP do not need to mirror shares redeemed Aggregate Company value declines Per share value declines vs. straight redemption Cash leaves company, future earnings are lower due to future ESOP compensation expense, shares outstanding change depends on size of re-leverage 34 Wrap-Up Make sure you understand the consequences of your decisions regarding plan design and administration, repurchase method, and funding strategy, when thinking about managing repurchase obligations and employee benefit levels, and for the sustainability of the ESOP How you structure your ESOP loan amortization, and the choices you make with respect to distribution policies, repurchase method, & funding strategy, can be combined in a variety of ways to best manage and fund the ESOP in the long term 35 BARBARA M. CLOUGH, QPA, QKA; Managing Director; Blue Ridge ESOP Associates Phone: (434) bclough@blueridgeesop.com Barbara M. Clough Barbara Clough is a Managing Director at Blue Ridge ESOP Associates, a nationally recognized third-party administration firm, which provides employee benefit plan administration and related services exclusively to ESOP Companies. During Ms. Clough s tenure in the Qualified Plan Administration field, she has been the ESOP Manager for a midsized consultant firm and responsible for the training and oversight of a staff of twelve administrators. Administration experience includes private and publicly-held plans ranging in size from 20 to 20,000 employees as well as extensive experience with ERISA law, Department of Labor Regulations, IRS code compliance, IRS/DOL audits. Ms. Clough has worked closely with Plan Sponsors, accountants and legal counsel to provide guidance on plan design, resolution of legal and compliance matters as well as audit discrepancies. Ms. Clough holds a Bachelor of Science degree from the University of Massachusetts. She is the current Chair of The ESOP Association s Administrative Advisory Committee, past Administration Representative of The ESOP Association Interdisciplinary Committee, Vice President of Programming for The New England Chapter of The ESOP Association, frequent author and speaker at NCEO and ESOP Association conferences. Ms. Clough is a member of ASPPA, the ESOP Association and NCEO. 12

13 Tina M. DiCroce; Vice President; ESOP Economics, Inc. Phone: Tina M. DiCroce Tina M. DiCroce is Vice President at ESOP Economics, Inc., a nationally recognized firm specializing in repurchase obligation studies, software, and consulting. Tina manages repurchase study projects and consults with ESOP companies on how best to manage and fund the repurchase obligation. She also provides technical support and training to software clients. Tina has spoken at several national as well as regional conferences, specifically on the topic of repurchase obligation planning, and she is known as an expert in her field. She is an Associate Member of the ESOP Association Finance Advisory Committee, and serves as a Chapter Officer for the PA/DE Chapter of the Association. Tina received her B.A. in Economics from Villanova University, where she also earned a M.A. in Liberal Studies, which included a Certificate in the Great Books Literature Program. Michael J. McGinley, ASA, CVA; Vice President; Prairie Capital Advisors, Inc. Phone: mmcginley@prairiecap.com Michael J. McGinley Mr. McGinley operates out of Prairie Capital Advisors Atlanta, GA office. He specializes in the valuation of businesses, business interests, and tangible and intangible assets for purposes of mergers and acquisitions, employee stock ownership plans (ESOPs), gift and estate planning, strategic planning, financial accounting and reporting, tax planning and compliance, buy-sell agreements, and dispute resolution. Mr. McGinley has provided financial advisory services to clients ranging from private equity firms to international public companies to smaller family-owned and start-up businesses. Mr. McGinley holds a Master of Business Administration degree in Finance from Georgia State University s Robinson College of Business and a Bachelor of Science degree from Georgia Institute of Technology. Mr. McGinley is a member of the National Center for Employee Ownership (NCEO), The ESOP Association, and the Association for Corporate Growth (ACG). He is a member of The ESOP Association s Valuation Advisory Committee and often is a presenter at both national and regional events sponsored by The ESOP Association and the NCEO. Mr. McGinley is an Accredited Senior Appraiser (ASA) American Society of Appraisers and a Certified Valuation Analyst (CVA) National Association of Certified Valuators and Analysts (NACVA). 13