The Obligation Every ESOP Company Carries
Every ESOP company has made a promise to its employee owners: when they leave, the company will buy back their shares at the value set by the annual valuation. That promise is the repurchase obligation, and for a mature ESOP it can be one of the largest financial commitments the company carries.
The difficulty is that the obligation does not appear on the balance sheet, and the most common way of estimating it looks only at the current year. Few leaders can see how a rising share price, a long-tenured workforce, and a cluster of retirements will combine over the next five to ten years.
This post explains what drives the repurchase obligation, why single-year estimates fall short, how much cash Menke generally recommends holding in reserve, and how to structure an investment policy for those funds. The full conversation is below.
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Video Transcript
Trevor Gilmore (00:00)
Hi everyone, welcome to ESOP Radio. Most ESOP companies have a multi-million dollar liability that never shows up on their balance sheet until it does. The repurchase obligation, or simply known as RO, is a silent obligation. It’s real, it’s growing, and it’s off balance sheet, so it’s easy for boards and leaders to ignore it.
We’ve built a proprietary tool that models, forecasts, and manages that obligation. It’s called the ESOP Success Score. Today you’ll walk away with three things. Number one, what the repurchase obligation actually is. Number two, why traditional planning methods fall short. And number three, how the score gives boards a repeatable, defensible funding plan. Once you understand cash flows, you really understand business. Welcome to ESOP Radio. I’m Trevor Gilmore.
CEO of Menke, and I’m joined today by Ben Spadt, our director of ESOP Strategy. Let’s dive in. Alright, Ben, what is an ESOP repurchase obligation?
Ben Spadt (01:03)
Question, Trevor, and simply put, it’s just the obligation of the ESOP to buy the shares back from employees or participants that have left the company.
Trevor Gilmore (01:12)
Well that sounds simple enough. Why is this complex?
Ben Spadt (01:14)
Yeah.
Well, it can be complex because i i it just is sort of this looming obligation.
That is not on the balance sheet because you know it’s it’s undetermined as to when it’ll happen. it’s whenever a person leaves. So it can grow and grow as your share price grows and grows, and as participants get more and more shares over time. And so at certain moments it can be just this big question mark hanging over.
Trevor Gilmore (01:44)
Okay, so let’s talk about valuation and the correlation with valuation and your obligation. Now, I know you and I both have valuation credentials. Valuation is a big thing of what we do day in and day out, working on the ESOP deals, of course, all the various clients we have at Menke. It’s often said that your valuation as an ESOP company, that’s your true liability at that point in time. Take a look at the allocated shares in the ESOP.
Take a look at the value and bam, you know, that is your in essence your obligation. But there’s timing considerations. What’s the biggest driver been you found throughout your career that that drives your purchase obligation? Is it retirements? Is it diversification features in the plan? Is it just normal turnover?
Ben Spadt (02:32)
Yeah, by and large it would be retirement, death and disability, which are all treated the same. And a lot of times that’s what drives it because we’ve had these people with the company for a long period of time that have helped, you know, grow the company to what it is today, and they’ve amassed a good number of shares in their account and so those have to be paid out and there’s no delay for retirees, so it’s pretty immediate.
Trevor Gilmore (03:00)
Okay, so all these soft companies have a repurchase obligation. So
Ben Spadt (03:04)
Correct.
Trevor Gilmore (03:05)
it’s off balance sheet. Why is it off balance sheet?
Ben Spadt (03:08)
Yeah, well, you know, according to Gab or generally accepted accounting principles, because it’s it’s in the future, it’s contingent on, you know, several factors, but they’re participant events, not events that the company can control or has a reasonable understanding of the likelihood of that event happening. And it’s just not recognized as a as a true liability under the d definition.
Trevor Gilmore (03:34)
Okay, so you have employees or guinea shares allocated in the ESOP, typically over a long period of time. A lot of employees tend to stick around at ESOP companies for a long time as well. There’s studies out there that say if you work for an ESOP company and you’re in your 40s, you’re probably gonna stay there all things equal until you retire. So we’re talking about people with 20, 25 year runway of stock allocations and that value that increases in their account over time.
Value compounds, company growing at seven percent a year is is basically gonna double in value every ten years. You know, so so we see that, but you have to pay the piper at the end of the day. So all these people with these sizable account balances have to be bought out.
Ben Spadt (04:14)
It’s true.
Trevor Gilmore (04:15)
How common
is it for the board of an eSop loaned company to have a real handle on what their repurchase obligation looks like and how that correlates to their cash flow planning and budgeting?
Ben Spadt (04:30)
You know, early in my career I I didn’t really kind of understand what a good handle on this was myself. But you’ll see I will even see sophisticated CFOs that are, you know, really good at their job do what you described previously. They’ll just take what the current share price is and how many people that they think might retire, or what you know, they’ll apply some percentage to what turnover might be and
That’s what they assume. They don’t really go out into the future, you know, and think about, okay, well, you know, how does that affect subsequent years? How does share price growth affect subsequent years? and so I would say at the very best, it’s just what is the most current year, what’s the worst case scenario? you know, if everybody says I quit and wants their money.
Trevor Gilmore (05:24)
Ben, in your opinion, what is a proper forecasting period? Is it one year? Is it three? Is it five? Is it ten?
Ben Spadt (05:31)
Yeah, I you know, and this is getting into when we’ll talk about our success score, our model. I think the most accurate you can be is probably in that three to five year range. We look at a ten year range for a number of reasons, but one we make some assumptions about future events, share price growth, headcount growth, things like that. And that ten year window gives you
a glimpse into are my assumptions based in reality or am I going wildly off the charts by year 10? So but that three to five year range is really what we can reasonably expect to have happen.
Trevor Gilmore (06:11)
And a part of this repurchase obligation slash sustainability studies is projecting share price. And as we all know, no one has a crystal ball. But directionally you wanna be right. Are you gonna be precise? Absolutely not. but you wanna be directionally correct. And that’s what the RO forecasting does is takes a look at those peaks and valleys. Cause repurchase obligation is not the same every year for businesses as Ben as we just discussed. You have people with concentrated shares retiring.
also death disability et cetera those factors kicking in that will drive the obligation Ben in your opinion would most companies when they plan for purchase obligation are they reactive or proactive and let’s talk about what’s needed to become proactive
Ben Spadt (07:00)
Yeah, I th you know, ninety-nine times out of a hundred it’s reactive. it’s wow, we had a really expensive year of repurchase. Why was it that way? Is it going to happen again? are we going to run into any regulatory limits, contribution limits by having to, you know, fund the ESOP with some cash? there’s just a whole host of questions that happen because
An event happened, typically a high year. some big account balances have retired.
Trevor Gilmore (07:34)
And if you’re the CFO of an ESOP owned company, you never want to be surprised by the repurchase obligation because you have to budget carefully over the next one, three, five years. Both CapEx, if you’re going through MA, you need to have capital set aside for that. And of course, you need cash set aside to fund the repurchase obligation. So this is crucial. And being reactive is not a place you want to be. so let’s Ben, let’s talk about the ESOP success score and how we really empower CFO.
and boards to give them the data they need to make smart, proactive decisions around cash flows required for the obligation.
Ben Spadt (08:17)
Absolutely. So what we have created here is a proprietary long-term cash flow kind of framework or tool that will look at that repurchase obligation and and its forecast and help you make decisions. We give recommendations on you know how much cash should be on hand to anticipate that. and we you know we take a look at several different things and and I guess.
At a high level, Trevor, what you know, what are some probably three major things that you think we we view as the most important here?
Trevor Gilmore (08:57)
And the most important is getting timely data and working off of that. With with our TPA team, we have access to that data. So we have access to the ESOP plan allocations and be able to forecast and include the current data so that you’re not working off some old stale data and trying to create some sort of cash plan around that.
so number one, timely data, that’s probably the biggest hurdle because eSOPs are very much looking to the past. You have so many things that need to happen. Sto stock allocations. That happens after you get the valuation, which that happens after you get your your financial statement audit done and so on. So timing is a huge issue, of course, and getting accurate data. also factoring in the population demographics as accurately as well. And making those key assumptions, because all the ESOPs out there are designed different.
There’s no
Two ESOPs that are the same out there. And they all have different stock concentration issues. So being able to forecast when key people in the ESOP are going to act a certain way, that’s that’s crucial, of course. And CFOs and boards, CEOs as well, need to be concerned with ROI on their cash. So
Is cash best deployed? Are you storing cash on the balance sheet to fund these future buyouts? Are you transferring cash over to the trust? Reminder: once cash goes over to the trust, it is a trust asset and does get allocated to people in the ESOP. So, Ben, our ESOF success score gives a clear 10-year forecast of where you’re headed, what those peaks and value valleys are.
When you talk about the results of the success score with the boards.
What have you found to be the most impactful? Is it the cash required that they should either have on the company balance sheet or in the ESOP trust to fund the RO? Is it the effective benefit rate? Because ESOP benefit rates are a few things. One is what the testing shows, two is what that fringe is, meaning the benefit rate derived from the obligation. So it’s kind of an esoteric concept there. And what have you found that boards need the most so that they feel
like they are managing their ESOF sustainability the right
way.
Ben Spadt (11:16)
Yeah, and you know, before I even put pen to paper, so to speak, with this, I ask those questions because what is important to you? Is it maintaining a healthy benefit level? Is it just understanding the cost? You know, I I want I don’t want any sticker shock, so I need to know how much cash I need to manage this. But I would say by and large, it’s they don’t want to be caught off guard. You know, much like you said earlier, I don’t want to be reactive.
I’ve either been burned by it in the past or I know somebody that has. So I want to be able to anticipate something coming down the road. And so all of those things that you mentioned previously work in concert to help understand and not get caught off guard and help make decisions about, you know, how much cash do I keep on the company balance sheet? Or or do I put it in the ESOP trust?
because I know this is relatively certain to happen this this r repurchase. so things like that. And then also how does that affect the benefit rate? Because if I move cash into the plan, it’s gotta go somewhere. And so it these participants are enjoying either a high or low benefit rate that may be driven purely by repurchase. And so we have those conversations as well.
Trevor Gilmore (12:38)
Generally speaking
What is a rec recommendation for a let’s say an ESOP company that is 100% ESOP? so the ESOP owns 100% of the shares, all the debts repaid, it’s doing well, stock price is increasing 10% and so on, and they have key retirements coming up over the next three, five, seven years. How much cash using that fact pattern would you generally recommend the board and the C-suite?
keep on the balance sheet to fund RO and be comfortable that they have enough cash to meet that obligation.
Ben Spadt (13:14)
That’s a great question and one I hear every single time I have one of these meetings. And with our success score, with the deliverable that we give, we talk about having three years of cash reserves so that you know if for whatever reason your expectation, your forecast doesn’t go according to plan and it’s perhaps a little bit more expensive, you’ve got the cash. If it’s less expensive, you know, okay.
These people either are working an extra year and retiring later or whatever, but that repurchase is going to get more expensive. So it’s nice to have that sort of safety net there. And that three-year balance grows as the ESOP grows. So, you know, if it’s early, it may be only a a few thousand dollars.
But if we’re a twenty, thirty year old ESOP, sometimes that can be three, four, five million dollars that you need to have held back. So we like to be ahead of those things rather than reactive, like you know, which is a common theme throughout here today.
Trevor Gilmore (14:17)
Let’s talk about investment policies. So, all e-sops should have an investment policy in place that talks about what the cash in the ESOP is invested in and also tie it to the future obligations. so, Ben, what are the some key tips here for listeners on if they don’t have an investment policy, which all ESOPs absolutely should by definition, but some don’t, or they are outdated and they need to update those policies. What are some tips to give to listeners?
to include in that policy and tie it to the the feature RO so that they make sure that they have cash set aside for those future liabilities and still getting a decent return as well that’s risk adjusted.
Ben Spadt (15:00)
Yeah,
sticking it in the mayonnaise jar in the backyard or the mattress, you know, that doesn’t provide a a very good return. So it’s a very good question to ask. But you know, w with that that three year amount balance that I was talking about, that amount should probably be in pretty something pretty liquid because
you need to deploy it relatively quickly. So you don’t want to have it tied up in something that’s long term. But we do have, as like I said, part of our deliverable, we do talk about making these decisions and having an investment policy. And in the broad strokes, having some in a very liquid investment, as as simple as a money market account sometimes
however you want, but the majority of that balance should be in something that’s safe, like you know, US Treasury bonds, long-term triple-A rated corporate bonds, and a minority should be invested in you know an index fund, something like that. We’re still talking about relatively conservative things. We you know
we go from the majority being in risk less or very low risk items and then having some so that you can enjoy, you know, at least a decent return in an index fund, something like that.
Trevor Gilmore (16:27)
And generally speaking, would that recommendation be the same whether we’re talking about funds in an ESOP trust and funds on the company balance sheet? So and again, we’re talking about funds earmarked for future obligations, not funds earmarked for CapEx
Ben Spadt (16:41)
Right.
Trevor Gilmore (16:42)
or MA activity and and so on, working capital, you know, excess working capital investments. We’re talking about funds the company is earmarking specifically to fund this off balance sheet liability.
Ben Spadt (16:54)
That’s a very good question. And so the the the way I have it illustrated is probably the most common recommendation for cash that’s already in the ESOP trust or the other investment account as it’s called OIA. And that
You know, you don’t want to ever have what’s deemed an imprudent investment in there and have somebody make a claim and says, you know, you you had my some of my retirement funds in here and it was invested in something foolish.
So you don’t ever want that. When it’s on the company balance sheet, that’s a board decision and can be invested in a way that the board sees fit, just understanding that this is deemed for future repurchase. It’s just on the company balance sheet. I have not yet, you know, gone over the wall into the trust.
Trevor Gilmore (17:46)
And Ben, thinking about our ESOP success score above and beyond just forecasting what that repurchase obligation looks like based on reasonable assumptions, actuarial, mojo, all that good stuff.
Ben Spadt (17:57)
Yeah.
Trevor Gilmore (17:58)
One key item that it includes is the comparison of future cash flows against the obligation to show you, and you get a score from zero to hundred percent. It shows you we call that the RO cash burn. That’s crucial because especially for companies that have
High values relative to their cash flows, the RO can be a very deadly killer
Ben Spadt (18:23)
Mm-hmm.
Trevor Gilmore (18:24)
at the end of the day. So you need to understand how much your cash flows are truly being used to fund that RO in the future. And that is something that the success score includes, is that tenure projection.
Ben Spadt (18:38)
Absolutely. And Trevor, that is the success score. I mean, that is where we get its name from. And it does show you each one of those years, how healthy are you? how much cash does this require? And it looks at the sources of cash, you know, EBITDA, the money that’s already that in the trust, that other investment account, and how much of that are we consuming on each year of this repurchase? And then we have recommendations if if we, you know, ever get in some some territory that might not be so favorable.
Trevor Gilmore (19:08)
And of course, recommendations on modifying the ESOP. ESOPs can always be modified, such things as vesting, lump sum limits, you know, all this kind of technical ESOP mumbo jumbo. There’s tons of that out there.
That’s part of this
Ben Spadt (19:20)
Yeah.
Trevor Gilmore (19:21)
too. Ben, I think we’re out of time, sadly. Thanks for joining us today. I hope everyone enjoyed today’s presentation. We could talk about this for hours on end, of course. But
Ben Spadt (19:31)
Yes.
Trevor Gilmore (19:31)
three key takeaways here: the repurchase obligation, it’s simply
the value of ESOP stock that you have to buy back each year. And it’s obviously tied to your value. That’s a huge component of this. If you’re an ESOP owned company, understand your population demographics, especially at the board and the C suite level, and truly understand what that repurchase obligation trajectory is. And
Also, key takeaway is make sure that your investment policy is up to date. we often see that they’re not, and that is absolutely crucial to understand all that and also act on real-time data versus data that is one, two, three, four years in the past, which we often see with eSOL companies out there. Have an awesome day. Be sure to check us out, our future episodes on your favorite podcast channel, whether that’s Apple, Spotify, YouTube. Also check out our site.
You can reach out to me, Trevor Gilmore, I’m on LinkedIn. I’m the one with the the bike photo and the main photo there. and Ben, how can listeners reach you?
Ben Spadt (20:36)
Yeah, find me on LinkedIn. shoot me an email, check me out. I don’t have a biking photo, but I’m out there. So anyway, have a wonderful day.
Trevor Gilmore (20:44)
All good.
Also, Menke.com. We have tons of information on there about the success score and so on. Always happy to chat. Have an awesome day, everyone. Take care.
Ben Spadt (20:56)
Take care.
What Drives the Repurchase Obligation
The repurchase obligation is the company’s duty to buy back shares from participants who have left. The value of the shares allocated to participants’ accounts represents the total obligation at any moment. What makes planning hard is timing: the company does not know exactly when each participant will leave.
Retirement, death, and disability
In Menke’s experience, retirement, death, and disability drive most of the obligation, and the three are generally treated the same for distribution purposes. These participants are often long-tenured employees who helped build the company and accumulated large balances. Their distributions also tend to begin soon after they leave, so the cash need arrives quickly. Exact timing depends on the plan document and ERISA rules; confirm the specifics with plan counsel.
Why it stays off the balance sheet
Under generally accepted accounting principles, the obligation is not recorded as a liability. It depends on future participant events that the company does not control and cannot predict with enough certainty to meet the definition of a liability. Your CPA can explain what your financial statements must disclose.
How balances compound
Employees at ESOP companies often stay for decades, which can mean 20 or 25 years of allocations growing in value. A company whose value grows 7% a year roughly doubles about every ten years, and each of those balances eventually has to be bought out.
Why Common Estimates Fall Short
Even experienced CFOs often estimate the obligation by taking the current share price, applying an assumed retirement count or turnover rate, and stopping there. That misses how share price growth and future departures change the cost in later years.
Menke’s view is that a forecast is most reliable over three to five years, the range in which departures can reasonably be anticipated. Menke also models ten years, mainly to test whether assumptions such as share price and headcount growth stay realistic. No forecast will be precise, but it should be directionally right and show the peaks and valleys, since the obligation rarely holds steady from year to year.
Moving From Reactive to Proactive Planning
Most companies plan reactively. A year of unusually high repurchase, often a few large balances retiring at once, prompts the questions: Why did it cost so much? Will it happen again? Will funding the ESOP with cash run into contribution limits?
Those surprises are costly because repurchase competes with capital expenditures and acquisitions for cash over the next one, three, and five years. Getting ahead of it requires three things:
- Timely data. ESOP information lags: allocations follow the valuation, which follows the financial statements. Stale data produces stale plans.
- Accurate demographics. Every ESOP has its own design and its own concentration of shares among key people. A forecast should reflect when those individuals are likely to leave.
- A view on return on cash. Leaders need to decide whether repurchase cash is best held on the company balance sheet or contributed to the ESOP trust.
How Much Cash to Hold: A Common Scenario
Consider a company that is 100% ESOP-owned, has repaid its acquisition debt, has a share price rising about 10% a year, and expects key retirements over the next three, five, and seven years. How much cash should the board keep available?
Menke generally recommends holding about three years of projected repurchase in reserve. If departures cost more than forecast, the cash is there. If they cost less, perhaps because people work an extra year, the obligation has only been deferred and will likely be larger when it arrives. The reserve grows as the ESOP matures: modest for a young plan, but potentially $3 million to $5 million for an ESOP that is 20 or 30 years old.
Company balance sheet or ESOP trust?
Cash contributed to the trust becomes a trust asset and is allocated to participants. That raises the plan’s benefit rate, the value participants receive relative to pay, which can end up driven largely by repurchase funding. Cash on the company balance sheet stays a company asset. Boards should weigh both effects with their advisors.
Setting an Investment Policy for Repurchase Funds
Every ESOP should have a current investment policy that ties how cash is invested to future repurchase needs. Menke’s general framework for funds earmarked for repurchase:
- Keep the near-term amount highly liquid, such as in a money market account, so it can be deployed quickly.
- Place the majority in low-risk holdings, such as U.S. Treasury bonds or highly rated corporate bonds.
- Invest a smaller portion in something like an index fund for a reasonable return.
Where the cash sits matters. Cash in the ESOP trust, typically in the other investments account, is participants’ retirement money and must be invested prudently. Cash on the company balance sheet is a board decision. This is general guidance, not investment advice; work with the plan’s trustee, ERISA counsel, and an investment advisor on specifics.
Measuring Cash Burn With the ESOP Success Score
Menke’s ESOP Success Score compares projected sources of cash, including EBITDA and funds in the trust’s other investments account, against the projected obligation for each of the next ten years. The result is a score from 0 to 100% showing how much cash the obligation is expected to consume. Menke calls this the cash burn.
The measure matters most for companies with high valuations relative to cash flow. When the forecast shows unfavorable years, recommendations may include plan design changes such as vesting schedules or limits on lump-sum distributions. Plan amendments carry legal constraints and should be reviewed with ERISA counsel.
Looking Ahead
The repurchase obligation is the value of ESOP stock the company will have to buy back. Boards and executives who understand their workforce demographics, keep their investment policy current, and plan from today’s data rather than figures one to four years old are far less likely to be caught off guard.
A practical first step is to answer three questions: How far out does the company forecast repurchase? How many years of projected repurchase does it hold in reserve? When was the investment policy last updated?
If your company has an ESOP and you want a clearer view of its repurchase obligation, contact Menke to talk through a forecast and funding plan. If you are an owner considering an ESOP and want to understand how repurchase would fit, complete our feasibility questionnaire for a free preliminary analysis.
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About ESOP Radio
ESOP Radio is the official ESOP podcast from Menke ā where real stories of growth, succession, and long-term wealth building are told.
Hosted by Trevor Gilmore and Ben Spadt, the show features conversations and educational episodes designed to help business owners better understand employee ownership.
Disclaimer
This podcast is provided for educational purposes only and does not constitute legal, tax, investment, or fiduciary advice.
Phil DeDominicisĀ is an ESOP strategist and M&A advisor who has guided 300+ companies through ESOP formations, financing, and transactions overĀ 20+ years at Menke & Associates. He specializes inĀ selling ESOPāowned businessesĀ to financial or strategic buyers and inĀ helping ESOP companies acquire other businesses.
