Apple Growth Partners ESOP Team | Davin Gustafson, Matt Silla, Eric Flickinger
March 24, 2020
Dear Clients and Friends:
We have been closely monitoring the ever-changing situation with COVID-19 and continue to discuss how this will impact our clients. We are also answering many questions about the impact of the COVID–19 virus and resulting changes in the economy on the December 31, 2019 valuations. The questions lead to several common questions and discussion topics that we want to share with you.
Can / should the December 31, 2019 valuation reflect the current events?
Valuations are based on facts known or reasonably knowable as of the date of the valuation. So, the technically correct answer is that the COVID-19 outbreak should have no impact on a valuation as of December 31, 2019. There was virtually no information about the COVID-19 virus as of December 31, 2019. It was not even identified in China until January. Additional compelling evidence includes the performance of the stock market in the first two months of 2020. The various stock markets were strong well into February. Both the S&P 500 and NASDAQ closed at record highs on February 19, 2020. We understand that with all the change, doing a valuation and ignoring these subsequent events may be extremely difficult for companies and Trustees that have not completed their December 31, 2019 valuation. But for ESOP administration, the December 31, 2019 valuation should not reflect the changes after year end.
What should we do about 2020 ESOP payouts?
This answer is more challenging and likely fact specific. The first issue to consider is whether the effect of the last 30 days is material? This requires considering if the possible repurchase is material to the overall Company value. We have several clients that are early in their ESOP or do not anticipate meaningful repurchase obligation in 2020. We also have a number of clients that are in sectors (defense or healthcare) that have not yet been substantially affected. Companies in this position may take no action. It may still be wise to revisit the issue as these companies get closer to the actual ESOP events.
However, far more clients have experienced a material impact to business operation over the last 30 days. Further, the real-world implications of a higher December 31 valuation may have a significant impact on repurchase and diversification related activities going forward. Some companies are concerned about sustainability and the long-term implications. These companies (and their Trustees) may want to consider the issue of an interim or mid-year valuation.
What should I consider for an updated or interim valuation?
Like most ESOP issues, the first place to look is the ESOP Plan document. Many ESOP Plans specify that a valuation is done at the end of the plan year (thus the December 31 valuations). However, many also provide for interim valuation or interim valuation under certain circumstance. So, the starting point is to review the ESOP Plan document for provisions related to valuation (may also be a “definition”). The plan provision will likely indicate who should call for an interim valuation. Most commonly, this is the “Plan Administrator.”
If your ESOP Plan does not provide for an interim valuation, it may be appropriate to amend the plan. That is a settlor or Company function.
Other practical consideration:
*It is important to remember that in selecting the interim valuation date, the Plan Administrator is acting as a plan Fiduciary under the ERISA. As such, the Plan Administrator’s decision to use an interim valuation date must be made for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering the Plan. A decision to utilize an interim valuation date cannot be based merely on the desire to manage an ESOP company’s cash flow. Instead, the Plan Administrator must decide to use an interim valuation date with the best interests of all participants and beneficiaries in mind.
*Selecting a date for an interim valuation will also pose a challenge. It may be the understatement of the century to say that the current economic conditions are uncertain. So simply saying an ESOP Company will use a March 31 or April 30 valuation may cause other issues depending on if conditions continue to deteriorate further or improve as the year progresses. We think ESOP Companies will need to be practical and flexible and strive for common sense and fairness in all actions taken or not taken.
*We have not yet seen or heard anyone suggest that it could become a Trustee duty to consider or initiate an interim valuation. But if repurchase obligation is significant enough to impact the long-term well-being of the Company and all participants, we could not rule out Trustees starting to raise the issue.
*For the valuations that have been completed for December 31, 2019, the bias of the last 30 days should not be an issue. However, for those valuations still in process or those valuation that have not commenced, the prospect of bias from the events of the past 30 day has to be acknowledged. Valuation advisors should discuss the issue with ESOP Trustees as they review the valuation. If a valuation update is being planned, the December 31, 2019 valuation may only be used for annual statements and Company financial statement. So, any bias that may be human nature in light of the events of the last 30 days may not be meaningful if the value is updated for subsequent activity.
Our biggest take away at this point is to suggest that ESOP Companies, ESOP Plan Administrators and Trustees start to consider and discuss these issues amongst themselves and with their advisors. Also think about what you want to communicate with ESOP participants. Safe to say communication is as important now as ever.
There are a number of other possible issues to consider, but we suspect you are already on COVID-19 overload and will pause for now. Please be safe and healthy and feel free to reach out to any or our Team members with questions, comments and thoughts. We understand that these are difficult times for many businesses and want to help our clients and friends as we work through this together.
We realize that there is an exorbitant amount of information of the COVID-19 legislation that is posted to the web and being circulated. Apple Growth Partners wants to provide you with accurate and current information to assist your planning. Remember, the legislative process is not completed once the legislation is passed. Regulatory guidance from federal agencies such as the Department of Labor, Department of Treasury, Department of Health and Human Services, and the Internal Revenue Service will be necessary to fully explain the value and impact that these provisions might have on your business, your employees and yourself.