The lower maximum corporate tax rates in the recently-enacted tax bill are welcomed by most businesses, but they are likely to have a negative impact on 100% ESOP-owned S corporations by increasing repurchase obligations without a corresponding increase in cash flow. Here’s why.
Most ESOP companies are valued in part using a discounted cash flow method (DCF). The earnings used in the DCF are typically tax-effected, even if the company is taxed as an S corporation and is 100% ESOP-owned. In most valuations that we see, the earnings are tax-effected at the maximum rate, which is now 21% instead of the previous 35% (plus any state and local taxes that might be relevant.) The higher projected after-tax earnings would result in a higher stock value, which would result in higher repurchase obligations. While most increases in expenses reduce income, that’s not true of repurchase obligations, because many valuations use a normalized benefit expense instead of the actual ESOP contributions.
Offsetting the increase from the lower rate at which earnings are tax-effected would be an increase in the weighted average cost of capital (WACC), since the after-tax cost of debt will be higher. This would increase the discount rate used in the DCF, which would result in a lower value, but this will have a smaller effect than the change in the earnings.
Another offsetting factor will be the “tax shield”, i.e., the present value of the tax savings that are attributed to the principal payments on internal ESOP loans. The value of the tax shield would be lower as a result of the decline in the tax rate, partially offsetting the increase in value from the higher tax-effected earnings.
Valuations that utilize a market approach can also be expected to increase, as earnings multiples in the market have risen since December, at least partly attributable to higher long-term growth prospects as a result of lower tax rates.
The higher cash requirements for repurchase obligations can be expected to negatively affect a company’s financial strength, which may eventually offset the higher value that resulted from the lower tax rate. However, even if the share value eventually resolves to its former trajectory, the company would still be worse off – it would have the same valuation with less cash.
So how big an impact will all of these factors have? We looked at three different 100% ESOP-owned S corporations for whom we recently completed repurchase obligation projections that were incorporated in a financial model. We were able to estimate the impact of the tax reduction on the following:
As expected, the share value would increase in the first year in which the tax rate is reduced for all three companies.
The impact was largest for a mature ESOP company that no longer had an internal ESOP loan and had no synthetic equity, with a year one increase in share value of 22% and an 11% increase in the cumulative cost of repurchase obligations over a 10-year period. In this company, the increased repurchase obligations gradually eroded the financial strength of the company as they consumed a greater portion of available cash flow.
For the second company, which still has a significant portion of its shares in loan suspense and relatively large amounts of SARs, the impact was smallest. Because the increase in value from the lower tax rate was offset by increases in the value of SARs and a decrease in the tax shield from the internal loan, the impact on share value was only around 2% in the first year, and the cumulative cost of repurchase obligations over the 10-year period also increased only 2%. The SARs holders benefited proportionately more than the ESOP participants.
The third company has a significant number of shares in loan suspense, but the amount of synthetic equity is much smaller. The impact on its share value in the first year was 12%, and there was an 11% increase in its 10-year cumulative repurchase obligation cost.
These results suggest that repurchase obligation studies will need to be updated to reflect the higher valuations. The potential financial impact of higher share values makes it more important than ever to build a dynamic financial model into which repurchase obligations are integrated. With some iterative modeling, the effect of repurchase obligations on the company’s cash position and share value can be analyzed. For some companies, the increased cost of repurchase obligations may constrain future growth.
The bottom line is that 2017 year-end ESOP valuations and future values will be higher than they otherwise would have been, thereby increasing future repurchase obligations. The reduction in tax rates is likely to cause the greatest increases in value for mature ESOPs that have relatively few or no shares in loan suspense and minimal amounts of synthetic equity. The higher repurchase obligations will require more cash, and growth could be constrained in companies where repurchase obligations are already consuming a significant portion of free cash flow. The impact will, of course, be determined on a case-by-case basis for each company.
Founded in 1993, ESOP Economics has worked with hundreds of ESOP companies of all sizes and stages and in a broad range of industries to help them forecast and plan for their repurchase obligations. ESOP Economics helps clients identify and analyze strategies for managing and funding their repurchase obligations to plan for the long-term sustainability of their ESOPs. In addition to repurchase obligation studies and consulting, ESOP Economics offers its proprietary Telescope™ software to ESOP companies who want to do their own forecasting.
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