Ohio s Employee-Owned Network May 26, 2005 Cincinnati, Ohio Planning for ESOP Repurchase Obligations Presented by Judith L. Kornfeld ESOP Economics, Inc. Philadelphia, PA Phone: 215-546-6590 Email: judy@esopeconomics.com
What we ll cover... What are repurchase obligations? Why do you need to plan for repurchase obligations? How do you forecast repurchase obligations? What techniques are available for managing repurchase obligations through plan design and distribution policy? How can you fund the repurchase obligations?
Repurchase obligations defined Code Section 409(h)(1)(B) requires that if the employer securities are not readily tradable on an established market, [a participant] has the right to require that the employer repurchase employer securities under a fair market valuation formula
Repurchase obligations defined Basically, repurchase obligation is the employer s obligation to fund the benefit accrued under the ESOP Repurchase obligations are a claim on the future cash flow of the company that sponsors the ESOP They occur as a result of distributions being made from the ESOP
Repurchase obligations defined The timing of the repurchase obligations depends upon the distribution rules and the demographics of the employee population
Distribution rules timing Death, disability and retirement Distributions must begin no later than the end of the plan year after the year in which the triggering event occurred Other terminations (turnover) Distributions must begin no later than the end of the fifth plan year after the year in which participant terminated
Distribution rules timing Exceptions: For stock acquired prior to 1987, distributions may be delayed until normal retirement age or death Leveraged ESOPs can delay distributions until loan repaid
Distribution rules timing RMD rules Apply for a participant age 70½, unless the participant is working and not a 5% owner, then rules apply upon termination Diversification Employees age 55 with at least 10 years of participation are eligible to diversify 25% of shares acquired by the ESOP after 1986 for the first 5 years of eligibility and 50% for the 6th and final year
Distribution rules mode Once distribution begins, it may be made in a lump sum or in substantially equal periodic payments (not less frequently than annually) over a period that does not exceed five years Your plan document governs it may be more liberal than statutory requirements
Put Option Two Put Option Periods 60 days following date of distribution 60 days in plan year following plan year of distribution Other than during these two put option periods, employer has no obligation to repurchase distributed stock
Repurchase Obligation Who??... The repurchase obligation is the responsibility of the employer (not the ESOP) The employer may permit the ESOP to repurchase the distributed shares, but the ESOP is not obligated to do so
Why you need to plan for repurchase obligations IRC Sec. 409(p) creates obligation repurchase shares from participants who are entitled to receive a distribution from the plan Company has duty to prudently manage this obligation Therefore, it has duty to develop a plan for how it will meet this repurchase obligation
Fiduciary duty: Armstrong v. Amsted Industries Company, as plan fiduciary, had a duty to prudently manage their repurchase obligation Despite fact that repurchase obligation estimates were wrong, there was no breach of fiduciary duty Company had done periodic forecasts of its repurchase obligations Most recent forecast was based on reasonable assumptions Company had planned for the repurchase obligation and had what appeared to be adequate resources to meet it
Lessons from Amsted case 1. Don t ignore repurchase obligations 2. Use reasonable assumptions when forecasting repurchase obligations, and document them 3. Develop and document a plan for managing and funding the repurchase obligations 4. Test your repurchase obligation strategy in multiple scenarios e.g., optimistic and pessimistic forecasts as well as the best guess scenario 5. Update your forecast and your strategy regularly
Planning for repurchase obligations Three key questions: 1. How large are the repurchase obligations and when will they occur? 2. How can the company manage repurchase obligations through distribution policies and ESOP design? 3. How can the repurchases be funded?
How large are the repurchase obligations? To quantify them, you need to do a repurchase obligation study This is a long-term projection of ESOP distributions and the associated cash requirements that a company will face It is based on assumptions about a number of variables It may include multiple scenarios, i.e., projections based on unique combinations of assumptions
When should you do a study? Do first study early in the life of the ESOP Review assumptions annually Update every 2 to 3 years, or sooner if Assumptions or census change significantly ESOP is considering transaction that will affect repurchase obligations
Should you do the study yourselves, or have it done professionally? It depends On your resources Do you have the time? The staff with adequate knowledge? On your experience With ESOPs With financial projections
Survey data Who does the projections? 14% 3% 11% 50% President/CEO CFO Controller/other financial staff Benefits/HR manager or staff Other (please describe) 22%
Survey data How long does it take to prepare the study? 25% 17% 18% <5 hours 5 to 10 hours 10 to 20 hours 20 to 30 hours >30 hours 13% 27%
Should you do the study yourselves, or have it done professionally? If you do the study yourself, you can run additional scenarios and update results more readily Hands-on involvement may provide deeper understanding of repurchase obligation issues
Should you do the study yourselves, or have it done professionally? A consultant brings Experience to the project Reasonableness of assumptions Data setup and review Analytical experience The ability to analyze the results and their implications for you
Should you do the study yourselves, or have it done professionally? Using a consultant does NOT mean Here s the data, call me when you are done You will need to be involved in the process, because your input will be needed to develop the assumptions
The forecasting process 1. Define scenarios 2. Acquire software or build model 3. Develop assumptions 4. Do projections 5. Analyze results 6. Project additional scenarios if necessary
Step #1 - Define scenarios What questions are you trying to answer? What are the key variables that will affect your projections? What is the likely range of values for each of the key variables? The goal is to provide information that is needed for planning and decision-making
Step #2 - Acquire software or develop model If you build your own model, it needs to include sufficient level of detail to provide meaningful projections and should include flexibility to vary assumptions
Step #3 - Develop assumptions Good assumptions are essential! Assumptions need to be: Reasonable Internally consistent Consistent with other financial planning Get buy-in on the assumptions from key members of management
Step #3 - Develop assumptions The smaller the population, the more important it is to plan for contingencies, especially for large account balances The smaller the population, the greater the impact of individual events The smaller the population, the less credible the actuarial projections
Step #3 - Develop assumptions Turnover is a critical variable Group employees so you can fine-tune turnover assumptions Calculate historical turnover rates Identify factors that may cause variation from historical rates Select or construct an appropriate turnover table for use in the study Test results to make sure table is producing results you expected
Step #3 - Develop assumptions Stock value is also a critical variable Understand methodology used by your appraiser Be consistent with business plan Adjust for ESOP or other debt as appropriate Adjust all related assumptions when adjusting growth assumptions
Step #3 - Develop assumptions Small errors grow large over time! What appears logical on its face may not turn out to be, especially over the long term
Step #4 - Do projections Enter the assumptions into repurchase obligation software or spreadsheet model Check your results to make sure that they make sense Project additional scenarios, if necessary
Step #5 - Analyze results What are the answers to the questions that defined your scenarios? What other issues have emerged from the projections? How large are repurchase obligations relative to: Cash flow? Earnings? Payroll?
Step #5 - Analyze results Can repurchases be handled without interfering with growth? What is the best method of handling repurchases? Redeeming shares, recirculating them in the ESOP, or some combination Should changes in the plan or in distribution rules be considered? What funding methods are appropriate? We ll come back to these issues later...
Step #6 Project additional scenarios Initial analysis may suggest additional scenarios that need to be considered Test robustness of your repurchase obligation strategy by projecting additional scenarios under more extreme assumptions
Some tips for getting good results Don t wait until the week before the board meeting to start the process! Really focus on developing good assumptions Involve the key members of management in the process Look at the results in the context of your business models and forecasts, and adjust assumptions iteratively, as necessary
Remember... The projections are part of the planning process not an end in themselves! The purpose is to provide information that you can use to plan for, manage and fund the repurchase obligations
Managing with distribution rules There are a number of techniques that can be used to manage the repurchase obligations Delayed vs. immediate distributions Installment vs. lump sum distributions Redeeming vs. recirculating shares Segregating accounts at termination Reshuffling accounts
A sidebar redeeming vs. recirculating shares Basic to the funding decisions (and implicit in the projections) is the issue of whether repurchases will be made by the company ( redeemed ) or handled through the ESOP ( recirculated ) The decision depends on a number of factors, and can be changed as circumstances dictate
Redeeming vs. recirculating The two basic choices are redeeming and recirculating Redeeming ESOP distributes stock and company buys it Payments are not deductible Recirculating ESOP distributes cash, shares stay in ESOP Payments are deductible In S corp with 100% ESOP, deduction is irrelevant
Redeeming vs. Recirculating There are different consequences for the ESOP and the participants Redeeming Recirculating # of shares in ESOP declines ESOP s ownership % declines Lower # of shares repurchased Individual account balances have less shares # of shares in ESOP unchanged ESOP s ownership % unchanged Higher # of shares repurchased Individual account balances have more shares
Funding alternatives There are basically six types of funding for repurchase obligations Current cash flow Advance funding/ sinking fund Life Insurance ( COLI ) Debt Internal markets Third party solutions
Funding alternatives Many companies find that a combination of funding methods works best The challenge is to find the combination that is most appropriate for your company
Funding alternatives Finding the right combination requires that you address several questions: To what extent can repurchases be handled out of current cash flow? Is some sort of advance funding (sinking funds or insurance) necessary and feasible? Will it be necessary to use debt or look to third party solutions to meet the repurchase obligations?
Putting it all together... The ESOP sponsor has an obligation to plan for repurchase obligations A repurchase obligation study provides essential information for the planning process Repurchase obligations can be managed and funded in a variety of ways Test the robustness of your strategy at the extremes Update your planning regularly