Creating a Sustainable ESOP Distribution Policy
Discusses how to manage distribution policies to remain employee-owned in the long term.
By Barbara Clough, Michael Fischer, Tina Langlois, Corey Rosen, and Kevin Rusch
Format
Description
Managing how and when employees get distributions from their ESOP accounts is a critical strategic issue for an ESOP company. Too often, companies simply follow the distribution and diversification policies established when the ESOP was set up. That policy often calls for shares to be distributed only after termination and on the slowest schedule allowable. Similarly, employees often cannot begin to diversify their accounts until they have reached the statutorily required age and participation minimums. This is the right approach for some companies, but for others, it creates avoidable problems. ESOP companies should periodically review their distribution and diversification policies with their advisors. This book explains the issues and the options to consider.
Table of Contents
Introduction
1. Doing a Sustainability Study
2. Legal Issues for Distributions and Diversification
3. Managing Diversification
4. Illustrative Models for Distribution Policies
About the Authors
About the NCEO
Excerpts
From chapter 1, "Doing a Sustainability Study"
The first step when approaching the topic of sustainability is to establish the company’s goals and strategic objectives, considering issues the company has identified with current practices and how it would like to grow.
In establishing objectives, a company should consider its ideal growth plan and what it would take to achieve those goals. For instance, if a company seeks to be a high-growth business, will it need to be acquisitive to achieve its goals, and if so, what kinds of financial resources are required? How might cash needs for managing the ownership structure (in this case an ESOP, and in some instances individual direct or synthetic ownership) affect the company’s ability to make such investments?
The goals related to the ESOP or broader ownership philosophy may be less defined, but the company may have set a stake in the ground that it would like to remain 100% employee-owned indefinitely or that it would like to provide a certain level of retirement benefits through the ESOP. In some cases, the company may have identified particular concerns related to the ESOP’s management, leading to the development of more specific goals.
For example, if one of the issues a company is facing is an increasing repurchase obligation, the goal may be to reduce the cost of the future repurchase obligation such that the annual ESOP funding need can be met with free cash flow. Or perhaps the ESOP distribution policy has resulted in former employees owning a significant percentage of the company’s stock, in which case a goal may be to reduce the ownership in former employees’ accounts and drive more value to current employees, who are contributing to the company’s ongoing performance. Perhaps the ESOP’s shares were allocated quickly, which has resulted in significant concentration in the accounts of a relatively small group, and the goal is to spread the value more broadly in the future. Once a company at least has a rough understanding of where it wants to go, it can examine its routine operating practices more closely and consider whether any changes may be necessary to help achieve its goals.
From chapter 4, "Illustrative Models for Distribution Policies"
ESOP distributions can be delayed until the sixth plan year following the plan year of termination for participants that terminate for reasons other than the attainment of normal retirement age under the plan, disability, or death. The plan sponsor can pay earlier than the sixth year and may find that approach more favorable because the participant does not continue to share in stock price appreciation. Paying distributions earlier can have a cash flow savings, especially in the earlier years of an ESOP when the stock price can increase rapidly as the debt on the company’s balance sheet from the original ESOP leveraged transaction is repaid. Table 4-9 reflects how an ESOP account balance of $25,000 can grow to over $50,000 during a six-year delay period at a 15% annual stock value growth rate.
Many plan sponsors opt to pay distributions earlier for smaller account balances as opposed to distributing more than double the value of the account six years later.
Distribution policies can be written to state that balances less than a defined amount will paid in the year following termination of employment to get the balances distributed earlier. Balances greater than the stated amount could still apply a distribution delay to give the plan sponsor more time to fund the repurchase obligation as needed. Other plan sponsors may only impose a three-year delay for larger account balances, for example, to disincentive the employee to terminate employment to get access to their funds. The plan sponsor still has time to plan for the repurchase obligation, but with continued stock value appreciation, the obligation will be less than it would be if delaying for the full six years.