ESOP Repurchase Obligation A Study in Best Practices

As 10,000 Baby Boomers turn 65 every day, many of whom are private business owners, they face exiting their long-held ownership in their businesses. This is not an easy or simple process. Exit planning generates many issues to consider:

Sell to a competitor? Sell to a private equity firm? If the company is large enough, go public? How does one do the tax planning to make sure a large sale price is not given away in income taxes?

Traditionally, Employee Stock Ownership Plans (ESOPs) are an effective method for selling a company to its employees, tax efficiently, and without the transactional risk of an outside sale.

An ESOP is a tax-qualified defined contribution plan designed to provide employees with an ownership stake in their employer company. Unlike other defined contributions plans, ESOPs are intended to invest primarily in the stock of the sponsoring corporation. What’s more, ESOPs can borrow money to purchase the sponsoring corporation’s stock, making it a compelling corporate finance technique.

ESOP Valuation─Overview

How you value a corporate stock is critically important to how you implement and administer an ESOP. Under IRC Section 401(a)(28)(C), a closely-held company that sponsors an ESOP must conduct an annual appraisal of its shares each time the Plan acquires stock and at each Plan year end after that.

Both the IRS and DOL regulations use fair market value as the appropriate standard to be applied in ESOP valuations. As stated:

“Fair market value, in effect, is the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having a reasonable knowledge of relevant facts.”

Business appraisers use a variety of approaches to valuation that effectively adhere to the IRS/DOL guidelines for estimating the fair market value of a business entity. The determination of which methods to employ depends on the unique aspects of the subject company and circumstances of the appraisal.

Factors that the appraiser must consider (including those outlined in Revenue Ruling 59-60): the nature and characteristics of the company; the earning capacity and financial condition of the company; the availability of reliable financial forecasts for the company; whether suitable guidelines on publicly traded companies can be identified; and the availability of data on comparable private market transactions.

A business appraiser may use three traditional approaches: 1) a market-based approach; 2) an income approach; or 3) an asset/cost-based approach.

Market-based approaches to valuation attempt to estimate the value of a company using pricing data from either reasonably similar publicly traded companies or mergers and acquisitions of privately held companies.

We base income approaches to valuation on the fundamental premise that the value of a business enterprise equals the present value of the future cash flows. Common applications of this approach include the capitalization of earnings method and the discounted cash flow or “DCF” method. Both methods require determination of an appropriate risk-adjusted rate of return to apply to the cash flow stream.

The third approach─the asset or cost-based approach to value─is used when future earnings are uncertain, such as in a liquidation scenario, or when the company holds significant tangible assets.

ESOP Exit Advantages

ESOPs can be optimal exit solutions for companies, enabling the business owner to:

  • Realize a tax-free transaction
  • Earn full-market value price
  • Gain significant cash at close
  • Exceed a third-party sale with after-tax proceeds
  • Avoid leaks to employees, customers, suppliers, competitors with confidential transaction
  • Experience a rapid, successful closing
  • Complete transaction faster than third-party sale─closes in less than six months
  • Become permanently tax-exempt
  • Control company, remain active (if desired) until debt fully repaid
  • Align sellers’ interests with executives, managers and employees
  • Preserve company legacy and culture
  • Enjoy equity-upside participation paid post-closing with high-yield seller note

Understanding Stock Repurchase Obligation

In a stock repurchase obligation, it is the responsibility of a sponsoring ESOP company to buy back the economic interests of employee account balances upon retirement, termination, or diversification in the form of cash distributions.

Under Generally Accepted Accounting Principles (GAAP), this ongoing liability represents an unfunded obligation not directly reflected on the ESOP company balance sheet.

When estimating the value of the ESOP company stock, the appraiser must consider, where applicable, if and how the ongoing stock repurchase obligation impacts the underlying share price. It is a complex and frequently debated topic within the ESOP appraisal community to quantify the impact of the repurchase obligation, given the multitude of interrelated factors and assumptions to consider including:

  • size and stage of the ESOP
  • retirement benefit level vs. non-ESOP company replacement benefit
  • degree of leverage
  • funding strategies
  • operating cash flows
  • recycling versus redeeming
  • income tax liability (C corp. sponsor vs. S corp.)
  • participant ages/demographics
  • plan features/ distribution policy
  • diversification
  • company compensation strategy
  • expected share price growth
  • perpetuity vs. finite-life ESOP program

The appraiser measures the stock repurchase obligation with professional judgment based on facts and information available, including a third party actuarial study. Notwithstanding, the consensus shows that stock repurchase obligations impact share value, and demand careful consideration.

Planning goals for an ESOP repurchase obligation dictate the company be able to financially fund cash distributions to participants when such obligations become due. The government mandates funding for other types of retirement benefit liabilities; however, ESOP sponsors have no such requirement. Current management and the Board of Directors must ensure that the company be able to financially fund distributions through a well-planned cash management strategy over the long term.

Hedging for the ESOP Future Liability

Funding for repurchase obligations can be segmented into five categories:

  • Current operating cash flow (“pay as you go”)
  • Advance funding/“sinking fund”
  • Borrowings/ debt
  • Internal markets
  • Third-party solutions (sale)

Some companies find a combination of funding methods works best, although finding the right combination requires you assess the advantages and disadvantages of each strategy. Further, the strategies carry varying levels of flexibility and can be modified each year as the facts change.

In a frequent first step in the evaluation process, the ESOP company obtains a third-party actuarial repurchase obligation study which often leverages proprietary software. This software integrates the various financial and non-financial factors and assumptions that impact the timing and magnitude of the ongoing liability.

The following is a brief summary of main funding strategies for repurchase obligation, including an alternative sinking fund technique using corporate-owned life insurance (COLI):

Best Practice Hedge for the Corporate Balance Sheet

COLI is an institutionally priced and managed asset used to fund certain corporate benefit obligations. It is a unique, high-cash-value asset which displays significant tax efficiencies when offsetting balance sheet liabilities. Used as a best practice investment vehicle, optimally in long-term forecasting (10-20 year repurchase obligation liability), COLI can be actuarially sized to hedge the ESOP repurchase obligation.

COLI tax advantages include:

  • Earnings and cash value increases from policies’ investment allocations not subject to current income tax.
  • Policy cash values can be accessed tax-free via policy loans and withdrawals.
  • Employees’ lives insured by the policies, and death benefits payable not subject to income tax.

COLI does carry certain costs of insurance that need factoring into the funding decision. But over a multiple-year period, the costs of COLI (plus typical death benefits paid) showcase COLI as a best practice funding approach, particularly when compared to a sinking fund or taxable investments.

So if you’re planning to sell your company, but unsure if you want to sell to your employees, speak with one of our knowledgeable consultants to learn how an ESOP repurchase with COLI may work best for you.

For more information on ESOP repurchases and COLI, contact Managing Director Don Curristan at EBS: Voice: 760.788.1321 Cell: 619.318.6620 or email to or Josh Edwards, ASA, Managing Director 949.719.2270 or email

Executive Benefit Solutions (EBS) innovates executive compensation and benefit plans for companies to attract, retain, reward, and motivate its key talent. To our knowledge, no other firm in executive benefits possesses the capability to optimize your plan as we do.

Eureka Capital Partners LLC, through its affiliate Eureka Valuation Advisors, specializes in advising public and closely-held businesses on valuation matters for financial and SEC reporting, ESOPs, mergers and acquisitions, capital raising, tax planning, estate and gift, and related purposes. Clients range from early stage to Fortune 500 companies, and the projects span all business sectors and industries including manufacturing, business and professional services, distribution, warehouse, technology, software, retail, and consumer products.