Does a high benefit level make an ESOP unsustainable? To judge from recent conversations with a number of ESOP companies and advisors, many believe that it does. However, the sustainability of an ESOP depends on the sponsor company’s ability to generate sufficient cash flow to meet its needs for operations and growth as well as repurchase obligations, not on the benefit level provided by the ESOP. Generally, 100% ESOP-owned S corporations have high repurchase obligations but are also generating ample cash flow to manage the repurchase obligations without impairing growth.
The benefit level is typically defined as the value of stock or other investments added to participants’ accounts from employer contributions. It includes the value of shares released from loan suspense by contributions, but does not include dividends or changes in the value of the stock. The benefit level is measured as a percentage of compensation.
Historically, many companies have made ESOP contributions in whatever amount is needed to meet the repurchase obligations and have handled those obligations within the ESOP (i.e., recycled or recirculated shares), so the benefit level is being driven by repurchase obligations. The result, at least in 100% ESOP-owned companies, is contributions that are high relative to the retirement plan contributions of non-ESOP companies and that may also vary significantly from year to year.
Repurchase obligations in 100% ESOP companies are always high relative to what would usually be considered “normal” benefit levels in non-ESOP companies. Repurchase obligations are a function of the relationship among the value of the shares that are allocated to participants accounts, the covered compensation of the ESOP participants, and the number of shares being repurchased each year:
The value of shares relative to compensation is directly related to the percentage of stock owned by the ESOP and also varies by the nature of the business. In businesses such as manufacturing and distribution, where assets like equipment and inventory contribute to value, value will be high relative to compensation, while in businesses like engineering and architecture, value and compensation will be much closer. It is typical for ESOPs to repurchase, on average, about 6% annually of the allocated shares, although it can be dramatically higher in some years. So if, for example, value is 3x compensation, repurchase obligations would average 18% of compensation. Higher value-to-compensation ratios result in even higher repurchase obligations.
ESOP companies are being advised to manage their repurchase obligation funding in ways that avoid over-compensating employees through benefits that are too high. The reasoning behind this is that overcompensating employees negatively affects the value of the company and thus shifts value from the shareholders to the employees. Even though these may be the same individuals in a 100% ESOP-owned company, they are affected differently by contributions and changes in share value. (Contributions typically are allocated pro rata to compensation or by some other formula and go only to active employees, while changes in share value affect everyone who has shares - including terminated participants who still hold stock in their accounts - as well as the value of whatever shares remain in loan suspense.)
To manage benefit levels, companies are counseled to limit their ESOP contributions to an amount that is consistent with an “appropriate” benefit level, rather than letting repurchase obligations drive the amount of contributions, and to handle any excess repurchases through redemptions. In companies with consistently high repurchase obligations, the amount of redemptions is significant. The resulting decline in the number of shares outstanding causes value per share to rise faster than the aggregate equity value of the company. While there is nothing inherently wrong with that (and it is an “appropriate” outcome from a valuation perspective), it creates a disconnect for companies that communicate performance through the change in value per share. An alternative is to handle those “excess” repurchase obligations by paying S distributions (dividends) to the ESOP.
Increases in share value and dividends benefit all shareholders, including those who have terminated employment but still hold shares in their accounts. This creates an incentive for ESOP companies to sub-optimize their distribution polices by cashing participants out of company stock as quickly as possible, while also encouraging terminated participants to keep their ESOP accounts invested in company stock as long as possible. To deal with this, companies can adopt accelerated distribution policies and implement segregation of terminated accounts. However, those policies accelerate the cash requirements for the ESOP and make the repurchase obligation funding requirements less predictable. ESOP distribution policies that provide a planning horizon, such as delays and installments, are more financially prudent.
What is often overlooked in the discussion is that it is not the benefit level that determines the sustainability of the ESOP, but rather the availability of cash to meet the repurchase obligations on an ongoing basis without constraining growth. Whether the repurchases are handled through contributions, redemptions, or S distributions, they require cash, and managing the benefit level does not change that. Furthermore, ESOP companies tend to forget that the 100% ESOP ownership that leads to high repurchase obligations also generates cash flow through the tax savings associated with S corporation tax status.
ESOP companies seeking sustainability would do well to tolerate higher-than-normal benefit levels in the interest of balancing repurchase funding requirements, a prudent distribution policy, and minimizing the disconnect in communications about performance that arises from redemptions.
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