This question comes up often and it seems to be a hot topic for mature ESOP companies. This article addresses the tax, policy and valuation concepts that are affected by the decision to keep ESOP shares in the plan rather than distributing them (i.e., to "recycle" them within the ESOP) or to reduce the number of ESOP shares outstanding by having the company redeem them when distributed.
What Exactly Is "Recycling"?
Most of us are familiar with the concept of a stock redemption by a company. But what exactly is meant by "recycling" ESOP shares?
"Recycling" refers to the method of funding a distribution to a participant from an ESOP by converting the participant's ESOP stock account into cash within the plan and paying the distribution out of the participant's cash account. This option is available for plans with sufficient cash in the trust (due to either contributions or earnings) to pay distributions. The shares in the participant's account are sometimes referred to as having been "purchased" within the plan by the accounts of other plan participants. In actuality, the departing participant's stock account is debited the shares and the participant's cash account is credited the fair market value of the shares. The remaining participants' cash accounts are debited their proportionate share of cash necessary to fund the departing participant's distribution, based on relative cash account balances. Their stock accounts are credited with shares in proportion to the debits from their cash accounts. Recycling shares is treated for all reporting and withholding purposes as a cash distribution.
What Are The Tax Differences?
For tax paying companies, the issue is driven in large part by the cost of benefits. Redeeming shares comes at the cost of taxes paid on the income used to redeem the shares. Redemptions are made with after-tax corporate income. They are not deductible by the company. Recycling avoids that cost. Recycling is funded with deductible contributions to the ESOP. Non tax-paying 100% ESOP owned S corporations are immune to this distinction.
What Are The Policy Differences?
In our experience, recycling shares is the most common method in growing companies. Recycling retains and provides shares to allocate to current active participants, because they are funded with contributions to the plan. The shares are reallocated based on the allocations of the contributions. This leaves the total holdings of the ESOP unchanged. Redeeming shares is most common in companies that are concerned with shrinking or terminating their ESOP programs, as this method will typically result in fewer shares being held by the ESOP.
What Are The Pros And Cons For Participants?
Redeeming shares has a potential benefit for ESOP participants. When ESOP shares are redeemed, the equity value is divided by a smaller number of shares, which increases the value per share (all other factors being equal). As a result of this reverse dilutive effect of redeeming shares, the account values of participants holding shares will appreciate in value more quickly. If the aggregate equity value of the firm is growing, the reverse dilutive effect of redemptions will result in per share values that grow at rates that exceed the rate at which per share values would grow in an equally growing company that recycles shares. Confused yet? That's just the start of the comparison.
Redeeming shares provides greater percentage upside growth in share value for existing ESOP participants because no shares are allocated to new participants. As a result, it may be most appropriate to redeem shares in years where it is desirable to boost the value of the share price. This approach may provide an additional benefit to senior employees by boosting their account balances when they otherwise would not get a material increase in their share balances due to allocation restrictions or other limitations.
Redeeming shares may also be desirable when the objective is simply to provide some support to the stock value, which is, for example, not appreciating as rapidly as desired (i.e., is on a "plateau"). Public companies do this often in lieu of paying dividends to show that they are a "growth stock," and not an "income stock." S corporation ESOP companies may have this same perspective. Instead of paying an S corporation "dividend," which may get allocated to participants' accounts in proportion to compensation on suspense account shares, they may want to redeem some shares.
Are There Other Valuation Considerations?
It is important to note that the reverse dilutive effect of redeeming shares may be offset in the current year stock value due to lower cash balances on the corporation's balance sheet as a result of the redemption (or more debt if the money for the redemption is borrowed). In other words, some valuation professionals tell us that, in most cases, the per share value in a redemption is unchanged in the year the redemption is made, all things being equal. In our experience, appraisers have differing opinions and the cash impact on the balance sheet may not have a material impact on the overall value of the company, depending on the appraiser's view and method for valuing the company. An asset method of valuation would have a direct correlation. Other methods may be worth examining with your valuation professional.
To fully understand the impact of share redemptions, you should project and model share growth in order to estimate when such an increase may accrue to larger share balances. In addition, current year earnings used to fund the redemptions ideally should be sufficient support to the accretive effect of redeeming shares. If not, then the valuation methods and assumptions should be examined as should the redemption decision itself.
One more very important concept must be mentioned here. If redemptions are being used to support the value of stock accounts, the accounts of inactive participants will also be affected. Participant accounts that are pending distribution will share in the reverse dilutive benefit. The timing of distributions and the size of inactive participant account balances should be considered. In S corporation ESOPs certain mechanisms may be used to move inactive participants' account balances out of stock and into other investments. This should be considered at the same time the timing of redemptions is analyzed. These mechanisms will be discussed in an upcoming article.
What Else Can A Company Or ESOP Do?
Although senior employees may receive a value benefit from redeeming shares, it does not provide "targeted value" to senior employees, because all participants receive the same relative increase. In contrast, other forms of equity compensation (e.g., options or restricted stock) or synthetic equity (e.g., stock appreciation rights (SARs) or phantom shares) can be targeted to specific employees as an additional benefit and be a more effective way to motivate certain valuable employees. SARs or phantom shares will of course have a dilutive effect on all ESOP participants and non-ESOP shareholders.
One strategy to provide meaningful benefits to valuable employees is to couple a SAR issuance or option with the redemption of ESOP shares. This provides a company with the ability to target equity to senior employees while protecting ESOP participant per share value. Redemptions of ESOP shares could be coupled with SAR issuance to provide dilution protection for all ESOP participants and targeted offsetting equity to senior employees.
Recycling and redeeming may also be used simultaneously (i.e., recycling just a portion of distributed shares while redeeming the balance) to allocate only some level of benefits to new participants.
A third tool of "re-leveraging" might be coupled with a combination of repurchasing shares and SARs. The basic concept of re-leveraging is for the company to loan the ESOP the money to fund repurchases, rather than contributing the money to the ESOP. Then, future contributions would be used to repay the loan(s). In this way, the repurchased shares are allocated to participants over a longer period of time, thereby increasing the shares available to allocate to newer participants.
Equity ownership targets should be arrived at by prioritizing or balancing equity among key or senior managers, current ESOP participants and new employees not yet in the plan. Once target equity levels have been defined, then a company can use several different tools to achieve its goals. These may include a combination of re-leveraging, recycling, redeeming options or SARs to provide targeted incentives for key or senior managers while protecting account value for both veteran and new and future employees.