A private company’s stock price shot up. Employees who owned shares through the company retirement plan saw a chance to cash out big.
They did.
Then the company landed in Chapter 11 bankruptcy.
That episode is now drawing attention from accounting advisers, who are asking whether privately held companies with employee stock ownership plans—ESOPs—should have to give clearer warning about future cash demands when workers redeem their shares.
“No one was aware of the potential of the cash and capital outflow from that situation,” David Pesce, head of surety at Munich Re Specialty Insurance, said at a June 1 meeting of the Financial Accounting Standards Board’s Private Company Council.
Pesce described an ESOP-owned company that had a strong two- or three-year run. Its stock valuation climbed so quickly that employees eligible for payouts moved to lock in the higher value.
They took the money.
The company later buckled.
The case has become a cautionary tale in a growing debate over ESOP repurchase obligations—the duty private companies often have to buy back shares from workers when they retire, leave, die, become disabled or otherwise qualify for a payout.
For employees, that right is the point of the plan. It lets them share in the company’s success.
For companies, lenders and insurers, it can become a sudden cash crisis.
Why Private ESOP Cash-Outs Can Strain Companies
Unlike public company stock, private ESOP shares do not trade on an open market. When workers want to cash out, there usually is only one buyer: the company itself.
That can be manageable when payouts are steady. But if a wave of employees heads for the exits, or if the company’s stock price spikes and workers rush to lock in gains, the bill can hit hard.
The issue affects a large corner of the economy. Roughly 6,500 ESOPs cover about 14 million employees, according to figures discussed at the meeting.
The Private Company Council is not proposing a new accounting rule yet. But it is researching whether financial statements should give lenders, surety firms and creditors a better look at future buyback risks.
The concern first surfaced at a March meeting, where lenders and surety firms warned that current disclosures do not always show how large future ESOP cash demands could become, or when they might arrive.
At that meeting, the fear was a downturn: workers might seek payouts before valuations fall further or before company liquidity worsens.
The June discussion showed the flip side.
Trouble can also come when business is booming.
A rising stock price may encourage employees to take payouts while values are high. Either way, the company needs cash.
Robert Messer, a partner at BR Messer and a former bank chief financial officer and chief risk officer, said ESOPs can be a “wonderful thing” for long-term employees.
But he said the obligation to buy back shares is still a claim on company capital.
“There needs to be conversations about the ESOP obligations,” Messer said.
The question is how much of that conversation belongs in audited financial statements.
Lenders Want More Warning
Lenders and surety firms want more warning.
Companies and auditors are wary of turning financial statements into crystal balls.
Future ESOP payouts can depend on a long list of unknowns: who retires, who quits, who dies or becomes disabled, how many shares are vested, what the company is worth and whether eligible workers actually choose to cash out.
PCC Chair Jere Shawver summed up one concern from outreach: detailed estimates could amount to “forecasting a forecast.”
Still, council members appeared interested in a middle ground.
Instead of forcing companies to produce full five-year cash-flow predictions, they discussed requiring more factual disclosures, such as:
- how many vested employees are eligible to retire;
- how many more may become eligible over the next three to five years;
- the current share value and date of the latest valuation;
- historical ESOP repurchase payments; and
- whether the company has completed a repurchase obligation or liquidity study.
Pesce said even basic information would be better than what some users see now.
“At the current stock price that’s been calculated, what is the maximum potential cash outflow?” he said. “I would live with three [years], if I could get three. Today I get zero.”
Banks may be able to ask companies directly for ESOP studies, projections and covenant details. Surety firms may not have that access, Pesce said, because communications often go through agents or brokers.
That leaves some financial statement users trying to judge a company’s risk with only a blurry picture.
An Extraordinary Dividend?
Messer compared a major ESOP payout to an extraordinary dividend.
A lender may be able to block a big dividend through loan covenants. But if the company must fund ESOP redemptions, the cash may leave anyway.
“If that ESOP obligation is out there and it’s possible, I need to know that when I’m underwriting the company,” Messer said.
Not everyone is calling for new rules right away.
Katherine Curtis, an audit partner at Grant Thornton, said education may come first because existing ESOP disclosure rules appear to be applied unevenly. Others warned that too many assumptions could produce numbers that look precise but are not useful.
The council asked staff to keep studying the issue and is expected to revisit it in September.
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