The Repurchase Obligation: Planning for Sustainability
An Employee Stock Ownership Plan, or ESOP, is a qualified retirement plan that gives employees an ownership interest in a company through employer stock.1 Employees build benefits in their ESOP accounts over time, and as those benefits vest, they earn the right to keep them. When an employee retires, dies, becomes disabled, or otherwise leaves the company and becomes entitled to a distribution, the value in that account has to be paid.12
For a closely held company, that takes some planning because there isn't a public market where employees can simply sell their stock. Depending on the terms of the plan, participants may receive cash or company stock that can be sold back at fair market value.12 Either way, enough cash has to be available when those benefits have to be paid. Liquidity simply means having cash, or assets that can readily be turned into cash, when the money is needed. Those future cash needs are what's known as the repurchase obligation.13
The Obligation Grows Over Time
As an ESOP matures, more employees become vested, account balances grow, and more people get closer to retirement. If the company becomes more valuable over those same years, so does the stock held in employee accounts, which means more money will eventually be needed to pay those benefits.
The payments also won't necessarily come due on a smooth schedule. Several long-term employees may retire around the same time, or larger account balances may become payable at a time when the company would rather use its cash for other business needs.
A repurchase-obligation study gives the company a way to look ahead and estimate how much money may be needed and when. It considers the value of the company, when employees are likely to retire or leave, how much of their benefits are vested, and when the plan requires those benefits to be paid. Those estimates can be updated as the company and its employees change.13
The earlier the company has a reasonable idea of what's coming, the more time it has to prepare without putting unnecessary pressure on future cash flow.
Planning for Liquidity
There are several ways to make sure the money will be there when it's needed, and a company may use more than one.
Future operating cash flow can cover some or all of the payments if the business is expected to generate enough cash when distributions come due. A company can also establish a sinking fund, which is simply money set aside over time for a known future need. Building that reserve gradually can make a large future payment much easier to handle.
Corporate-owned life insurance can provide another source of cash. A properly structured policy may build cash value that the company can access while the insured person is alive, and it can pay a death benefit when that person dies. Insurance can be used alongside operating cash flow and accumulated reserves to help cover future obligations.14
Which sources make sense will depend on the company and how large the obligation is likely to become. What matters is knowing where the money is going to come from when employees have to be paid.13
Protecting Plan Assets
If the ESOP trust is holding cash or other investments, somebody has to be responsible for how that money is handled. ESOP trustees and other plan fiduciaries are required to manage plan assets prudently and in the interests of the employees participating in the plan.7
That responsibility should include clear written rules about who is allowed to make investment decisions and what they can do with the money. An Investment Policy Statement can spell out the kinds of investments that are allowed, how much cash needs to stay readily available, how much risk can be taken, and who is responsible for reviewing those decisions.15
Money being held for employee retirement benefits should not be allowed to become somebody's personal trading account or be used for speculative bets. The rules should be clear enough that the people handling the money know what they can do, what they can't do, and who is checking.
When employees build value in their ESOP accounts, that value eventually has to be paid. The company needs to know where the cash will come from, and any money being set aside for that purpose needs to be protected. If the planning starts early enough, the company can meet those obligations without scrambling for cash when employees are entitled to receive what they've earned.