ESOP Repurchase Obligation: Developing your Forecast Assumptions

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Mon, Apr 30, 2012
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We recently took a look at the importance of Identifying your Long-Term ESOP Objectives as part of the ESOP Repurchase Obligation process.  Another important part of the process is developing your forecast assumptions.  While any first attempt at preparing assumptions is better than not making an attempt at all, it is essential to continuously revisit the assumptions to ensure that they are accurate.  If you don't use accurate assumptions in your forecast, then you won't have an accurate repurchase obligation forecast.  In other words, garbage in, garbage out. 

Comparing your results to your financial and strategic planning is an ESOP Repurchase Obligation (RO) best practice:

Review your financial forecast and strategic planning to ensure the assumptions are consistent with your RO forecast. 

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Here is a discussion of the important assumptions that go into a repurchase obligation forecast:

  • Employee Groups – One of the first steps in the repurchase study process is to organize the participant data into groups. Groups of employees tend to have similar characteristics, such as compensation, account activity, vesting, turnover rates, and employee growth rates. While some companies prefer to group their employees by a method such as job classification or hourly vs. salaried, using a statistical approach to create groups based on the previously mentioned characteristics generally tends to be more accurate. 

  • Stock Growth Rates – This is the most important factor in the study, yet the most difficult to predict. The values used in this study should agree with the enterprise values used by your appraiser and in your corporate and strategic planning. A best practice is to include the appraiser in the repurchase study process, especially given the interrelationship between the stock appraisal and the repurchase obligation.

  • Employee and Eligible Compensation Growth Rates – How many net new participants will be added to the plan each year as a result of hiring new employees? At what rate will your eligible compensation increase? These questions will need to be answered and the results will be combined to project eligible compensation in the future. While you could combine the numbers into one projection, projecting the numbers separately is another planning best practice and the projections should agree to your corporate and HR projections. These rates can be projected at a company level or by employee group.

  • Termination Rates – One of the most accurate ways to project future termination rates is to use your own employment history. You will want to adjust your terminations to remove any terminations due to retirement, death, and disability as needed to avoid any double counting. You will also want to account for any unusual circumstances that would inflate or deflate the projected termination rates going forward. You may want to look at multiple years and use a weighted average. These rates should be projected by employee group as their termination rates will vary significantly.

  • Retirement Rates – In addition to termination rates, you will need to project when active employees will retire from the company. Many plans will use the retirement age of the plan, but it is important that this age somewhat represent the age that most people retire from the company. The retirement age for key individuals with large balances may need to be adjusted accordinly.

  • Diversification Rates – If your plan is less than 10 years old, diversification may be the first major repurchase obligation for the company. You will need to determine if your plan has the statutory minimum requirements or if provides for more liberal rules. One of the most challenging items to project for a company is the diversification rate, generally communicated as a percentage rate. The natural instinct of many companies is to assume 100% diversifications, but this method will likely overstate the projected diversification distributions in the short-term and, assuming a continuing growth in stock price, understate the long-term repurchase liability. A best practice is to monitor the diversification rate from year to year and make adjustments accordingly. I often see companies prepare multiple scenarios using various diversification rates.

  • Death and Disability Rates – Generally speaking, the rates of death and disability are statistically insignificant to a repurchase obligation study. As an alternative you could apply a fixed percentage or other actuarially assumptions.

  • Contribution Rates – This is another area that sparks a lot of discussion. While a loan is outstanding contributions will be made to the plan for loan payments. When the plan is paying distributions, a decision will have to made as to whether shares are recycled or redeemed and this will impact the plan contributions projection. This discussion becomes even more important when the loan is paid. This discussion will generally lead to a very important strategic question of what is the target employee benefit level (EBL) that the company will provide their employees in the long-term.

  • Special Events – Major corporate events such as acquisitions, dispositions, and layoffs will affect the assumptions. If you are aware of any such events, we should include them in our calculations.

  • Future Share Activity, ESOP Transactions, Synthetic Equity - If the plan is not 100% ESOP owned, a study would be incomplete if it didn't account for future share activity inside and outside the ESOP as well as any other significant draws on equity such as synthetic equity and deferred compensation.

Because there is a lot of overlap between your repurchase obligation assumptions and the information involved in the financial and strategic planning process, some companies will integrate the repurchase obligation forecasting process into their strategic planning.

Topics: Employee Stock Ownership Plan (ESOP), ESOP Repurchase Obligation

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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