The ESOP repurchase obligation is the company’s obligation, as created by the ESOP put option, to buy back shares from ESOP participants according to the company’s ESOP document and ESOP Distribution Policy.
Under IRC Section 409(h), if your company stock is not publicly traded, a participant must be given the right, the ESOP Put Option, to demand a distribution in the form of shares. A put option gives the participant a right, but not the obligation, to require the company to repurchase the stock under a fair valuation formula as determined by an independent ESOP appraiser.
The right to demand securities with the ESOP put option is what creates the company’s ESOP Repurchase Obligation.
Forecasting the ESOP Repurchase Obligation
An ESOP repurchase obligation forecast is a long-term projection of the company cash needed to satisfy the plan’s ESOP distribution timing, form, and method requirements per your plan document and ESOP distribution policy.
The results of the forecast are dependent on many factors, including the participant data/demographics of the participants, your company and ESOP repurchase obligation assumptions, and your ESOP distribution policy. In addition to corporate and ESOP planning, the repurchase obligation forecast helps quantify the projected ESOP repurchase obligation for financial statement reporting and stock appraisal purposes.
ESOP Distribution Policy
To the extent consistent with regulatory requirements and your plan documents, a written ESOP distribution policy documents the timing, form, and method of how the company processes ESOP distributions. A written distribution policy can be modified as needed to ensure the policy continues to meet the objectives of the company, to manage cash flow, and to control the employee benefit level. Every distribution policy starts with the Internal Revenue Code requirements and the terms of the plan document and is then modified as needed to meet the objectives of the company, to manage cash flow, and to control the employee benefit level.
After reviewing the results of your repurchase obligation forecast you may decide to run different scenario(s) using alternate distribution policy(s). A change in distribution policy could significantly change your cash flow and company projections (and potentially the ESOP valuation) now and in the future which could have an impact on your other assumptions.
Reporting the ESOP Repurchase Obligation
The ESOP repurchase obligation is NOT a balance sheet liability required to be reported on the financial statements. [At one point there were concerns that FASB Statement No. 150 would include ESOPs, but that initiative appears to have been tabled indefinitely.]
The company should disclose the repurchase obligation per Statement of Position 93-6 Employers’ Accounting for Employee Stock Ownership Plans (SOP 93-6):
The existence and nature of any repurchase obligation, including disclosure of the fair value of the shares allocated as of the balance sheet date, which are subject to a repurchase obligation.
Funding the ESOP Repurchase Obligation
Regardless of the distribution being paid in stock or cash, the plan sponsor (the company) has to plan for the funding of the redemption of the stock or getting cash in the plan to fund the distributions. A company needs to have an understanding of the short-term and long-term financial commitment needed to satisfy the future liability obligation. The most common method to obtain this understanding is by performing an ESOP repurchase liability study also known as an ESOP repurchase obligation forecast. As a result, it is an important responsibility of the Board and management that you know your future repurchase obligation and plan accordingly. The ESOP Trustee will also need to understand the company’s funding strategy.