ESOP Valuation Issues Q&A (Employee Stock Ownership Plan)
ESOPs have become an effective tool in corporate finance and tax planning.
Not only do they provide retirement benefits and incentives to employees but an
ESOP can provide unique ways to transition company management in tax favored environments.
An ESOP can even be used to increase cash flow or convert debt to a pre-tax environment.
Why do we need to engage an outside party to value our ESOP shares?
From a strictly regulatory standpoint, a valuation of ESOP shares by an independent
third party is required by the Department of Labor (DOL) and the Internal Revenue
Service (IRS). The regulatory requirement stems from the practical need to
insure that the value is determined by a party who does not have a personal or financial
interest in the valuation result. The valuation, moreover, should be performed
on behalf of the ESOP trustee since it is the duty of the trustee to insure that
transactions with the ESOP are consummated at “fair market value.”
What is meant by “fair market value”?
Fair Market Value (FMV) is a concept and not a price that emerges from application
of some standard formula. In simple terms, FMV is the price for which property
would sell under the existing market conditions for such property as established
in arms-length negotiations between knowledgeable and independent parties.
The “market” implied in definitions of FMV encompasses all potential buyers and
sellers of the property involved.
How is “fair market value” determined?
There are many method used in the determination of FMV. The nature of the
property being evaluated determines what methods are appropriate. For example,
the FMV of a single family home is determined by the price for which similar property
is selling in the area in which such property is located. The FMV of business
interests that is generating earnings, however, is determined to a large degree
on the basis of what a knowledgeable buyer would be willing to pay for the earnings
stream considering available rates of return on relatively risk-free investments
and the risks associated with the investment being appraised. Although not
the only method that might be considered, the present value of future earnings using
a risk adjusted market rate is one of the most common approaches, referred to in
business valuations as Discounted Future Earnings (DFE).
Reference to the results of mathematical formulas is not the sole determinant of
FMV. The judgment and experience of the valuation analyst is also a critical
element since there can be many factors that can not be quantified by reference
to the underlying financial information alone.
What is meant by a “control premium”?
A control premium is that amount which a buyer may be willing to pay to acquire
a controlling interest in a business over and above the value of the interest based
solely on the underlying financial factors. The element of control, in this
case, has a value which is added to the value that can otherwise be ascribed to
the assets and earnings of the business. The payment of a control premium
in the purchase of a business does not necessarily add any value to the business.
Synergy value, unlike control, is susceptible to being measured in more concrete
terms of increased financial benefits to the buyer over and above those being enjoyed
by the selling parties. Examples are the prospects of increased sales of the
buyer’s products to the seller’s customer base or lower overall materials costs
due to volume purchase discounts, etc. Whether or not a control premium is
appropriate in the purchase of shares by an ESOP must be determined on the facts
in the individual case. Moreover, since the ESOP generally doesn’t control
a company itself, there is much debate as to whether or not an ESOP can pay a control
premium for shares purchased, even if purchasing a controlling percentage.
How do ESOP valuations differ from valuations for other purposes?
Because of the regulatory requirement established in the Employee Retirement &
Income Security Act of 1974 (ERISA) that an ESOP pay no more than “adequate consideration”
in the purchase of employer securities, ESOP valuations must support the decisions
of the trustees and must also withstand review by DOL and the IRS. Valuations
that are subject to being reviewed by third parties, whether for ESOP or other purposes,
must include considerable discussions on the methods and factors employed as well
as explanatory information on the sponsoring company’s financial and operating history
and the industry in which it competes. For similar reasons, valuations supporting
tax related values for gift and estate or charitable deduction purposes must also
include considerable background detail so that potential third party reviewers will
have a clear understanding of the process leading up to the value conclusion.
In addition, ESOP regulations place various obligations on the sponsoring employer
and allow for limitation of the voting rights of ESOP shares. These, and other
features specific to the ESOP require special consideration in the determination
of the fair market value of ESOP owned securities of privately held companies.
It is strongly recommended that an ESOP trustee utilize an appraiser who is knowledgeable
in the design and use of ESOPs since they are extremely unique in their different
What is the cost of an ESOP valuation?
The fees charged for ESOP valuations vary considerably from one valuation firm to
the next. There is no set industry standard or prescribed range. This
is due to the wide variation in the amount of work that may be involved between
one engagement and another. As a general rule, the cost of an initial valuation
for a newly formed ESOP will be higher than the subsequent annual update valuations.
This is because of the amount of time and work involved in gathering and analyzing
all of the financial, industry and other pertinent information for the initial report.
The update, on the other hand, need only focus on changes in financial and other
factors that have occurred since the prior report.
Are there different types of ESOP valuations?
Because few companies are willing to adopt an ESOP before determining whether or
not the value of company stock will support management objectives, Greenstein, Rogoff,
Olsen & Co., LLP offers limited valuations for feasibility purposes to reduce
the initial costs of implementing an ESOP. Since this valuation is for company
management purposes, all of the time consuming company and industry background report
writing can be eliminated. The company’s management is fully aware of these
matters and need not pay for the privilege of reading about them in a valuation
report prepared exclusively for management use only. All pertinent factors
are considered in the analysis leading to the value conclusion and all requisite
financial data and valuation methods used for a full report are outlined in the
limited report as well.
Is Greenstein, Rogoff, Olsen & Co., LLP (GROCO) considered an independent
party for ESOP valuation purposes?
It is common knowledge in the valuation industry that “independence” means that
the appraiser is not affiliated with nor has any present or intended future financial
interest in the company for which the ESOP valuation is being provided. However,
in a recent court case (Santa Monica Pictures et al v Commissioner, T.C. Memo 2005-105,
May 11, 2005) the Court expressed concerns that portions of an expert’s report “have
the distinct quality of advocacy.” Although this case does not involve ESOPs
or an ESOP valuation, the case points out the importance that valuation conclusions
be relevant, reliable and unbiased. Although an appraiser may not have any
present financial interest in the company being appraised, if their firm provides
ESOP installation and administration services and the decision to install an ESOP
rests largely on the results of the valuation, can the appraiser in that situation
truly provide an unbiased opinion of value, given their obvious financial benefit
from the installation of the ESOP? GROCO does not derive income from the drafting
of plan documents, plan submissions to the IRS, and other activity involved in the
adoption of an ESOP by the client. In addition, GROCO does not offer annual
ESOP administrative services. Accordingly, we have no pecuniary interest in
the client’s decision to adopt the ESOP or the continued operation of the ESOP and
therefore can truly give an unbiased opinion of value in feasibility situations.
Therefore, GROCO is truly an independent party for ESOP valuation purposes.
To read a recent article about employee ownership, click
To view charts of ESOP Structure Alternatives, click here.