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ESOP Companies Should Address Cash Flow Before It’s Too Late

April 1, 2020Alerts

Employee Stock Ownership Plans are a unique form of retirement plan designed to invest primarily in employer securities. Under most privately held ESOP companies, employees receive a distribution of company shares upon retirement or termination of employment.

Management of Repurchase Liability

By law, employees have the right to force their employer to repurchase the shares at the current value. It is this “put” right that imposes a cash flow requirement upon most companies (known as repurchase liability), which requires judicious management – even in the best of times. During a financial crisis of unprecedented scope, proper management of repurchase liability can make the difference between a company’s survival and its insolvency.

ESOP sponsors need to appreciate the extent of the financial strain imposed on their company by a simultaneous layoff of a sizeable portion of their workforce. Each one of these terminated employees will receive a distribution of shares from the Plan at the same time and therefore will become eligible to “cash-out” all or part of those shares concurrently. It is this spike of simultaneous cash out requests by a significant number of employees – at a time when the company is least able to afford to make these payments – that may put a catastrophic financial strain upon an ESOP sponsor.

Employers have control over two plan design elements that determine the amount and time of the cash distributions to terminating employees:

  • valuation timing
  • distribution policy 

Of these two elements, valuation timing requires immediate attention by the ESOP sponsor and therefore is the subject of this client alert. The law requires that shares of an ESOP company be valued once per year. For most ESOPs that operate on a calendar year, that valuation date is December 31, 2019, and, absent immediate sponsor intervention, employees who have already terminated or retired must be paid using that value. Indeed, most calendar year ESOPs have already begun the administrative process to determine the 2019 year-end value.

Implementing an Interim Valuation Date

The problem is that the 2019 year-end value, in many cases, is not a fair representation of the current value of the company. Cashing out a significant number of employees based upon an outdated, and arguably inflated share value, is unfair to the remaining participants and could irreparably endanger the company’s financial health. Accordingly, it is prudent that ESOP companies consider implementing an interim valuation date. Clearly, the company’s near-term prospects will play a critical part in the decision-making process. By way of example, a company that manufactures medical equipment will likely recover its share value much more quickly than one in the hotel industry.

Employers that decide to implement an interim valuation date may need to act quickly to avoid the requirement to pay employees at the 2019 year-end values. If the existing plan language does not provide discretion to the company or Plan Administrator to implement an interim valuation date, the ESOP document must be amended to provide such discretion. If an amendment is required, it must be adopted prior to the termination of the employment of the affected employees. The few court decisions addressing this issue make it clear that the manner of determination of the value of an employee’s shares may not be altered once he or she has satisfied all of the conditions for entitlement for payment. It, therefore, is critical for ESOP sponsors to decide whether an interim valuation date should be implemented and to review their ESOP document as soon as possible and determine whether they have the flexibility or need to amend the plan to declare an interim valuation date.

Employers that decide to implement an interim valuation date must select a specific interim valuation date. This decision should be made in consultation with the trustee of the Plan and the valuation professional that the Trustee relies upon to help it determine the annual share values. In the author’s view, the date chosen should be one that represents a reasonable snapshot of the company’s near-term prospects. Sponsors should not seek to “time” the interim valuation date to target a lower value, but rather try to achieve a balance that is fair to both terminated employees and those still employed by the company.