The Process of Forecasting & Analyzing Repurchase Obligations: A Case Study

Presented by

Ms. Tina M. DiCroce ESOP Economics, Inc.

and Mr. Shawn Richard

Palmer-Donavin Manufacturing Company

Agenda

• Introduction to the Repurchase Obligation

• Background on Palmer-Donavin Manufacturing Company (“Palmer-Donavin”)

• The Forecasting Process

– Defining the issues

– Gathering data

– Developing assumptions

– Modeling a “base case” and additional scenarios

– Analyzing results/developing conclusions

• Concluding Thoughts

Introduction to the Repurchase Obligation

• An ESOP’s repurchase obligation is defined as the ESOP plan sponsor’s legal obligation to fund participant distributions by buying back shares of ESOP stock at fair market value

• Forecasting repurchase obligations is a critical part of the process of planning for future liquidity requirements

Why you need to plan for repurchase obligations

• The repurchase obligation can represent a significant liquidity requirement that affects cash flow, earnings, and potentially the value of the company’s stock

– Many appraisers now ask for repurchase obligation projections

• With advance planning, you can develop strategies for meeting these obligations that are consistent with corporate goals such as:

– Benefit levels

– ESOP sustainability

– Availability of stock for future participants

Definition of RO study

• A long-term projection of ESOP distributions and the associated cash requirements that a company will face

• Not just a set of numbers – it is a process that is intended to provided answers and potential solutions

• Ideally, it is also an analysis of strategies for managing and funding the resulting obligations

• It is an important component of financial planning for ESOP sponsors, and a tool to help you make informed decisions about how best to manage and fund your repurchase obligations

Some of the things you can learn from a Study

• Number of shares to be repurchased

• Cost of repurchase obligations

• Repurchase obligations as a percentage of covered compensation

• Sufficiency of planned contribution strategy

• Effect of redemptions on ESOP ownership level

• Flow of shares available for future participants

When should you do a Study?

• Do first Study early in the life of the ESOP

• Review assumptions annually

• Update as necessary – Whenever there are material changes in your business

or the Company’s strategic plans

– Assumptions or census change significantly

– ESOP is considering transaction that will affect repurchase obligations

• Otherwise, update every 2 to 3 years

Palmer-Donavin Manufacturing Co.

Palmer-Donavin Manufacturing Co.

• Highlights – Founded in 1907 as a manufacturing company

– Transitioned from manufacturing to distribution

– Two distinct business units • Wholesale building materials distribution

• Residential entry door fabrication

– 470 employees in 8 locations serving 13 states

– Family oriented company with very tenured employees

– Long history of Appreciation Pay and Profit Sharing

– Became employee owned in 2006

ESOP Transaction

• ESOP formed in 2006 – Leveraged Transaction

– Acquired 100% of Company in the initial transaction

– Allowed employees to purchase ESOP shares using profit sharing money

– Used subordinated shareholder notes to help finance

– Made a $1,000,000 initial contribution which created non-leveraged shares

– 250 participants

– Company is taxed as an S Corporation

– Continued our 401K with company match

Complicating Factors

• Very rich plan (415 and 404(a) issues)

• Leveraged shares

• Non-leveraged shares

• PS Transfer Shares – Participant directed money in the plan

– Additional voting rights

– Additional diversification rights

Since 2006

• 2007 – 2009: recession & recovery period

• 2010: Completed first RO Study, started to integrate RO forecast w/financial planning

– Paid off all external debt!!! • 2012: Acquisition of Seal-Rite door 12/31/2012

• 2013: Divestiture of the HVAC business; engaged ESOP Economics for updated Study, modeled additional scenarios on our own

• 2014: Acquisition in Oct ’14

• Share price has increased every year since the initial transaction

Palmer-Donavin Manufacturing Co: Repurchase Study

• Completed first study in 2010 • Why we did a study?

– Important planning tool so you know your future liabilities and you can plan your funding method

– Specifically requested by FBT – Part of the study is developing future business

assumptions, which is also very helpful; stimulates thinking in areas you may not look at as you focus on daily operations

• Licensed Telescope software in June 2010 to model additional scenarios internally

• Began integrating RO forecast / output from Telescope into financial model

• Engaged ESOP Economics for Study Update in 2013 to incorporate the acquisition and divestiture

The forecasting process

• Define issues and questions to be addressed

• Gather data

• Develop assumptions, including repurchase method & funding strategy

• Model a “base case” forecast

• Analyze results & identify potential strategies for managing & funding the RO

• Model additional scenarios

• Develop conclusions & present results

Defining the issues

• How big are the repurchases and when will they occur?

• Can we afford to meet the repurchase obligations and still grow the business?

• Is the current funding strategy adequate?

• What are the implications of the ESOP acquiring more shares?

• What are the implications of amending the current distribution policy?

What questions are you trying to answer?

• Initial Issues: – Cash flow projections – Sinking fund – 404(a) considerations – 415 considerations – Setting precedents regarding distribution options and

the consequences of each • Most recent Issues:

– Cash flow projections – 415 Considerations – Impact of acquisitions on the ESOP – Tying projections to our strategic plan

Palmer-Donavin Manufacturing Co: Defining the Issues

Gathering data: What data will you need?

• Plan Document, SPD, Amendments, Distribution Policy (if separate from Plan Document)

• Most recent allocation file

• Historical allocation files (to perform an analysis of historical turnover rates)

• Most recent valuation report

• Business plan/financial forecasts

• ESOP loan amortization schedule

Developing assumptions: variables that affect repurchase obligations

• Plan provisions / distribution policy

• Demographics / actuarial assumptions

• Financial assumptions

• Repurchase method

• Funding strategy Some of these variables in turn are affected by the company’s

business and financial strategy and by exogenous variables (the economy, the industry, etc.)

Plan provisions

• Eligibility & vesting rules

• Allocation method

• Accounting method / rebalancing

• Distribution policy • Segregating Accounts • Diversification rules

• In-Service distributions • Retirement age(s)

Plan provisions: distribution policy

Main components of distribution policy: • Lump sum distributions vs. installments

• Immediate distributions vs. delays

• Segregating accounts at termination

Distribution policy: delays & installments

• Advantages – Company has additional time to develop the cash needed for

the repurchases

– Makes repurchases more predictable

– Reduces year-to-year variation in cash requirement

• Disadvantages – A percentage of the shares in the ESOP is in terminated

participants’ accounts

– Can result in higher distributions to participants, as terminated participants benefit from increases in stock value

• Unless accounts are “segregated” at termination

Delays and installments can be combined in various ways

Distribution policy: immediate & lump sum distributions

• Advantages: – Makes shares available to new participants – Most shares are held by active participants – Potentially lower distributions to participants, as terminated

participants do not benefit from increases in stock value

• Disadvantages: – No time to plan – could result in a “run on the bank” – Repurchases are less predictable – More year-to-year variation in cash requirements (and

potentially, benefit levels)

Distribution policy: segregating accounts

• Segregating accounts – a terminated participant’s account is cashed out of company stock as soon as possible; the account is invested in other investments until it is finally distributed

– Company can maintain distribution policy (with delays and installments) without having terminated participants share in stock value fluctuations

– The drawback – cash requirements are often equivalent to immediate lump sum distributions

Plan provisions: diversification & in-service distributions

• Diversification – Age 55 and 10 years of participation

– Up to 25% of eligible stock over the first 5 years, then up to 50% in the 6th and final election year

– Calculation is cumulative

• In-Service Distributions (an optional provision)

– Allows participants to take a distribution prior to termination from service

– Plan can dictate any age and/or service or participation requirements, as well as percentage of a participant’s account balance that is available to be withdrawn

Palmer-Donavin Manufacturing Co. Key Assumptions

• Plan Provisions – Diversification rights:

• PS Transfer shares • ESOP shares

– What assumptions are made regarding diversification?

– What impact does declining share value have?

– Distribution policy: • Our options • Our philosophy • Our obligations

Demographic/actuarial assumptions

• Age profile of existing population

- Will drive timing of age-related events like diversification & retirements

• Turnover rates/patterns

- Consider analyzing 3-5 years of historical census data for turnover, to develop assumptions for Study

• Death/disability

• Changes in size of workforce

• Salary Increases

• Age/compensation of future new hires

• Election rates of diversification rights

Palmer-Donavin Manufacturing Co: Key Assumptions

• Demographic assumptions – Employee Groups – Retirement Age

• Assumed a certain age for most participants • Specific assumptions for those already past NRA

– Turnover • Assumed turnover consistent with historical

averages (related to length of service) – Future changes in headcount and salaries

• Assumptions differed by employee group based on business plans

– Diversification election rates

Financial assumptions: stock value

• When developing assumptions about share value for the Study, it may be helpful to:

– Look to your internal financial projections – Understand the methodology used by your appraiser for

valuing the ESOP shares • If you have a built a financial model, or one has been

developed for you by an outside professional, integrate the repurchase obligations into the financial model to help develop stock value assumptions

• Adjust all related assumptions when adjusting growth assumptions

– For example, if you have adjusted your assumptions about share value for the Study, what other assumptions for the forecast need to be adjusted?

Stock value is a critical variable

Assumptions are inter-connected!

Stock Value Combined with Demographics,

Distribution Policy, and Funding Method

Repurchase Obligations

Earnings and Cash Flow

Palmer-Donavin Manufacturing Co: Key Assumptions

• Financial assumptions – Growth in share price – Turnover Rate – Payroll growth

• Cyclical business – downturns every 5-7 years

• Long-term growth rate

Repurchase method: redeem vs. recirculate

• Repurchase obligations can be handled by: – Having the company buy back the shares

(“redeeming”), or – Within the ESOP, using cash from contributions and/or

dividends/ S corporation earnings distributions (“recirculating”)

• The repurchase method you choose affects: – Number of shares owned by the ESOP – Number of shares to be repurchased over time – Tax treatment and cost of repurchases – Size of participants’ accounts – And potentially, the value per share of the company’s

stock

You can change from redeeming to recirculating or combine the two methods

Funding strategy

• Pay-as-you-go-funding

• Pre-funding inside the ESOP

• Creating a cash reserve on balance sheet

• Releveraging

Typical funding methods:

Palmer-Donavin Manufacturing Co: Key Assumptions

• Funding Strategy – “Pay-as-you-go” up to 23.5% of covered payroll

• IRC 404(a) deductible limit is 25% of covered compensation

• Palmer-Donavin also sponsors 401(k) plan to which it makes matching contributions averaging ~1.5% of covered payroll annually

– Pay S Corporation Earnings Distributions to the shortfall

– Considered re-leveraging in some years but now may not have to…

– Also considered a combination of redeeming/recycling but ultimately decided it was best to recycle all shares – and why

A note on developing assumptions

• Your projections will only be as good as the assumptions on which they are based

– Ever heard the phrase, “garbage in, garbage out?”

• Assumptions need to be: – Reasonable – Internally consistent – Consistent with other financial planning

• Get “buy-in” on the assumptions from key members of management

Good assumptions are essential!

Model a “base case” forecast

• Incorporate plan provisions, assumptions, current repurchase method and funding strategy into model and run forecast

• Check results for accuracy and reasonableness: – Do the results make sense?

Analyze results/identify alternative strategies

• What are the answers to the questions that you initially identified?

• What other issues have emerged from the projections?

• Can repurchases be handled without interfering with growth?

• Should changes be considered in the plan or in distribution rules?

• What is the best method for handling repurchases?

• What funding methods are appropriate?

Model additional scenarios

• Analysis of the “base case” scenario may suggest additional scenarios/strategies to be explored

• You won’t necessarily be able to determine the impact of making changes without modeling the alternatives

• Results and potential strategies should be “stress-tested” by looking at a range of assumptions

Palmer-Donavin Manufacturing Co: Analyzing results

• Results of the study – confirmed some tweaks to assumptions were necessary

– Adjusted retirement ages, etc. • After “tweaking” assumptions, we finalized a base case

– In 2018, our repurchase is higher and in 2025, the number doubles due to the number of projected retirements

– Found that our repurchase goals are achieved • Planned funding strategy is sufficient • Cash requirement will be manageable

– However: Base case scenario did show a “haves vs. have-nots” effect

• S distributions allocated pro rata to share balances

Palmer-Donavin Manufacturing Co: Additional scenarios

• In the base case, financial assumptions were a problem…

• Being overly conservative in financial projections can have the exact opposite impact on your repurchase study. Your obligations are under-reported

• Having internal model has also helped stress-test different strategies

– Different growth assumptions, etc. – Impact of acquisitions to existing shareholders…is it

dilutive?

Develop conclusions/present results

• What have you learned from the analysis?

• What are the pros and cons of the alternatives?

• Prepare a final report, including a “Board-friendly” summary of the findings, which usually includes:

– Background information – Summary of the issues – Summary of the results and implications – Pros and cons of potential strategies – Recommendations and/or issues for further analysis

Remember . . .

• The repurchase study is not just a set of numbers. It is an analysis of potential problems and solutions.

• The study is a tool to help you make decisions about how you will manage and fund the repurchase obligations

Palmer-Donavin Manufacturing Co: Benefits of doing the Study

• Study provided visibility on future cash requirements so that excess cash could be invested efficiently (to grow the business)

• Helpful thinking through the assumptions • Understand the impact of distribution decisions before

making them • Make decisions or know that you need to make

decisions about some of these factors • Provides detailed information for use in workforce

planning (turnover, retirements, job growth, etc.) • Ties the ESOP to HR and Finance and Strategic

Planning

Final words of wisdom

• Don’t wait until the week before the board meeting to start the process – it takes time to do it right

• Developing good assumptions is critical – involve key members of management

• Understand how repurchase obligations are reflected in stock valuation and integrate into your financial model

• Stress test your strategy • Update your Study whenever ‘meaningful’ changes

take place or you would like to evaluate alternative strategies

Questions?

Shawn Richard, VP Human Resources Palmer-Donavin Manufacturing Co.

(614)324-7369 Shawn.Richard@palmerdonavin.com

Tina DiCroce, Director ESOP Economics, Inc.

215-606-3593 tina@esopeconomics.com