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Marketability Discounts After the Eyler Decision

David Johanson

May 1995

The United States Tax Court issued a memorandum opinion on March 23, 1995, in the case of Gary L. Eyler v. Commissioner that raises questions about the level of marketability discounts in valuing closely held companies for purposes of sales to employee stock ownership plans and trusts (ESOPs). It also questions whether the loan that an ESOP incurs to purchase stock from a selling shareholder must be taken into account in determining whether the ESOP pays more than fair market value for the stock.

The Eyler case involved Continental Training Services, Inc. (CTS), which was a very healthy company in 1986. In December 1986, CTS established an ESOP, the ESOP borrowed $10 million from an outside lender, and the ESOP purchased 14% of CTS's outstanding stock from CTS's founder and primary shareholder. CTS and the seller guaranteed the loan that the ESOP incurred to purchase the stock. The ESOP did not retain an independent financial advisor or appraiser to assist it in evaluating the reasonableness of the purchase price to be paid and the fairness of the transaction to the ESOP.

The purchase price per share paid by the ESOP was $14.50. A few months before the sale to the ESOP, the seller had explored the possibility of taking CTS public through an initial public offering (IPO). The underwriters estimated the offering price between $13 and $16 per share, but the IPO was postponed because of a weak IPO market and a lack of interest at the $13 to $16 per share range.

The Tax Court upheld the Internal Revenue Service's position that under these circumstances the ESOP paid more than fair market value for the stock, but the Eyler decision is not significant because of that holding. The fact that the purchase price for the ESOP transaction was established by CTS's Chief Financial Officer and by reference to the price range for the failed IPO and that the ESOP fiduciary did not receive advice from an independent financial advisor or appraiser (note: this requirement applies to stock acquired after December 31, 1986, and after the CTS ESOP transaction) in evaluating the amount to be paid to the seller and the fairness of the deal supports the Tax Court's conclusion that the ESOP paid more than fair market value for the stock.

The Eyler decision is significant primarily because of the Tax Court's observation that the right of ESOP participants to sell their stock back to the company upon distribution at the stock's then fair market value does not preclude a proper determination of fair market value from taking into account a discount for lack of marketability. The Tax Court's opinion indicates that a discount for lack of marketability may not be necessary if ESOP participants are entitled to a fixed price upon selling the stock back to the company or to the ESOP, so that the amount such participants receive does not decline dramatically over time.

I have spoken with a number of reputable independent financial advisors and appraisers during the last month regarding the significance of the Tax Court's discussion of marketability discounts in the Eyler decision. I have received varying responses, but none have indicated that they will drastically modify their approaches to examining marketability discounts for purposes of ESOP transactions.

A very good analysis of the Eyler decision appears in the Spring 1995 issue of Value Insights Quarterly, a digest of current corporate finance and related valuation topics published by Duff & Phelps Capital Markets Co. Daniel D. Bayston's article includes the following insightful remarks: "When examining the appropriateness of a marketability discount for ESOP shares, we [Duff & Phelps] are most concerned with the ability of the company (or an ESOP trust) to meet its statutory obligation to purchase the ESOP shares of a departing employee at fair market value if the stock is not readily tradable in an established market. In assessing such ability, we examine, among other things, the nature of the put obligation including the timeliness of payout, the financial condition of the company and/or trust (in some cases the trust may have excess cash), the company's ongoing capital requirements including the timing and magnitude of expected future ESOP share repurchases, and the company's history with respect to share repurchases." This provides a good framework for analyzing marketability discounts in light of the Eyler decision.

To the extent the ESOP owns a controlling interest in the company, the issue of marketability discounts raised by the Eyler decision is not as important because one could argue then that the block of stock owned by the ESOP is marketable and the discount (if any) should be smaller. Many independent financial advisors and appraisers have taken this position.

The other significant issue in the Eyler decision is the implication that the $10 million ESOP loan should have been taken into account in determining whether the ESOP paid more than fair market value for the stock. The Tax Court apparently reached this conclusion even though the Department of Labor abandoned a similar position in 1991 in the Dole v. Farnum case after ESOP companies, professionals and consultants strongly argued that the position did not make any sense. Assuming the ESOP company has the financial strength to meet its obligations to the ESOP at the time of the initial ESOP transaction, both in terms of contributions required to repay the ESOP's debt and in terms of repurchasing shares from departing employees, the selling price should probably not be reduced in the manner the Tax Court implies.

The marketability discount and ESOP debt issues raised by the Tax Court are significant and should be monitored accordingly in each ESOP transaction. This is not to say that the Tax Court's position on these issues should be adopted, but to ignore the issues entirely is not a prudent practice, especially for ESOP fiduciaries and advisors. I will keep readers of this ESOP Forum current on any future developments in this area.

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