If you are currently an ESOP or considering selling to an ESOP, you will need to have an ESOP valuation completed. An ESOP valuation follows the same professional standards used when performing business valuations for other purposes, such as the sale of a business upon retirement. However, there are several unique attributes about ESOP valuations that need to be considered.
ESOPs were created by the Employee Retirement Income Security Act (ERISA) of 1974 and are primarily regulated by the Department of Labor (DOL) and the Internal Revenue Service (IRS). ERISA requires that an ESOP must acquire employer securities for not more than adequate consideration and sell not less than adequate consideration. In the late 1980s, the DOL proposed, but never finalized, regulations which were meant to provide guidance that could be followed to comply with the law. Within these proposed regulations, a two-part test was included for determining adequate consideration. The two parts are 1) consideration must reflect fair market value, and 2) as determined in good faith by the fiduciary. While these regulations were never finalized, the are commonly referenced in practice.
More recently, the DOL has been litigating more ESOP transactions. As a result of this activity, the DOL has established settlement agreements with several independent trustees. While these settlement agreements are specific to the parties involved, many in the ESOP community suggest these settlement agreements provide the best insight on how the DOL interprets the law and may provide a good roadmap for an ESOP transaction.
ESOP Valuation Nuances
An ESOP valuation is performed using the same professional business valuation standards used as valuations for other purposes, but ESOPs include unique features that need to be understood and considered. One significant consideration is regarding the ESOP contribution. ESOP contributions are similar to employer contributions to other defined contributions plans. ESOP contributions are used to administer the ESOP trust. This can include paying down the debt the ESOP owes to the company and allocating shares or funding the repurchase of retiring or terminated employees. In order to administer the ESOP, these contributions can at times be significant. This may require an earnings adjustment to be made by the ESOP valuation advisor. The reason for this is the ESOP valuation advisor is required to determine the “fair market value” of the stock of the company held by the ESOP. Basically, the appraiser may consider what a willing buyer would ultimately pay in employee benefits to retain the workforce. If the ESOP compensation exceeds this amount, an adjustment may be made.
If the employer securities held by the ESOP are not readily marketable, the sponsoring company must provide a put option to participants. The put option creates a market for the stock by giving participants the ability to sell their stock to the company in accordance with the terms of the ESOP plan at the most recent appraised value after retirement or other termination. This put option is typically considered to have an impact on the discount for lack of marketability. The history of executing this put option, as well as a company’s ability to honor it, are likely to be considered in the ESOP valuation.
This put option creates what is known as a repurchase obligation and is a financial obligation of the sponsoring company. Because of this, a common question is, “How does repurchase obligation impact the valuation?” The answer is the liability itself is not directly considered. However, if the repurchase liability would impact the company’s ability to meet projections or change the long-term capital structure of the business, then different assumptions would be used in the ESOP valuation. Review a previous article discussing repurpose obligation for more information on potential adjustments. The reason the actual dollar amount of repurchase obligation is not directly a reduction of future cash flows is the obligation is theoretical. In other words, if the company would sell to a third party, there would be no repurchase obligation liability to pay off. Therefore, to directly consider it in the cash flows would undervalue the business on a willing buyer, willing seller standard required for the fair market value standard.
One significant benefit of S Corporation ESOP companies is the entity no longer pays federal and in most cases state taxes. However, when performing an ESOP valuation, the appraiser must use the fair market value standard. That is assume a willing buyer and a willing seller. As such, the appraiser cannot assume the buyer would be specifically a tax-exempt S corporation ESOP. Therefore, typical corporate tax rates are included in the calculations.
Another tax benefit ESOPs have is the ability to deduct not only interest but also principal payments on repaying the ESOP loan. The ability to deduct principal payments essentially creates a “tax shield.” The present value of this tax shield may be considered in the value conclusion.
Qualified ESOP Valuation Appraiser
Due to the nuances of ESOP valuations, a qualified independent appraiser is required to provide the most accurate and defensible valuation. The appraiser should be independent, have significant experience appraising companies, and have relevant ESOP and industry experience. Independence requires only performing valuation services on behalf of the ESOP trust. An appraiser who has historically performed valuation services directly for the sponsoring company can be perceived as not being independent. The recent process agreements have emphasized the need for the trustee to evaluate the professional advisors’ qualifications. Institutional trustees have a screening process that assesses an ESOP appraiser’s experience, capabilities, and involvement with ESOPs. Failure to choose a qualified appraiser can increase your risk of issues with the regulators down the road as the business valuation tends to be the number one issue with the DOL.
Fall 2022 ESOP Conference Schedule
This fall 2022, our ESOP valuation experts are hitting the road for national and regional ESOP conferences. As frequently requested speakers, our ESOP valuation team delivers timely updates for valuations & ESOP feasibility studies. To register for these events, visit: