Article by Judy Kornfeld
(Page 2 of 3)

Nine Steps to Funding the Repurchase Obligation
Step 1: Define the Corporation's Objectives

The first step in the planning process is to define the corporation's objectives regarding control, ownership, and growth. Thought should be given to both long- and short-term goals. Some of the critical questions to be answered include the following:

* Is the goal to sell the business or go public?
* What are the goals for growing the business?
* What are the goals for the ESOP, e.g., will the ESOP be maintained at its current ownership share, will it acquire additional stock, or is the goal to reduce the ESOP's ownership share?
* How important is it to allocate stock to new participants in the ESOP?
* What is the ideal level of employee benefits for the company?

As the planning process proceeds, some of these questions may need to be revisited if it becomes apparent that there are constraints that make it impossible to meet the objectives. However, at this stage of the process the focus should be on what the corporation would ideally like to achieve.

If the goal is to sell the business or go public, the repurchase obligation is likely to be a short-term planning issue. If ownership by the ESOP is to be perpetuated and the company is to remain closely held, planning for the repurchase obligation involves a very long-term planning horizon to achieve an appropriate matching of assets and liabilities and to ensure that there will be adequate liquidity.

Step 2: Project the Liquidity Requirements for the Repurchase Obligation

The second step in the planning process is to project the timing and magnitude of the liquidity needs the company will face by doing a repurchase obligation study. This study should take into account turnover, diversification, and retirement, as well as mortality and morbidity (disability) where appropriate. The assumptions regarding these variables should be carefully developed. The study should also reflect the company's goals regarding the size of the ESOP; it should be based on the company's current intentions concerning additional shares to be acquired by the ESOP, and whether shares will be repurchased by the corporation and retired or recirculated within the ESOP. The purpose of this study is not to pinpoint the exact amount and timing of individual repurchase obligations, which is, of course, impossible to do. Rather, the study should include several scenarios utilizing a range of assumptions. The projections should be done in numbers of shares, rather than dollar amounts, so that a range of value assumptions with respect to the stock price can be applied. This study should provide projections for 20 years or more, to facilitate long-term planning. Ideally, developing projections should be an iterative process that takes into account the relationship between valuation of the company's stock and the cash requirements associated with repurchase obligations. The cash flow required for repurchases can affect stock value if it causes working capital shortages or interferes with the company's ability to take advantage of profitable investment opportunities. This should be taken into account in the stock price used in the repurchase obligation projections.

Although repurchase studies can be done in a computer spreadsheet program, model that takes into account all of the relevant variables is complicated and time-consuming to develop. Most companies have studies done by outside consulting firms or purchase specialized software.

Step 3: Determine Whether the Corporation Should Make Cash Contributions to the ESOP

If the corporation's goal is to shrink the ESOP, ongoing cash contributions to the ESOP to provide funding for repurchases do not make sense. It is better to keep all funding in the corporation and use it to redeem shares in order to reduce the ESOP's ownership percentage. (Of course, in a situation where the ESOP owns 100% of the outstanding stock, this would have no effect.)

On the other hand, if the goal is to maintain or increase the size of the ESOP, cash contributions to the ESOP are an efficient funding mechanism to the extent that the total employee benefit costs do not exceed what is appropriate for the company. Cash contributions to the ESOP are an efficient way to fund the repurchase obligation because they are deductible, and investment returns within the ESOP are not taxed. However, they are also a component of employee benefit cost; to the extent they exceed what is appropriate for the company, they can have a negative affect on the company's competitive position and value.

To determine the appropriate level of employee benefits, data for the industry and the geographical area should be developed. The valuation firm that provides the ESOP's regular stock valuations will often be able to provide some useful information. The company's current employee benefit costs (excluding cash contributions to the ESOP other than for debt service) should then be calculated and compared to the range of appropriate costs.

If there is room to increase employee benefit costs, the next step is to compare the projected repurchase obligation with the amount by which benefit costs could be increased. If the repurchase obligation can be readily accommodated, cash contributions to the ESOP on an "as needed" basis are a suitable funding method. In other words, there is no real need to "pre-fund" the repurchase obligation, and one can skip to Step 7 below.

If the repurchase obligation varies significantly from year to year or if it is expected to increase significantly over time, the company can equalize the contribution to the ESOP and create a cushion for the years when the repurchase obligation is high. This creates a "sinking fund" within the ESOP.

Finally, if the repurchase obligation is greater than what can be covered with a normal employee benefit expense, the company can still make cash contributions to the ESOP and supplement them with other funding methods.

Conceptually, sinking funds represent an appropriate method of matching assets and liabilities. However, accumulating a sinking fund in the ESOP has the disadvantage of removing assets from the corporation where they could have been used in operating the business. It also tends to result in additional concentration of stock in the accounts of longer term and higher paid employees. While there is nothing wrong with this (and it may be the desired result in some companies), some mature ESOPs seek mechanisms that favor the allocation of company stock to the accounts of newer ESOP participants. There is also a fiduciary issue; the trustee of the ESOP must act in the best interest of plan participants. Circumstances could occur such that the trustee considers it better to distribute stock and have the corporation take responsibility for redeeming the stock. The corporation cannot compel the trustee to use the cash in the plan to provide liquidity for distributions; the ultimate responsibility for providing liquidity rests with the company.

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