How Does ESOP Repurchase Obligation Impact My Valuation?
Each year, Apple Growth Partners issue updated annual valuations to many ESOP companies. We typically see and feel the excitement of growing stock prices from everyone at the Company, except for one person – the CFO. Commonly, the first thought from the CFO with a growing stock price is “My repurchase obligation just became a bigger problem”. As a result, one of the first questions we get after reviewing our valuation report is “How has repurchase obligation taken into consideration?”.
The first step to understanding the impact of repurchase obligation on the valuation is to understand the current and future repurchase liability and distribution rules of the plan documents. If current cash balances and forecasted cash flows are sufficient to meet the repurchase obligation and fund future working capital and capital expenditure needs for growth, no material adjustment is typically necessary. However, if the repurchase obligation would require the company to take on debt or limit the company’s ability to reinvest into growth, some adjustment may need to be done in the valuation.
There is no definitive method to adjust the valuation for the repurchase obligation. However, there are several common methods used by valuation professionals. If a discounted cash flow method is used, an adjustment to the forecasted future cash flows can be made to account for the restrictions on future growth. Alternatively, a valuation professional could make an adjustment in the discount rate selected which assumes there is greater risk in hitting the current forecast. If a market approach is used, an adjustment could be made to the multiple selected due to greater liquidity risk than the guideline group. Further, an argument could also be made that the ability of the Company to repurchase shares is impaired and therefore a higher discount for lack of marketability should be applied. The type of adjustment applied will depend on specific facts and circumstances of each company.
A growing repurchase obligation is generally a good thing as this commonly means the Company is becoming more valuable. However, a growing repurchase obligation can place restrictions on available capital, which is a primary concern of CFO’s. A good understanding of the Company’s repurchase obligation and its ability to meet these obligations is important to determining the impact on a valuation.