Best Practices for Repurchasing Shares after Employee Termination

At the point of hiring, you are mostly concerned about attraction and retention. Here, employee equity programs such as Employee Stock Option Plans (ESOP) come in handy. They are prime incentives to get the best hands on your team. These programs drive your employees to adopt an entrepreneurial mindset, fostering a deeper sense of commitment to the company's success. They also serve as a powerful retention tool, encouraging employees to remain dedicated to the organization. Moreover, they offer tangible value to employees by enabling them to share in the company's achievements.

‍

But there’s one major concern you may have; what happens when such employees leave? And if you want to buy back those shares, how do you settle on how much it’s worth? 

‍

The fear of former employees departing with ownership stakes or the potential disputes over stock valuation during buyback scenarios may stop you from dropping off the ESOP offering. 

To address such apprehensions, various strategies exist to protect you in cases where employees depart. 
‍

In this guide, you will get nine (9) working strategies to buy back shares from departing employees without hassle. 
‍

Laws guiding ESOP Repurchase
‍

You should know that repurchasing ESOPs is an obligation backed by law. Hence, whatever best practices you adopt should be in accordance with each law. Laws governing ESOP repurchases primarily fall under the purview of federal securities laws, tax laws, and regulations set forth by the Internal Revenue Service (IRS) and the Department of Labor (DOL).
‍

Overall, Employee Stock Ownership Plans (ESOPs) are typically obligated to repurchase shares from participants when they exit the plan or wish to diversify their holdings. If the ESOP cannot carry out the repurchase, the company must purchase the shares from the participant using a "put option" as outlined in Internal Revenue Code (IRS) Section 409(h). According to these rules, the company must either provide enough cash to the ESOP for stock repurchases if there are insufficient assets available within the ESOP or fund the repurchase of shares outside of the ESOP.
‍

Here are some other key laws and regulations that guide ESOP repurchases:
‍

1. Employee Retirement Income Security Act (ERISA): ERISA sets standards for private sector employee benefit plans, including ESOPs. It outlines fiduciary responsibilities for plan administrators, including the prudent management of plan assets, disclosure requirements, and the duty to act solely in the interest of plan participants and beneficiaries.
   ‍

2. Securities Laws: ESOP repurchases may involve the transfer of securities, subjecting them to federal securities laws administered by the Securities and Exchange Commission (SEC). Companies must comply with registration, disclosure, and anti-fraud provisions under the Securities Act of 1933 and the Securities Exchange Act of 1934 when repurchasing ESOP shares.
   ‍

3. Tax Code (Internal Revenue Code): Various provisions of the Internal Revenue Code govern the tax treatment of ESOPs for both employers and employees. This includes rules regarding the tax-deductibility of contributions to ESOPs, the taxation of distributions, and the treatment of gains and losses on ESOP shares.
   ‍

4. IRC Section 409A: This section of the Internal Revenue Code imposes strict requirements on nonqualified deferred compensation plans, which may include certain types of stock repurchase arrangements. Compliance with IRC Section 409A is essential to avoid adverse tax consequences for both the company and the employees.
   ‍

5. Department of Labor Regulations: The DOL issues regulations and guidance related to ESOPs under ERISA, including rules governing prohibited transactions, reporting and disclosure requirements, and the valuation of plan assets. Compliance with these regulations is crucial to avoid penalties and enforcement actions.
   ‍

6. State Corporate and Securities Laws: Companies must also consider applicable state laws governing corporate governance, securities offerings, and shareholder rights when repurchasing ESOP shares. State laws may vary, so it's essential to consult legal counsel familiar with the laws of the relevant jurisdiction.
   ‍

7. Plan Documents and Agreements: In addition to statutory and regulatory requirements, ESOP repurchases must comply with the terms and conditions outlined in the plan documents and repurchase agreements. These documents typically specify the procedures for repurchasing shares, valuation methods, and any restrictions or limitations on repurchase transactions.
   ‍
   ‍

Best Practices for Repurchasing Shares after Employee Termination

A. Establish Clear Policies and Procedures

‍

Your equity agreement plan is the first point of ensuring best practices. Here, you have the option of clarifying things from the onset between all stakeholders. In your equity agreement plan, you should make of these:

‍

1. A Comprehensive Policy: Begin by drafting comprehensive policies that outline the procedures and guidelines for repurchasing shares following employee termination. These policies should clearly articulate the circumstances under which shares will be repurchased, such as voluntary resignation, termination for cause, or retirement. Additionally, specify any conditions or restrictions that may apply, such as vesting schedules or eligibility criteria.

‍

2. Communication and Documentation: Once the policies are finalized, it's crucial to effectively communicate them to all relevant stakeholders, including employees, shareholders, and management. Incorporate these policies into employment contracts for employees who are eligible for share ownership or include them in shareholder agreements for broader applicability. Ensuring that everyone is aware of these policies helps prevent misunderstandings and conflicts down the line.

‍

3. Standardized Procedures: Implement standardized procedures for executing share repurchase transactions to ensure consistency and efficiency. Define clear timelines for initiating and completing the repurchase process, taking into account regulatory requirements and internal approval processes. Establish guidelines for determining the valuation of shares to be repurchased, considering factors such as market value, book value, or an agreed-upon formula.

‍

4. Valuation Methods: Choose appropriate valuation methods that accurately reflect the fair value of the shares being repurchased. This might involve engaging independent appraisers or utilizing predetermined formulas based on the company's financial performance or market trends. 

‍

5. Payment Processes: Outline the payment processes for repurchased shares, specifying acceptable methods of payment and any applicable tax implications. Ensure that payment procedures comply with relevant legal and regulatory requirements to avoid any legal complications or financial liabilities. Providing clarity on payment processes helps facilitate smooth transactions and enhances trust between the company and shareholders.

‍

6. Regular Review and Updates: Finally, recognize that policies and procedures may need to be reviewed and updated periodically to adapt to changing circumstances or regulatory requirements. Conduct regular audits of the share repurchase process to identify any areas for improvement and ensure ongoing compliance with best practices and legal standards.

‍
‍

B. Transparent and Fair Valuation
‍

Use fair and transparent methods for valuing shares to be repurchased. Transparent and fair valuation in the context of share repurchase after employee termination involves ensuring that the price at which shares are bought back from departing employees accurately reflects their true value. This practice is essential to maintain fairness and avoid disputes.

‍

In other words, the method used to determine the share price is clear and accessible to all parties involved. This can include using commonly accepted valuation methods, such as market-based approaches (comparable company analysis, precedent transactions), income-based approaches (discounted cash flow analysis), or asset-based approaches (net asset value method).

‍

Fair valuation ensures that departing employees receive a reasonable price for their shares, reflecting their actual worth in the market. Fairness can be achieved by considering factors such as the company's financial performance, future prospects, industry trends, and any recent transactions involving similar companies.

‍

To achieve these, consider the following measures:

‍

1. Independent Valuation: Employing an independent valuation firm can enhance transparency and fairness by providing an objective assessment of the company's value. This helps avoid conflicts of interest and ensures that the valuation process is conducted impartially.

‍

2. Documentation and Communication: It's crucial to document the valuation process thoroughly and communicate it clearly to departing employees. This includes providing them with information about how the share price was determined and giving them an opportunity to ask questions or seek clarification.

‍

3. Legal Compliance: Ensure that the share repurchase process complies with relevant legal requirements, such as securities regulations and corporate governance standards. Failure to adhere to legal guidelines can lead to legal challenges and reputational damage. Consult with legal professionals to review and update repurchase agreements and policies regularly. 

‍

4. Regular Review: Periodically review and update the valuation methodology to ensure that it remains relevant and reflective of the company's current circumstances. Changes in market conditions, financial performance, or industry dynamics may necessitate adjustments to the valuation approach.

‍

C. Ethical Considerations

‍

Ethical considerations in share repurchase after an employee termination involve several key aspects:

‍

1. Fair Treatment: Fair treatment entails ensuring that the decision-making process regarding the share repurchase is conducted impartially and without bias. This means treating all employees, including terminated ones, equitably and in accordance with established company policies, procedures, and applicable laws.

‍

2. Confidentiality: Maintain confidentiality regarding the circumstances of the employee termination and the details of the share repurchase transaction. Respect the privacy rights of the terminated employee and refrain from disclosing sensitive information without proper authorization.

‍

3. Avoid Coercion: Even while carrying out this process based on legal standards, you should refrain from exerting undue pressure or coercion on the terminated employee to sell their shares at a disadvantageous price or under unfavorable terms. Respect the employee's right to make an informed decision based on their own best interests.

‍

4. Board Oversight: Ensure that the share repurchase decision is reviewed and approved by the company's board of directors or an appropriate committee, particularly if the transaction involves a significant amount of shares or has material financial implications.

‍

5. Conflict of Interest: Identify and mitigate any potential conflicts of interest that may arise in connection with the share repurchase transaction, particularly if executives or directors have personal or financial interests at stake.

‍

6. Reputation Management: Consider the potential impact of the share repurchase on the company's reputation and stakeholder relationships. Strive to uphold the company's reputation for integrity, fairness, and ethical conduct in all business dealings, including employee terminations and share repurchases.

‍

D. Financial Planning and Impact Analysis

‍

Before proceeding with share repurchases, it's crucial to conduct a comprehensive assessment of the financial implications. This involves analyzing the impact on the company's cash flow, balance sheet, and income statement.

‍

•  The cash flow analysis helps determine the availability of funds for repurchases and assesses whether the company can sustain the repurchase program without jeopardizing its liquidity or financial stability.

‍

• The impact on the balance sheet involves evaluating changes in equity, assets, and liabilities resulting from the repurchase transactions. This assessment ensures that the repurchases align with the company's overall financial strategy and objectives.

‍

• Analyzing the income statement helps forecast the effects of share repurchases on earnings per share (EPS), profitability metrics, and other financial performance indicators.

‍

Based on the financial impact assessment, you should then develop strategic plans to manage the share repurchase process effectively. This includes setting clear objectives, timelines, and allocation of resources for executing the repurchase program.
‍

•  Mitigation strategies may involve staggering repurchase transactions over time to mitigate market impact, optimizing capital allocation to balance repurchases with other investment priorities, and considering alternative financing options if necessary.
• You should also anticipate potential risks and uncertainties that could affect the financial outcomes of share repurchases, such as changes in market conditions, regulatory developments, or unexpected events.

‍

Share repurchases can affect the ownership and value of shares held by remaining shareholders. It's essential to evaluate how repurchases may impact shareholder equity, ownership concentration, and stock price dynamics.

‍

You should ensure that repurchases do not unfairly dilute the ownership or value of shares held by remaining shareholders. This requires careful consideration of the number of shares repurchased relative to the total outstanding shares and the potential impact on EPS and shareholder returns.

‍

Furthermore, in making complex financial analysis, you would need to involve sophisticated financial analysis and modeling techniques. You must make informed decisions based on accurate data, market insights, and sound assumptions. In this regard, financial analysts use various methodologies, such as discounted cash flow (DCF) analysis, earnings-based models, and scenario analysis, to estimate the financial impact of share repurchases and assess their implications for shareholder value.

‍

Estimating a "Repurchase Obligation", essentially, requires forecasting future cash flows, capital requirements, and market conditions to determine the optimal timing and magnitude of repurchase transactions.

‍

E. Communication and Negotiation

Maintaining open lines of communication with departing employees regarding the repurchase process is fundamental to fostering trust, clarity, and a sense of fairness within the organization. Here, you should ensure to initiate early discussions with departing employees to outline the steps involved in the repurchase process, clarify expectations, and address any concerns they may have. 

‍

It's important for you to be prepared to adapt and negotiate terms if standard policies do not adequately accommodate the unique circumstances or contributions of the departing employee. This requires a nuanced approach that acknowledges the individual's tenure, performance, and any exceptional circumstances surrounding their departure.

‍

For example, if an employee has made significant contributions to the company or is facing unforeseen challenges, the company should be willing to explore alternative arrangements that reflect the employee's value and align with the company's broader objectives.

‍

Effective negotiation in such situations involves active listening, empathy, and a willingness to find mutually beneficial solutions. This may include adjusting the repurchase terms, providing additional incentives, or offering alternative forms of compensation. 

‍

F. Documentation and Record-Keeping

‍

Keeping detailed records of all share repurchase transactions is crucial for maintaining transparency, accountability, and compliance within the organization. This involves meticulously documenting every aspect of the repurchase process, from initial valuations to final agreements and communications with stakeholders.

‍

Property documentation establishes a clear benchmark for determining the fair value of the transaction. This helps prevent discrepancies or disputes regarding the pricing of shares and ensures that transactions are conducted fairly and in accordance with applicable regulations and accounting standards.

‍

Additionally, maintaining comprehensive documentation of communications and agreements provides a thorough audit trail that can be referenced in the event of any discrepancies or disputes. Records of discussions with shareholders, correspondence regarding the terms of repurchase, and any amendments or modifications to agreements give room for effectively addressing any inquiries or challenges that may arise and demonstrate compliance with legal and regulatory requirements.

‍

Ensuring that documentation is thorough and accurate is essential for mitigating risks and safeguarding the interests of the company and its stakeholders. In the event of future disputes or audits, detailed records serve as evidence to support your company's decisions and actions. They provide clarity and transparency, enabling stakeholders to understand the rationale behind repurchase transactions and ensuring that all parties are treated fairly and equitably.

‍

G. Post-Repurchase Review

‍

A post-repurchase review is a critical step in the share repurchase process that allows you to assess the effectiveness of its procedures, identify any shortcomings, and implement improvements for future transactions. This review is essential for ensuring that the repurchase process is conducted efficiently, fairly, and in alignment with the company's objectives and values.

‍

The review process typically involves evaluating the entire process, gathering and analyzing feedback, identifying areas for improvement, and implementing and monitoring these improvements. 

‍

1. Evaluation of the Repurchase Process: The first step is to evaluate the overall effectiveness of the repurchase process. This includes assessing factors such as the timeliness of communications, the accuracy of documentation, adherence to company policies and legal requirements, and the fairness of valuation methods.

‍

2. Gathering Feedback: Soliciting feedback from all involved parties is crucial for gaining insights into their experiences and perspectives. This includes departing employees whose shares were repurchased, as well as other stakeholders such as HR personnel, legal advisors, and finance professionals. Feedback can be collected through surveys, interviews, or informal discussions.

‍

3. Analysis of Feedback: Once feedback is collected, it should be carefully analyzed to identify common themes, concerns, or areas for improvement. This analysis may reveal patterns or issues that were not apparent during the initial stages of the repurchase process.

‍

4. Identification of Areas for Improvement: Based on the feedback and analysis, the company should identify specific areas where enhancements can be made to the repurchase process. This may include streamlining communication channels, clarifying policies and procedures, providing additional training or resources to staff involved in the process, or revising valuation methods to ensure fairness and accuracy.

‍

5. Implementation of Improvements: After identifying areas for improvement, the company should develop an action plan to implement necessary changes. This may involve updating internal protocols, revising documentation templates, conducting training sessions, or establishing new communication protocols. It's essential to involve relevant stakeholders in the implementation process to ensure buy-in and alignment with organizational goals.

‍

6. Monitoring and Continuous Improvement: Finally, you should establish mechanisms for monitoring the effectiveness of the implemented improvements and making further adjustments as needed. Continuous review and refinement of the repurchase process are essential for adapting to changing circumstances and maintaining best practices over time.

‍

These proactive steps help build trust among stakeholders and reinforce the company's reputation as a responsible and transparent organization.

‍

Good Leavers Vs Bad Leavers and the Impact on ESOP Repurchase

‍

To maintain equitable treatment of employees in the ESOP repurchase process, you should understand the concept of good leavers and bad leavers, and how they affect the process. 

‍

• Good leavers depart under favorable circumstances such as retirement, resignation for valid reasons, or involuntary termination due to factors like redundancy or health issues. ESOPs often have measures in place to treat good leavers more favorably during share repurchasing. They may receive fair market value for their shares upon departure or retain certain rights to their shares post-employment. Fair treatment of good leavers is crucial for fostering positive morale and encouraging sustained loyalty to the organization.

‍

• On the other hand, bad leavers exit under less favorable conditions, including termination for misconduct breach of contract, or resignation without justification. ESOPs typically address bad leavers differently, potentially requiring them to sell their shares back at a discounted rate or forfeit their ownership entirely. This differentiation ensures that those failing to meet their obligations to the company do not enjoy the same benefits as those departing on amicable terms.
• Repurchasing shares from good leavers often involves paying fair market value or providing some other form of fair compensation, which can impact the company's finances, while repurchasing shares from bad leavers might involve buying back shares at a discounted price, which can be advantageous for the company but may also lead to legal or morale issues if not handled properly.

‍

Properly managing the repurchase process for both good and bad leavers is essential for maintaining the integrity of the ESOP and ensuring equitable treatment of employees. It also impacts the overall ownership structure of the company and can influence its financial health and stability

‍

Bonus Tip: Equity Agreement Template 

‍

Your equity agreement plan should have the following:

‍

1. Introduction

‍

• Purpose of the Equity Agreement Plan.
• Overview of the equity offering.

‍

2. Definitions: Define key terms used throughout the agreement.

‍

3. Equity Offering

• Description of the equity being offered (e.g., stock options, restricted stock units, etc.).
• Total number of shares available for issuance.
• Vesting schedule, if applicable.
• Exercise price, if applicable.

‍

4. Eligibility

• Criteria for eligibility to participate in the equity offering (e.g., employees, consultants, advisors, etc.).
• Any exclusions or limitations.

‍

5. Grant Process

•   Procedures for granting equity awards.
•   Approval process (e.g., board approval, committee approval, etc.).
•    Documentation requirements.

‍

6. Vesting and Forfeiture

• Vesting schedule (if applicable) outlining when equity awards become exercisable.
• Conditions for forfeiture of equity awards (e.g., termination of employment).

‍

7. Exercise of Equity Awards

•  Process for exercising equity awards.
•  Exercise period and deadlines.
•  Payment methods (e.g., cash, stock, etc.).

‍

8. Transfer Restrictions

• Restrictions on the transfer of equity awards.
• Pre-emptive rights, if any.

‍

9. Adjustment Provisions

•   Provisions for adjusting equity awards in the event of corporate actions (e.g., stock splits, mergers, etc.).

‍

10. Termination and Amendment

• Circumstances under which the Equity Agreement Plan may be terminated or amended.
• Process for termination or amendment.

‍

11. Governing Law: Jurisdiction and governing law for interpreting the Equity Agreement Plan.

‍

12. Miscellaneous

•  Severability clause.
•  Entire agreement clause.
•  Notices provision.

‍

13.  Signatures

•  Signature lines for parties involved (e.g., company representatives, participants, etc.).

‍

14. Appendices: Any additional documents or schedules referenced in the Equity Agreement Plan.

‍

Note that these are just vital components based on general practices. Your final template should match your organizational framework and standard of practice (SOP). 

‍

FAQs

‍

Here are some frequently asked questions about repurchasing shares after an employee termination:

‍

1. How is the price determined for repurchasing shares?

‍

Answer: The price for repurchasing shares is often determined by the terms outlined in the company's agreements or by the fair market value of the shares at the time of termination.

‍

2. Can a terminated employee retain ownership of their shares?

‍

Answer:  It depends on the specific circumstances and the agreements in place. In some cases, terminated employees may be allowed to retain ownership of their vested shares, while in others, they may be required to sell them back to the company.

‍

3. What happens to unvested shares upon termination?

‍

Answer:  Unvested shares may be subject to forfeiture upon termination, depending on the terms outlined in the company's agreements. In some cases, employers may allow terminated employees to retain a portion of their unvested shares, while forfeiting the remainder.

‍

4. Can a terminated employee challenge the repurchase of their shares?

‍

Answer: It's possible for a terminated employee to challenge the repurchase of their shares if they believe it violates the terms of their agreements or if they believe they are entitled to greater compensation for their shares. In such cases, legal action may be necessary to resolve the dispute.
‍

Conclusion
‍

Adhering to best practices in managing the complex process of repurchasing shares from departing employees is paramount for ensuring fair treatment, legal compliance, and upholding company values. These best practices serve as a framework to guide your organization through the intricacies of share repurchases, ultimately benefiting the company and its employees in several ways.

‍

Moreover, adherence to best practices helps ensure legal compliance with applicable regulations and laws governing share repurchases. You will be mitigating the risk of legal disputes, regulatory penalties, and reputational damage. This not only protects the company's interests but also safeguards the rights and interests of departing employees.