Introduction to ESOP Sustainability: Why and When to Consider a Sustainability Study

Over time, companies that are owned, in whole or in part, by an Employee Stock Ownership Plan (“ESOP”) may find that preserving the ESOP over the long-term while at the same time maintaining the health of the business can become a challenge. To help navigate the issues that will inevitably arise as the ESOP matures—including repurchase obligation, which is the responsibility of the company to fund any departing participant’s stock repurchase at its current fair market value—and to simultaneously address the company’s goals, many ESOP-owned firms find it helpful to engage in a sustainability study.

Why You Should Consider an ESOP Sustainability Study?

A sustainability study is more than simply putting together a forecast of the number of shares of stock that will become eligible for repurchase each year. By reviewing repurchase obligation as well as a number of other dynamic variables that can work in tandem to perpetuate the ESOP and grow the business, a sustainability study can show the ESOP stakeholders—the Board, Trustees and management team—the various options they have to optimize the ESOP company’s sustainability.

One issue that is central to sustainability is the interrelationship between repurchase obligation and the company’s value trajectory. As part of the analysis of value trajectory, there are multiple considerations that should be taken into account regarding the repurchase of ESOP shares. Not only does a company need to make decisions about the timing of distributions to participants and whether they will be paid in a lump sum or in installments, but the method for the repurchase of future shares must also be established.

A sustainability study may prompt an ESOP company to consider modifying its distribution policy. For example, when shown that a large percentage of allocated shares are in the accounts of terminated or retired participants, a company may consider segregating the share balances of terminated participants into cash or other investments, thus allowing shares to remain in the accounts of active participants.

Another factor that impacts value trajectory—and, as a result, the sustainability of both the company and the ESOP—is whether the ESOP company manages to a certain benefit level, which is the rate at which contributions are made by the company to its employee retirement plans. These contributions can take a variety of forms such as safe-harbor contributions made to a 401(k), ESOP loan amortization payments or contributions directly to the ESOP.

Sustainability studies also review the company’s future cash flow requirements since the company must be able to fund repurchase obligation, as well as investments and future growth, from its cash flow. Management succession is another important aspect of the sustainability of ESOP companies. Part of ensuring the continuing prosperity of any company is putting a clear management succession plan in place.

While Prairie considers these along with other factors when conducting a sustainability study, our goal in all cases is to help the stakeholders understand their options and the likely consequences of the decisions they make in terms of sustaining both their business and their ESOP over the long term and for future employees joining the company and the ESOP.

The bottom line is that ESOP sustainability is dependent on business sustainability.

When to Consider a Sustainability Study?

We have identified a few specific inflection points in the lifecycle of an ESOP that may prompt one or more of the stakeholders to decide that they want to take a formal look at sustainability in order to come up with an analysis to help frame a company’s future decision making.

Based on Prairie’s experience, some common events that spur interest in a sustainability study are as follows:

The company has made additional contributions in the early years of the ESOP, exceeding the Board’s target benefit level.

In the early years following the formation of an ESOP, the initial ESOP allocations are often underwhelming to participants because the company is typically in a significant amount of debt from the ESOP transaction. In response to this sense of disappointment, some ESOP companies choose to contribute more than they are required to under the terms of the ESOP loan. As those shares are released and some of the debt is paid off, the share price tends to accelerate rapidly, which may create an outsized benefit level.

As a result, just three or four years after the ESOP is established, some ESOP companies have allocated a rather high percentage of their ESOP shares and the benefit levels are significant. While this may be wonderful from the participants’ perspective, the stakeholders may be wondering whether these trends are sustainable and if the plan can continue to provide the same level of benefit over a long period of time. As a result, we sometimes see early-stage ESOP companies requesting a sustainability study. If a sustainability study is done in the early years of the ESOP, we have found it is a good way to get the stakeholders to understand their options and to be more proactive than they may otherwise have been had they waited until they were a more mature ESOP to get a sustainability study done. This helps to get ahead of potential challenges down the road.

A repurchase obligation analysis has caused concern about how the company will manage cash flow, repurchase obligation related to participant terminations and other business needs.

A repurchase obligation study can help an ESOP company anticipate considerations such as the scale and timing of the cash flow needed to fund share repurchases, along with projected future share price, participant turnover and more. Following the conclusion of a repurchase obligation study, some ESOP companies become concerned about how they will manage the cash flow needs of the business, especially in those cases when a company has significant repurchase obligations as well as the other cash needs of the business. Oftentimes, this induces the ESOP company to move forward with a sustainability study.

In the case of a leveraged ESOP with an internal loan, when the shares in the ESOP Suspense Account are fully allocated, or are nearly fully allocated, to current participants.

If the ESOP transaction involves the use of an internal loan from the company to the ESOP, there will be an Unearned ESOP Shares account which represents the shares that are held as collateral for the internal loan which reduces over time as the internal loan is repaid. Meanwhile, the ESOP shares will be held in a Suspense Account, meaning that the shares in that account are not yet allocated to participant accounts. As the loan is paid off over time, more shares will be released from the suspense account. In other words, when the company’s ESOP has few, or no, additional shares to allocate, they have reached the status of a “mature ESOP.” It is common for mature ESOPs to seek out a sustainability study.

Once an ESOP company has completed a sustainability study, we recommend an update to the sustainability study every two to three years. That said, as a best practice, should the company undergo a significant, unexpected change, the sustainability study should be refreshed sooner rather than later. Examples of such a change would include if several key employees with large balances retire earlier than planned or the company experiences a much larger increase in stock price than predicted.

Bonus: Examples of WHAT Some Prairie Clients Hope to Achieve Through a Sustainability Study

Aside from some of the common events outlined previously that motivate ESOP companies to seek out a sustainability study, some of our clients have also expressed the desire to achieve certain objectives when working with us on a sustainability study. Following are some examples:

Dave Horvath is a Managing Director at Prairie Capital Advisors, Inc. He can be contacted at 630.657.8157 or by email: dhorvath@prairiecap.com.

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