The benefits of utilizing an employee stock ownership plan (ESOPs) are clear, but ESOPs are not without risk. When employees leave the company or make certain elections allowed within the plan, the business is required to repurchase their vested shares. These repurchase obligations can pose a problem to employers if they’re not prepared.

What is an ESOP Repurchase Obligation?

ESOPs can be used to meet a variety of objectives, but one of their main functions is to reward employees for their loyalty to the company. As an employee’s tenure grows and the company becomes more profitable, the value of their shares in company stock will increase. These stock shares are held in trust for their benefit until they retire.

When employees are ready to retire, the company is required to provide a marketplace for their shares so that retirees can divest themselves of company stock. If a company is publicly traded, selling a retiree’s stock shares is simple. But if the company is not publicly traded, it is the company’s duty to repurchase those shares from the employee in cash, typically within one to five years following retirement. This is called a repurchase obligation. 

What Triggers a Repurchase Obligation?

Retirement isn’t the only event that triggers a repurchase obligation. Your company might be required to repurchase employees’ stock shares in any of the following scenarios:

• • An employee voluntarily leaves the company prior to retirement.
    If an employee chooses to leave the company prior to retirement age, they won’t forfeit their ESOP investment; they can take with them the value of their vested stock shares. Depending on the vesting schedule, this could be most or all the value in their ESOP account.
    
    Stock repurchases must be done following the schedule outlined in the plan documents, but in general, the payout to former employees must commence five years after they terminate and must be completed in the five years that follow. There are a couple exceptions to this rule. First, some large account balances can be distributed over more than just five years. Additionally, if the ESOP is leveraged (i.e., funded by a loan), the final payout can be delayed until the loan is repaid.

• • An employee is terminated.
    Terminated employees receive the same ESOP payout rights as self-terminated employees. In general, they will receive the vested value of their ESOP accounts within ten years: five years until cash payouts commence, plus five years of cash payouts, if these options are included in the plan document.

• • An employee exercises their diversification rights.
    All ESOPs are required to have diversification clauses. A diversification clause allows employees to exchange vested company stock in their ESOP accounts for cash or other investments (like assets held within a 401(k)). This option is mandated by the IRS to ensure employees are given ample opportunity to diversify their retirement portfolios.
    
    ESOP diversification clauses can vary, but employees must be allowed to diversify at least 25% of their ESOP portfolios when (1) they are at least age 55, and (2) they have participated in their employer’s ESOP for at least 10 years. If an employee elects to diversify their ESOP portfolio, the company must repurchase their shares immediately.

What’s the Best Way to Manage Repurchase Obligations?

Repurchase obligations are inherent in all ESOPs, but it can be tricky estimating when those obligations will come to fruition. Here are a few factors you’ll need to consider:

• • Employee age.
    Age can help you assess how close your workforce is to retirement.

• • Employee turnover.
    Knowing how long you typically retain employees can help you prepare for pre-retirement departures from the company.

• • Your plan’s vesting schedule.
    Combined with employee age and company turnover, a vesting schedule can help you estimate potential payouts.

• • Your plan’s repurchase provisions.
    There are minimum repurchase obligations your ESOP must follow, but your plan document might have more generous provisions, like allowing immediate payout to retirees or allowing younger or less tenured employees to exercise diversification rights.

• • Value of company stock.
    When your company repurchases company shares, you are required to do so at fair market value, so pay close attention to your business’s value projections.

If your company already has an ESOP, look to your plan document to refamiliarize yourself with your ESOP’s repurchase obligations. If you don’t yet have an ESOP and are drafting your plan document, think carefully about how to design your stock repurchase plan. It is much more difficult to change your ESOP plan documents after it’s in operation. If you have questions, please contact us.