Emily R. Langdon402.978.5386
email@example.com email Emily
ESOP releveraging is an innovative strategy for plan sponsors to handle the ESOP repurchase obligation in certain circumstances. While releveraging is not the most common repurchase method and may be more complicated than alternative methods, there can be significant advantages to using the releveraging structure when it aligns with the plan sponsor’s goals.
There are three alternatives to handling the ESOP repurchase obligation: (1) recycling; (2) redeeming; and (3) releveraging. Recycling and redeeming are the most frequently used approaches.
Recycling is simply the exchange of cash for the shares of stock subject to repurchase within the ESOP. The repurchased shares are then “recycled” and allocated within the ESOP to those participants whose cash was used to purchase them. Because the shares are purchased from the participant, the distribution to the participant is made in cash. Recycling keeps the same number of shares outstanding and the same number of shares allocated to participants within the ESOP.
Redeeming takes place when the company redeems shares that have been allocated to an ESOP participant or when the company directly redeems shares from the ESOP. Depending on state law, the redeemed shares are then either retired or placed in treasury. This process reduces the total number of shares in the ESOP and the total number of outstanding shares.
When the company redeems shares from a participant, the purchase price is based on the share price at the most recent valuation. When the company redeems shares directly from the ESOP, the purchase price must be at least as great as the fair market value on the date of purchase.
The releveraging process has several steps:
While releveraging keeps the same number of shares outstanding, all the shares are not immediately allocated to active participants. This allows the ESOP to stretch out the allocation of shares to participants over the term of the promissory note, typically over a 20- to 40-year time frame.
The ESOP trustee generally requires a fairness opinion to make sure that it is not paying more than the fair market value on the date of the sale. If the transaction occurs at a time other than the ordinary fiscal year-end, an additional valuation may be required. To avoid going through a full second valuation mid-year, companies will often make an administrative loan to the ESOP to cover distributions during the plan year. Then, at year-end, the ESOP sells shares to the company to pay off the administrative loan and then completes the releverage transaction.
While releveraging is a somewhat complex process, there are significant advantages to this strategy:
Releveraging benefits the ESOP participants, the ESOP trust, and the company. The shares are not immediately redistributed because they are subject to an internal loan. Rather, the shares are held in suspense to be allocated in future years, which benefits future ESOP participants. In companies that have direct shareholders or synthetic equity holders, the ESOP trust also benefits from releveraging because it retains a higher percentage of ownership and, in turn, a higher percentage of any future equity growth. Finally, because shares are held in suspense and not immediately allocated, the repurchase obligation is less than if such shares had been immediately allocated to a participant who may soon terminate or retire, which benefits the company.
When stock prices increase and repurchase obligations become high, the company’s sustainability is jeopardized.
Under this scenario, Company X was initially able to handle its repurchase obligation while its sales and profits increased. Over time, the repurchase obligation grew to 50% of compensation. The company recycled the entire repurchase obligation by contributing up to the maximum contribution limit (25% of compensation) and paying a dividend. This dividend increased the repurchase obligation because a large portion of the shares were held by a combination of terminated participants, retirement-eligible participants, and participants nearing retirement.
Due to economic fluctuations, the company’s sales stagnated for a few years. Initially, Company X’s executives provided positive projections to the appraiser with solid goals to respond to the market issues. This resulted in a level valuation even though repurchase obligations were depleting the company’s cash reserves. The outside pressure on certain existing lines reduced sales, and overall profits and cash flow did not increase. In essence, the repurchase obligation had skyrocketed, and Company X needed a solution fast.
Releveraging resulted in a huge benefit to the active ESOP participants, as well as the ESOP participant shareholders and synthetic equity holders. The corporate strategy prior to releveraging was harming future ESOP participants, and any shareholder who did not cash out would only be entitled to a lower share price due to lower surplus corporate cash.
In essence, Company X eliminated the dividend and cut the contribution amount. Annually, the company negotiated releveraging a substantial portion of its repurchase obligation. After several years of utilizing this structure, the company began to see progress. The share price fell substantially over several years due to a declining cash balance, but not nearly as far as it would have declined had the company continued to use an ESOP recycling strategy.
Bottom Line – A high repurchase obligation depletes corporate liquidity, requiring the company to take on debt. The company cannot realistically continue to make repurchase payments at this high level. Releveraging provides a solution that lowers repurchase obligations to a level that no longer exceeds cash flow.
Under this scenario, Company Y has a high repurchase obligation that it is currently able to meet, but it will not be sustainable in the long term. Company Y decides to proactively employ a releveraging strategy to avoid corporate losses.
Prior to employing the releveraging strategy, Company Y was using a redemption structure and contributing shares up to a benefit level of 10% of compensation. But over time, the repurchase obligation would increase to over 60% of compensation for the next 10 years and over 85% of compensation for years 10 to 20.
If Company Y continued to profit, it would have sufficient liquidity to handle the ESOP redemption strategy for the next 10 years. However, after 10 years had elapsed, the repurchase obligation would undoubtedly exceed cash flow.
To solve this long-term issue, Company Y worked with the ESOP trustee to redeem all shares currently owned by terminated employees. Company Y also redeemed approximately 5% of shares owned by active employees. A portion of these shares were releveraged back to the ESOP. Company Y and the ESOP trustee then agreed upon a minimum 14% stock contribution and extended the existing ESOP loan to ensure that future ESOP participants would continue to benefit.
In effect, this strategy created a more equitable overall balance among ESOP stakeholders and allowed terminated participants to receive their ESOP distributions sooner. As an added benefit, the ESOP participant shareholders and synthetic equity holders received an increase in share value as a result of the improved current performance and reduction in outstanding shares.
Bottom Line – This strategy resulted in active ESOP participants receiving a greater percentage of growth because terminated participants no longer shared in continued growth. There was greater diversification for active participants, and future participants would receive more consistent benefits because the existing loan had been extended. Finally, Company Y’s repurchase obligation was reduced to the extent that it was affordable and maintainable in the long term.
ESOP releveraging is an excellent, cost-effective strategy for companies with ESOP in many instances. Releveraging may not always be the best strategy, but when it makes sense, it really works.
ESOP releveraging is a somewhat complex process, but if you work with an employee benefits attorney with ESOP experience, it can be streamlined to meet your corporate needs.
It is truly a win-win for the company and the current and future ESOP participants.
For additional information, please contact Emily Langdon at firstname.lastname@example.org.
This article has been prepared for general information purposes and (1) does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation, (3) is not intended to convey or constitute legal advice, and (4) is not a substitute for obtaining legal advice from a qualified attorney. Always seek professional counsel prior to taking action.