GAAP accounting for leveraged ESOPs can be misleading when looking at shareholders’ equity on a balance sheet for new ESOPs. This matters to bankers and sureties in particular since the negative impact on shareholders’ equity can be dramatic.
Companies sponsoring leveraged ESOPs are required to charge the cost of a leveraged purchase to debt and equity, thereby creating a‘double hit’ to the right side of the balance sheet.
In the typical “back to back” leveraged ESOP loan structure, a company first borrows from a lender then lends the proceeds to the ESOP. This second loan is called the ESOP or inside loan. When the ESOP loan is accounted for, a contra-equity account entry is made thereby creating a negative charge to shareholders’ equity.
The followowing example illustrates the impact of a $4.2 million ESOP loan. Notice in particular what happens to the shareholders’ equity and the debt-to-equity ratio.
From an accounting perspective, net worth is reduced 97% and debt to equity goes through the roof. If a net worth covenant is used by the lender, some explanation and special consideration will be necessary to set the covenant so the the loan can be properly monitored.
What is the “unearned ESOP account?” It is an account name used to differentiate between shares that have and have not been paid for, i.e., “allocated” to employee accounts. When the ESOP first borrows money and buys stock, all its shares are held in a suspense account. Immediately after closing, there are no shares allocated to employee accounts (since none have been paid for) and all shares are in the suspense account. Each year when the ESOP make a debt payment, a number of shares are “released” from the suspense account, allocated to employee accounts and a future repurchase cost created. Since an ESOP typically repays its loan over a 10-20 year period, this allocation and related future repurchase obligation grow slowly.
For example, assume an ESOP purchases 150,000 shares of stock and repays the inside loan over 15 years. Each year, 10,000 shares would be allocated employee accounts. If the bank loan is repaid in five years, only 50,000 shares would be subject repurchase and not the 100,000 shares still on the balance sheet.
The irony of this accounting treatment is that as the unearned ESOP shares account on the balance sheet goes down and shareholders’ equity “improves," the number of shares subject to repurchase go up! Beyond the balance sheet and cash flow impact of the bank leverage (which is monitored by other covenants), the unearned ESOP shares account does not further impair the company’s financial strength.
What Does All this Mean?
Many bankers unfamiliar with ESOP accounting become alarmed by the balance effect and scratch their heads since many still use net worth covenants in their loan agreements. The main point of this post it to offer that the net worth accounting is much less important than the future share repurchase costs.
For those lenders required or accustomed to having net worth covenants, we recommend one of the following:
- Adjust the net worth covenant to exclude the unearned ESOP shares
- Change the covenant itself to accommodate the net worth impact from the ESOP
- Simply require retained earnings to go up
- Drop the net worth covenant entirely
For loans being made to existing ESOPs for second stage transactions, be sure to review a share repurchase study to ensure the costs for buying back shares from departing employees is budgeted.