What is your strategic vision for your ESOP?

Planning Throughout the ESOP Lifecycle

Owen Schmidt, Director Sales Consulting

Five years ago I wrote an article about the options available to mature ESOPs once the initial ESOP loan is repaid and all the shares have been allocated to participants. I thought this would be a good time to update the article based on my experiences with mature ESOP companies over the last five years.

As ESOPs mature, the issues that need to be addressed change. In the early years of a leveraged ESOP, the overriding concern is repayment of the debt incurred when the ESOP shares were purchased. Other matters including the communications of post-transaction stock price and benefits to participants are at the top of the list of concerns for many ESOP companies in the early years. In a leveraged ESOP, the release of shares each year as the loan is repaid provides the benefit level that participants receive. After the ESOP loan is repaid and all the shares have been allocated new issues arise. As I have met with clients over the past several years to do year-end planning, the questions that have come up more often in recent years are: “What do we do now that our ESOP loan is paid off?” and “How do we get shares to new participants going forward?”

As with most ESOP planning, the earlier you start planning for this the better. There are several options available, but your situation will dictate the best one for your company. As with most ESOP issues, the first questions that need to be answered are: What are your long-term plans for your ESOP? Is it short-term ownership strategies to help with ownership transition on a tax-favored basis? If so, you will probably use a different strategy than a company that has an ESOP as part of its long-term ownership strategy. If employee ownership using your ESOP is your long-term ownership strategy, there are several strategies available to make shares available for allocation after your ESOP loan is paid off.

If your ESOP currently owns less than 100% of the company, is there a desire by any of the current shareholders to sell additional shares to the ESOP? If the long-term goal of the ESOP is to continue to increase ownership over time, a sale of additional shares to the ESOP from an outside shareholder or from treasury stock could be an option to make additional shares available for allocation to participants. This could be achieved by a leveraged transaction or a sale of stock each year to the ESOP based on the amount of company contribution each year.

If your ESOP currently owns 100 percent of the outstanding stock in your company, the issues become a little more complex. One option that has been used more in recent years is re-leveraging. One way re-leveraging can be effective is by having the company purchase shares from terminated participants and retiring them into treasury stock. When the ESOP loan is repaid, these shares can then be sold to the trust for a note back to the company to release these shares in future years. This strategy could be repeated each time the current ESOP loan is repaid. Some companies do not wait until the current ESOP loan is repaid, they re-leverage the ESOP each year by selling the shares that the company has repurchased from terminated participants back to the trust for a note. This keeps the number of outstanding shares constant while allowing the shares purchased to be allocated to participants over a number of years to help control the benefit level participants receive. It is important to work with your valuation firm to determine how this strategy will affect stock price both in the long- and short-term.

Another option for re-leveraging your ESOP if you have not been repurchasing shares from terminated participants, would be to issue new shares to be sold to the ESOP in return for a new ESOP loan. This will have a dilutive effect on stock price and should be discussed with your valuation firm before implementation to be sure everyone understands how this will affect stock price both in the short- and long-term.

The impact of re-leveraging on stock price has become a bigger issue in the last five years. Plan fiduciaries need to understand how re-leveraging can negatively affect the account balances of participants, especially those close to retirement age. Price protection for the shares allocated to participants before a re-leveraging transaction should be considered to protect current participants.

Some companies choose to contribute cash to the ESOP after the loan is repaid. The amount of cash that is contributed is an amount equal to the desired benefit level for plan participants for the year. The cash is allocated to all eligible participant accounts and then used to recycle shares within the ESOP. If there is still cash available after all distributions are made, the plan could then “rebalance” the accounts of all participants so everyone has the same percentage of cash and stock in their accounts. Some ESOP companies will take this a step further and use the cash to convert terminated participants’ accounts out of company stock first and then “rebalance” active participants if cash is still available.

Whenever “cash” is left in the ESOP, it is important for the plan fiduciaries to be sure the cash is invested prudently. The same rules apply to the investment of cash in an ESOP as any other qualified plan. In some cases allowing the participants to elect how the “cash” in their account is invested in the ESOP may be appropriate. In other cases, it may be more appropriate for the trustees to manage the investment of these funds.

One other option that companies are using is to redeem shares from terminated participants’ accounts and contribute shares equal in value up to the benefit level they want to provide for their participants. Some years this may require more shares be contributed to the trust than were purchased from terminated participants, and some years there may be shares to be retired. This method may have less effect on the stock price than re-leveraging and may give the company more flexibility in the future.

The option or combination of options that will work best for your company will depend on many factors. Most importantly, what are your long-term plans for ESOP employee ownership in your company? If the answer is that your ESOP will be the long-term ownership strategy, it is important to get a good understanding of the interaction between repurchase liability, distribution policy, stock price and benefit level for participants. As with most ESOP decisions, there is not an answer that fits all ESOPs and the answer can change from year to year. 

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

Insurance products and plan administrative services provided through Principal Life Insurance Co., a member of the Principal Financial Group®, Des Moines, IA 50392.

Principal, Principal and symbol design and Principal Financial Group are trademarks and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group.